Xiaomi: "Three Arrows" for Reversing the Downturn

Xiaomi is facing numerous challenges that shake the market's confidence in the company, causing its stock price to drop from over HKD 30 to less than HKD 10. So, does Xiaomi at around HKD 10 have investment value?

In the opinion of Dolphin Analyst, Xiaomi below HKD 10 has adequately reflected the market's pessimistic view of the company's numerous challenges. In general, investing is often buying the expectation of the future. Looking ahead to the end of 2022, Xiaomi's numerous challenges are expected to see a turning point in 2023.

What are the main concerns about Xiaomi Group-W.HK in the market?

Challenge 1: When will the continuously rising inventory be digested?

Challenge 2: When will the mobile phone market recover?

Challenge 3: When will profits from car production recover as it has significantly dragged down profits?

On November 23, Xiaomi released its third-quarter report. The specific situation of the company in the third quarter can be read in Dolphin Analyst's commentary titled "[Xiaomi has been lying down for too long, and is finally about to see the "light"] (https://longbridgeapp.com/topics/3680818?channel = t3680818&invite-code=294324)." In this article, Dolphin Analyst mainly combines the changes in the third-quarter report and the industry to analyze Xiaomi's challenges, performance inflection points, and valuation pricing.

Dolphin Analyst believes that Xiaomi needs three "arrows" to reverse its challenges: "inventory digestion, mobile phone shipments recovery, and car production implementation."

First Arrow: Inventory Digestion - Coming into its Own. Xiaomi's continuously rising inventory began to decline this quarter, and Dolphin Analyst defined a real finished-product inventory digestion index ("Inventory-Raw Materials + Impairment Reserves" - unsold finished products and semifinished mobile phones) to track and see the inventory digestion situation of old products while eliminating the influence of hoarded materials.

Dolphin Analyst discovered that Xiaomi's real finished-product inventory decreased by HKD 7 billion in this quarter, significantly higher than the apparent reduction in inventory seen directly by the market. In other words, Xiaomi's inventory digestion has exceeded market expectations. With the digestion of old products' inventory, the market supply and demand are expected to rebalance, and Xiaomi's inventory situation will move towards a reasonable level.

Second Arrow: Mobile Phone Shipments Recovery - Preparing for Growth. In the mobile phone market, the recovery of overseas markets may be prior to the domestic market, and Xiaomi's overseas income accounts for half of its total revenue. At the same time, looking at the share changes in recent quarters, Xiaomi's market share in the EMEA and Latin American regions is still showing an upward trend, highlighting the company's competitiveness, which will benefit from the demand recovery in these regions after the epidemic. At the same time, adjustments to domestic policies will also help to repair expectations in the domestic market, and both overseas and domestic demand may recover in 2023 simultaneously.

Third Arrow: Implementation of Car Production - Anticipating. While Xiaomi's car manufacturing brings expectations, it also brings pressure to the company's performance in recent quarters. In the third quarter, Xiaomi's R&D expenses for smart vehicles and other projects have reached more than HKD 800 million, while Dolphin Analyst estimated that Xiaomi's core operating profit (gross profit minus three fees) in the third quarter was only HKD 1.5 billion. Car making has made a significant erosion to Xiaomi's performance. **"The Third Arrow" in Xiaomi's predicament may have to wait for the landing of cars. While bringing new business to Xiaomi Automobile, it can also digest huge automobile investment. In the face of heavy difficulties, the current time is probably the most difficult time for Xiaomi, but we can gradually see the dawn of the marginal improvement of "The Three Arrows" (①inventory is beginning to be digested; ②expectations of domestic and foreign demand will be repaired; ③the timetable for landing cars is getting closer). At the current price of around HKD 10, the market has already foreseen Xiaomi's "three heavy difficulties". Since it is the most pessimistic and difficult time, leaving enough safety cushions for oneself, what may come next is the landing of "one arrow" and "one arrow", gradually welcoming marginal improvement.

