How Does Xiaomi Technology Make Money?

By Markets Fool.com

Xiaomi , one of China's top smartphone makers, is currently the world's most valuable start-up with a valuation of $46 billion. Last year, the company sold over 70 million smartphones as sales rose 5% to 78 billion yuan ($12.5 billion). However, that missed the company's previous goal of selling 80 million phones and generating 35% sales growth.

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Nonetheless, IDC reports that Xiaomi still captured 4.6% of the global smartphone market in the fourth quarter of 2015, making it the fifth-largest smartphone maker in worldwide after Samsung , Apple , Huawei, and Lenovo -- in that order.

That's pretty solid progress for a company that was founded just six years ago. Let's discuss how Xiaomi achieved that growth in such a short time, and whether its business model can withstand upcoming headwinds in the smartphone market.

Image source: Xiaomi.

Xiaomi's business model

Xiaomi sells smartphones that have nearly identical technical specifications as high-end flagships, but at much lower prices. It then cuts costs by relying solely on online sales and employing social media and word-of-mouth campaigns instead of traditional ads. Xiaomi reportedly only spends around1% of its annual revenues on advertising, compared to 2% forSamsung. But neither company is as efficient as Apple, which spentonly 0.8% of itsrevenue on ads last year.

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Xiaomi's latest flagship phone, the Mi 5, offers just slightly lower specs than Samsung's Galaxy S7 for less than half the price. However, that aggressive strategy produces paper-thin margins for Xiaomi. A filing at the end of 2013 revealed that Xiaomi's operating margin was just 1.8% -- a figure which haslikely contracted over the past two years due to the ongoing commoditization of the smartphone market. Apple had an operating margin of 30.5% last year, while Samsung's IM (IT and Mobile) business had an operating margin of nearly 9%.

Xiaomi is also following Apple's and Samsung's lead by developing its own ARM based SoCs, codenamed Rifle, for some ofits phones. This move could reduce its dependence on Qualcomm , which currently supplies the SoCs for Xiaomi's top-tier devices, as well as cut operating expenses and tighten up its supply chain.

Expanding into new markets

Xiaomi was recently overtakenin annual smartphone sales by China's Huawei, which replicated Xiaomi's business model of selling low-margin devices online. Huawei's smartphone shipments surged 44% last year to108 million, thanks to robust overseas sales offsetting slower demand in China. Meanwhile, Xiaomi still generates about 90% of its sales from China. The company has taken baby steps into Brazil and India, but its of lack of overseas patents have prevented it from charging aggressively into saturated Western markets like the United States.

Instead, Xiaomi is diversifying its product portfolio with new devices, like smart TVs, set-top boxes, air purifiers, Wi-Fi routers, audio devices, power banks, fitness trackers, Yi Technology's action cameras, and 4K drones. At first glance, this scattergun strategy seemingly indicates that Xiaomi wants to become the next Sony or Samsung with a diverse basket of consumer electronics.

Xiaomi's Mi TV and Mi Headphones. Image source: Xiaomi.

However, Xiaomi founder and CEO Lei Jun told Reuters in 2013 that his company should be compared to Amazon instead of Apple, noting that it only sold its devices at such thin margins to expand its MIUI ecosystem. "Xiaomi selling mobile phones is like Amazon selling Kindles," stated Lei. "So you understand why we sell them for so cheap." MIUI, a "forked" version of Android, is installed across most of Xiaomi's devices and features its own app store.

Xiaomi previously expected to generate $1 billion in Internet services revenue in 2015, but an internal document reviewed by Reuters indicated that salesonly hit $564 million. Online games revenue doubled, but stiff competition in China's O2O (online-to-offline) mobile ecosystem market probably prevented many of Xiaomi's new digital initiatives --like mobile payments and a partnership with Uber -- from gaining much ground.

Will Xiaomi ever go public?

Back when Xiaomi was posting triple-digit sales growth in 2014, many investors wondered if the rapidly growing start-up would go public. But now that its sales growth has slowed to the single digits, investors are likely wondering if the start-up should really be valued at nearly four times its 2015 sales.

Xiaomi International VP Hugo Barra recently toldReuters that the company had "no plans" to raise new funds or file an IPO -- indicating that the world's most valuable start-up won't get more valuable anytime soon. Tech investors won't be able to invest in Xiaomi, but they should keep an eye on its evolving strategies -- which could impact a wide range of companies including Apple, Samsung, Qualcomm, Fitbit and GoPro in the near future.

The article How Does Xiaomi Technology Make Money? originally appeared on Fool.com.

Leo Sun owns shares of Amazon.com and Qualcomm. The Motley Fool owns shares of and recommends Amazon.com, Apple, GoPro, and Qualcomm. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool recommends Fitbit. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.