Technology Author:Beier Kan , Ivan Platonov Editor:Luke Sheehan Nov 29, 2020 07:38 PM (GMT+8)

Xiaomi's recent surging stock price has revealed increasing investor confidence. Its recently released financials lived up to high expectations. However, the company's pain points behind the numbers are likely to pull down the market cap in the short term.

Xiaomi technology campus

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● The 5G rollout and Huawei's fall in Europe have boosted Xiaomi's smartphone sales, which contributes the most to the firm's brightest quarter financials so far.

● Among US and Hong Kong-listed Chinese tech stocks, Xiaomi is one of the top performers in the capital market during the first three quarters in 2020.

● It remains questionable if Xiaomi can maintain its global smartphone market share, as it faces fierce competition from Apple in the global market and the 'new' Honor in the Chinese market.

● Xiaomi's high-margin Internet service business has not yet driven the company's profitability to a higher level.

● The firm's IoT strategy spans beyond its current consumer electronics scope, however, the bigger picture of Chinese high-end manufacturing requires more time and front investment to show effect. 

3Q 2020 financials and stock performance

Recently reported as the world's third-largest smartphone shipper in the third quarter of 2020, the Chinese technology company Xiaomi (01810:HK) released its 3Q financials. Unsurprisingly, its revenue and adjusted net profit hit historical highs driven by the increasing smartphone sales in its overseas markets.

Three superlative adjectives are the third-quarter financials' highlights.

First, the company reported the highest quarterly revenue and adjusted net profit. During this period, its total revenue amounted to CNY 72.2 billion, representing an increase of 34.5% year-over-year. The adjusted net profit for the period was CNY 4.1 billion, representing an increase of 18.9% year-over-year.

Second, Xiaomi's global smartphone market share has climbed to an all-time high at 13.5%. Its smartphone shipments increased by 45.3% year-over-year, reaching 46.6 million units worldwide.

Third, the overseas revenue and the overseas revenue contribution also marked the highest quarterly numbers. Xiaomi's overseas revenue reached CNY 39.8 billion, with a 52.1% year-over-year increase, accounting for 55% of this quarter's total.

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As for the stock performance, from the beginning of 2020 to November 24, the stock price of Xiaomi increased by around 150%. Though the market cap enhancement looks encouraging, it is not the best among the younger Chinese technology companies such as Pinduoduo (PDD:NASDAQ) and Meituan (03690:HK).

Short-term growth obstacles

1. Is Xiaomi's smartphone growth sustainable?

Apparently, smartphone sales contributed the most to Xiaomi's exciting financial results. However, it remains questionable if the company can keep the growth pace and maintain its current market share.

In mainland China, Xiaomi's smartphone market share climbed to 12.6% in the third quarter of 2020 from 9.0% in the same period in 2019, letting it keep its top-four position, according to Canalys. Despite the relatively high growth in China and massive promotions, the company failed to return to the top three. It is somehow hard to shake the positions of Huawei, vivo, and OPPO China's mature smartphone market, as their branding, marketing techniques, and offline sales channels are outcompeting Xiaomi to some extent.

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Moreover, upon Huawei's sale of its co-brand Honor, opinions polarize. Some analysts project a positive impact on Xiaomi as Honor may lose Huawei's technology, management, and financial support. However, we consider Honor's independence as a long-term threat to Xiaomi for two reasons. First, as Xiaomi's most direct competitor in terms of target consumer group and pricing strategy, Honor's independent operation allows it to make a more comprehensive product layout instead of functioning as supplementary products to Huawei flagships. Second, no longer restricted by Huawei's supply issues, Honor could better utilize the supply of key components and software services such as the Google Kit. Once topped in some European countries, the 'new' Honor is still competitive in Xiaomi's main overseas markets and China. Experiences tell a similar story – industry leaders' sub-brands tend to thrive as well, like OPPO's Realme.

In the global market, there is a slight chance that the company's current achievement could last, as the iPhone 12 series were released globally in October and its sales will be presented from the fourth quarter of 2020. Besides, Xiaomi, as well as vivo and OPPO's fast growth in Europe is out of Huawei's shrinking sales rather than some internal traits. In other words, Xiaomi's European consumers might consider it not quite different from other Chinese brands that are priced similarly like vivo and OPPO. The company's risk of being replaced is relatively high in the short term before it managed to have a stronger brand image and better cooperation with local operators and distributors.

