Xiaomi’s initial public offering in Hong Kong has attracted a lot of attention. One of the interesting debates centers on how the company should be valued.
If Xiaomi is viewed as a smartphone company, then its valuation of at least 39 times earnings doesn’t seem justified given that Apple’s price-earnings multiple is only in the teens.
It’s also not quite appropriate to compare Xiaomi with internet giants such as Tencent, Alibaba and Amazon as it is basically a hardware company.
So how could Xiaomi justify its seemingly expensive valuation?
Founder Lei Jun said of his company: “We are a rare company that combines hardware business, internet business and e-commerce business into one.”
In my view, Xiaomi can be likened to US warehouse retailer Costco.
Costco, which has about 500 stores in the United States, has a market cap of over US$90 billion, corresponding to a P/E ratio of 35 times, far above that of other supermarket companies like Walmart (19 times) and Kroger (14 times).
Costco is considered to have a chic business model. Its share price has jumped more than sixfold in the last decade, regardless of the competition from e-commerce players such as Amazon.
In fact, Costco earns little profit from selling goods. It has clearly stated that the gross margin of its goods is capped at 12 percent, while its net profit margin is close to zero after various costs are deducted.
Costco makes money from membership fees and commercial cooperation with third-party service providers such as credit card companies.
It is one of the very few supermarkets that have adopted the membership system. Customers have to become a member first. It charges an annual membership fee of US$120 for gold star executive members and US$60 for gold star members.
With about 35 million members, the company collected US$2.6 billion in membership fees last year. This is where most of the profit comes from.
Why would consumers want to pay a membership fee when there are so many supermarkets and convenience stores?
Because they are able to buy products of better value with the same budget given the zero net margin pledge.
Also, Costco can secure better prices from suppliers as it has a large number of loyal members. It can further cement customer loyalty with better pricing.
Currently, goods cost one-third less at Costco when compared to rivals.
The amount of money a family can save at Costco in a year could be several times the cost of an annual membership fee.
Likewise, Xiaomi offers smartphone and other hardware products with a gross margin of 10 percent, compared with 40-60 percent for iPhone and over 30 percent for a Samsung handset. In fact, it says the net profit margin of its products will never exceed 5 percent.
That being the case, consumers can be assured of good quality products at the best price.
Lei, in fact, admitted that Costco was one of the companies that inspired him to create Xiaomi and offer consumers better products at affordable prices.
Currently, Xiaomi has over 190 million users worldwide. The problem is, hardware now accounts for over 90 percent of its revenue.
Can Xiaomi find other ways to monetize its customer base?
The company intends to generate profit from internet services, which only represent a tiny fraction of its revenue so far.
Before Xiaomi finds that magic formula, perhaps it should trade at a 30 percent discount to Costco’s PE level, or around 24 times earnings.
This article appeared in the Hong Kong Economic Journal on June 26
Translation by Julie Zhu
[Chinese version 中文版]
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