Xiaomi: a shaky start for the Chinese tech giant

Xiaomi’s initial public offering could have gone smoother, but following a shaky start for its shares, the Chinese smartphone maker and tech firm has started to gain ground.

Joshua Warner @JoshWarner_IG
Analyst, London

Publication date : 2018-07-23T17:57:17+0100

Source: Bloomberg

Founded in 2010, Xiaomi has since grown to become the fourth largest smartphone maker in the world by charming its customers (which it likes to call ‘fans’) with quality products and services at lower prices than the competition.

Although the Chinese company has built a name for itself as a low-cost smartphone maker, its ambitions go far beyond selling handsets. Xiaomi has unleashed a swathe of other connected products over the years such as smart speakers, cameras and a TV – all of which are powered using the same operating system as its smartphones, and are marketed under the Mi brand.

The story of Xiaomi so far…

2012: Xiaomi annual sales hit over $1 billion, just two years after being founded

2014: becomes the biggest smartphone maker in China based on unit shipments, three years after launching its first model, with annual sales of over $10 billion

2015: Monthly Active Users (MAU) of MIUI, its proprietary Android-based operating system, climbs to over 100 million

2017: declares it has built the ‘world’s largest consumer Internet-of-Things (IoT) platform’, based on the amount of connected devices (excluding its smartphones and laptops)

2018: makes first-of-a-kind listing to join the Hong Kong Stock Exchange

As investors continue to debate Xiaomi’s valuation, the company is under pressure to justify its worth and get its strategy across to the market. So, what is Xiaomi’s ambition and how does it plan to achieve it?

Xiaomi’s IPO plans prove overly ambitious

Markets were paying attention to Xiaomi as it prepared to start its life as a public company. Investors had been peddled the message that the firm was looking to join the Hong Kong stock exchange, boasting a valuation of around $100 billion in what was expected to be the biggest global offering since fellow Chinese giant Alibaba Group listed in New York in 2014.

Xiaomi had planned to raise $10 billion to attain that valuation, with about half coming from what would have been the first time Chinese Depositary Receipts (CDRs) had been issued. But after suddenly abandoning that plan and pricing its initial public offering (IPO) at the lower end of its guided range at HKD17 a share, Xiaomi’s listing ended up being a disappointment: raising just $4.7 billion to carry a valuation of about $54 billion.

Xiaomi’s decision to shelve plan to issue CDRs knocks valuation

The CDRs were to be the first ever to be issued as China is looking to entice its tech firms that have opted to list abroad, mostly in New York, to list domestically. Acting like American Depositary Receipts (ADRs), CDRs allow Chinese firms to have a secondary listing in China. While Xiaomi put its plans to issue CDRs on the backburner without reason, it has been reported that the Beijing-based company believes the listing rules prove too restrictive on the tech companies that the CDRs have been designed for.

In addition, Xiaomi was the first company to list in Hong Kong under new rules that were introduced, allowing firms to have dual-class share structures. This meant that companies can have different sets of shares that carry different voting powers, ultimately allowing founders that have kept (and want to maintain) their deep roots in their business to take it public. In Xiaomi’s case, this meant its string of founders could keep control of the business, with chief executive and chairman Lei Jun holding close to 55% of the voting rights but just 29% of Xiaomi’s issued share capital following the IPO.

Although Xiaomi’s plans to issue CDRs didn’t materialise, the company was still expecting investors in China to invest through Stock Connect, a platform that links trading bourses between China’s equity markets in Shanghai and Shenzhen to those in Hong Kong. But soon after Xiaomi’s IPO it was announced that China was to exclude companies with dual-class share structures from Stock Connect, cutting them off from Chinese investment. Bearing in mind that Xiaomi is presently the only company to have listed under the new dual-class share rules, the decision was a direct blow to Xiaomi’s new life as a public company.

China argued that investors were not familiar with dual-class share structures, so it was protecting them from putting their money in something they did not understand. Others argued it was China’s attempt to damage Hong Kong’s reputation as the financial centre of Asia, or to stop cash from flowing out of China amid sharp sell-offs as the trade war between the US and China ramps-up.

