|Shares Out. (in M):||25,200||P/E||0||0|
|Market Cap (in $M):||89,520||P/FCF||0||0|
|Net Debt (in $M):||-11,279||EBIT||0||0|
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In case you’ve missed out on some of last week’s tech-world headlines, then you should know that in Q2 Xiaomi has captured the #2 spot in the global smartphone market for the first time in its history, surpassing Apple in the process. This is quite the achievement for a company that’s about to celebrate the 10th anniversary of the launch of its first product next month. But despite the recent media hype and the solid performance of the shares over the past ~2 years, we think Xiaomi is still largely misunderstood by global investors, and that the shares are likely to compound at a high rate for a big part of the rest of the decade.
YesTroy has written-up Xiaomi in January this year. He provided a high-level overview of the company’s founding story, business model, and current KPIs. The write-up was rather short, but we wholeheartedly agree with the crux of the thesis: at some point in the not-so-distant future, Xiaomi will re-rate as a global technology powerhouse rather than a Chinese smartphone manufacturer. Coupled with continued revenue growth and increasing operating leverage, this should create a very nice upside from current levels.
This writeup isn’t a complete investment thesis by any means. Its purpose is to highlight Xiaomi’s unique business model, corporate culture and mission statement, and to intrigue others to do more digging and complete the puzzle. We’d be happy to further discuss any specific issue/topic about the company that isn’t mentioned below in the comments section.
Xiaomi is the fastest-growing smartphone and smart IoT hardware vendor globally. The company operates a distinctive business model combining affordably priced, high-quality smartphones and a smart IoT hardware product ecosystem with Internet services-based monetization. It is led by a visionary leader, Lei Jun, and has a well defined mission statement: “to build amazing products with honest prices so that everyone in the world can enjoy a better life through innovative technology”. Xiaomi operates the largest IoT platform worldwide and owns one of the most impressive VC portfolios on the planet. Notwithstanding all of the above, and despite being one of the most impressive growth stories the corporate world has ever seen (USD $0 to $50B of revs in less than a decade), the shares trade at 21x EV/EBIT on our estimates for current year and closer to 18x on FY22. With underlying revenue CAGR of over 20% over the next 3 years, we think the shares are poised to rerate higher sooner rather than later and that by the end of the decade it’s not unfathomable that we’ll see Xiaomi knocking on the $1T club.
Most of you have probably heard of Xiaomi and associate it with little more than affordable smartphones. The Beijing-based company, which started out by bulk-selling phones in China on weekly online auctions, shipped over 146 million smartphones in 2020 and 49m in Q1-21, representing 12.1% and 14.1% market share, respectively. Impressive as this sounds, especially for a ten-year old company, the reality is that smartphone manufacturers that aren’t named Apple (and to a much lesser extent Samsung), have struggled to generate sustainable profits over the last decade due to intense competition and minimal differentiation. At the end of the previous decade, analysts estimated Apple’s share of the total smartphones profit pool to range between 70% and 90%, leaving very little “meat” for the Android-based manufacturers. Xiaomi was no exception, with gross margins on its smartphone devices ranging from 3% to 13% over the past three years. Despite running a very efficient organisation with around 8.5% of revenues as operating expenses, such a gross-margin profile makes it almost impossible to turn meaningful operating profits on its smartphone division.
However in Xiaomi’s case this is more of a feature than a bug. As a late entrant to the smartphone market, Xiaomi’s founders were already well aware of the industry’s dynamics when the company launched its first smartphone in 2013. The weak economics of selling smartphones were used as a building block in cultivating an innovative business model in which handset sales are viewed as customer acquisition costs for Xiaomi’s advertising platform, gaming and subscription services, and its impressive ecosystem of other internet-of-things and lifestyle products.
Monetising low-to-no margin hardware by selling add-on subscription services and placing ads isn’t unique to Xiaomi. Other companies have implemented a similar strategy with varying degrees of success over the last few years (Roku is one example that comes to mind). The hardware ecosystem on the other hand is quite unique, and might be the most misunderstood and under-appreciated part of the business model.
THE HARDWARE ECOSYSTEM
Xiaomi launched its first smartphone in 2013 with the idea of offering high-end specs at significantly lower prices. They did this by selling via online auctions only, and by settling for lower gross margins. The products were well-received, and within a few months the company started attracting a cult-like following of “Mi-Fans” all around China. A natural step at this point would have been to expand and use a similar strategy with other consumer electronic products — the classic story of the disruptor coming from the bottom and slowly eating everyone else’s lunch.
But Xiaomi’s founders had a slightly different vision. They wanted to create a truly scalable platform, one that can produce dozens of new products in short periods of time, and they wanted every product to have a “mom and dad” behind it, as they believed such an environment is necessary to become a true market leader. They were looking for a way to keep the entrepreneurial spirit going with every new product even as the company grows larger.
One way to do this would be to create a decentralised organisation that cultivates a start-up within a start-up mentality. Some tech firms around the world are currently taking that approach to support the growth of certain products internally (WIX is a fine example of that approach). However, this is very hard to execute and still doesn’t completely solve scalability issues. You can’t cultivate hundreds of different start-ups within one organisation, which was what Lei Jun was aiming for.