Dolphin Analyst's valuation of Xiaomi's normal business operations (without researching and developing cars in the company): Since the R&D of automobiles occupies a part of the expense, if the R&D expense of automobiles is added back, the operating situation of the existing business can be seen simply. Dolphin Analyst expects that the R&D investment in automobiles will be approximately 3/5/6 billion yuan from 2022 to 2024. The core operating profit after the addition and subtraction can be expected to be 9.1/12.7/17.4 billion yuan in 2022-2024, a year-on-year increase of 40%/37%.

Assuming a 15% tax impact, the corresponding profit in 2023-2024 is roughly 10.8/14.8 billion yuan. Combined with expected growth rate and historical valuation (with reference to the exchange rate of HKD 0.88), a 25-30 times PE valuation reference is given for 2023, corresponding to a market value of HKD 306.8-368.2 billion (HKD 12.32-14.78 per share), with an upside potential of 17.8%-41.3% based on the current stock price.

The following is Dolphin's analysis of Xiaomi's predicament and investment judgment:

Predicament 1: When can the continuously rising inventory be digested?

Inventory turnover days

First, let's take a look at a chart. Xiaomi's inventory turnover days have shown a significant upward trend since 2021. Especially in the past two quarters, Xiaomi's inventory turnover days have exceeded 80 days. In comparison, even in the first half of 2020, when the epidemic had the most severe impact, the company's inventory turnover days did not exceed 80 days. Faced with this continuously rising inventory turnover days, the company's "first" predicament was brought about.

What does inventory turnover days reflect? It directly reflects that Xiaomi's inventory turnover has slowed down, and this time it can no longer push the blame to the supply chain & logistics. This is mainly due to two reasons: ①too much hoarding of goods in the early stage, and the company prepared too many materials (originally targeting over 200 million units in 2021); ②there was a lack of demand recently, and global smartphones have experienced a double-digit decline this year. The imbalance between supply and demand directly led to the squeeze of company materials and a slower inventory turnover. 2) Composition and Trend of Inventory

So, when will the inventory situation improve on the supply side? From an absolute value perspective, Xiaomi's inventory showed signs of improvement starting from the third quarter. At the end of the third quarter, Xiaomi's inventory was RMB 53 billion, a decrease of RMB 5.8 billion QoQ, the first quarterly QoQ decline this year.

Of course, we can also see that the company made nearly RMB 2.9 billion in impairment provisions this quarter. But even if the impairment part is added back, the company's inventory still declined this quarter, indicating that its inventory digestion is working to some extent.

However, since the inventory items include raw materials, finished products, work in progress, impairment provisions etc., breaking down the structure of inventory can reveal more changes in the company's operations.

From the chart, we can see that Xiaomi stocked up a lot in the first three quarters of 2021, with raw materials remaining above RMB 20 billion, and when market demand weakened, stocked raw materials turned into a large amount of finished products. Therefore, Dolphin Analyst believes that after removing the impact of raw materials and impairment provisions from inventory, the company's inventory digestion can be seen more clearly.

3) Inventory Digestion

The raw materials in Xiaomi's inventory increased in the third quarter, and part of it was prepared for materials such as the SoC chip for the release of the Mi 13 product line. Regarding the inventory digestion of old products, Dolphin Analyst thinks it's clearer to look at the figure "Inventory - Raw Materials + Impairment Provisions".

After eliminating the impact of raw materials, Xiaomi's total inventory has been rising quarter by quarter since the beginning of 2021. But this third quarter is the first time that inventory began to decline in seven quarters. Dolphin Analyst thinks that after the company's quarterly shipments exceeded 50 million units in the second quarter of 2021, the company had full confidence in future sales and set unreasonably high shipment targets, which strengthened its stocking. However, later it suffered from the "Rebirth of Honor" and "market weakness", and the previously stocked items gradually piled up into a large amount of inventory.

But the good news is that we see a glimmer of hope in inventory digestion this quarter. After removing the impact of raw materials and impairment, Xiaomi's inventory this quarter declined to RMB 36.3 billion, a decrease of RMB 6.6 billion QoQ (much higher than the decrease in inventory), indicating that Xiaomi's inventory digestion may be better than market expectations and is expected to return to normal levels in the next 1-2 quarters.