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In addition to the intense competition in Europe, Xiaomi also faces strong opponents like Realme and Samsung in India. Since the first quarter of 2020, Xiaomi has been suffering from a year-over-year smartphone shipment decline majorly due to the supply-demand gap.

2. The declining high-margin Internet service revenue proportion indicates weakening profitability in the short term

The firm's third-quarter financial reveals a decline of gross margin from 15.3% in 3Q 2019 to 14.1%. Both smartphone and Internet service segments reported decreased gross margins due to enhanced promotional efforts. Despite the reputation of a light marketing model with few celebrity endorsements, Xiaomi in this quarter rose nearly 42% year-over-year on selling and marketing expenses. In EqualOcean's view on Xiaomi's 1Q 2020 performance, it was expected that by late 2020 or 2021, the company would see more earnings from its gaming and financial service business as lavishly increased expenses in these two sectors emerged. However, it turns out that the two areas require more time and investment to grow.

In the third quarter, though the Internet service revenue increased by 8.7% year-over-year to CNY 5.8 billion, the contribution rate to the total revenue has declined from 9.9% to 8%, indicating the high-margin business is not getting stronger internally. In the long-term, with a gross margin at around 60%,  the Internet service segment is destined to be the most critical profit driver, while it requires more to be the case when the company's smart hardware product becomes stronger.

3. Xiaomi's Internet service profit model – Investors might be overly bullish on Xiaomi's software capacity

It is commonly agreed that Xiaomi's Android-based operating system MIUI is the most successful software developed by the company. In the third quarter of 2020, it is reported the monthly active user (MAU) of MIUI reached 368 million globally, which is approximately the same amount as Jinritoutiao (the News app empowered by Bytedance) and JD.com (JD:NASDAQ). However, the smartphone operating system is not quite similar to the growth or profit pattern as other Internet services such as e-commerce platforms or social media, as the operating system largely relies on its hardware sales. The total addressable market size differs. Though technically MIUI can be applied on Android-based phones, the installation is much more complicated than downloading from app stores.

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Moreover, the profit channels on MIUI are quite limited – basically the app store commission and advertising fee. Apple has 22.49% of its total revenue from the apple store commission charged from its app developers in 2Q 2020 with USD 14.55 billion, which approximately equals Xiaomi's total revenue in the same period. Though Xiaomi set a similar commission at around 30% from its app developers on in-app purchases, the Android-based phone app stores have less bargaining power than the iPhone since Android phone users can install apps through multiple ways other than the brand's app store only.

Other Xiaomi developed software such as Mi Home, Youpin e-commerce and Mi Fit have not yet reached a significant active user scale.

4. The first-mover still has a long way to go – Xiaomi's IoT evolution

The year of 2020 ushered in a new era of smart hardware – an era of transformed industrial, medical, automotive, and astronautic hardware. Xiaomi is among the pioneers who started working on smart hardware and the Internet of Thing (IoT) before these concepts became prevalent. However, currently the company's IoT achievements are primarily in the consumer electronics category with its smart wearables at global top five and its smart TV leading in the Chinese market for several quarters. These rather conventional consumer electronics and appliance areas are mature and highly competitive, resulting in less profit for vendors. Xiaomi could hardly build its economic moat based on its current IoT layout.

The positive side is that in 2020 Xiaomi announced its 'smart factory' to be operational and fully automated. The current production capacity can reach a million premium smartphones per year. Besides, the CEO Lei Jun emphasized that 92% of the smart factory equipment are empowered by hundreds of Xiaomi ecosystem companies, indicating the company's new industrial IoT is not only beneficial for its own business but also the Chinese manufacturing industry's automation upgrade.

Nevertheless, the smart factory currently functions more in promotional ways than real economic benefits. The company's plan for the manufacturing industry is at the 'burning money' stage. Thus in the short term, Xiaomi's IoT business, which is rather constrained in consumer electronics and is being massively 'copied' by its competitors, would struggle to bring in a  'technology premium' and boost its market capitalism.

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