Elevator Pitch
I maintain a Neutral rating on Hong Kong-listed internet company and smartphone manufacturer Xiaomi Corporation (OTCPK:XIACY) (OTCPK:XIACF) [1810:HK].
This is an update of my prior article on Xiaomi Corporation on December 18, 2019. Xiaomi's share price has increased by +22% from HK$10.52 as of December 16, 2019 to HK$12.86 as of June 8, 2020. Xiaomi currently trades at 31.7 times trailing twelve months' P/E and 23.3 times consensus forward next twelve months' P/E.
Xiaomi's 1Q2020 financial results were above expectations with its geographical diversification being a key positive factor, but overseas markets could potentially be a drag for the company in 2Q2020 and beyond. Year-to-date, Xiaomi's share price is up +22%, while the Hong Kong benchmark Hang Seng index is down -12% over the same period. Positives from Xiaomi's 1Q2020 better-than-expected financial results have already been priced into the company's share price. There is a significant risk of valuation de-rating, if Xiaomi's financial performance in subsequent quarters falls short of expectations. As such, I think that a Neutral rating for Xiaomi is fair.
Readers have the option of trading in Xiaomi Corporation shares listed either on the Over-The-Counter Bulletin Board/OTCBB as ADRs with the tickers XIACY and XIACF or on the Hong Kong Stock Exchange with the ticker 1810:HK. For Xiaomi Corporation shares listed as ADRs on the OTCBB, note that liquidity is low, and bid/ask spreads are wide.
For Xiaomi Corporation shares listed in Hong Kong, there are limited risks associated with buying or selling the shares in terms of trade execution, given that the Hong Kong Stock Exchange is one of the major stock exchanges that is internationally recognized, and there is sufficient trading liquidity. Average daily trading value for the past three months exceeds $250 million, and market capitalization is above $39.8 billion, which is comparable to the majority of stocks traded on the US stock exchanges. Institutional investors which own Xiaomi Corporation shares listed in Hong Kong include The Vanguard Group, BlackRock Institutional Trust Company, Norges Bank Investment Management, and Wells Capital Management among others. Investors can invest in key Asian stock markets either using US brokers with international coverage, such as Interactive Brokers, Fidelity, or Charles Schwab, or local brokers operating in their respective domestic markets.
1Q2020 Results Above Expectations, But More Uncertainty In 2Q2020
Xiaomi's 1Q2020 financial results were above expectations. Earlier, there were concerns that economic weakness resulting from the coronavirus pandemic will lead to weaker-than-expected smartphone demand and lower-than-expected advertising spend. But detractors were proven wrong.
Xiaomi's revenue grew by +13.6% YoY from RMB43,757 million in 1Q2019 to RMB49,702 million in 1Q2020, and the company's adjusted net profit increased by +10.6% YoY to RMB2,301 million over the same period. The company's geographic diversification and overseas expansion in the past years have paid off, as evidenced by the strong performance of its overseas markets in 1Q2020.
Xiaomi's overseas revenue contribution crossed the 50% mark for the first time in the company's history, as its overseas revenue grew +47.8% YoY to RMB24.8 billion in the most recent quarter. In other words, Xiaomi's 1Q2020 financial performance was better than expected, because the company was relatively less affected by the coronavirus pandemic and lock-downs in Mainland China in the early part of the year. Xiaomi is geographically diversified, and strong growth from overseas markets such as Europe and India helped to offset the weakness in Mainland China in 1Q2020.
On the flip side, this also suggests that Xiaomi's financial performance is very likely to be weaker QoQ in 2Q2020, as the coronavirus pandemic spread to the company's overseas markets such as Europe and India, especially in April and May 2020. While most domestic-focused Chinese smartphone companies will see a strong recovery in 2Q2020 as the coronavirus pandemic gets under control in Mainland China, Xiaomi's 2Q2020 financial performance is expected to be relatively more muted, due to the company's significant exposure to overseas markets outside of China.
On the positive side of things, Xiaomi noted at the company's 1Q2020 earnings call on May 20, 2020, that smartphone activations in Europe and India are already back at 90% and 60% of normalized levels prior to the coronavirus pandemic in the third week of May.
Nevertheless, the coronavirus pandemic is at different stages in Xiaomi's key markets, as per the charts below. The coronavirus pandemic is largely under control in Mainland China, while daily confirmed cases of coronavirus infections have been on the decline in Europe. On the other hand, the number of daily confirmed cases of coronavirus infections continues to increase in India.
A Comparison Of Daily Confirmed Cases Of Coronavirus Infections In Mainland China, Europe And India
Source: Worldometer
EMEA Weakness Expected To Be A Drag On The Smartphone Business In 2Q2020
Xiaomi's segment revenue for the smartphone business grew by +12.3% YoY to RMB30.3 billion in 1Q2020. This was driven by a +4.7% YoY expansion in smartphone shipments to 29.2 million units, and a +7.2% YoY increase in smartphone ASP (average selling price) with the launch of new premium smartphone models Mi10 and Mi10Pro for the most recent quarter.
