Xiaomi IPO: What Investors Need to Know

Xiaomi is a company investors need to know if they're interested in either China or technology. Founded in 2010, Xiaomi is the fastest-growing smartphone vendor in the world, and currently the fourth-largest by market share.

As one of China's "unicorns," it will also be going public soon, likely in July.

The initial public offering (IPO) date has been delayed over valuation haggles with investors. While the smartphone giant initially hoped to raise $10 billion at a $100 billion valuation, it now looks as if it will have to settle for a $6 billion raise at a valuation range of $54 billion to $70 billion.

That's quite a huge gap, and says a lot about this unique company. At a lower valuation, is Xiaomi a bargain, or just an another overhyped hardware company?

Image source: Xiaomi.

Unique "triathlon" business model

Xiaomi was founded by Lei Jun and a small group of engineers and designers with the goal of making high-quality smartphones for under $300; "Amazing products at honest prices" is the company's slogan. The company is dedicated to low costs through efficiency; its mostly online business model limits its retail footprint and marketing costs. The company has cultivated a fan base called Mi Fans, who it says are "intensely loyal," and who are very active on Xiaomi's message boards. Mi Fans often deliver feedback and feature requests directly to the product development department.

The company is so dedicated to its low-cost model that management has vowed to limit net margin on its hardware to 5%. That's right: If the company suddenly sees itself becoming too profitable, it vows it will return the cash to users. That might make investors cringe, but it's music to the ears of consumers -- and it's consumers who Xiaomi is clearly looking to please.

There's an interesting strategy here. Cultivating a large base of smartphone customers, Xiaomi has expanded into selling internet services (including advertising and online gaming apps), as well as other consumer hardware. The company has invested in over 90 other companies, across phone accessories (such as selfie sticks and chargers), Internet of Things (IoT) "smart" devices (air purifiers, rice cookers, security cameras), and lifestyle products (toothbrushes, pillows, and more). So investors shouldn't confuse the 5% hardware margin with the overall company margin; the internet services segment generates a huge gross margin of over 60%, and it's growing as a percentage of revenue.

The combination of smartphones, ancillary hardware, and internet services is what management calls its "triathlon" business model.

Explosive growth

Xiaomi has the fourth-highest market share both globally and in China. While that may seem underwhelming, remember that Xiaomi is a very young company compared with global phone giants, and it is also the highest-growth vendor of them all.

In 2017, Xiaomi grew revenue a whopping 67.4% over 2016. Not only did Xiaomi increase its Chinese market share from 8.9% to 12.4%, but the company also became the No. 1 smartphone vendor (by volume) in India, another high-growth emerging market.

Another plus is that the company seems to be generating operating leverage, expanding operating margins as it grows:

Data source: Xiaomi stock-exchange filings. Revenue figures are in yuan.

The margin expansion is likely due to the increased proportion of services revenue, which Xiaomi has impressively grown as a percentage of its business over the past two years:

Data source: Xiaomi stock-exchange filings.

The founder gets how much?

The fates of most young companies (if Xiaomi can be called one) are largely determined by a young founder or management team, for good or ill.

Make no mistake, co-founder Lei Jun will control this company. As of the most recent filing, Lei will own about 29.4% of shares outstanding after the IPO. And by virtue of the dual-class share structure, he will control over half the voting rights.

Also eyebrow-raising was the fact that in early 2018, Xiaomi's board awarded Lei $1.5 billion in stock. While this will be worth a bit more or less depending on the ultimate IPO valuation, it comes with no strings attached, or benchmarks that need to be reached. The award was given by the board, headed by another co-founder, Lin Bin, compensating Lei for his "contribution to the company."

Hmmmm.

Still compelling despite wrinkles

Initially, Xiaomi will only be traded in Hong Kong; it's unclear whether there will be American Depositary Receipts available for U.S. investors. In order to buy Xiaomi at present, you'll have to check with your broker to see if you have access to the Stock Exchange of Hong Kong. If you do, you'll also have to contend with exchange rates between Chinese yuan, Hong Kong dollars, and U.S. dollars.

Despite some questionable corporate governance, I think Xiaomi's story is still compelling. While investors are clearly concerned about its margin profile, Xiaomi's model is to dominate the low-end smartphone market globally, then sell accessories and high-margin apps on a large installed base. It's remarkably similar to Apple's (AAPL 1.27%) services revenue model, only on a mass-market level.

Based on 2017's revenue of just over $17 billion, Xiaomi's discussed valuation range would be only about 3.1 to 4.1 times sales. By comparison, Apple trades at about 3.6 times sales. While Apple is obviously much more profitable, it is not growing nearly as fast, nor does it have Xiaomi's potential runway in cost-sensitive emerging markets.

All this is to say Xiaomi will make headlines once shares list.