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Morningstar | Xiaomi Reports Strong Sales Growth but Weak CNY and Higher Memory Costs Crimp Margins

Xiaomi's second quarter was slightly ahead of expectations at the top line with revenue up 75.4% but below on profitability with underlying EBIT down 4%. The result included one-off share-based compensation of CNY 9.9 billion in the form of 640 million shares valued at CNY 9.9 billion to Smart Mobile Holdings, a firm controlled by CEO Lei Jun, which we have excluded from our underlying calculations. There were no performance hurdles associated with this share issue and no public release of the reasoning for such a generous issue, except to reward the CEO for services rendered to the company. Revenue was driven by strong growth in hardware with smartphones up 59% and Internet of Things and lifestyle products up 85%. Our view Xiaomi is predominantly a hardware firm was backed-up with internet services representing only 8.8% of revenue, down from 9.0% in the same period last year. We make only minor changes to our forecasts and retain our fair value estimate at HKD 10 per share. Our no-moat rating is also retained as we believe Xiaomi is predominantly an electronics hardware supplier with limited switching costs with its internet services business not yet well-developed enough to assign moats to. The stock looks slightly overvalued at current levels with investors seemingly at least partly applying internet services multiples to the stock.

While we are dubious about the firm's internet services credentials, its track record and success in supplying low price smartphones cannot be denied. The firm sold around 32 million smartphones in the second quarter, up from 22.2 million in the same period last year, with an average selling price of CNY 952 compared with CNY 864 in the same period last year. Xiaomi's global market share of shipped smartphones increased from 8.4% in first quarter of 2018 to 9.3% in the second quarter putting Xiaomi in fourth place on the global smartphone sales tables in terms of units. It was number one in India and number two in Indonesia.

The increase in ASP was mainly due to strong sales of its mid- to high-end models such as MIX 2S and Mi 8 in the China market. However, the gross profit margin for smartphones declined to 6.4% from 8.9% in the previous period due to the weak Chinese yuan and Indian rupee compared with the U.S. dollar in which many of its smartphone parts are priced. Increased prices for items such as memory also didn't help the gross margin.

Revenue from Internet of Things and lifestyle products segment increased by 104% to CNY 10.4 billion in the second quarter, primarily due to strong sales growth in existing products, particularly smart TVs and laptops. Revenue from the sales of key Internet of Things products, including smart TVs and laptops, increased by 147% from to CNY 4.2 billion. However, gross margins declined to 10.6% from 11.4% primarily due to CNY weakness.