Inventory turnover has been completed, and the write-back of impairment has increased profits (Xiaomi 2Q23 conference call)

Xiaomi Group (1810.HK) released its second quarter earnings report for 2023 (ending in June 2023) after the Hong Kong stock market closed on the evening of August 29, 2023. The key points of the conference call are as follows:

1. $ XIAOMI-W(01810.HK) Conference Call Highlights:

1) Inventory Situation: Both Xiaomi's own inventory and channel inventory have been fully adjusted.

2) Gross Margin: Inventory impairment reversal and exchange rates have contributed to the increase in gross margin. The company's inventory depreciation in this quarter is about 3.3 billion yuan.

3) Indian Market: The company faced significant pressure in the second quarter, but a rebound is expected in the third or fourth quarter.

2. Xiaomi Conference Call Transcript

2.1 Management Speech

From the perspective of management, we are satisfied with the performance of the second quarter because almost all financial indicators have shown remarkable improvement, including increased gross margin, reduced expenses, significant inventory reduction, and substantial increase in profit margin.

Some friends may have questions. First, why has Xiaomi's financial performance changed like this? Second, is the change in Xiaomi's results sustainable in the future? I will answer these two questions next.

From a macroeconomic perspective, although the global macroeconomy is gradually recovering this year, the pressure is still significant. According to the report released by the IMF, global economic growth this year is likely to slow down to 3%. However, one advantage is that the easing of global inflationary pressures is higher than expected.

The global smartphone market is still in a downturn this year. In the first half of the year, the global smartphone market declined by 12% YoY, and the Chinese market declined by about 5%. We believe that the rate of decline will slow down in the second half of the year, possibly entering single-digit decline. Despite the lack of significant improvement in the overall external environment, Xiaomi's financials have undergone significant changes. We believe that this is not due to external factors, but rather internal changes, mainly in two aspects.

The first aspect is the timeliness and correctness of the adjustment of our operating strategy. Last year, apart from recognizing the pressure from the overall financial environment, we also predicted that this year would pose significant challenges. Therefore, we timely adjusted our operating strategy to focus on both scale and profitability. After the first year of adjustment, the development of each business line has been very balanced, and we have executed the group's strategy very well. The comprehensive capabilities of the second Xiaomi have been greatly improved through management upgrades and other measures over the past few years. I even believe that a qualitative change may have occurred. At the same time, I believe that the improvement in operational performance based on these enhanced capabilities is sustainable. Let me briefly introduce the operational performance in the second quarter.

In the second quarter, revenue reached 67.4 billion.

The gross margin reflects the overall competitiveness of the company, reaching a historic high of 21%.

In terms of expenses, you can see that R&D investment continues to increase, but the expenses of existing businesses decreased by 1.1 billion compared to the second quarter of last year, indicating that the effects of cost reduction and efficiency improvement have already emerged.

Profit reached 5.1 billion, a year-on-year increase of 147%, which is approximately 2.5 times the same period last year. At the same time, you can see that the level of profitability in the first half of this year is basically on par with last year's full year.

Investment in new businesses continues to increase. The investment in new businesses is approximately 1.4 billion, slightly lower than the internal target in the original budget, which indicates the high efficiency of investment in new businesses. The profit from existing businesses reached 6.5 billion in the second quarter.

High-end strategy:

This year, Xiaomi has maintained its position in the top three in the global smartphone market, achieving significant breakthroughs in the high-end segment. In the Chinese mainland market, the market share of smartphones in the price range of 4,000 to 6,000 yuan has increased from 6.5% to 12.7%, roughly doubling. At the same time, the internal proportion has also increased by 3.3% to reach 20%. This has also driven the ASP to increase to 1,112, especially the ASP of smartphones in the Chinese mainland has increased by 24% year-on-year.

As you can see, when it comes to the second generation of foldable screens, we proposed that thinness is the direction of future foldable screens. Therefore, the second generation of foldable screens is the thinnest and lightest in the world. This year, you can see that a series of new products released by other companies have followed this direction. However, we believe that thinness alone is not enough for the future. It must be both thin and versatile, meaning that a foldable phone should first be a versatile flagship phone, and then a foldable phone.

