Hey Xiaomi, maybe your future really is in smartphones

Internet services are supposed to be what differentiates Xiaomi from every other smartphone maker. It’s the reason Lei Jun says he’s willing to sacrifice hardware margins.

A hint as to why internet services aren’t contributing more comes from a look at its MIUI user figures. (REUTERS)

For a smartphone company trying really, really hard not to be one, Xiaomi might actually have a future as, well, a smartphone company.

Late Wednesday, the Chinese technology outfit reported its first set of quarterly earnings since its Hong Kong IPO and the numbers were all over the place.Revenue was up 68 percent, but gross profit climbed only 47 percent. Net income flipped from loss to profit, while operating profit switched from positive to negative. Confusion through the income statement came down to a mix of one-time share-based compensation and a revaluation of shares tied to last month's listing.

Among the mess, smartphones remained the dominant contributor to the top line at 67 percent, little changed from the prior quarter. Internet and lifestyle products — the other category of hardware — inched up slightly to 23 percent of total sales.

But that wow category, the one we heard so much about during the pre-IPO fanfare, the business that founder Lei Jun keeps talking up? It's underperforming.

Internet services are supposed to be what differentiates Xiaomi from every other smartphone maker. It's the reason Lei Jun says he's willing to sacrifice hardware margins. More than 62 percent of the category comes from advertising and 18 percent from gaming. But for the second quarter, the internet services division contributed just 8.75 percent of total corporate sales. That's down from 9.39 percent the prior quarter and 9 percent a year earlier. Furthermore, gross margin in that sector barely budged.

Admittedly, unchanged gross margins sound pretty good when compared with a slide in that same metric for both smartphones and other hardware. But when you're building economies of scale in a services business, size should count for something. Quarter over quarter, revenue climbed a mere 22.5 percent, well below the corporate average of 31.5 percent.

A hint as to why internet services aren't contributing more comes from a look at its MIUI user figures. MIUI is the skin that Xiaomi lays over the Android operating system on its phones, and it serves as the platform for dishing out ads, games and other content. It's at the heart of Xiaomi's internet services strategy. Monthly active users expanded to 206.9 million for the June quarter, which isn't bad, but that 42 percent year-over-year growth rate is actually slower than the 46 percent increase in smartphone shipments over the same period.   

This makes me think that internet services isn't going to create the long term value Lei Jun is betting on at the expense of profits in hardware, a point the company reiterated in a press release on Wednesday:

"In order to lay the groundwork to capture long term value, we will selectively prioritize high growth to capture market share in key products over higher gross margins."

Smartphones, on the other hand, are showing some positive signs. It's unfortunate the gross margins fell so much, for which the company pointed to US dollar appreciation against the yuan and Indian rupee. But offsetting that fact is expansion in the average selling price, which climbed 10 percent from a year earlier. This is important because it indicates that Xiaomi can actually increase shipments and prices at the same time, something competing brands like Huawei, Samsung and OnePlus have shown a penchant for. 

Tim Culpan is a Bloomberg Opinion columnist covering technology. He previously covered technology for Bloomberg News.