Xiaomi – Reality check

There is very little left for investors at $45bn. 

• If Xiaomi can raise money at a valuation of $40bn-$50bn, this will be its greatest achievement to date.
• Now that Xiaomi is the leader in the Chinese smartphone market, it is beginning to turn its eye to other potentially huge markets such as India and Russia.
• Its strength at home lies in two places.
  • First: It sells nicely specified devices at excellent prices.
  • Second: Its media offering is very attractive to Chinese consumers and Xiaomi devices rack up more usage than iPhone in China does.
• Offering nicely specified phones at great prices is a good way to get started but it is a disaster when it comes to making money.
• It is through its second strength which represents the acorn of its ecosystem, that it has a chance to make some real money.
• If it can make its ecosystem popular and demanded, then it can start to raise its prices and it is from there that the profits will come.
• At the moment, I very much doubt that Xiaomi is making any money at all. If it was, it would not be raising funds.
• I suspect that it wants to the money to invest in expanding into these overseas markets.
• Its ecosystem as it stands today is very Chinese centric and to have a chance overseas it will have to develop something that is more to applicable to those markets.
• If it has no ecosystem offering for those markets it will just be a commodity box shifter like every other Android maker.
• That is going to need investment and this is what I suspect the money will be used for.
• However, at a valuation of $45bn investors are already assuming huge success and upside from there looks challenging.
• RFM forecasts that Xiaomi will ship 65m units in 2014E and 85m units in 2015E.
• Assuming that the ASPs are around $250 (its flagship MI4 currently sells for $327), 2014E and 2015E revenues will be $16.3bn and $21.3bn respectively.
• Xiaomi is considered by many to be very like Apple which is currently trading at 2.9x 2014E and 2.6x 2015E EV/Sales.
• Applying this multiple to Xiaomi’s revenues one comes up with a valuation of $51.3bn which is how I suspect the current valuation of Xiaomi has been derived.
• The flaw in this calculation is that Apple trades at this EV/Sales multiple because it has huge margins but Xiaomi does not.
• Looking at its Android brethren, it is unlikely to make more than 4% EBIT margins unless its ecosystem is wildly successful.
• In the best case scenario, this is going to take a very long time and there is a high risk that it never happens.
• Assuming that Xiaomi never makes it past 4% margins then 2014E and 2015E EBIT would be $650m and $850m respectively.
• Putting this against Apples 10.3x 2014E and 9.1x 2015E EV/EBIT gives a valuation of just $7.2bn for Xiaomi.
• Xiaomi is of course growing much faster than Apple but even if I give the company a 300% premium to Apple to account for this, I still only get a $21.6bn valuation.
• This is less than half the valuation that is being thrown around.
• Consequently, money that goes in at $45bn is already paying for huge success in the ecosystem, monetised through high handset margins, all of which is extremely uncertain.
• Hence, the main winners from a fund raising at $45bn will be the existing investors who will be giving away much less equity in return for the cash the company needs.
• I would steer clear of this at any valuation above $21bn.