Xiaomi inspired by Costco business model - will it work in the tech world?
Published : Wednesday, 27 June, 2018There’s been a lot of hype around Xiaomi’s Hong Kong IPO, and a really fascinating discussion is unfolding about the issue of the approach to company valuation.
For a smartphone company, Xiaomi’s estimated valuation that amounts to 39 times its revenue, just doesn’t seem reasonable. For instance, if Apple is taken as an example, its price-earnings ratio does not merely match that level and is just in the teens.
Considering Xiaomi an internet company doesn’t seem justified either, since it basically manufactures hardware and doesn’t stand the comparison with giants like Alibaba, Tencent or Amazon.
What, then, is the reason behind Xiaomi’s expensive valuation that seems so inappropriate at first glance?
According to the founder of the company Lei Jun, Xiaomi is unique (and uniquely expensive) in combining its internet and e-commerce entrepreneurship and hardware manufacture.
Well, that would seem like it’s beginning to resemble a company as unlikely as... Costco in the United States.
The warehouse retail company, which has a whopping 500+ retail outlets in the US, has an impressive market cap in excess of US $90 billion. Its price/earning ratio of 35 is similar to Xiaomi’s, and exceeds that of its peer companies like Kroger (14) and Walmart (19).
Costco’s business model is an interesting one. Over the last ten years, its share price has increased in excess of six times over, while most other companies have suffered from the incredible expansion of e-commerce, and the industry giants, such as Amazon.
Most of Costco’s revenue, in fact, comes from actual sales, which is somewhat of a surprise. There’s a 12% cap on their goods’ gross margin, and after the deduction of numerous business costs, its net profit margin actually approximates zero.
What, then, is the reason behind its success on the stock exchange?
The company makes money from other sources – namely, membership fees, commercial collaboration with credit card companies and other third-party service providers.
Another one of its unusual features is its membership system, which is not typical of US supermarkets. Being a member costs US$120 or $60 per year, depending on the membership level. The membership fees alone account for the revenue of US$2.6 billion last year alone, making membership fees the single main profit source for Costco.
For consumers, the membership fee is not particularly burdensome, since the products sold by the store are, in fact, of a better value than in a regular supermarket, and the membership requires no net margin pledge.
Better prices from the suppliers are ensured for the retail giant by the amounts of wholesale goods it purchases, with better pricing inevitably leading to customer loyalty.
Costco is now able to offer goods at an average of 30% lower price compared to its competitors, making the amount of potential annual savings for a family that would exceed the price of annual membership several times.
Coming back to Xiaomi and its business model, what are the similarities to Costco? Well, there’s a 10% gross margin cap an Xiaomi’s hardware products (including smartphones), while for iPhone this number ranges between 40% and 60%, and exceeds 30% for a Samsung headset. The company claims that the net profit margin will never go above 5%.
Meanwhile, the product quality remains the same, and the price is lower than competitors’.
Lei actually claims that Costco served as an inspiration to him as he was creating and launching Xiaomi with the aim to offer quality products at reasonable prices to consumers all over the world.
More than 190 million international users choose Xiaomi, however, there’s an issue – over 90% of its revenue comes from hardware.
The company needs to find other ways to monetize its already impressive customer base.
Internet services are one area Xiaomi is exploring, but as of now it’s still responsible for only a small share of its revenue.
However, while the company is still soul-searching, perhaps it should trade at a 30% discount compared to Costco’s P/E level, at least until it finds the perfect combination of goods and services.