Xiaomi: A Chinese company that can be bought below their IPO price.
Xiaomi is primarily known for their smartphones but as you will see in this analysis, the company is much more than that. Xiaomi made their IPO in July 2018 with a share price of $17, and now trades at much lower price. Does that mean it is time to buy shares in Xiaomi? In this analysis, I will share my opinion.
This is not a financial advice. I am not a financial advisor and I only do these post in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.
This analysis will be a bit different from what you are used to read in my blog. Xiaomi did their IPO in July 2018, meaning I don't have access to the historical numbers dating back longer than that. So instead of using the principles I have learned from my Phil Town workshop, I use the principles I have learned from the GOAT academy. I should also mention that most of the numbers I use in this analysis is from Finbox, which I believe is a great tool to easily get the numbers you need from various companies.
Before I start with the analysis, I should mention that I do not currently own shares in Xiaomi. However, I do own shares in Zepp, which manufacture products to Xiaomi. I don't have any experience with Xiaomi products either. If you would like to see or copy my portfolio, you can read how to access it here. Even though I own shares Zepp and because of that has some skin in the game when it comes to Xiaomi, I will keep this analysis unbiased.
Xiaomi was founded in 2010 in China. Xiaomi is most known for their smartphones and is the third largest smartphone company with a global market share of 12,6 %. They are known for their cheap smartphones, which is due to their strategy that their products should not exceed a net profit margin of 5 %. Besides smartphones, they have two other different business segments: IoT that sells smart TV's, white goods (such as refrigerators), pads, and wearables (such as smartwatches) and Internet Services that includes advertising, games, etc. In the last quarter, revenue from smartphones were 62,4 %, IoT were 26,6 % and internet services were 9,7 % (they also have a few minor revenue streams). If looking at gross profit margins, smartphones delivered a 9,9 % gross profit margin, IoT a record high 15,6 % gross profit margin and internet services a 70,8 % gross profit margin. It is important to understand the different business sectors of Xiaomi to understand their business model. They have described their business model as a triathlon: First, invest in companies producing hardware and devices. Second, sell the products through their online and offline stores. Third, offer services for product users on the internet. Hence, Xiaomi should be able to generate profit not only by selling the products but also afterwards. It is the reason they sell their products at a 5 % net profit margin. Looking for a moat in Xiaomi isn't hard. If a company is the third largest smartphone company with a global market share of more than 12 %, this company has a brand moat.
Their CEO is Lei Jun. He is not only the CEO but also the co-founder of the company. I like when founders or co-founders are still in management, as they usually more concerned about growing their business than their wallets. And as Lei Jun is the 118th richest person in the world, I suppose it is what we will see in this case. Before founding Xiaomi, he gained experience from management positions in companies such as Kingsoft in which he was the co-founder and now the Chairman of the board and Joyo, another company that he co-founded and sold to Amazon for $75 million in 2004. He has a bachelor's degree in Computer Science from Wuhan University, where he is also a member of the board. In 2021, he was awarded as China's best CEO by Forbes. As described in the previous paragraph, Lei Jun is determined in growing the internet business and has previously stated: "if we don't offer internet services, our model would be the same as hardware company, and our company wouldn't be sustainable". It means that Lei Jun is determined to grow their high margin business, and that combined with his outstanding history, I feel very comfortable with Lei Jun leading this company moving forward.
I believe that Xiaomi has a brand moat. I like the management as well. Later I will do a discounted cash flow model to calculate a price for Xiaomi but before I do so, let us just have a look at some key financial metrics.
Down below we see some key financial metrics Xiaomi over the last three years. As I got the numbers from Finbox, the numbers are in U.S. dollars and not in Hong Kong dollars. The numbers I use in this analysis will be in dollars except for my calculation of the share price, which I have changed from dollars to Hong Kong dollars by today's exchange rate. Revenue is growing nicely year over year. The gross profit margin is also growing year over year, which is very nice to see. The operating margin is lower in 2021 than in 2020, which is something you prefer not to see. It should be increasing and not decreasing. However, we did have some different challenges in 2021 that pressure margins, more about that later. The lower operating margin also affects the net income, which is slightly lower in 2021 than in 2020 despite higher revenue. All in all, the numbers look good, but I would like to see operating margin growing moving forward.
