Xiaomi (XIACY, HK:1810) is renowned for going against the tide with its smartphone pricing. Its stock price has increased over 178% since the height of the pandemic, which has caught the attention of investors worldwide.

The Chinese phone maker’s stock price increase has consequently led its valuation to surge higher than American smartphone giant Apple (AAPL). However, as Xiaomi is still growing, can its valuation be justified?

Company business model

Firstly, we must understand how Xiaomi differs from other smartphone companies. Although Xiaomi’s hardware contributes 60% of its total revenue, the company limits net profits from the segment to just 5%.

Due to its tiny margins on hardware, Xiaomi’s phones are incredibly affordable. The company’s flagship smartphone is being sold for £599, whilst Apple’s top-of-the line iPhone (iPhone 12 Pro Max) with the same gigabyte capacity costs just over double at £1,199. Apple’s iPhone SE is being marketed as the company’s cheapest current smartphone, priced at £399. Meanwhile, Xiaomi’s cheapest offering, Redmi Go, is being sold for just £79. Even the Redmi S2, which offers an en par camera with the iPhone SE, is priced at only £179. Any way you cut it, Xiaomi is severely undercutting Apple.

So, how does Xiaomi make its money? Xiaomi describes itself as an “Internet Company” rather than a smartphone company. Instead of enjoying margins on its hardware, the company focuses its margins on internet services. Whilst Apple makes money from consumers purchasing their smartphones, Xiaomi makes money from consumers using their smartphones.

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Xiaomi’s business model may seem left-field compared to smartphone giants Apple and Samsung (SSNLF), but its strategy is not too distant from the “freemium” model in which software is offered for free in the hope that consumers will spend money using it. Free-to-download mobile games Clash of Clans, Candy Crush and Pokemon Go are prime examples of this and have generated $7 billion, $5.4 billion and $4.8 billion in revenue, respectively. It’s an incredibly lucrative business model, which Xiaomi is keen to capitalise on.

How has Xiaomi performed?

The global pandemic has had polar opposite effects on companies around the world. Whilst some have sadly met their demise, others have prospered to unprecedented heights. Xiaomi is one of the latter. In its most recent quarter, the company set 15 new records of financial achievements.

Total revenue grew 34.5% from last year, net profit increased 18.9% and smartphone revenues surged 45.7%. Revenue from internet services increased 8.7%, and largely due to its strong smartphone sales, monthly active users grew by 26.3% to 368.2 million with 109.4 million in China.

Xiaomi is also expanding its global footprint. Overseas internet revenue grew 75.6%, and overall revenue from overseas markets increased 52.1%. Western Europe Xiaomi smartphone shipments increased 107.3%.

In terms of market share, Xiaomi has even surpassed Apple to become the third-largest smartphone brand in the world. Apple has 11.8% market share compared to Xiaomi’s 13.1%.

How will Xiaomi perform?

Xiaomi’s business model has proven to be lucrative in China and is steadily gaining traction in Western markets. However, Xiaomi’s success in the Chinese market may not necessarily transition easily to the rest of the world.

Whilst Xiaomi’s interface MIUI is based on Android, the Chinese company is still keen to farm out its OS rather than stock Android. Furthermore, Xiaomi customers in China happily utilise the Mi Store App because Google Play Store (GOOG, GOOGL) is inaccessible. Both of these aspects work well in China, where users have not been relying on Google.

However, expansion Westward means penetrating a market which has been heavily reliant on Google. Smartphone users who have become familiar with Android could be unwilling to adjust to the MIUI interface. Google Play Store also offers a wider range of apps than Xiaomi’s app store.

In order for Xiaomi’s business model to work successfully, consumers will be required to adjust their mobile experience expectations. If smartphone users are already frustrated with being bombarded by adverts on a daily basis, Xiaomi will only compound this irritation.

An argument could also be made that bargain hunters who are attracted to Xiaomi’s low-end priced smartphones would also spend frugally on its respective app store. This is merely speculation, but a correlation still worth considering.

Nonetheless, Xiaomi’s 2020 financial numbers suggest that the company’s expansion to the West is working. Additionally, the concerns listed above are solely software-related, which the company can adjust as time goes on.

Valuation

Perhaps Xiaomi’s biggest concern is its current valuation. Xiaomi’s current stock price is HKD26.5 In March, its stock price was HKD9.5, with a 52-week low of HKD8.76. Consequently, its P/E ratio is currently sitting in the 50s at the time of writing.

Conversely, Apple, which also had a stellar year amid the pandemic, has a P/E ratio of 36. Although you’ll pay a nominally higher price per stock, its price to earnings is much lower. There’s also a case to be argued that even Apple’s stock price is overvalued, but that’s an article for another day. Citigroup was so deterred by Xiaomi’s valuation that the investment bank changed its Xiaomi rating from a “Buy” to a “Sell” last month.

Xiaomi is still in a “growth” period – especially considering its expansion to the West. Growth companies tend to have higher P/E ratios, but with a P/E ratio of 50, it’s fairly reasonable to assume that this growth potential is baked in.

Even though Xiaomi has overtaken Apple in terms of smartphone market share, the scale of Apple’s financials is not only incomparable to Xiaomi’s, but is unmatched by pretty much every other company out there. Apple has a net income of $58 billion, with revenue totalling $273.9 billion. Xiaomi’s revenue comes in at RMB¥205 billion (≈USD$31 billion) with net income of RMB¥10 (≈USD$1.5 billion). In terms of value, one Apple stock offers a great deal more than one Xiaomi stock.

Conclusion

Xiaomi is certainly an exciting company which has thrived amid a global pandemic. Its expansion to the West is burdened with a handful of concerns, but none that Xiaomi can’t overcome with time. In 2019, Apple’s best-selling iPhone was the iPhone XR – its cheapest offering at the time. Clearly, there is market demand for cheaper smartphones, and Xiaomi could easily fill this void.

However, with a valuation which is higher than Apple’s in terms of P/E ratio, Xiaomi is a difficult buy when Apple is on the table for a lower valuation. That’s not to say that Xiaomi shareholders should shred their stock, but rather, newcomers have better options to place their money in the smartphone field.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.