Xiaomi Q3 18 – Can carrier.

Internet Services can’t carry the can.

• Xiaomi reported good results but remains so dependent upon hardware from which it intends to limit its profitability, that it has very little hope of ever justifying its valuation.
• Internet Services looks like it will always be too small to carry the can of the $39.5 enterprise value (EV).
• Q3 18 revenues / EBIT were RMB50.8bn / RMB2.2bn representing 49% YoY growth for revenues but a 38% decline in operating profit.
• This was caused by weakening gross margins which fell to 12.9% in Q3 18 from 15.4% in Q3 17 and R&D and marketing expenses which grew faster than revenue.
• The net result was EBIT margins which fell to 4.3% from 10.5% in Q3 17.
• This is symptomatic of a company pursuing growth at any cost, which Xiaomi has to do to have any chance of justifying its EV/EBIT multiple which is currently at 31x current annualised EBIT.
• Xiaomi is very slowly reducing its dependence on smartphones, but the real problem is Internet Services which is where Xiaomi is clearly hoping to derive most of its value.
• The company has said that it will limit hardware margins to 5% which means that Internet Services has to carry the lion’s share of the 31x EV/EBIT multiple.
• Internet Services is predominantly (68%) driven by advertising revenues with Gaming making up 14% and financial and e-commerce making up the remaining 18%.
• This is the ecosystem of which Xiaomi speaks so much, but which is far too small to carry the valuation of the company.
• These services are predominantly in Chinese (international Internet Services account 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 with heavy regulatory interventions.
• Hence competition here is going to intensify and its Xiaomi’s 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.
• Hence, I find it very difficult to see how Internet Services is capable of carrying the valuation of the company at HKD304bn / $39.5bn.
• I continue to think a valuation of $33.3bn with an optimistic scenario is the highest point at which I can place fair value (see here).
• Share price performance has been poor since the IPO and I see no reason why that should not continue.