|Shares Out. (in M):||61||P/E||7.9||6.5|
|Market Cap (in $M):||601||P/FCF||6||6|
|Net Debt (in $M):||-228||EBIT||69||89|
|TEV (in $M):||372||TEV/EBIT||5.4||4.2|
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Huami (HMI) is a wearables company based in China selling fitness bands and watches globally. With ~$4 / share of cash and $1.25 of estimated non-gaap earnings expected this current year, I believe the current price of roughly 10 / share is far too low as it implies 8x P/E or 5x P/E excl. cash. Given the company is profitable, cash flowing, and scheduled to grow topline >30% this year with continued growth into 2020 and beyond, upside in the share price to $15 - $20 is easy enough to see. The product itself gets mostly strong reviews with Huami’s Amazfit Bip watch rated by Amazon’s editorial team as the best overall smart watch. In general, the products – which are mostly fitness-tracking wrist bands – are most attractive to customers for their value (very low prices, without giving up much performance) and battery life. Before going further, one notable factor in assessing Huami is its relationship with Xiaomi, one of the world’s largest smartphone and consumer electronics companies. In fact, a majority of Huami sales are for Xiaomi-branded products, although it has recently ramped its own self-branded products which offer higher margins. I’ll touch on this more in the Xiaomi relationship section.
The other risk to mention upfront is that Huami is a China based company and is therefore at risk from the ongoing U.S.-China trade war. With respect to tariffs in particular, wearables weren’t included in the current batch of tariffs but would naturally be captured if the U.S. decides to place tariffs on all Chinese goods. HMI’s filings indicate that international shipment volume was 44% in 2018, up from 24% in 2017 and so international is an important part of the story. Though the percentage of U.S. sales – i.e., those subject to potential tariffs – isn’t disclosed, the filings do indicate “cross-border business between China and the U.S. may not be an area of our focus..” and I suspect U.S. bound sales are a minority percentage of the international volume. Therefore, I don’t think trade war or potential tariffs fundamentally alters the outlook (competitors also produce in China and so HMI’s relative price advantage into the U.S. would likely persist). Nevertheless, a continued worsening of the U.S.-China relationship complicates value realization and I’ll leave it for the reader or comments section to assess the probability of trade war outcomes or to find an appropriate hedge for this macro risk.
As you pull up the chart, you’ll notice HMI stock has been extremely volatile YTD. I don’t have terribly unique insight into this move. Chinese stocks are often subject to frenzy in both directions but it is worthy of noting that the company’s financial results have been quite impressive since IPO (the 2019-2020 outlook today is well above that from the time of IPO) and 4Q’18 revenue was a full 11% above consensus. Perhaps the run-up early in 2019 was a combination of China market rebound plus anticipation of a great quarter 4Q result, and profit-taking ensued thereafter (the 1Q guide also may have underwhelmed high expectations or perhaps management offered less certainty than some desired with respect to the product launch schedule in 2019). In any event – post 4q – shares fell to $13.71 on 4/12 after peaking at $19. Then post-close on 4/12, the company filed with the SEC for an up-to $150 mm equity offering. No press release nor detailed primary / secondary offering amounts information was provided. HMI shares fell further through the next week when the company then updated the offering documents to indicate the issuance would be for up to $114 mm of equity (down from the $150 mm) and of the issuance, just 793k ADS would be primary (less than US$ 10 mm) which helps minimize dilution, while 7.1 mm ADS would be a secondary offering. After further trading declines subsequent to this release, the offering eventually priced 4/25 at $9.75 per share, and shares have remained near there since. The selling shareholders comprising the 7.1 mm secondary offering consist of (a) 5.35 mm ADS from Shunwei High Tech Limited (b) 1.3 mm ADS from Banyan Capital Holdings (also a VC fund) and about half-a-million ADS from the CEO+CFO, or about US$5 mm of proceeds to those guys. The CEO still owns 35% of the company (down from 36%). So the big seller is Shunwei, which Lei Jun’s – the famed founder of Xiaomi –venture capital fund. This could be perceived as problematic i.e., the fact that Xiaomi-founder’s VC fund is selling down their HMI stake could be viewed as a big negative with respect to the health of the ongoing Xiaomi relationship. I don’t wish to gloss over this risk. However, VC funds often exit investments, and sometimes at less than ideal prices for a variety of reasons. Based on a recent article, Shunwei manages US$ 3 bn whereas this sale netted the fund ~US$50 mm, a relatively inconsequential sum. I also believe that Shunwei was involved from a very early stage of Huami and may have earned 20x their original investment. I’d also note that Xiaomi itself owns 14.8% of Huami outright and they did not sell any of this stake in the secondary. Therefore, part of the wager here is that the Shunwei sale is innocuous and not a harbinger of bad news for Huami. To reiterate I don’t have any special insight but the details above lead me to favor this conclusion.
