Business Context and Reporting Period
Huami Corporation, now Zepp Health Corp., filed an annual Form 20-F for the fiscal year ended December 31, 2018, prepared under U.S. GAAP. The source is not a standalone 2018 fourth-quarter filing; it provides full-year results and notes that fourth-quarter sales are seasonally higher.
The company develops smart wearable devices, including smart bands, smart watches, smart scales and health-related products. It operates through PRC subsidiaries and consolidated variable interest entities (VIEs), and its ADSs began trading on the NYSE on February 8, 2018 under the symbol HMI. Each ADS represents four Class A ordinary shares.
Financial Metrics
| Metric | 2018 | 2017 | Change |
|---|---|---|---|
| Revenue | RMB3,645.3 million (US$530.2 million) | RMB2,048.9 million | +77.9% |
| Gross profit | RMB939.5 million | RMB494.7 million | +89.9% |
| Gross margin | 25.8% | 24.1% | +170 basis points |
| Operating income | RMB365.7 million | RMB182.0 million | +101.0% |
| Net income | RMB336.3 million (US$48.9 million) | RMB167.1 million | +101.3% |
| Net income attributable to Huami | RMB340.0 million | RMB167.7 million | +102.8% |
| Basic earnings per ordinary share | RMB0.54 | RMB0.68 | Lower due to post-IPO share count and allocation effects |
| Diluted earnings per ordinary share | RMB0.51 | RMB0.65 | Lower due to post-IPO share count and allocation effects |
| Operating cash flow | RMB707.6 million (US$102.9 million) | RMB238.3 million | +196.9% |
| Capital expenditures | RMB69.2 million | RMB24.5 million | Higher investment |
Revenue from Xiaomi Wearable Products was RMB2,439.5 million, or 66.9% of total revenue, compared with 78.8% in 2017. Self-branded products and others revenue increased to RMB1,205.8 million, or 33.1% of revenue, from RMB434.4 million, or 21.2%.
Shipments increased to approximately 27.5 million devices in 2018, including approximately 24.4 million Xiaomi-branded units and 3.1 million self-branded units. Registered mobile-app users reached 93.1 million at year-end.
At December 31, 2018, cash and cash equivalents were RMB1,441.8 million and cash, cash equivalents and restricted cash were RMB1,451.8 million. Total assets were RMB3,258.5 million and total liabilities were RMB1,448.9 million. Bank borrowings were RMB20.0 million, all classified as current and held by a consolidated VIE without recourse to the group. Amounts due from related parties were RMB656.4 million, including RMB648.4 million from Xiaomi and its affiliates.
Material Changes Versus the Prior Comparable Period
- Revenue growth accelerated, led by higher shipment volumes for both Xiaomi and self-branded products.
- Self-branded revenue increased 177.6% and its gross margin rose to 31.8% from 26.0%, while Xiaomi segment gross margin was 22.8% versus 23.6%.
- Overall gross margin improved because of scale, supply-chain efficiencies and product mix.
- Research and development expense rose 71.1% to RMB263.2 million; general and administrative expense rose 86.3% to RMB214.0 million; selling and marketing expense rose 119.3% to RMB96.5 million.
- Operating cash flow strengthened substantially, although inventories increased to RMB484.6 million from RMB249.7 million and amounts due from related parties increased from RMB578.5 million.
- The company completed its IPO, receiving approximately US$103.9 million of net proceeds. It used approximately US$15.9 million for research and development, US$7.6 million for selling and marketing, US$14.4 million for general corporate purposes and working capital, and US$31.6 million for strategic investments and acquisitions.
- Preferred shares converted into ordinary shares in connection with the IPO. The company recorded a RMB209.8 million deemed dividend to preferred shareholders, which affected income attributable to ordinary shareholders but not consolidated net income.
- Revenue recognition changed with adoption of ASC 606 using the modified retrospective method. The filing reports a RMB33.3 million increase to opening retained earnings and a RMB33.3 million increase in related-party receivables; reported 2018 revenue was reduced by RMB50 thousand compared with the prior standard.
Guidance, Outlook, Commentary, Risks and Unusual Items
Management stated that existing cash, anticipated operating cash flow and IPO proceeds were expected to fund general corporate needs for at least the following 12 months. No specific revenue, earnings or margin guidance was provided in the filing.
- Xiaomi concentration: Xiaomi was the company’s sole customer and distribution channel for Xiaomi Wearable Products, which represented 66.9% of 2018 revenue. The strategic cooperation agreement expires in October 2020 and may be terminated earlier under specified conditions.
- Related-party exposure: Xiaomi and its affiliates accounted for approximately RMB2,816.7 million of 2018 revenue, and most year-end related-party receivables were collected in the first quarter of 2019 according to the filing.
- Product and supply-chain risk: The company relies on contract manufacturers and limited or single sources for certain components. It experienced PPG sensor shortages and longer lead times in 2018.
- Warranty charge: Warranty expense increased to RMB68.9 million in 2018, and the company recorded a one-time additional warranty charge related to an irregular quality issue involving a specific product batch. The year-end warranty liability was RMB55.6 million.
- Investments: Long-term investments totaled RMB208.9 million at year-end. The company recorded RMB7.6 million of impairment losses on long-term investments, partly offset by a RMB7.9 million fair-value gain.
- Internal controls: Management concluded that disclosure controls and internal control over financial reporting were ineffective because of one material weakness involving inadequate supervisory review of complex transactions and their U.S. GAAP treatment. The company was exempt from external auditor attestation as an emerging growth company.
- Corporate structure: Substantially all PRC operations are conducted through VIE contractual arrangements. Changes in PRC law or enforcement could impair control over the VIEs or the ability to consolidate their results.
- Regulatory and market risks: Key exposures include PRC data-privacy and medical-device regulation, cybersecurity, intellectual-property disputes, foreign-exchange controls, trade restrictions, competition and volatility in consumer demand.
- Liquidity restrictions: Cash was concentrated in China and the VIEs, and transfers to the offshore holding company are subject to PRC dividend, foreign-exchange and tax restrictions. The company does not expect to pay cash dividends in the foreseeable future.
Important Facts for Investors to Verify
- Whether Xiaomi concentration continues to decline and whether self-branded growth can offset any change in Xiaomi demand or contractual terms.
- The collectability and timing of related-party receivables, particularly Xiaomi-related balances and any unbilled profit-sharing consideration.
- Whether the identified internal-control material weakness has been fully remediated and whether additional weaknesses or restatements arise.
- The sustainability of the 2018 gross-margin improvement after product mix, scale benefits and promotional activity normalize.
- The adequacy of warranty reserves and the operational impact of the specific product-quality issue disclosed for 2018.
- The legal and regulatory durability of the VIE structure, including implications of China’s Foreign Investment Law and future data or medical-device rules.
- Component availability, contract-manufacturer capacity and inventory levels as product volumes and international shipments expand.
- The valuation, liquidity and impairment exposure of the company’s strategic and early-stage investments.