However, it has since been revealed that China and Hong Kong have agreed to find a way to allow companies with dual-class share structures (including Xiaomi) to attract investors on the mainland through Stock Connect – although they are to be phased in to ensure there is time for investors to understand that their voting rights will not directly correlate to their shareholding. Interestingly, some have argued that the fact investors in mainland China will be able to invest in Xiaomi through Stock Connect means the need to issue CDRs would be null and void, as the primary purpose of the CDRs was to gain exposure to investors on the mainland.

Xiaomi shares start to find ground after a shaky start

After closing below its IPO price on what ended up being a lacklustre first day of trading on 9 July, Xiaomi shares started to rise the following day. After climbing over 26% in its first week of trading to hit a high of HKD22, Xiaomi shares have since dropped off but have managed to remain consistently above the IPO price.

Xiaomi chart

Xiaomi: revenue rapidly rising but it remains firmly in the red

Having decided that it was not strong enough to keep up the rapid rate of growth it was experiencing, Xiaomi states it deliberately put on the brakes in 2016 so it could make sure the three key foundations of the business - innovation, quality and supply management – were laid, allowing impressive growth to resume last year.

Xiaomi returns to growth following slowdown in 2016

(RMB, billions)	Full year			Q1
(RMB, billions)	2015	2016	2017	2017	2018
Revenue	66.8	68.4	114.6	18.5	34.4
Gross profit	2.7	7.2	15.2	2.5	4.3
Operating profit (loss)	1.4	3.8	12.2	2	3.4
Pre-tax profit (loss)	(7.5)	1.2	(41.8)	(7.5)	(6.7)
Adjusted profit (loss)	(0.3)	1.9	5.4	0.7	1.7

Xiaomi: more than just a low-cost smartphone maker

‘Although our hardware business is essential to building our user base, we do not expect it to be the main source of our profits. We maintain excellent design and outstanding quality in our products, while pricing out products as close as possible to cost by selling them to users through highly efficient online and offline new retail channels. We then provide our users with comprehensive internet services,’ – Xiaomi.

Xiaomi was founded to invent a ‘very cool’ smartphone, but the company is simply laying the foundations by rolling-out its smartphones as it looks to place its operating system in the hands of as many people as possible, in order to flog what it believes to be the future of the business: internet services, selling the likes of online games and advertising space.

Xiaomi’s smartphones and other gadgets have proven popular because they undercut rivals in terms of price, hence why it has performed particularly well in emerging markets (EMs). This includes India, where Xiaomi is the market leader rivalling the likes of Samsung, which is also trying to carve out a chunk of the world’s fastest growing economy for itself.

Smartphone market share by unit shipments in Q1 2018

	Global		Mainland China		India		Emerging markets
	Share	Rank	Share	Rank	Share	Rank	Share	Rank
Xiaomi	8.4%	4	15.1%	4	30.3%	1	9%	2
Apple	15.7%	2	11.3%	5	1.5%	11	6.7%	4
Huawei	11.8%	3	24.2%	1	2.3%	8	8.4%	3
Lenovo	2.7%	8	0.1%	26	3.4%	6	4.5%	7
OPPO	7.4%	5	18.9%	2	7.4%	3	5.1%	6
Samsung	23.5%	1	1.3%	6	25.1%	2	32.3%	1
Vivo	5.6%	6	16.3%	3	6.7%	4	2.9%	9

Xiaomi is so focused on its future business that it has pledged to keep its net profit margin on hardware below 5% to ensure it can keep undercutting the competition, promising to ‘return the excess to our users’ should it fail to keep margins down. It may seem odd to be talking about keeping margins down, but this helps expand the use of its operating system.

The reasons Xiaomi is chasing this strategy is clear considering that its internet services boast a gross margin of over 60%. But the firm has a long way to go before it can truly convince the market that is where its future lies: internet services account for just 9.6% of Xiaomi’s revenue, and 67.5% of its overall revenue that comes from smartphones is capped by its pledge to keep margins down.

There is evidence that the transition is working. While smartphones still drive revenue, it is much less so than it was back in 2015 when smartphones made up 80% of all sales and internet services accounted for just 5%.

