Xiaomi Corporation: New Low-Priced 5G Phone Sparks Share Price Recovery

Elevator Pitch

Hong Kong-listed internet company and smartphone manufacturer Xiaomi Corporation (OTCPK:XIACY) (OTCPK:XIACF) [1810:HK] currently trades at 22.6 times consensus forward FY2019 P/E and 18.7 times consensus forward FY2020 P/E based on its share price of HK$10.52 as of December 16, 2019.

This is an update of my initiation article published on Xiaomi Corporation on September 6, 2019. Xiaomi’s share price has increased by +18% from HK$8.94 as of September 5, 2019 to HK$10.52 as of December 16, 2019.

I maintain my “Neutral” rating on Xiaomi. I am positive on Xiaomi’s planned launched of China’s cheapest 5G smartphone (Redmi K30 5G) and the company’s better-than-expected gross margin for the recent 3Q2019 quarter. But I am not certain if Xiaomi can still maintain its leading market share in smartphones after the 5G replacement cycle ends. Although the IoT business is growing strongly, I am not sure of the IoT business’s growth sustainability, as the IoT space is hugely competitive and Xiaomi has to fight larger and more well-capitalized rivals to stay ahead.

Readers are advised to trade in Xiaomi shares listed on the Hong Kong Stock Exchange with the ticker 1810:HK where average daily trading value for the past three months exceeds $100 million and market capitalization is above $3 billion. Investors can invest in key Asian stock markets either using U.S. brokers with international coverage such as Interactive Brokers, Fidelity, Charles Schwab or local brokers operating in their respective domestic markets.

Cheapest 5G Phone In China Announced On December 10

Xiaomi’s share price increased by +14% from HK$9.21 on December 10, 2019 to HK$10.52 on December 16, 2019. Prior to this, Xiaomi’s share price was an all-time low (since its IPO in July 2018) of HK$8.35 on September 2, 2019. Xiaomi’s share price recovery was sparked by the company’s announcement regarding the launch of the new 5G phone, Redmi K30 5G, on December 10, 2019.

Redmi K30 5G, planned to be launched in late-January 2020, is priced at RMB1,999 (6GB/64GB model), making it the cheapest 5G phone in China, and the first 5G phone to be priced below RMB2,000. Prior to the announcement on Redmi K30 5G, the cheapest 5G phones available in China were Xiaomi’s own Mi 9 Pro 5G priced at RMB3,699 and Vivo’s iQOO Pro 5G priced at RMB3,798. Redmi K30 5G has set a new benchmark for 5G phones in China with respect to price, being 46% cheaper than the company’s own Mi 9 Pro 5G.

Notwithstanding the price, Redmi K30 5G’s specifications are comparable to any flagship smartphone in the market. Redmi K30 5G’ specifications include a Qualcomm (QCOM) Snapdragon 765G integrated 5G processor; a 6.67-inch screen with a 120Hz screen refresh rate; 64MP+2MP+5MP+8MP quad camera and 20MP+2MP dual front camera; a decent 4500mAh battery with fast charging capabilities.

The market’s positive response to the company’s announcement regarding the launch of Redmi K30 5G, as evidenced by Xiaomi’s share price surge, is due to two key reasons.

One reason is that the new Redmi K30 5G is an illustration of Xiaomi’s production capabilities and operating efficiency, as the company is able to launch a 5G smartphone with such specifications at an affordable price. The fact that the price of the new Redmi K30 5G is significantly lower than competing 5G smartphones suggests that competitors are not able to sell 5G phones at such low prices while maintaining a decent profit margin.

The other reason is that the new Redmi K30 5G increases Xiaomi’s competitiveness in the 5G smartphone market. The 5G replacement cycle could see a new round of musical chairs and significant shifts in the market shares of smartphone manufacturers in the future, as consumers purchase new 5G smartphones to replace their existing 4G smartphones. If competitors are unable to introduce competing 5G smartphones with similar specifications at lower prices, Xiaomi is well-positioned to gain, or at least maintain, market share in the smartphone market going forward. Also, the new Redmi K30 5G’s low price might entice some existing 4G smartphone users to make the switch to 5G smartphones earlier.