This time, you can see that this product fully embodies the concept of the entire product. Currently, there are several excellent technologies. One of them is the hinge, which is crucial for foldable screens. Therefore, we have introduced a self-developed dragon bone hinge. In addition, we have also introduced a dragon scale fiber material. Currently, this product is in high demand. The combination of these two technologies has achieved a product that is both thin and sturdy. At the same time, for the first time, we have equipped the foldable screen phone with four cameras, especially the periscope lens, and it is equipped with Leica's full focal length quad-camera, making it the only product of its kind in the world. At the same time, you can also see that the battery capacity has increased significantly, and the battery life has also greatly improved. I have been using this phone myself. I switched from the original Xiaomi 13 Ultra to the K60 Supreme Edition, and then to the MIX fold3. After using these three phones, I have not experienced any impact on battery life, which means that foldable screens have completely solved some of the shortcomings of previous foldable screens in terms of functionality. The overall competitiveness of the product will reach a new height. However, there is currently a severe shortage of goods. If we are not conservative at the beginning, I believe its sales will be even higher.

Core Technology -

In the extremely difficult internal and external circumstances last year, Mr. Lei firmly stated that he would continue to invest in the future, that is, invest heavily in technology, and believe that with the investment in technology, Xiaomi's return may be faster than monthly installments when the market environment improves.

Everyone also saw that at Mr. Lei's press conference in August, he also talked about the overall strategic upgrade of Xiaomi and timely put forward Xiaomi's technological concept, which is to "persist in long-term investment in technology that has long-term value for human civilization." Specifically, I think there are several aspects that everyone is particularly concerned about. The first is AI, and the second is robotics.

AI progress is very fast. Now the AI team has reached about 3,000 people, and there are clear directions for the development of large models, which are "lightweight and localized deployment." This is a path based on the characteristics of Xiaomi's entire business. And the progress is also very good. Based on such large models, we rank first in the world's authoritative list of large models with billions of parameters. At the same time, the large models on the mobile side have been successfully run in some scenarios, comparable to some cloud-based computing power sharing. At the same time, Xiao Ai has also been upgraded and invited for testing, and the recent feedback from the testing is very good.

At the same time, we also pay special attention to investment opportunities in the field of AI. The AI special fund jointly established by Xiaomi, Kingsoft, and Shunwei has also fully deployed large models and has now invested in 6 related companies.

As for robotics, everyone saw that after the release of Cyberdog 2, everyone is particularly concerned about the direction of robotics. In 2021, the first generation of Iron Egg was released, and this year the second generation was released. As you can see, progress in the field of bionic robots is very fast, and this time it is decided to have the maximum degree of open source.

At the same time, you can see that in some self-developed training aspects, in some core construction, self-developed micro motors and you can see that this dog is more intelligent this time, that is, it has AI fusion perception and decision-making systems. This dog is lighter, smarter, and more bionic.

Internationalization Strategy -

Xiaomi is very determined in terms of internationalization, mainly because it believes that the consumer electronics industry still has scale and must go international and make in-depth layouts in strategic markets.

Based on the investments made in internationalization in the past few years, in terms of smartphones, we can see that not only does Xiaomi maintain its position in the top three globally, but in the second quarter of the European market, it has reached a market share of 21%, and in the Middle East market, it has reached 17%. The stable development of smartphones has also driven the global MAU of MIUI to a new high, with a monthly active user base of 600 million worldwide and approximately 149 million in China. Therefore, existing users are also very important to Xiaomi. In addition, in the process of globalization, in order to ensure the efficiency of the entire global business, we have made great efforts in digital capacity building. As we all know, China's new retail digital capabilities are definitely leading the industry. With the realization of such capabilities, the entire international business can achieve efficiency, security, and control, and it also enhances the organizational capacity of the team.