Dilemma 2: When will the smartphone base show signs of recovery?

Returning to earnings, the market's attention to Xiaomi is mainly divided into two parts: when will its existing business stabilize and recover, and when will new businesses such as cars go into mass production and increase revenue? **

Currently, the main contribution to performance comes from existing businesses, while new businesses such as automobiles have to some extent imposed a burden on performance. Looking at the revenue structure change of Xiaomi, the intelligent smartphone business has always contributed to over 60% of its revenue. Therefore, the focus is still on the basic business of smartphones when will Xiaomi's existing business stabilize and rebound.

Dolphin Analyst combines industry and company perspectives to look at the "second arrow" of Xiaomi's smartphone business.

1）Changes in the industry landscape of the smartphone market

①Global Smartphone Market: Still Weak. In the third quarter, the decline continued from the previous two quarters, with global shipments down 8.8% YoY to just 302 million units.

②Xiaomi Market Share: Still Steady. Due to the early release of the iPhone 14 series, Apple grabbed more market share in the third quarter this year. By contrast, OV's market share saw a significant decline YoY in the third quarter, but Xiaomi still maintained a 13.4% market share.

So why does Xiaomi's market share outperform OV, another domestic Android manufacturer? This is mainly due to Xiaomi's globalization strategy.

Ignoring the new Apple devices, comparing the changes in Android manufacturers, it can be found that Xiaomi and Samsung's market share were relatively stable this quarter, while OV's market share declined significantly this quarter. Dolphin Analyst believes that this is mainly due to the different shipment structures of each manufacturer. OV has a higher proportion of shipments in China, while Xiaomi and Samsung have more overseas layouts. Looking at the changes in market share structure, Android manufacturers performed better in overseas regions, while the Chinese Android market is still mired in double-digit declines in the third quarter.

2）Changes in Xiaomi's company perspective

In the third quarter, Xiaomi's mobile phone shipments were 40.2 million units, down about 3.7 million units YoY. Combining IDC/Canalys data, Dolphin Analyst estimates that Xiaomi's third-quarter decline in shipments was mainly due to 2 million units in China and 2 million units in India. Therefore, Xiaomi's smartphone shipments in other overseas regions (excluding India and China) have basically stabilized in the third quarter.

①Especially in the EMEA region (Europe, Middle East and Africa), Xiaomi's mobile phones had the most significant increase in the third quarter, with a 9% YoY growth. In the EMEA region, where mobile phone sales are declining, Xiaomi's market share continued to rise (+3pct), surpassing Apple to become the second-largest smartphone manufacturer after Samsung. ②In the domestic market, three Android manufacturers have all seen a nearly 20% decline this quarter, and there is no sign of improvement in demand. The significant decline of Android manufacturers in the third quarter is mainly due to the overall sluggish mobile phone market and the impact of Apple's new machines.

However, in terms of segmented fields, since Xiaomi began its high-end strategy, it has gradually gained a foothold in the high-end market. Although it is still clearly behind Apple, it is not behind other Android manufacturers, and the high-end strategy still has some effect.

3) In the opinion of Dolphin Analyst, the "second arrow" for Xiaomi's dilemma to be reversed is the rebound of Xiaomi's mobile phone sales. In the mobile phone market, the recovery of overseas markets may be prior to the domestic market, and Xiaomi's overseas revenue accounts for half of its total revenue. At the same time, looking at the changes in market share over the past few quarters, Xiaomi's market share in the EMEA and Latin America regions is still showing an upward trend, highlighting the company's competitiveness and benefiting from the demand recovery in these regions after the pandemic. At the same time, adjustments to domestic policies will also help repair market expectations and is expected to achieve demand-side recovery in 2023.

Dilemma 3: Will car production affect earnings and when will it return to growth?

1) Xiaomi cars are the "third arrow"

Since announcing car production, Xiaomi's stock price has fallen by more than 50%. Undoubtedly, Xiaomi's entry into car production is bound to increase the company's expense items, and it will continue to put pressure on earnings before the launch of Xiaomi cars.

