Huami (NYSE:HMI), the Chinese wearables maker that produces Xiaomi's (OTC:XIAC.F) devices, Timex devices, and its own Amazfit products, recently turned in a mixed second-quarter report.

Its revenue rose 9% annually to 1.14 billion yuan ($161 million), which marked its slowest growth rate since its IPO two years ago and missed estimates by $2.4 million. Its adjusted net income dropped 83% to 19.1 million yuan ($2.7 million), or $0.04 per ADS, but still met expectations.

I once declared Huami had a "much brighter future" than Fitbit (NYSE:FIT), which lost more than 80% of its value over the past five years as it ceded the market to its competitors. Huami's support from Xiaomi, which owns a major stake in the company, also enabled it to stay profitable as Fitbit drowned in red ink.

Huami's Amazfit T-Rex.

Image source: Amazfit.

However, Huami's sluggish second quarter might remind investors of Fitbit's slowdown in 2016, which caused its stock to fall off a cliff. Could Huami's stock, which remains slightly above its IPO price, follow a similar trajectory?

Why did Huami's revenue growth decelerate?

At first glance, Huami's weak revenue and shipments growth during the second quarter likely stunned investors:

Growth (YOY)

Q2 2019

Q3 2019

Q4 2019

Q1 2020

Q2 2020

Revenue

37%

73%

72%

36%

9%

Shipments

54%

67%

60%

36%

7%

YOY = Year-over-year. Source: Huami quarterly reports. *Non-GAAP.

Huami mainly attributed that slowdown to the COVID-19 crisis, which had a "significant negative [effect] on retail sales in all areas of the world" across "most product categories."

Huami noted its recovery in China, which reopened many of its stores during the second quarter, was offset by ongoing outbreaks in the Americas and Europe, which kept stores closed and reduced orders for new devices.

On the bright side, Huami claims the supply chain disruptions that occurred throughout the first quarter had been resolved, with "minimal lingering impacts in the second quarter." It's also shifting its focus toward first-party and third-party online sales to offset its loss of brick-and-mortar sales. Huami also claims that "people gaining weight during lockdowns" could spark fresh demand for new wearables after the pandemic passes.

Huami expects its revenue to rise 13%-16% annually in the third quarter, which indicates its second-quarter slowdown was temporary. It didn't offer any full-year guidance, but analysts expect its revenue to rise 16%. By comparison, Fitbit's revenue is expected to tumble 17% this year.

Why are Huami's margins contracting?

Huami's gross and operating margins contracted annually and sequentially during the second quarter:

Period

Q2 2019

Q3 2019

Q4 2019

Q1 2020

Q2 2020

Gross Margin

26.7%

25.2%

23.8%

22.5%

22.3%

Operating Margin

8.9%

11.8%

10.3%

1.9%

0.8%

Net Income Growth* (YOY)

10%

56%

46%

(73%)

(83%)

YOY = Year-over-year. Source: Huami quarterly reports. *Non-GAAP.

Huami generates most of its revenue from Xiaomi-branded products, which are sold at lower gross margins than its own Huami-branded (Amazfit and Zepp) and Timex devices. Huami doesn't regularly disclose its shipments by brand, but it noted its Amazfit shipments grew 30% annually during its conference call.

During the second quarter, Huami's gross margin was "positively affected" by a growing mix of its Huami-branded devices, but that expansion was offset by higher shipments of Xiaomi's devices. Many of Xiaomi's older devices were also marked down to clear the way for its new Mi Band 5.

Huami's operating margin was weighed down by a 32% annual increase in its operating expenses, which reflected higher R&D, talent acquisition, and marketing costs. However, Xiaomi covers all of Huami's overhead costs for its Xiaomi-branded products, while Huami only covers the operating expenses for its own branded devices and Timex's devices.

Therefore, Huami sells Xiaomi-branded devices at lower gross margins with higher operating margins, but it sells its Huami-branded and Timex devices at higher gross margins with lower operating margins.

That messy relationship, along with Huami's reluctance to disclose each brand's operating profits, makes it difficult to gauge its future profit growth. But one thing is clear: Xiaomi's support keeps Huami's profitable. If Huami ever lost its partnership with Xiaomi, its margins would crumble.

Huami didn't provide any bottom-line guidance, but analysts expect a 27% earnings decline this year before stabilizing next year. That's a wobbly outlook for a stock that trades at 21 times forward earnings.

Huami isn't doomed to become the next Fitbit

Huami's second-quarter numbers were disappointing, but its outlook indicates it isn't doomed to become the next Fitbit. Huami's ability to grow in the first half of the year as Fitbit's revenue plunged 23% annually was impressive, and Xiaomi's support should keep it profitable.

I wouldn't buy Huami right now, since its stock doesn't look cheap relative to its near-term growth and challenges, but I also wouldn't write it off like Fitbit -- which would likely be worth a lot less without Alphabet's takeover bid.