Xiaomi — a Chinese company that is best known for cheap smartphones but makes any number of other somehow smart things, from a smart digital scale to a smart rice cooker — is preparing for a mega IPO. As recently as May, it was gunning for a $100 billion valuation as it sought to raise $10 billion in Hong Kong. It was only four years ago that it was valued at $45 billion, still a lofty figure, in a fundraising round. It seems like, between May and now, Xiaomi has realized there is no way it will convince investors it’s worth $100 billion. Instead, it’s now looking at a valuation of $70 billion to $80 billion.
The new target is still a stretch built on the rosiest of rosy projections — the bottom end of the range is a large enough figure to make the IPO the biggest since Alibaba’s 2014 stock market debut. A handy calculator built by Reuters Breakingviews lets you play around with numbers to see how hard a sell a $70-something billion Xiaomi would be. The default assumptions are more than lavish. The company would fetch the midpoint of the target range if 1) it continues to grow revenue from hardware sales by 70 percent at a net profit margin of 5 percent this year 2) it doubles revenue from the internet business at a net profit margin of 35 percent 3) a multiple of 24 is applied to 2018 net profit in the former segment and 4) the latter is valued at 38 times earnings.
Although only sky seems to be the limit when it comes to the valuations of tech stocks, particularly Chinese ones, a price-to-earnings ratio of 24 for the hardware division would be hard to justify. Whether Xiaomi can sustain 70 percent revenue growth annually for that business is another question. Apple, which Xiaomi aspires to be, is trading on less than 20 times projected 2018 earnings. As hard as Xiaomi tries to emulate Apple, the Cupertino, California, company is a vastly different proposition than Xiaomi. The Chinese group is predominantly a maker of low-margin hardware, earning 90 percent of revenue from that business, whereas Apple is far more diversified, with high-margin software and services now making up about a quarter of its top line. A multiple of 38 times for the software segment makes more sense, only because this is a much more profitable area where you can pretty much put any number on a popular company, but that doesn’t mean it is sensible either. For starters, Facebook trades on less than 25 times and so does local peer Baidu.
With these assumptions, a $75 billion valuation would translate into more than 38 times overall earnings, an outrageous figure, given Xiaomi would still be nothing but a hardware maker even if software revenue leaps 100 percent this year. The PE ratio for Samsung Electronics, a far purer hardware company than Apple, is not even 10, although granted, its shares are discounted because of risks including poor governance.
But then, corporate governance is also a potentially troublesome area for future Xiaomi shareholders. The company’s stock on offer in Hong Kong has a dual-class structure, giving CEO Lei Jun and co-founders way more voting power per share than minority shareholders. And in theory, the group can convene a board meeting with Lei and only one other director. All this raises governance red flags, which is a good enough reason Xiaomi’s share price should include some discount, rather than command an unreasonable premium.
Xiaomi has been growing extraordinarily fast, and this may help lure investors even at a ludicrous valuation. But anyone falling for that should brace for a big setback when all the euphoria fades and reality sets in.