Looking at this year's third quarter, Xiaomi's research and development costs for smart cars and related projects have reached more than 800 million yuan in just one quarter. Although more than 800 million yuan is not too large compared to Xiaomi's quarterly revenue of 70 billion yuan, due to the low profit margin of Xiaomi itself, the cost of more than 800 million yuan has not brought any output, and will greatly erode current profits. Dolphin Analyst estimated Xiaomi's core profit in the third quarter to be 1.51 billion yuan. Without the use of more than 800 million yuan for car production, the core business profit will increase by more than 50%.

Xiaomi still expects to launch cars in the first half of 2024, and the costs of car production will continue to erode Xiaomi's current profits. The "third arrow" in Xiaomi's dilemma may have to wait until cars are launched to digest the investment in car production.

2) Earnings forecast and valuation

①Revenue expectations: Dolphin Analyst expects overseas markets to recover before the domestic market, and also expects the domestic market to see signs of the rebound before the Q3 2023; ② Expectations for gross profit margin: Dolphin Analyst expects that as inventory is digested, the company's inventory will return to a reasonable level and the company will reduce its inventory impairment. The reduction in inventory impairment and the recovery of the market will help to improve the company's gross profit margin, and it is expected that the gross profit margin of smartphones will return to above 10%.

③ Expectations for expenses: With the recovery of the market, sales expense ratio and management expense ratio are expected to decrease under economies of scale. However, research and development expenses will remain at a high expense ratio before the mass production of cars.

④ Calculation of core operating profit: Dolphin Analyst expects that Xiaomi's performance will face a trough in 2022, and a recovery will come in 2023. Since cars have not been launched, only the existing business (smartphones + IoT + internet services) has been calculated separately for the expectations of 2024-2026.

⑤ Valuation judgment:

A) Valuation of normal business operations itself (not considering the automotive business, i.e., no additional valuation is given to the automotive business, but also not based on capital depreciation due to investment failure): Since the automotive research and development business occupies a portion of the expense items, if the automotive research and development expenses are added back, the business operation of the existing business will be observed solely. Dolphin Analyst expects that the automotive research and development expenditures will be around 3/5/6 billion in 2022-2024. The expected core operating profit after adding back the expenditure is 9.1/12.7/17.4 billion yuan from 2022 to 2024, representing a year-on-year growth of 40%/37%. Assuming a 15% tax impact, the corresponding profit in 2023-2024 is approximately 10.8/14.8 billion yuan. In combination with expected growth and historical valuation (with a reference exchange rate of 0.88), a 25-30 times PE valuation reference is given for 2023, corresponding to a market value of 306.8-368.2 billion Hong Kong dollars (12.32-14.78 Hong Kong dollars per share). Based on the current stock price, there is still an upside potential of 17.8%-41.3%.

B) Valuation with the influence of car manufacturing (if the expected car research and development fails in 2024): This is the most pessimistic hypothesis and is only used as a bottom reference. The significance is mostly to reflect the basic fundamental risks priced at this level. Since the automotive research and development expenses are sunk costs that have already been invested, Dolphin Analyst expects that the core operating profit from 2022 to 2024 will be 6.1/7.7/11.4 billion yuan (without adding back automotive research and development expenses), representing a year-on-year growth of 25.5%/48.5%. Assuming a 15% tax impact, the corresponding profit in 2023-2024 is approximately 6.55/9.7 billion yuan. In combination with expected growth and historical valuation (with a reference exchange rate of 0.88), a 25-30 times PE valuation reference is given for 2023, corresponding to a market value of 186.1-223.3 billion Hong Kong dollars (7.47-8.97 Hong Kong dollars per share). **

Dolphin Xiaomi Group Historical Article Review:

Earnings Season

November 24, 2022 Phone Meeting: "Inventory Starts to Digest, Supply and Demand Reaching Balance (Xiaomi 22Q3 Phone Meeting)"

November 23, 2022 Earnings Review: "Xiaomi Fell Too Long, Finally Seeing the 'Light'"

August 19, 2022 Phone Meeting: "After the Overall Decline in Earnings, How Will Management Explain (Xiaomi 22Q2 Phone Meeting)"

August 19, 2022 Earnings Review: "Layoffs Cannot Rescue Xiaomi's Difficulties"

May 19, 2022 Phone Meeting: "What Does Xiaomi Management Say About Its Internal and External Difficulties? (Xiaomi 22Q1 Phone Meeting)"

May 19, 2022 Earnings Review: "Internal and External Problems Make Xiaomi Not the Optimal Choice"

March 22, 2022 Phone Meeting Summary: "After a Mediocre Earnings Report, What Does Xiaomi Management Say?"