Notably, Xiaomi was the only company among the top four global smartphone manufacturers to achieve positive YoY smartphone shipment volume growth in 1Q2020, according to research by IDC. Xiaomi's geographical diversification meant that lower smartphone shipments in Mainland China in 1Q2020 was offset by growth in smartphone shipments in overseas markets which have yet to be badly affected by the coronavirus pandemic. Xiaomi's China smartphone shipments fell by -33.8% YoY from 10.6 million units in 1Q2019 to 7.0 million units in 1Q2020.
EMEA (Europe, the Middle East and Africa) was the bright spot for Xiaomi's smartphone business in 1Q2020, but the region is expected to be a drag for the company in 2Q2020. Xiaomi's smartphone shipments in Europe, Middle East and Africa grew by +58.3%, +55.2% and +284.9% YoY respectively, in 1Q2020. The positive growth momentum for smartphone shipments in EMEA is likely to reverse in 2Q2020. IDC expects the EMEA smartphone market to "contract by close to a quarter in value terms" in 2Q2020.
Apart from Xiaomi's geographical diversification, another key factor for the out-performance of Xiaomi's smartphone business was its online sales channel. At the company's 1Q2020 earnings call on May 20, 2020, Xiaomi highlighted that "we are very, very focused on the online channels, right, both in China and in many of the countries" and "our customers still buy our products through the online channel" notwithstanding lock-downs in many of the company's key markets. This suggests that Xiaomi's smartphone shipments and sales could decrease to a smaller extent compared with its rivals and peers, as the company is relatively less reliant on physical distribution channels for its smartphones.
Advertising Revenue Surprises On The Upside For Internet Services Business In 1Q2020
Xiaomi's internet services business saw segment revenue grow +38.6% YoY to RMB5.9 billion in 1Q2020. It is noteworthy that advertising revenue (one of the key sub-segments for the internet services business) increased by +16.6% YoY to RMB2.7 billion over the same period.
It was initially feared that the coronavirus pandemic will lead to a severe cut in advertising budgets of many companies, and result in a significant decline in advertising revenue for Xiaomi in 1Q2020. There are three key reasons for Xiaomi's better-than-expected advertising revenue growth in 1Q2020.
Firstly, similar to Xiaomi's smartphone business, geographical diversification meant that overseas markets less affected by the coronavirus pandemic in 1Q2020 helped to support the company's overall advertising revenue growth last quarter. However, there is no guarantee that Xiaomi's robust overseas advertising revenue growth will be sustained in 2Q2020.
Secondly, Xiaomi's advertising revenue used to be concentrated with the major internet companies. But the company has continued to diversify its advertising client base over time, so it was less affected by the cut in advertising spend for certain internet companies.
Thirdly, Xiaomi has made tweaks to the advertising business' operating model and technologies. The recommendation algorithm has been improved to provide more relevant advertisements for consumers, which translate to more clicks and higher advertising revenue. Also, instead of relying solely on traditional online and mobile ads, Xiaomi has been growing advertising revenue from other sources such as news feeds and search.
IoT Business Was A Disappointment Last Quarter
In comparison with the smartphone and internet services businesses, Xiaomi's IoT or Internet of Things business segment was a disappointment. The company's IoT business revenue increased by only +7.8% YoY to RMB13.0 billion in 1Q2020. This was mainly attributable to a significant decline in sales of large home appliances (e.g. television sets) which required installations, as a result of the coronavirus pandemic.
On the positive side of things, specific IoT products in the area of internet connectivity and wearable saw strong revenue growth last quarter. For example, Xiaomi's sales of WiFi routers, TWS earphones (True Wireless Stereo), smart wristbands expanded by +124%, +620%, and +56% YoY, respectively in 1Q2020. Xiaomi is guiding for sales growth in excess of +40% for IoT products which do not require installation for the full-year FY2020.
In the medium to long term, overseas markets remain the key growth driver for Xiaomi's IoT business. The penetration rate of IoT products in international markets is on average lower as compared to China. Xiaomi also faces relatively less competition in the international IoT market; Huawei, home appliance company Midea and internet giant Alibaba (BABA) are among the domestic giants that pose serious competition to Xiaomi in China's IoT market.
Valuation
Xiaomi trades at 31.7 times trailing twelve months' P/E and 23.3 times consensus forward next twelve months' P/E based on its share price of HK$12.86 as of June 8, 2020. Since the company's listing on the Hong Kong Stock Exchange in July 2018, Xiaomi has traded between 15.1 and 43.5 times consensus forward next twelve months' P/E with a mean of 22.6 times.
Risk Factors
The key risk factors for Xiaomi include weaker-than-expected smartphone demand (affects the smartphone business) and lower-than-expected advertising spend (affects the internet services business) due to economic weakness resulting from the coronavirus pandemic.
Note that readers who choose to trade in Xiaomi Corporation listed as ADRs on the OTCBB (rather than shares listed in Hong Kong) could potentially suffer from lower liquidity and wider bid/ask spreads.
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