At Xiaomi’s 3Q2019 results briefing on November 29, 2019, the company highlighted that its industry-leading operating efficiency (which leads to a superior price-to-performance ratio for its smartphones), healthy 4G smartphone inventory levels (de-stocking done earlier to prepare for 5G replacement cycle) and commitment to research & development spending (company spent more than RMB5 billion on R&D expenses in 9M2019) are Xiaomi’s key competitive advantages in the smartphone market. Furthermore, Xiaomi expects to launch at least 10 new 5G smartphone models in 2020, and it thinks that 5G smartphones could be as cheap as RMB1,000 by 2021.

On the flip side, Xiaomi could potentially spark a new price war in China with the announcement regarding Redmi K30 5G. Even if competitors can’t match Xiaomi’s production capabilities and operating efficiency, they might be compelled to sell certain new 5G smartphones at a loss to avoid being overtaken by Xiaomi. In other words, the overall profitability of smartphone manufacturers in China, including that of Xiaomi, could be hurt with the onset of an early 5G smartphone price war in China.

Specifically, the gross margin for Xiaomi’s new Redmi K30 5G smartphone is likely to be lower than the company’s 3Q2019 smartphone segment gross margin of 9%. But Xiaomi could also have strategic considerations with respect to the pricing for the new Redmi K30 5G smartphone. Maintaining the company’s smartphone user base is necessary to support the growth of the company’s internet services business which revolves around its smartphone users (e.g. advertising, gaming, fintech etc).

Apart from the announcement regarding the new Redmi K30 5G smartphone, Xiaomi’s 3Q2019 results announced on November 29, 2019, was also another factor for the company’s share price recovery. In terms of top line, weakness in the smartphone business was offset by strong growth for the IoT (Internet of Things) business. More importantly, the improvement in Xiaomi’s overall profitability in 3Q2019 was a positive surprise as the company’s gross margin improved from 12.9% in 3Q2018 in 15.3% in 3Q2019, which was mainly driven by a +290 basis points expansion in smartphone segment gross margin to 9.0%.

Smartphone Business Disappointed With Lower Sales

Revenue for the smartphone business declined by -7.8% YoY to RMB32.3 billion in 3Q2019, as the number of smartphone units sold decreased by -3.6% YoY to 32.1 million units, and ASP (Average Selling Price) was down -4.3% YoY at RMB1,006.5 due to a different product mix.

Based on data from IDC’s 3Q2019 Worldwide Quarterly Mobile Phone Tracker published on November 7, 2019, Xiaomi’s worldwide shipments declined by -3.3% YoY to 32.7 million in 3Q2019. Xiaomi maintained its status as the fourth largest smartphone manufacturer in the world, but the company’s market share fell from 9.7% in 2Q2019 to 9.1% in 3Q2019. Notably, among the five largest smartphone manufactures, worldwide shipments for Samsung (OTC:SSNLF) (OTC:SSNNF), Huawei and Oppo grew by +8.3%, +28.2% and +4.1% YoY, while Apple’s (AAPL) worldwide shipments declined by a marginal -0.6% YoY.

In other words, Xiaomi was the only smartphone manufacturer among the top five players to suffer a significant YoY decline in worldwide shipments in 3Q2019. Xiaomi’s domestic weakness was the key reason for the decrease in sales and shipments for its smartphone business. In its 3Q2019 Worldwide Quarterly Mobile Phone Tracker report, IDC noted that Xiaomi “for the first time saw less than a third of its shipments delivered domestically in China” and “shipments declined under pressure from Huawei.” Besides more intense competition from Huawei, Xiaomi’s weaker-than-expected domestic smartphone shipments is also due to Chinese consumers adopting a “wait-and-see” attitude in anticipation of new 5G smartphone launches.

