Xiaomi Q2 18 – Margin gadfly

Gross margin of 6.7% is all one needs to know.

• Xiaomi reported what is being received as a reasonable set of results, but in my opinion, these results further highlight Xiaomi’s chronic inability or unwillingness to make money for its owners.
• Q2 18 revenues / adj-EBIT were RMB42.2bn / RMB1.6bn (3.9%) after removing the one-off impact of stock compensation and the accounting adjustments to the value of financial assets.
• This goes hand in hand with the anaemic gross margin of 12.6% where smartphones made just 6.7% gross margin despite a 100bp gain in market share (Counterpoint), and steady price increases.
• Internet services, which is where all the money to justify the valuation is supposed to be made, is still less than 9% of sales meaning that its good contribution margin of 57% has a very small impact on group profitability.
• The problem with this chronically low profitability is that it leaves Xiaomi very little space to make the investments that it so badly needs to compete long-term.
• R&D expenses are tiny at just 3.0% of sales meaning that its competitors (BATmen et al) can invest far more and create better and more intuitive services than Xiaomi can.
• This means that it will be they that earn the Internet services revenues leaving Xiaomi’s internet ambitions in tatters.
• I think that this is a real problem because it means that the outlook for Internet services to become a powerhouse of profit growth inside Xiaomi is very poor indeed.
• This is why I continue to see Xiaomi not as an internet services company (as the market demands) but as a smartphone maker with a fledgling ecosystem attached.
• Hence, the most logical valuation methodology is to value the different profit streams separately.
• This I have done (see here) and I see no rational reason to change either the methodology or the result following these results.
• Consequently, being as optimistic as I dare, I can reach a valuation of $41.6bn some 13% below where the shares are today at HKD17.84 (Bloomberg).
• However, this does not take into the issue of corporate governance and the benchmarks I used (Apple and Tencent) have good corporate governance.
• By contrast, shareholders of Xiaomi will remain hostage to the whims of the founders, and for that, I think it should trade at a 20% discount to its calculated fair value.
• Therefore, I think that as a public company, a valuation of $33.3bn is where I would put fair value with an optimistic outlook scenario.
• This is 30% below the current valuation leading me to believe that current holders should exit as soon as possible.
• There is nothing wrong with Xiaomi as a company, it is just that the company can never realistically hope to justify the valuation that the market is attributing to it.
• Alibaba or Tencent are far better and cheaper ways to invest in China Internet.

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