By Tim Culpan
Investors have been looking for reasons to forgive Xiaomi Corp. for its post-IPO slump. They don’t appear to have found them yet.
Shares of the Chinese smartphone maker reversed a 2.1% gain to plunge as much as 5.5% in Hong Kong on Wednesday morning after the company posted second-quarter earnings. They’ve dropped 47% since the July 2018 listing. The stock had rallied 7% in three days before the announcement, spurring hopes that a bottom had been reached. That’s in doubt again.
Xiaomi’s press release shows the gap in perceptions between the company and investors. Beijing-based Xiaomi proclaimed a “consensus-beating performance,” saying that adjusted net profit exceeded estimates for the first half and second quarter.
That jars with the report from Bloomberg News, which said that net income of 1.96 billion yuan ($278 million) fell short of the average analyst estimate of 2.6 billion yuan. Adjusted versus non-adjusted numbers explain the discrepancy. But the broader point is that Xiaomi is convincing itself that all is good by picking data that suit its thesis, while investors shake their heads in disagreement.
At the heart of the matter is Xiaomi’s business model. Since its IPO roadshow, the company has proudly boasted that it doesn’t make much profit from smartphones, instead using its base of millions of handsets with Xiaomi software installed to deliver ads and other services that provide more lucrative sources of revenue.
I didn’t buy into that thesis, and since the stock’s trading debut, investors haven’t either. They want to believe in Xiaomi. But that’s difficult when the company consistently fails to deliver.
The second-quarter numbers further undercut management’s long-term services strategy. Despite more people holding a Xiaomi phone in their hands, advertising revenue actually fell. Monthly active users of its MIUI interface – which is built over the underlying Android operating system – climbed 34.7% to 278.7 million in the 12 months through June 30. Ad revenue dropped 0.6% to 2.5 billion yuan. In other words, ad revenue per user is sliding. Overall internet services revenue – which includes ads and games – climbed 15.7%, again underperforming the expansion in user base.
Where investors are finding good news is in the “not-for-profit” smartphone segment. The gross profit margin on handsets climbed to 8.1%, the highest in almost two years. That’s curious, given founder Lei Jun’s insistence that they won’t be a money-maker for Xiaomi. (Before the IPO, Lei pledged to limit the net margin on hardware sales to a maximum of 5% in a sign of its commitment to building a service-based business.)
The reason is deceptively simple. Sales of high-end smartphones are looking strong, an indication that consumers are willing and able to pay a premium for good quality devices. Xiaomi doesn’t need to talk down to its customers by saying it will sacrifice handset profits to ensure they get a good price. Xiaomi can also stop talking down to investors by insisting that smartphone profits don’t matter. The second-quarter results show that making money on handsets isn’t incompatible with an increasing user base and happy fans.
The sooner Xiaomi management admits it was wrong and embraces hardware profits, the sooner the shares are likely to recover.