China's New Retail -

This is a topic that everyone is particularly concerned about. The theme of new retail this year is to integrate merchants and improve store efficiency. It can be said that in the second quarter, we have already seen the effects. The first is that the average monthly GMV of single stores has increased by more than 20% compared to last year, and the return on investment for partners is also very good. In the first half of the year, the average partner was about 30%, and the most important partner is the Blue Snow customer, which reached over 50%. This indicates that Xiaomi's series of efficiency improvements this year have achieved very good results. In addition, in August, a national customer conference was held, with over 700 partners participating. After listening to Xiaomi's development plans, everyone is full of confidence.

ESG -

In terms of ESG, an important announcement was made today, which is to achieve carbon neutrality and 100% use of renewable energy in operational aspects by 2040. As you may have seen, Xiaomi has been investing heavily in ESG because as a global technology company, it has high goals and long-term visions, so it must fulfill its social responsibilities. Therefore, overall, in the first half of this year, I have firmly implemented the company's operational strategies in various business units and focused on improving my own capabilities. At the same time, at the group level, I have been continuously upgrading management and refining operations to improve the overall operational efficiency of the company. I believe that the achievements I have made in these areas are not accidental, but a result of improved capabilities.

These are the returns for continuing to do the right things over the past few years, and I also believe that this is just the beginning. I believe that these capabilities will continue to be unleashed in the future and will be presented in the form of operational results. In the future, we will adhere to three principles:

First, we will continue to deepen our technological expertise and focus on the underlying technologies.

Second, we will persist in upgrading our brand to the high-end level and promote China's practices and experiences in high-endization globally.

Third, we will persist in upgrading management to reduce costs and increase efficiency to ensure that we maintain a competitive and efficient application system.

2.2 Q&A

Q1: What are the sales prospects for the domestic and overseas markets in the third quarter? What is the competitive landscape among domestic competitors?

A1: We handed in a satisfactory answer in the second quarter, but it is only the beginning. You may see some continued improvement in the third quarter compared to the second quarter. **Because we are already at the end of August (Q3), with one more month to go, we can almost see the data now, and the main change is the significant improvement in our capabilities.

Today, we also saw some information about the Huawei Mate series, and this is how I see the issue -

The Chinese market has always been the most competitive market globally. Based on our experience in the past few years, regardless of what our competitors do, the most important thing for Xiaomi is to focus on our own affairs. This means paying attention to the growth of our own capabilities, delivering excellent products, providing good user services, and improving our established strategies. Therefore, there will be no changes in the overall strategic direction of Xiaomi, and we believe that it will not have a significant impact on the release rhythm of our products and our sales expectations.

Q2: Has channel inventory returned to normal levels? How about overseas inventory?

A2: I can confidently say today that our inventory...

At the same time, our sales activation has been rapidly increasing recently, and we are currently experiencing shortages in various markets. In fact, there is quite a bit of pressure on our supply chain delivery. If you take a look at our recent product releases, apart from the Chinese market, you will see that all four of our products, including two smartphones, a tablet, and a smart band, are all out of stock. Therefore, Xiaomi's inventory situation is very healthy at the moment.

Q3: Regarding the cost side of smartphones, how does the increase in display panel/memory prices affect it? What is the outlook for gross margin?

A3: Increasing the gross margin is actually quite simple - it depends on two factors: selling price and cost. As long as the selling price increases and the cost decreases, the gross margin will improve.

In terms of cost, we still have advantages in the industry. Our advantages come from several aspects.

Firstly, our economies of scale. I have always emphasized the importance of scale in the consumer electronics industry, and we are committed to continuously expanding our scale. With scale comes better cost control. In addition, we have been improving our self-developed capabilities over the past few years. Good technology leads to good costs, and a good scale leads to good costs.

As for the increase in display panel prices, we haven't seen much of it yet. As for memory, there has been some cost increase, mainly due to two factors. Firstly, upstream suppliers have proactively reduced production, which is not driven by market demand but by their own initiative.

