Pricier than Apple? Xiaomi is again so hot that investors might get burnt

Some fear pursuing a sky-high valuation for a planned blockbuster IPO would be a mistake

Back in 2014, smartphone-maker Xiaomi Corp. became that rarest of unicorns, the most valuable startup in the world, with a $46 billion valuation.

Xiaomi applied a seemingly potent formula for conquering the China market. Its phones had quality features and looks, like those of Apple Inc.’s iPhones, but came with low prices. Adding to the allure, they were sold only online, with flashy marketing events—sometimes featuring co-founder Lei Jun looking like Steve Jobs in a black turtleneck—to stir up interest.

Then Xiaomi’s star dimmed after it missed sales targets, released phones with glitches and endured product delays.

Instead of fading, Xiaomi made a comeback. It doubled down on quality control, ventured into other developing countries for sales and changed tack on marketing to open bricks-and-mortar stores. Mr. Lei is looking to bring his phones to the U.S. late this year.

Now Xiaomi is planning a blockbuster initial public offering of shares, perhaps the biggest the world will see this year. Valuations range from $80 billion to $200 billion, depending on whom you ask.

So is Xiaomi in danger of repeating past mistakes?

Making phones is a brutal business. It requires a sense of tech trends, accurate supply-chain planning and meticulous execution. Miss a beat, you could be finished. That’s why Apple is the most successful hardware company and most valuable company in the world. Very few companies perform so consistently.

I covered telecom equipment makers for The Wall Street Journal in the years leading up to the first iPhone launch in 2007. That year, Nokia Corp. and BlackBerry-maker Research In Motion Ltd. dominated consumer and enterprise handset markets. Motorola Inc., once a crown jewel of American technology, was starting to slip.

A decade later, most of the companies I used to write about have disappeared or shriveled to near-obscurity.

In the case of Xiaomi (pronounced shao-me), some investors caution that pursuing a sky-high valuation would be a mistake. Whether for an unlisted tech startup or company seeking a public listing, a high valuation can bring exacting demands. It leaves little room for error and comes with a huge need for justification, these investors say.

Mr. Lei, Xiaomi’s co-founder, himself announced the ambitious 2015 target that the company later flubbed, raising doubts about its valuation. Stock markets can be unforgiving too.

“The stock market is a very humbling place. If you can’t deliver on your promises, the market is very likely to punish you,” says a chief executive of an asset-management company in Hong Kong. “Lei Jun would be like putting a mountain on his back by pursuing a lofty valuation.”

A person close to Xiaomi says bankers are excited about the IPO because, at its core, Xiaomi is an internet company and so deserves higher valuations than hardware companies.

Xiaomi’s management team proved itself with the 2017 comeback. Its China market share rose last year to 12%, and shipments grew 50% to 96 million units, according to research firm Counterpoint. In the final quarter, research firm International Data Corp. says, Xiaomi beat Samsung Electronics Co. to become the best-selling smartphone brand in the huge, growing India market.

Xiaomi’s revenue reached north of $15.2 billion with a profit of $1 billion in 2017 at the most, according to the company and estimates by bankers and investors.

How does a $1 billion profit justify a valuation of $80 billion or even $200 billion?

The answer depends on whether Xiaomi is a hardware company, as most phone makers are, or an internet company, which is the way the Xiaomi camp sees it.

Hardware companies aren’t favored stocks for fund managers. Three managers told me they wouldn’t buy into Xiaomi’s IPO because the Chinese hardware business is beset with low margins, ruinous price wars and low brand loyalty among consumers.

Xiaomi boosters argue the company isn’t a pure hardware play. Like Apple, they say, Xiaomi has an array of competitive offerings, including internet-connected devices from health-tracking wristbands to rice cookers. Its browser and app store generate advertising and games revenues, and at much higher margins than smartphones.

Apple is valued at $913.17 billion, making its price-to-earnings ratio 18.34. If that’s the model, then Xiaomi, based on its $1 billion profit, should be valued about $18.34 billion, much lower than its current valuation in the private market.

Xiaomi is expected by investment bankers to list both in Hong Kong and in Shanghai or Shenzhen. On the Hong Kong stock exchange, tech stocks have been sizzling hot for two years, and Xiaomi fans want to catch that wave. For example, China Literature Ltd. , an e-book company controlled by internet giant Tencent Holdings Ltd. , is trading at 343.22 times its P/E ratio.

Tencent became China’s most valuable tech company this past year. It trades at 63.7 times its P/E ratio. Even in that case, Xiaomi would fetch $63.7 billion—still far below the $80 billion that many say will be the low-end of the valuation.

Kiranjeet Kaur, an IDC analyst, says Xiaomi has a ways to go before its devices, apps and services form an ecosystem like Apple’s.

Others don’t think it is likely the company will evolve that far. “Xiaomi is not going to become Apple. Nor is it Tencent” with its huge social-media base, says the asset-manager CEO in Hong Kong. “It’s a hardware company.” Source: The Wall Street Journal