Xiaomi revenue and sales breakdown

RMB (billions)	Full year			Q1
RMB (billions)	2015	2016	2017	2017	2018
Smartphone revenue	53.7	48.8	80.6	12.2	23.2
Smartphones sold (millions)	66.5	55.4	91.4	13.1	28.4
Average selling price (RMB)	807.2	879.9	881.3	931.9	817.9
IoT revenue	8.7	12.4	23.4	4.2	7.7
IoT revenue per smartphone (RMB)	130.6	224	257	318	270.9
Overall hardware gross margin	(0.2%)	4.4%	8.7%	7.3%	7%
Internet services revenue	3.2	6.5	9.9	2	3.2
MIUI monthly active users (millions)	112.2	134.8	170.8	138.3	190
Internet service revenue per user (RMB)	28.9	48.5	57.9	14.7	17
Internet services gross margin	64.2%	64.4%	60.2%	60.4%	62.3%
Other revenue	1.2	0.7	0.7	0.1	0.2
Total revenue	66.8	68.4	114.6	18.5	34.4
Overall adjusted net margin	(0.5%)	2.8%	4.7%	3.6%	4.9%

Xiaomi’s operating system: MIUI

‘Compared to other internet platforms that acquire new users at high costs, we leverage the sale of our hardware to acquire users at a profit,’ – Xiaomi.

Meanwhile, its operating system has been designed as an open platform based on Android to allow a wide range of third party apps and content to be used. More importantly, its system means it can release its own stuff. The company has a ‘proven track record of developing killer apps’ – 38 of its own apps had at least 10 million MAUs in March while 18 of them had over 50 million. These include the likes of the Mi App Store, Mi Browser, Mi Music and Mi Video. Overall, there were 190 million MAUs using Xiaomi’s operating system in March of this year.

This concept is nothing new. Alphabet’s Android operating system powers 85% of the world’s smartphones and its dominance is unrivalled with at least seven apps including Google Maps, Chrome, Gmail, Google Play and Search all boasting over 1 billion MAUs. But its market leading position is the result of its aggressive push of Android onto smartphone manufacturers after Google’s failed attempts to release its own smartphones – something Xiaomi has had better luck with. While effective, Google has been punished for its aggressive stance, having been fined a record €3.4 billion by the European Union (EU) earlier this month for forcing smartphone manufacturers to pre-install its swathe of software into their products in order to gain access to its Android operating system.

The Xiaomi ecosystem: building a fan base rather than a customer base

‘We believe that our user base is differentiated by our “Mi Fans”, a large global community of passionate users who are intensely loyal to the Xiaomi brand, are highly engaged on our platform and actively contribute feedback and feature ideas to our product development,’ – Xiaomi.

Xiaomi has built a swathe of other products in addition to smartphones, some on its own and others in partnership with over 200 other companies. These products are all designed around IoT and the growing amount of connected devices appearing in homes around the world, with Xiaomi having invested in over 90 IoT partners.

IoT is still a relatively new market that no one has yet managed to dominate, giving Xiaomi every opportunity of grabbing a big slice of the action. In fact, according to Xiaomi, it has already got a head start over the competition, claiming it held a 1.9% share of the global IoT market in Q1 of 2018 compared to its more established players Amazon at 1.2%, Apple 1.0%, Google 0.9%, and Samsung 0.8%.

Its wide range of products coupled with heavy engagement with its customers (its MIUI forum has over 9 million MAUs) means 1.4 million people owned more than five connected Xiaomi products as of March this year. Again, this model is nothing new. Apple has been encouraging (or in many cases forcing) customers to buy other Apple products for years, as these are the only ones that work with that expensive iPhone they have purchased.

But Xiaomi, following the same tact as it has done with its smartphones, is about offering quality hardware at a cheaper price. An individual can buy ten products to build their Xiaomi ‘ecosystem’ for somewhere between $1185-$2990, whereas a comparable collection of rival products would cost anywhere between $3200-$7864. Not only does Xiaomi undercut rivals but it allows its customers, or ‘fans’, to build a collection of products at a far cheaper rate, thereby encouraging them to buy more products.