March 22, 2022 Earnings Review: "Xiaomi is Average: Tasteless to Eat, a Waste to Abandon"

November 30, 2021 Phone Meeting Summary: "With Xiaomi Launching Pure Electric Vehicles, What Will Ideal Auto Rely on for Competition?"

November 23, 2021 Phone Meeting: "Does Shortage Cause Smartphone Decline? Listen to How Xiaomi Management Explains (Xiaomi Phone Meeting)"

November 23, 2021 Earnings Review: "From Ups and Downs, Where is Xiaomi Heading?"

** invite-code=032064)》

Phone meeting on August 26, 2021, "What did Xiaomi's management say after the beautiful report card?" (https://longbridgeapp.com/topics/1079898?invite-code=032064)

Commentary on the financial report on August 25, 2021, "Don't Doubt Anymore, Xiaomi Ascends to the ‘God Altar’ Again" (https://longbridgeapp.com/topics/1079597?invite-code=032064)

Commentary on the financial report on May 26, 2021, "With Impressive Record, Will Xiaomi Be Tapped by Davis Double-Clicks?" (https://longbridgeapp.com/news/36690846)

Phone meeting on March 25, 2021, "How Does Xiaomi Answer the Questions about Chip Shortage, Slow Internet/IoT, and Car Making?" (https://longbridgeapp.com/topics/719211?invite-code=032064)

Commentary on the financial report on March 24, 2021, "What's Wrong with Xiaomi, with Greatly Low Expectations?" (https://longbridgeapp.com/news/31865503)

In-depth Analysis

June 17, 2022, "Consumer Electronics Market is Ripe: Apple Keeps Tough, Xiaomi Endures Hardship" (https://longbridgeapp.com/topics/2917540)

December 1, 2021, "After the Conquest by Honor, Xiaomi Encounters Another 'Life-and-Death Crisis'" (https://longbridgeapp.com/news/51240042)

November 24, 2021, "What Went Wrong with Xiaomi After a Deep Dive?" (https://longbridgeapp.com/topics/1370347?invite-code=032064)

June 11, 2021, "2021, Xiaomi's Transfiguration | Dolphin Analyst" (https://longbridgeapp.com/news/37872830)

March 16, 2021, "Dolphin Analyst | Xiao-mi Finally Out of Bad Luck?" (https://longbridgeapp.com/news/31271114)

Live broadcast

August 19, 2022, "Xiaomi Group-W (01810.HK) 2Q2022 Performance Phone Meeting" (https://longbridgeapp.com/lives/115331?channel=n115331) On May 19, 2022: Xiaomi Group-W (01810.HK) 2022 Q1 Results Conference Call

On March 22, 2022: Xiaomi Group (1810.HK) 2021 Q4 and Full Year Results Announcement

On December 28, 2021: Lei Jun x Su Bingtian · Xiaomi New Year Live Broadcast

On November 23, 2021: Xiaomi Group (1810.HK) 2021 Q3 Results Conference

On September 15, 2021: Unleash the Magic - Xiaomi New Product Launch Event

On August 25, 2021: Xiaomi Group-W (01810.HK) 2021 Interim Results Release Conference

On August 10, 2021: Lei Jun's Annual Speech 2021

On May 26, 2021: Xiaomi Group (1810.HK) 2021 Q1 Results Conference Call

On March 30, 2021: Xiaomi Spring New Product Launch Event Day 2

Risk Disclosure and Disclaimer for this article: Dolphin Research's Disclaimer and General Disclosure