Before we continue to the discounted cashflow model, I would like to investigate the risks and potential of Xiaomi. One risk is Competition. Xiaomi operates in a highly competitive sector, and they are losing market shares in both India and China. Especially in China, Honor is taking market share from Xiaomi at a fast pace, which resulted in Xiaomi now is the fifth largest brand in China. Furthermore, Xiaomi is currently facing some trouble in India, where they have been accused of tax evasion. Macroeconomics. Xiaomi is facing a lot of macroeconomics headwinds that also hurt margins in 2021. They are record high freight prices, supply chain shortages, COVID-19 lockdowns in China and inflation (especially in Europe). All of this will put pressure on Xiaomi, at last in the short term. Geopolitics. Xiaomi has struggled with politics in the past as it got blacklisted in the United States as former president Donald Trump made use of one of his own executive orders on "addressing the threat from securities investments that finance communist Chinese military companies" to ban Xiaomi on alleged ties with the Chinese military. Xiaomi responded with a lawsuit and was later removed from the blacklist. When investing in a Chinese company, you will always need to be prepared for political risks.
There are also potential for Xiaomi moving forward. Growing their high margin business. As described previously, Xiaomi wants to grow their internet services business. If they are successful in growing their internet services business, it will improve margins and profitability. Management is especially looking into growing it internationally, and in the first quarter of this year international revenue was up by 71,1 % year over year. However, international revenue in internet services is only 21,9 % of the total revenue of internet services. New markets. Xiaomi is growing nicely in Latin America and has gone from a 5 % market share in 2020 to a 15 % market share in 2021 and they expect Latin America to be a major growth area in the next couple of years. They also speak of a huge market opportunity in Africa, as most of countries go from 3G to 4G. Electric Vehicles. Xiaomi has announced that they will be mass producing electric vehicles in 2024. According to AlixPartners, the advantages for a company like Xiaomi in making EV's are they will be able to access more data on usage of their customers, while EV's also offer a potential lifetime source of revenue from products and services.
I have now investigated the financials, risks, and potential of Xiaomi. I will now look at the price by doing a discounted cash flow model. To do so I will need some numbers that you can see below. The numbers are the 2021 numbers, which I could find at Finbox. However, the perpetuity growth rate and the discount rate are numbers I have come up with myself. The reason I chose 3 % as perpetuity growth rate is that it is usually a between the historical inflation rate of 2-3% and historical GDP growth of 4-5%. I decided to go with a higher option in the middle. The chosen discount rate of 12% is because it is usually between 9-12%. I decided to go with the highest one because of the current market conditions. Remember that all the numbers made in these calculations are in millions.
I also need to determine how much EBIT, Depreciation & Amortization and Net Working Capital will evolve over the next couple of years. I decided to use an EBIT growth of 20 % year over year. It is a bit lower than what I have read from other analysts that usually expects a growth in the low twenties. I calculated with a growth in Depreciation & Amortization of 30 % a year, which is lower than the historical growth rate. Finally, I decided to keep the Net Working Capital at the 2021 numbers at -1.233 because it is expected to decline a bit in the coming years. I haven't found a smart way to share all my spreadsheet here but once I did my calculations, I found that the intrinsic value of Xiaomi to be $2 (15,69 Hong Kong dollars).
Having investigated Xiaomi, I find the company interesting. I really like their business model, despite them not being able to grow the internet services business as much as I had hoped. If they manage to grow the internet services business, it will result in higher margins. I really like the management of Xiaomi, and I feel very confident in the management moving forward. I wasn't sure if Xiaomi moving into the EV space would be a good idea but with management's track record, I do feel quite comfortable in them being able to execute. However, it will also result in much higher R&D expenses the next couple of years, so it is something to prepare for. I don't like the fact that they are losing market shares in China and India, and now also being accused of tax evasion is probably what keeps me from investing in Xiaomi for the time being. Once I get some clarity on the tax evasion in India, and if Xiaomi can continue to grow their internet services business, I could be tempted to open a position. Until then, I will not invest in Xiaomi unless I get a larger discount to intrinsic value.
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