Xiaomi – Under the wire.

Xiaomi finally in range.

• The noise and bustle of CES have distracted many commentators from the dreadful performance at Xiaomi which is now starting to be properly priced into the share price.
• Over the last few sessions Xiaomi has lost nearly 17% of its value (41.4% since IPO and 53.7% since its high on 18^th July 2018) as market concerns and the ending of investor lock-ups have spurred heavy selling.
• This has brought the valuation of Xiaomi to $30.8bn which is still high but within a range I would consider fair under an optimistic scenario.
• Unfortunately, that scenario is now looking challenging as the replacement cycle of smartphones is lengthening more than I thought it would, leading to cuts to expectations for smartphone shipments in 2019 and 2020.
• This means that competitive pressure between the smartphone makers is going to intensify.
• The problem here is that Xiaomi’s ecosystem is not nearly strong enough to generate the kind of brand preference that Apple enjoys meaning that it will have to cut price to hold onto share.
• The knock-on effect of this is going even lower gross margins, further eroding the ability of its fledgling internet services business to support profit generation.
• This is the ecosystem of which Xiaomi speaks so much, but which is still far too small to carry the valuation of the company.
• Furthermore, these services are predominantly in Chinese (international Internet Services accounts for 0.4% of total revenues) meaning that Xiaomi is totally dependent on China for its profitability.
• This is a market that is showing all the hallmarks of maturity and is currently being hit hardest by the lengthening replacement cycle.
• Hence competition in China is going to intensify and it is Xiaomi’s ecosystem competitors Alibaba and Tencent that are likely to come out on top.
• Furthermore, because Xiaomi is a Google Ecosystem device outside of China, all of its efforts to grow market share in these regions will have very little impact on its Internet Services business.
• Hence, Internet Services is likely to remain very small despite contributing 49% of gross profits as only device shipments in China will carry the services generating these revenues.
• Outside of China, Xiaomi will have to be content with the Traffic Acquisition Cost (TAC) that Google shares with handset makers that help it generate traffic for its services.
• The good news is that Xiaomi’s share price is starting to reflect both this reality and the shortcomings in corporate governance where founders still control the company.
• The shares are now in the range at which one can make a fair valuation argument meaning that there is no longer a strong case for selling the shares.
• However, I would not be rushing to buy them either as upside still looks very limited and the outlook may worsen from here.