Public Markets

Understanding Xiaomi’s Epic 2017 Loss

Xiaomi is going public in an IPO that could test or set records. The popular Chinese hardware firm is bringing its hypergrowth to the masses through a share sale that could set a high water mark for the year.

When the firm filed last night, headlines instantly began to set the stage for something special. “Xiaomi Files in Hong Kong for World’s Biggest IPO Since 2014,” said Bloomberg. “Chinese smartphone maker Xiaomi files for huge Hong Kong IPO,” said CNN. You get the drift.

And nearly as common as headlines noting the scale of Xiaomi’s potential flotation were notes describing its massive 2017 loss. For example, here is the above-linked Bloomberg story:

Xiaomi, reporting detailed financials for the first time, posted a net loss of 43.9 billion yuan ($6.9 billion) in 2017, reversing from a profit a year earlier.

That doesn’t sound very good. As Xiaomi hopes to extend its previously-set $45 billion valuation north towards $100 billion, such a staggering loss is surprising.

So where does the loss come from, and what does the loss mean for the hardware company?

In Order Of Margin

To work our way to the company’s huge net loss, we’ll start with revenue and drill down towards the firm’s red ink.

The company grew nearly 68 percent in 2017 compared to the year-ago period. The firm’s roughly $18 billion in revenue during the period led to gross profit of $2.4 billion. That’s a gross margin of around 13.3 percent for reference.

Moving down the income statement, the firm’s operating profit totaled $1.9 billion in the year. That’s a shockingly high number given that the firm’s gross margin was just a half billion dollars more. Did Xiaomi manage to run that lean? Of course not. Instead, the firm reported $1 billion in “fair value changes on investments” in the mix, along with a few other items.

However, even if you yank out that billion dollar gain, Xiaomi was still operationally profitable. Given that we know it recorded a huge loss, that may feel surprising. What happened next that managed to transform such a large operating profit to a huge net loss?

Accounting Magic

The answer: “Fair value changes of convertible redeemable preferred shares,” which cost the firm $8.5 billion (RMB54.1 billion) during the year.

Note 35 in Appendix 1 (pages I-87 through I-91 here) details what’s going on. In short, Xiaomi tracks the change in the “fair value” of its issued convertible preferred shares. That appreciation (the company is becoming more valuable over time) is calculated using a set discount rate (17 percent), a “risk-free interest rate… based on the yield of US Government Bond [sic] with maturity life close to the [IPO],” and two other factors that feed into a discounted cash flow analysis.

The chart on I-91 makes this all reasonably clear. So, in honor of boring you with details, check the figures, paying special care to track the yearly “changes in fair value:”

The company’s preferred shares greatly appreciated in value and that set a non-cash cost1 against the firm’s operating profit, turning that large positive result into something deeply negative. (You can spot our previously-mentioned RMB54.1 billion figure three lines up from the bottom, on the right.)

If the firm had a nice operating profit, and a non-cash gigantic net loss hole to report, where does the company’s cash flow land in the end?

Before we dive into nuance, here are the raw figures from the company’s filing (page 303):

Now what we care about the most in the above is operating cash flow, because we are working to understand the health of the company’s operating business, which seems to land somewhere between a (not unreasonably) inflated operating profit and a (not unreasonably) inflated net loss.

So how does the firm calculate its operating cash flow? Like this:

“Net cash (used in)/generated from operations represents cash (used in)/generated from operations minus income tax paid. Cash (used in)/generated from operations primarily comprise our loss or profit for the period adjusted by non-cash items and changes in working capital.”

That second sentence underscores why we care about this particular metric.

Now, Xiaomi notes that in 2017 “net cash used in operations amounted to RMB1.0 billion, representing cash generated from operations of RMB0.5 billion minus income tax paid of RMB1.5 billion.” So that should work out to about negative RMB1 billion.

And, as we can see above, the firm’s operating cash flow was negative RMB995,669,000, so, bang on. Also the firm’s consolidated income statement lists an RMB2.1 billion income tax expense, which is in the same neighborhood as the firm’s cash expense as noted before.

Having negative operating cash flow is never as good as having positive operating cash flow. But having positive operating cash flow before cash tax expenses isn’t so bad. Despite the Xiamoi’s large net loss inclusive of all costs, on a strictly operating-and-cash basis, the firm is not setting fire to pots of money.

Now let’s discern what that means before we melt under the sheer weight of numbers in a few different currencies.

So What?

In brief, here’s what we have discussed: Xiaomi has massively expanding revenue, adjusted operating profit, moderate operating cash burn, and a net loss that isn’t nearly as scary as it seems at first blush.

How precisely to value that mix isn’t obvious to your humble servant. However, I won’t be buying any of the stock in the debut, so it doesn’t really matter. What we wanted to do today was understand the company’s net loss as either the critical concern for the company or something driven by non-cash accounting instead of operating results. As it’s the former, we’ve accomplished our mission.

More when Xiaomi prices!

  1. The company makes it plain that the changes in fair value line item is non-cash on page 303, in the last paragraph of the page. Just in case you wanted to check our work!

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