Secondly, as you can see, the increase is only in LPDDR5X, and other parts have not seen an increase. This increase will not have much impact on Xiaomi in the short term because we have strategically stocked up on memory. Therefore, this will not have a significant impact on Xiaomi in the short term. In general, what I want to say is that in the future, whether it's the third quarter or any other quarter, cost factors will not have a significant impact on Xiaomi's gross profit margin. We can expect a continuous improvement in these financial indicators.

The rebound in inventory write-down and stable exchange rates have also contributed to the increase in gross profit margin. In this quarter, the inventory write-down was approximately 3.7 billion yuan, compared to around 3.3 billion yuan in the previous three quarters. The exchange rate of the US dollar this year has remained relatively stable compared to last year, so it has not had a negative impact on us.

Q4: How does the decrease in raw material prices affect costs? Is there a possibility of industry-wide promotions? What pressure does it put on ASP?

A4: The decrease in raw material costs has basically bottomed out, and there may be some rebound in certain components, but it is unlikely to cause a decrease in overall ASP.

Q5: How is the performance and outlook of the overseas IoT business? What is the inventory situation?

A5: As of today, most of the inventory for the overseas IoT business has been adjusted. By the fourth quarter of this year, our IoT inventory will be completely adjusted. In 2024, we expect the IoT business to perform well in overseas markets. However, looking at the overall market, the global recovery of consumer electronics is still slow and not very optimistic. But I believe that the decline in the overall market in 2024 will be slower than in 2023.

In the past one or two quarters, the growth of overseas IoT has not been as strong as domestic IoT. This is because the rapid growth of several major categories of IoT in China, including tablets and major appliances, has led to a relatively higher proportion of domestic IoT in the past few quarters. The proportion of overseas IoT may be relatively lower due to inventory issues and the impact of the overall market. However, with the adjustment of our business, inventory clearance, and market recovery, we believe that overseas IoT will contribute significantly to our growth.

Q6: What is the direction of future internet revenue? What are the future trends in advertising and gaming businesses?

A6: Internet services are closely related to the number and structure of our terminals. If we look at our MAU (Monthly Active Users), we can see that our global MAU continues to grow, and the MAU in the Chinese market is also growing.

Within this growth, there have been some structural changes, such as the increasing proportion of our high-end devices, which have a much higher ARPU (Average Revenue Per User) than the average.

As for advertising, we can see that the domestic advertising market has been gradually recovering and the overall market is growing.

The second point is that as the proportion of our high-end users in the domestic market continues to increase, it also helps improve the ARPU value of our advertisements.

The third point is about overseas advertising. With the growth of our MAU, we have attracted many new advertisers who are willing to advertise on our platform. As our user base grows and our operational capabilities become stronger, we have also attracted some international and local apps for advertising. Our overseas ARPU value has shown a significant increase.

In terms of gaming, we have benefited from the release of new games and our operations, including our high-end smartphones. As we have previously shown, the game ARPU of our high-end smartphones may be three to four times higher than that of low-end and mid-range smartphones. As the proportion of our high-end smartphones and high-end users increases, it will greatly contribute to our overall gaming revenue.

Q7: Can you share the AI layout?

A7: Regarding AI, we are currently focusing on two aspects of application.

The first aspect is to implement AI on the product side, both on the device and through localized deployment.

The second aspect is to enhance operational efficiency internally. As a simple example, in Xiaomi stores, we use AI technology for product allocation. This is just one of the many internal applications of AI.

Q8: What is the focus of the overseas market in the future?

A8: Apart from the US market where we haven't entered yet, we are expanding globally. However, the development focus and pace may vary in each market based on the timing of entry and strategic priorities.

In Europe, we already have a very high market share, as even the fourth-ranked company has less than 5%. The market structure in Europe is already well-established, with Samsung, Xiaomi, and Apple accounting for nearly 80% of the market share. Our next step is to optimize the structure and focus on developing high-end devices.

We also have several potential markets. In the Middle East, our market share is currently around 17%. Is there an opportunity for us to reach 25%?

Latin America is a very large market, but our current market share is around 14%-15%. Achieving a 20% market share in a single market is a significant opportunity for Xiaomi.