In late 2013, Xiaomi’s management began constructing an internal team that will be in charge of investing in hardware start-ups, while providing them with different services and growth opportunities in return for a share of their eventual profits. They came out with the following formula: Xiaomi will identify early stage start-ups that are working on products which could fit within the Xiaomi “ecosystem”. It will consequently participate in the start-up’s early funding rounds, and take an equity stake of around 15%-25% on average (which might get diluted at a later stage). Xiaomi and the start-up then enter into a profit-sharing agreement, where Xiaomi provides services which include branding, online and offline shelf space, marketing services, product advisory and supply chain management.
Clearly, the investment from Xiaomi has significant benefits to the start-up, with the Xiaomi platform acting as an amplifier and almost guarantees at least some initial traction in sales. From Xiaomi’s perspective the benefit is two-fold — it gets to share the profits from selling the products as it expands its own ecosystem’s line of products, while also potentially benefiting from the equity stake in the case the start-up ends up making it on its own, and growing not only within the Xiaomi’s ecosystem (a few good examples for this would be Roborock, Viomi and Zepp).
The team made its first investment in 2015, and only four years later some of Xiaomi’s ecosystem companies directly compete with iRobot (Roborock), Dyson (Roidmi), GoPro (YI Technology) and Fitbit (Zepp), while others are downright market leaders in their respective niches like Ninebot (electric scooters), Yeelight (smart lighting) and ZIMI (power banks). The products are sold online on Xiaomi’s official websites (mi.com), on its fully-owned e-commerce platform Youpin (xiaomiyoupin.com), or on its thousands of retail stores in China, India, and more recently in Europe, Latin America and the Middle-East. It is admittedly hard to keep track of all Xiaomi’s ecosystem partners and products, but recent reports pin the number of current ecosystem partners at just above 300, with only ~100 of them having already launched products. At least eleven of the ecosystem companies have been valued at more than a billion USD in private funding rounds.
Perhaps the nicest visualisation I’ve found for what Xiaomi is doing in so many consumer product categories was in the presentation of an ecosystem company called 1More.
The ecosystem business (referred to as IoT & Lifestyle segment in Xiaomi’s financial reports) is not only firing on all cylinders, but seems to be accelerating, as some of the investments made in 2017 and 2018 reach maturity and dozens of new products are released to the market on a monthly basis. The number of connected devices on Xiaomi’s network (excluding smartphones and laptops) grew from 50 million in May 2017 to 351 as of Q1-21, and the number of users with more than five devices connected to the Mi Home app is approaching 7 million and still growing about 50% year over year. Revenues from this segment grew from RMB 8.7b in 2015 to RMB 67B in 2020, and are on track to cross RMB 85B this year, as some higher-ticket products are launched in Europe and LatAm.
There are also reasons to believe we’ve only started to scratch the surface in terms of the revenue potential from the ecosystem outside of China. Xiaomi doesn’t break down the segment’s revenue by geography, but if we cross the reported numbers with comments made by management in recent interviews, we can estimate that Xiaomi sells around one dollar of ecosystem products for every five dollars of smartphones sales outside China, while in China this ratio is probably close to 1:1. In India, where Xiaomi is the market leader in both smartphones and smart TVs, penetration of most ecosystem products is still in its very early days. The flagship Xiaomi-Youpin store, which opened in Nanjing in 2018 is reportedly showcasing more than 2,500 different products, although it’s not completely clear if all of them actually emerged from the ecosystem.
In its earlier days Xiaomi was often referred to as “the Apple of China”, in part due to its emphasis on a slick and clear design, and in part because, well… it WAS copying plenty of the iPhone’s features. In a way, Xiaomi today is what Apple could’ve become if it was leveraging its brand more aggressively to capture new categories like Smart TVs, Refrigerators, Water purifiers and A/Cs. In terms of strategy, a better comparison to Xiaomi nowadays is probably the Japanese retailer Muji, which is known for a broad range of high-quality and yet attractively priced products.
We don’t expect the full product portfolio to travel from China to India and Europe as well as the smartphone business did (although it might), but the potential for the “job to be done” that Xiaomi is serving here is huge. Given its huge success soi far, it’s no coincidence that Lei Jun defined Xiaomi’s core strategy for the current decade as “Smartphone x AIoT”.
We’ve dedicated this writeup to Xiaomi’s hardware ecosystem because we believe it’s the most fascinating and under-appreciated part of its business. However on a higher-level, we’re getting a great deal simply by investing in one of the most loved and fastest growing consumer brands in China, India and South-East Asia, probably the most important consumer markets in the current decade, with an embedded upside option for the rest of the world.
Analysts still view Xiaomi as a smartphone manufacturer with an ambitious plan to monetise users via internet services. They seem to downplay the ecosystem, which is what really differentiates Xiaomi from the rest of the pack. They also ascribe close to zero value for the entire hardware business in their models, which is probably another reason we get a pretty sweet deal here. But perhaps most importantly, Xiaomi has a purpose, and companies with a (real) purpose tend to have more motivated employees and internal (and external) support to make tough decisions that will ensure their long-term success. We are well aware that grandiose quotes from CEOs should be taken with a grain of salt, but we did think this one below will be an appropriate way to end this section:
“From the Ford Model T to the rapid adoption of PCs, from Walmart to Costco, history shows that more efficient businesses tend to win over time. A company that truly achieves world-class efficiency will have the ability to navigate through economic cycles, seize new opportunities emerging in the industry, and maintain sound, long-term operational performance. We believe strongly in our mission to relentlessly build amazing products with honest prices to let everyone in the world enjoy a better life through innovative technology.” — Lei Jun, co-founder and CEO.
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