How This High-Flying Apple Inc. Competitor Just Validated the iPhone Strategy

Although some will undoubtedly disagree, Apple is the king of the global smartphone market.

As Google and Samsung both struggle in their own ways, those who still believe Apple doesn't rule the roost in the smartphone market are quickly running out of alternative examples. However, one recent upstart that has increasingly made its way into this discussion in the past year is Chinese handset upstart Xiaomi. However, as some recent data supports, Xiaomi can't and won't ever be the financial juggernaut that Apple is today. Here's why.

Xiaomi: Inside one of the world's most valuable start-upsFounded in June 2010, Xiaomi has seen a rapid rise that's been nothing short of remarkable. By emphasizing attractive design at affordable prices, Xiaomi has steadily gained global smartphone market share. In fact, Xiaomi claimed third place in researcher IDC's Q3 '14 ranking of handset shipments, a truly impressive feat for a company in its fourth full year of operations. For all of 2014, Xiaomi expects to sell roughly 60 million smartphones globally.

Xiaomi's rapid expansion has translated into similarly massive increases in its private market valuation. Recently, Xiaomi raised $1 billion in fresh financing at a valuation in excess of $45 billion, funding it plans to use to further its expansion into new international markets in the years ahead. However, for all its astounding success, Xiaomi remains largely levered to the Chinese smartphone market, which comprised 97% of its smartphone sales in Q2, according to Canalys. However, as Xiaomi sets its sights on broadening its international footprint, serious questions remain about the long-term profit potential of its low-end pricing strategy and its ability to justify its now-lofty valuation.

Growing pains ahead? Thus far, Xiaomi has relied on a highly effective mix of attractive low-cost devices, word-of-mouth organic marketing, and direct distribution to fuel its low competitively priced business model. However, there's plenty of reason to think this model might not prove tenable, as Xiaomi expands into high-growth smartphone markets such as Indonesia, Russia, and India.

Xiaomi's device lineup more closely resembles Apple's than Samsung's. It sells only six models in massive volumes, which gives it ample pricing leverage with its suppliers. This means its device input cost, or bill of materials, will probably remain flat or even decrease over its current multi-year expansion. However, the same probably can't be same of its currently low marketing expenditures.

As a tremendous homegrown success story, Xiaomi enjoys significant brand awareness within mainland China. This allows it to practically avoid spending the traditional 6% to 12% of revenue that JPMorgan Chase research estimates other smartphone brands allot toward marketing to draw attention to their handsets. And while it's certainly possible, it remains unclear whether Xiaomi can realistically gain significant traction in new markets while spending effectively nothing on marketing. And when it comes to sizing up Xiaomi's long-term investing prospects, relatively minor line items such as marketing expense will probably have an outsized influence Xiaomi's financial results.

Apple > Xiaomi Because of the complex rules regarding international investors, start-ups like Xiaomi often have byzantine corporate structures, making it especially difficult to ascertain their ultimate level of profitability. In researching for this article, I found recent estimates from credible sources, including Reuters and The Wall Street Journal, that projected Xiaomi's operating and profit margins were 1.8% and 12.8%, respectively.

Clearly, someone's math is off here.

However, the high-level point that Xiaomi operates at the more competitive, lower-margin portion of the smartphone spectrum remains beyond dispute. And with its upcoming international push, it appears more likely than not that Xiaomi's cost structure is likely to increase in the years ahead, which should further compress its already-narrow margins. And this is where Apple's business model re-enters the discussion.

For all the focus on Apple's shrinking smartphone market share, the company has been able to maintain its mind-blowing profitability even amid the rise of a new crop of emerging-market competitors such as Xiaomi. Over the past five years, Apple has averaged profit margins of 23.1%. Even more impressively, it's been estimated that, even as they face rising competition in emerging markets, Apple and Samsung have consistently generated nearly all of the smartphone market's profits. So while many will assuredly be transfixed by Xiaomi's ability to consolidate market share in the years ahead, rest assured that Apple's massive margins will ensure that it, and not Xiaomi, will remain the true rainmaker in the global smartphone market for years to come.

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Andrew Tonner owns shares of Apple. The Motley Fool recommends and owns shares of Apple and Google (A and C shares). Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.

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