Four years ago, if you had asked investors whether they would want to own a piece of Xiaomi Corp (XIACF -0.47%) or Lenovo Group Ltd (LNVGY 3.01%), most would have picked the former.
At the time, many investors thought Xiaomi would be China's version of Apple. It produced innovative and affordable smartphones on a huge scale. Investors believed Xiaomi would make lots of money from services, move up the value chain, and build a formidable ecosystem like Apple's.
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Lenovo, on the other hand, was doomed to remain a low-margin PC maker in a largely commoditized and shrinking business. However, fast forward to today and many people would say Lenovo is now the better investment. I believe those people might be right. Here's why.
Soft global smartphone demand
The smartphone market is slowing. According to Gartner, shipments of mobile phones worldwide are expected to decline by 0.5% year-on-year to 1.8 billion units this year before returning to slight growth of 1.2% in 2020.
Due to weaker consumer confidence in China, one of the biggest mobile phone markets, and weaker global macroeconomic conditions in general, consumers are holding onto their phones for longer before replacing them.
For a smartphone company like Xiaomi that depends on growth for a big part of its valuation, this is bad news. To sustain the growth that the market expects, Xiaomi needs to either increase its smartphone market share or sell more products in other categories such as in its Internet of Things (IoT) and lifestyle products divisions.
Although management has executed well despite challenging conditions – Xiaomi's smartphone segment sales grew 16.2% year-on-year to RMB 27 billion (US$3.9 billion) in Q1 2019 – the company will have a tough challenge ahead given how competitive Huawei is (as well as other Chinese smartphone manufacturers like Vivo and Oppo) both in China and overseas.
Lenovo has cloud exposure
Although global PC shipments are expected to decline by 0.6% year-on-year to 258 million in 2019, Lenovo fortunately has other divisions that are part of growing fields, such as its data center unit.
China's corporations are moving to the cloud and data center-related companies are reaping the benefits of this shift. For fiscal year 2019, Lenovo's data center group grew 37% year-on-year to US$6.02 billion. Given how many believe cloud adoption in China is still in its infancy, Lenovo's data center division has a lot of growth ahead.
Less money in smartphones
Xiaomi has always tried to sell itself as a services company. It sells hardware at close to cost, making razor-thin margins, and generates the majority of net income from services. Due to its strategy, in the first quarter of 2019 Xiaomi's hardware gross margin was 6% and its internet services gross margin was 67.4%. Yet despite the high gross margins, Xiaomi's customers haven't spent as much money on services as the market was hoping.
The company's internet services revenue amounted to RMB 4.3 billion in the first quarter of 2019, or less than 10% of Xiaomi's total sales of RMB 43.8 billion for the period. As a result, Xiaomi's stock trades around HK$9.50 when it launched its IPO at HK$17 per share last year.
To make a profit, Lenovo just needs to sell computers. Because it has the leading market share globally, it has greater economies of scale than its competitors and benefits from higher margins. This makes Lenovo's cash flows much more secure than Xiaomi.
Foolish takeaway
Although Xiaomi could still be a solid longer-term investment if management continues to execute, Lenovo looks like a better buy because it's hard to make money making smartphones right now. Lenovo, meanwhile, also has more exposure to the fast-growing cloud and the company's economies of scale allow it to earn a profit easier.
A version of article originally appeared on our Fool Asia site. For more coverage like this head over to Fool.hk.en.
