Xiaomi – No favours

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Xiaomi’s ecosystem remains its biggest weakness.

• Comparing itself to Costco helps Xiaomi’s valuation somewhat but does no favours when it comes to its business model.
• In a recent interview, Xiaomi founder said that he sees his company more like Costco than Apple which does make some sense.
• Xiaomi has pursued a typical Internet economy model which is to gather users as quickly as it can and then monetise when their numbers hit critical mass.
• It has done this by selling nice looking devices at very low margins and then hoping to monetise users through its ecosystem of services.
• What Costco does is similar in that it sells groceries at wafer thin margins and makes good margins on the subscription that it charges for membership.
• However, where Costco and Xiaomi differ is that Costco has a service that users are clearly willing to pay for but I am not convinced that Xiaomi does.
• Around 15% of all Chinese users have a Xiaomi phone but RFM research indicates that it is the ecosystems of the BATmen (see here) that Xiaomi’s users predominantly use.
• This strongly implies that users are buying Xiaomi phones due to attractive prices and form factor but do not care about the ecosystem that Xiaomi offers.
• Overseas the situation is even worse because outside of China, Xiaomi sells its devices with the Google ecosystem installed because its own ecosystem is irrelevant.
• This is the critical difference between Xiaomi and Costco.
• I have previously estimated that Xiaomi does make some money from selling content and games ($100m in 2016 (see here)) but this is very far from Xiaomi successfully monetising its ecosystem in China.
• To try and restore growth, Xiaomi is going into retail and plans to open 1,000 stores in China as well as a good number in India with revenues of $10bn targeted within the next three years.
• This is the right strategy to break out of the limitations of Internet-only sales, but will have the impact of increasing costs.
• Consequently, I am comfortable that Xiaomi could hit its RMB100bn ($14.4bn) sales target for 2017, but I am certain that margins will not be going up.
• If I take this outlook and compare it to Costco rather than Apple, I do get a slightly better valuation but not one that would make Xiaomi’s current shareholders very happy.
• Using Costco’s 2017 EV/Sales and EV/EBIT multiples and applying them to my estimates for 2017 Xiaomi (see here), I end up with valuations of $8.6bn / $8.3bn respectively.
• However, in using this methodology, the question needs to be asked should Xiaomi trade at a discount because Costco has already established the service it sells whereas Xiaomi has not?
• This is somewhat higher than my current $5bn valuation using Apple, but still way below the last raise at $45bn and the $20bn or so where I understand that the shares are changing hands.
• I do not see any threats to Xiaomi’s viability as a company but I still think it would make a good acquisition for one of the BATmen that I think will need to become more vertically integrated to continue growing in the home market.