The smartphone segment’s overseas operations and gross margin improvement were the bright spots. Xiaomi was ranked first in India with respect to smartphone shipments for nine consecutive quarters since 3Q2017, and Xiaomi had a 27.1% market share in India in 3Q2019.

The company’s smartphone shipments in Western Europe grew +90.9% YoY in 3Q2019, and Xiaomi was ranked fourth in Western Europe with a market share of 7.0% in the quarter. Xiaomi was also the second largest smartphone manufacturer in Spain in 3Q2019 in terms of shipments with a 22.9% market share, and smartphone shipments in Spain jumped by +63.7% YoY in 3Q2019. Notably, Xiaomi only entered the Western Europe smartphone market two years ago. But Huawei’s sales restriction outside of China likely also played a part in Xiaomi’s strong growth in Western Europe.

Looking ahead, Xiaomi has already cemented its market leadership in India, and its current focus for the international smartphone business will be Western Europe. In the medium to long term, Eastern Europe and South America are international markets that the company targets to penetrate in future, and these markets share certain common languages with Western Europe such as Spanish and French.

The smartphone segment’s profitability also surprised on the upside, as segment gross margin improved +290 basis points YoY and +90 basis points QoQ to 9.0% in 3Q2019. At the company’s 3Q2019 earnings call on November 29, 2019, Xiaomi emphasized that an 8%-9% gross margin is the “normal gross margin profile” for its smartphone business.

Weak Advertising Revenue Was A Drag On Internet Services Segment While IoT Business Delivers Strong Growth

The revenue growth momentum for Xiaomi’s internet services business continued to slow, as 3Q2019 internet services segment YoY revenue growth of +12.3% was a tad slower than 2Q2019’s +15.7% YoY segment revenue growth. This was largely because advertising revenue, which accounts for over half of the internet services business segment revenue, declined -9.0% YoY to RMB2.9 billion. The company attributed the decline in advertising revenue to a shift in advertiser preference for non-pre-installation advertising.

With the aim of addressing the weakness in advertising revenue, Xiaomi is diversifying its advertising base by targeting small- and medium-sized enterprises and financial services companies, instead of being over-reliant on its traditional advertising base of internet companies. In addition, Xiaomi is building more sophisticated recommendation engines for its advertising business to achieve higher ROI (Return On Investment) for its advertising clients.

Also, to offset the weakness in advertising revenue, Xiaomi is placing a stronger emphasis on growing its other non-advertising internet services such as gaming, fintech and e-commerce. For example, revenue from gaming increased by +26.0% YoY to RMB822.3 million in 3Q2019.

The IoT business was the bright spot for Xiaomi in 3Q2019, as segment revenue grew by +44.4% YoY to RMB15.6 billion in the recent quarter. A +59.8% YoY increase in smart TV shipments to 3.1 million units for 3Q2019 was the main growth driver for the IoT business. Notably, Xiaomi continues to expand its IoT product portfolio. The company launched its new wearable product, Mi Watch, in November 2019; and its current IoT product portfolio includes air conditioners, washing machines, refrigerators, fresh air ventilators and water purifiers among others.

More importantly, Xiaomi highlighted at the company’s 3Q2019 earnings call on November 29, 2019 that the company expects the new 5G era to have a “profound impact” on IoT user experience, as 5G technology was developed with IoT in mind. This could possibly drive strong growth for the IoT business in 2021 and 2022.

Valuation

Xiaomi trades at 22.6 times consensus forward FY2019 P/E and 18.7 times consensus forward FY2020 P/E based on its share price of HK$10.52 as of December 16, 2019.

Xiaomi does not pay a dividend.

Year-to-date, Xiaomi has spent roughly HK$3.1 billion repurchasing approximately 338 million shares at an average price of HK$9.21 per share.

Variant View

The key risk factors for Xiaomi are competitors introducing cheaper 5G phones, weaker-than-expected profitability for the smartphone business, lower-than-expected advertising spend which adversely impact the company’s internet services business, and a slower-than-expected growth for the company’s IoT business going forward.

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