As mentioned at the onset, the Huami-Xiaomi relationship is very important. Huami could be illustratively described as a subsidiary-of, extension-of, JV-with, or development partner of Xiaomi. I’m certain Huami leadership would object to such a characterization but Huami’s self-branded revenue in 4Q’18 was rmb 371.5 mm vs. total revenue of 1,225 mm (i.e., HMI earned more than twice as much from selling Xiaomi-branded products than its own Huami branded products). The two companies (HMI and Xiaomi) operate under a cooperation agreement that is terminable at any time by Xiaomi and has a three year term expiring late 2020. The Xiaomi relationship is risk factor #1 in the filings and more information can be found there. Together, Xiaomi and Huami are co-owners of certain patents related to the wearable products and Xiaomi could potentially self-develop products. Additionally, Huami leverages Xiaomi’s extensive global distribution channel. Arguably (or pessimistically), Huami has been built at least in part on the back of Xiaomi and perhaps Xiaomi could decide they wish to take more profits for themselves or object to Huami earning a 10% margin (higher than Xiaomi’s own margin) and demand that Huami sell cheaper to drive volume into the Xiaomi ecosystem. In reality, Chinese internet companies often have dependent relationships (e.g., Tencent + a bunch of companies) and the founders of these companies (Xiaomi and Huami) have a relationship and the nature of that relationship may be as important as any commercial factors. Xiaomi has also incubated various other companies in its ecosystem and the codependence here isn’t unique. Huami also is bringing specific wearables R&D, manufacturing, and customer service expertise to the table. I haven’t yet spoken to the company who could perhaps shed additional light on the current status of the Xiaomi relationship directly; however, I generally see no reason for undue fear and I believe the two companies will continue in what is described as a mutually beneficial relationship.
Margin and profits
Fitbit has long been such an unprofitable company that’s its worthy of reiterating that Huami is profitable, which is impressive when considering the low ASPs on the producs. I’ll leave aside a full margin comparison, but in general Huami has (a) much lower gross margin as compared to competitors like Fitbit and Garmin but has (b) much lower S&M costs likely due to the Xiaomi distribution benefits and a price point that provides its own marketing, coupled with (c) lean op-ex / R&D which often is seen in China tech. Margins were roughly 10% over the last couple years. Moreover, FCF (OCF less capex) was roughly US$100 mm last year.
As mentioned in the first paragraph, consensus calls for $1.25 of non-gaap eps in ’19 and $1.50+ in 2020 while topline growth is expected to be >30% annualized through the 2020 period. Attaching a 10x multiple to current year earnings and adding cash gets me 1.25*10=12.5+4=$16.50 share price or +60% upside. Using the trailing FCF figure of $100 mm corresponds to a TTM FCF yield of 17% using market cap and >25% using EV, which seems attractive and compensatory for the risks taken.
Overhang: Perhaps Shunwei seeks to sell off the remainder of their stake, or another large holder sells down.
Something goes awry with the Xiaomi relationship: Perhaps the selling by Shunwei Capital is indicative of a deteriorating relationship and proves to be a sustained overhang. Perhaps Xiaomi demands a lower margin at Huami.? Mitigant: discussed earlier / remains a tail risk.
Trade war? Mitigant: U.S. crossborder business not a key focus, competitors also affected by potential tariffs. Nevertheless, this remains a risk to investment performance.
consumer avoidance of China technology products? Mitigant: Depite Huawei’s difficulties, I don’t see any sign of avoidance of chinese consumer products despite some sensitivity of data collection here.
India or international expansion causes decline in profitability? Mitigant: while investment initiatives could create lumpy margins, the 2017-2018 progression has been smooth, despite a big international push already underway.
Product rollouts: next-gen product rollouts could further accelerate sales.
Reversal of recent events: market receives clarification regarding recent selling pressure.
Longer term, the new tech board in China: This new exchange will roll out in China this year and similar companies to Huami could list at far higher valuations.
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