Xiaomi IoT devices undercut rivals on price

Product type	Xiaomi Ecosystem		Rival products
Smart TV	Mi TV	$138-$1492	Samsung UA Series	$466-$3333
AI speaker	Mi AI Speaker	$26-$46	Sonos One	$279
Router	Mi Router	$15-$107	TP-Link DR Series	$13-$230
Scooter	Mi Electric Scooter	$308	Inmotion V Series	$508
Wearable	Mi Band	$23	Apple Watch	$249
Air purifier	Mi Air Purifier	$108-$231	Honeywell KJ Series	$325-$833
*IH rice cooker**	Mi IH Rice Cooker	$62-$154	Panasonic SR Series	$156-$586
Robot vacuum	Mi Robot Vaccum	$260	iRobot Roomba Series	$741-$1304
Security camera	Mi Home Security	$15-$62	Ezviz Smart Camera	$22-$81
Water purifier	Mi Water Purifier	$230-$307	Philips WP4170	$461
Water purifier	Total	$1185-$2990	Total	$3200-$7864

^{(Source: Xiaomi prospectus, iResearch. Note: scope of comparison is limited in mainland China. IH = Induction Heating)}

Xiaomi outperforms rivals to take top spot in India

Xiaomi has a sizeable share of the smartphone market in its home country of China, but with established players like Huawei and OPPO having taken a chunk of the market Xiaomi is only the fourth largest smartphone maker. Its low-cost hardware and open operating system have proven more popular in other EMs, where Xiaomi ranks as the second biggest smartphone maker. The most important EM is India because of the emerging middle classes and rapid economic growth. Here, Xiaomi has been growing sales by as much as double the rate of its closest competitor Samsung, and has recently taken over as the market leader.

According to research by Canalys, Xiaomi and Samsung each shipped 9.9 million smartphones to India in the second quarter (Q2) of 2018, the best quarterly performance for both companies. Together they now account for 60% of all shipments in India, compared to just 43% a year ago. But even with Samsung reporting an annual growth rate of 50% - the best on record since late 2015 – Xiaomi’s even more impressive growth saw the Chinese firm steal top spot from Samsung in Q2. In Q2 2017, Xiaomi had an 18% share of the Indian market to trail Samsung’s comfortable lead with 25%, but a year later Xiaomi has now overtaken its Korean rival, albeit marginally with both firms holding about 30% of the market.

Competition in India will heat up however, with Canalys reporting there is still untapped opportunities for ‘smaller and leaner smartphone vendors’, adding that the ‘climate is right for businesses to realign and re-enter the market’. That has been demonstrated by Apple, which is changing its strategy to focus on its brand first and volumes later.

Where next for Xiaomi?

‘We know it may take time for everyone to fully embrace our ideals. However, time is on our side,’ – Xiaomi.

Although the start of Xiaomi’s life as a public company has already seen the company overcome several challenges, its valuation is still being debated as investors try to grapple with its business model and strategy. For the time being, focus will remain on the performance of its smartphones. But with margins capped, investors needn’t focus on profitability but keep an eye on unit sales and the rate of growth. Like so many other young tech companies, a big challenge for Xiaomi will be maintaining the rapid growth that investors become used to.

Xiaomi’s recent efforts to improve its sales and distribution channels should go some way to maintaining (if not further improving) sales growth over the immediate future. In terms of online sales, Xiaomi holds a market leading position in both India and mainland China, and having built its online channel it has started expanding its bricks-and-mortar network of Mi Home stores.

But with Xiaomi still needing to convince the market that its future lies outside of the smartphone business that the company has been built on, all attention will be on Xiaomi’s ability to not only grow sales through its internet services business, but prove it can make some serious money from it. With its entire ecosystem of products operating under its one and all-important operating system, growing sales of its IoT products like smart speakers and cameras will be an important indicator for how its internet services division is potentially performing as the IoT platform lies at the heart of the unit.

Xiaomi may have won over its fans, but it has some way to go in winning over financial markets.