As for Africa, we divide the market into three regions. Africa is not a simple, single market. The North African region, which includes Arab countries such as Egypt, Tunisia, Algeria, and Morocco, has maintained a good market share, consistently ranking among the top two. The second area is South Africa, which is a typical operator market. Our market share here is not expected to be too high.

There is also a particularly large market in the middle, which includes East Africa, Central Africa, and West Africa. We refer to this region as "Black Africa." In terms of this market, it is not our main focus in the early stages.

However, recently we have been making efforts in two markets. One is Nigeria in West Africa, and the other is Kenya in East Africa. You will soon see that we have made significant breakthroughs in these two markets. So overall, Xiaomi still has a lot of room for growth globally. Even in the mature Southeast Asian market, I believe Xiaomi will make great progress. Although we faced significant pressure in the Indian market in the second quarter, if you look at the third or fourth quarter, you will see that Xiaomi has already hit bottom and rebounded. Therefore, we have great confidence in the global market.

Q9: How will AI be implemented on smartphones?

A9: Regarding the future application of AI technology on smartphones, I don't see it as a selling point. It is a technology that will ultimately be presented in the form of functionality or user experience. I believe AI and large models will have extensive applications on smartphones. In the future, when new products are released, you will gradually see the implementation of AI and large models on our smartphones.

Q10: How do you balance scale and profitability? Will investment increase in the second half to ensure growth?

A10: We have spent a lot of time finding the right approach to our operations. As you may have seen, earlier this year we established an Operations Management Committee to find the best solutions for the overall company direction and major decisions. So far, this mechanism has been very effective. With this foundation and our improved capabilities, I am personally very confident in achieving both scale and profitability in the second half of this year. You can wait and see.

Q11: Outlook on marketing and management expenses in the second half of the year?

A11: Indeed, we have made significant progress in cost reduction and efficiency improvement this year. Our expenses in the second quarter were about 100 million lower than the same period last year, and we have reaped many management benefits. Over the past few years, we have continuously undergone management reforms and upgrades, and the benefits we are seeing now are the result of these changes. From my perspective, there is still potential to tap into these benefits. Therefore, I am confident in overall cost control for the second half of the year. From a business perspective, we actually examine every expense in detail, including whether there is room for optimization, whether there are established systems or processes that need improvement, and whether there are opportunities for optimization. This is a gradual process aimed at ultimately reducing costs and increasing efficiency.

Q12: What is the specific direction of the AI dedicated fund?

A12: We have actually partnered with several companies, including Shunwei and Kingsoft, to establish a fund dedicated to the field of AI, with a scale of approximately $150 million. So far, we have invested in six AI companies.

Some AI projects are developed in-house, while others are open to third parties to utilize their technology for larger models. As Mr. Lei mentioned, our AI strategy focuses on lightweight and localized solutions. For models involving tens of billions of data points or more, we can collaborate with third parties. Therefore, we leverage our investments to empower our AI strategy.

Q13: How is the investment in computing power? What are the bottlenecks in development?

A13: Our team of over 3,000 people represents the results of our AI efforts over the past seven years. We not only develop large models but also apply AI to different areas, such as our Xiao Ai assistant and autonomous driving. Therefore, it's not just about the 3,000 people working on large models alone, as that would be impossible. Earlier this year, we established a team specifically dedicated to developing large models, which is our first point.

In terms of computing power, we are currently well-equipped. We have our own computing power companies, such as Kingsoft Cloud and Kingsoft Office, so we have sufficient resources in this regard. Therefore, I believe there are no issues.

Q14: What is the specific strategy and approach for open-source robotics?

A14: Robotics is still in its early stages, and as you know, we are pursuing two main paths. One is humanoid robots, which we primarily apply in the industrial sector. The other is our Cyberdog project, which aims to provide companionship in households. However, we believe there is still some distance to go before these projects can be commercialized.

Therefore, we currently adopt an open-source strategy and collaborate with universities, research institutes, and experienced individuals in the industry. Our open-source initiatives have expanded and cover a wider range than before. This is our basic strategy at present.

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