Chinese hardware manufacturer Xiaomi went live on the Hong Kong stock exchange this week, and international investors can finally get in on the action. In this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Evan Niu tell long-term investors what they should know first.

Click play to find out how Xiaomi makes its money and how the Apple (NASDAQ:AAPL) of China's business model could hardly be more different from Apple's; why Xiaomi products haven't come to the U.S. yet, and why that probably won't change anytime soon; what hoops international investors will have to jump through to buy the stock; the most important risks to watch; and more.

A full transcript follows the video.

This video was recorded on July 13, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, July 13th, Friday the 13th, and we're talking about Xiaomi. I'm your host, Dylan Lewis, and I'm joined on Skype by senior tech specialist Evan Niu. Evan, it's been a minute since we've done a show together. How's your summer been going?

Evan Niu: It's good. Kids are going to Dallas next week to visit the grandparents. Me and my wife will have a nice little break, get some actual time alone.

Lewis: What's the plan for that? Are you going to do stuff around the house, maybe take a little weekend trip?

Niu: I don't know yet. We have a friend coming to town, actually. It'll be nice to hang out with adults. [laughs] 

Lewis: I'm actually heading out of town this weekend as well. We're pre-taping today's show because I'm going to be on the road on Friday, heading out to Austin to visit some friends. Just keep that in mind as we talk about recent numbers and recent news, there might be some slight changes to some of the metrics that we're talking about, specifically market cap, as we get into the Xiaomi, this new issuance. But, I'm glad everyone seems to be having a good time so far this summer, Evan.

This name, Xiaomi, that we're going to be talking about today, is one that listeners may have heard of before, because [it tends] to come up when we talk smartphones and fitness wearables. Why don't you talk a little bit about what they do? This is going to be a name that consumers hear more and more in the next decade.

Niu: A few years back, Xiaomi used to be all over the news. They were this up-and-coming smartphone maker in China. They were selling so many units. They made a name for themselves initially by having these flash sales that would get tons of people really excited to buy their stuff. Then they'd run out of stock, and that creates more hype. 

Generally speaking, they've made a name for themselves by offering really, really good hardware at very, very affordable prices. We're essentially talking about premium flagship specs at mid-range and low-end price points, which obviously appeals to a lot of price-conscious consumers. They have pretty good products that are priced very aggressively. They've seen a lot of success there. At one point, they were actually the most valuable start-up in the world.

Lewis: They are in the Chinese market. The reason we are talking about them this week is because shares just hit the Hong Kong stock exchange earlier this week. It seems like it's been a rough start for this company so far.

Niu: Right. The valuation has come down a little bit since those private days. Right when the shares started trading, I think they closed down the first day, which is never something you never want to see for any IPO, because it shows that there's not a lot of investor demand for the stock. But it's been a roller coaster ever since then. It's been up and down a little bit, a little choppy trading. The company blamed that lackluster debut on President Trump's trade war with China, which is ongoing and continues to escalate. All of these traders had an overhang for what normally could be a momentous milestone, to hit the public markets.

Lewis: This is something we've seen impact shares of a lot of Chinese big companies. We've seen it with Tencent; we've seen it with Alibaba (NYSE:BABA) in particular over the past couple of months. Something that's going to basically impact any Chinese manufacturer that's big enough to have international exposure.

I want to do a quick note for folks that are looking to do their own homework on this company, Xiaomi is spelled like X-I-A-O-M-I. It's a little tricky, it's not a phonetic spelling.

Niu: It's Chinese pinyin, it means little rice.

Lewis: [laughs] I didn't know that! That's awesome. They may be little rice, but they're making a lot of money. A lot of people are talking about them in relationship to Apple. There's a very natural comparison, because they're both in the consumer hardware business. But I think they have totally different approaches to hardware, and you really notice that when you look at their books.

Niu: They've always invoked this Apple of China nickname, not because of, like you mentioned, strategically speaking, which we'll get on later. It's mostly because Xiaomi has been probably the most shameless with copying Apple in as many ways as possible. The product designs are almost identical; their marketing strategy and the way they make their website; even, the founder and CEO, Lei Jun, dresses like Steve Jobs with black turtlenecks. He even did this One More Thing presentation at one of their product unveilings a couple of years back, which is obviously a trademark of Steve Jobs. 

They have all these ways that they basically just rip off of Apple. Of course, the company has always denied it, but the evidence has been around for years. That's why they've earned this nickname, even though he actually doesn't like being called the Apple of China.

Lewis: When we think of Apple, we think of a really premium hardware business, and they make pretty good margins on their hardware. The strategy is quite a bit different with Xiaomi.

Niu: Right. Apple, their thing has always been to focus on product depth as opposed to product breadth. You take a very small number of products and put everything you have into developing those products to be the best they can be. It's pretty crazy. Tim Cook said recently, you can fit all of Apple's products on a kitchen table. It's crazy that they can generate over $200 billion in revenue based on products that you could put on a single kitchen table, and they're all there. 

Xiaomi takes the opposite approach. They do product breadth. They offer something like 1,600 different products, which is insane. They have air purifiers, they have scooters, they have routers, they have TVs, fitness trackers, it's insane. It's kind of overwhelming. It's a total opposite approach. They try to do everything at once, which has the risk of spreading yourself too thin. And, on the pricing side, they price very aggressively. They're trying to really make things as affordable as possible, which is obviously also in contrast to how Apple does it.

Lewis: You mentioned all their product lines. Smartphones make up 70% of the company's top line. They also have a huge bucket of what they call IOT and lifestyle products, which is basically any consumer product under the sun. It's incredible, you talked about it before, how many different products they make. That's 20% of their top line. You have 90% coming from consumer hardware, and those segments produce 9% gross margins. The reason for that is, the company has made this commitment to consumers, saying, "Our net profit margins will not exceed 5%. If they do, we'll pass whatever we got incrementally back to our consumers."

Niu: Right. That's starting this year. They laid that out in the prospectus, that's what they're going to do. Not clear what they mean by that, how they're going to do that. But, presumably, it would probably mean they'll cut prices or something going forward if they're too profitable. Basically, they're trying really hard to get these products into as many people's hands as possible and doing that with low prices.

Lewis: That makes sense for a lot of the markets they're serving. They're big in China, they're really big in India, and these are developing markets where there isn't as established a middle class, there isn't as much disposable income for a lot of consumers there. So, coming out with tech products that are basically, to spec, what you could be getting for Apple, at half the price, is going to be very appealing.

Niu: Right. Obviously, Apple does very well in China, but not in terms of unit volumes. They have a very big business there, but Xiaomi and local Chinese smartphone companies in general do much better than Apple in China in terms of unit volumes. Certainly, very true in India. Xiaomi is the No. 1 smartphone vendor in India by volume. Apple has an almost non-existent share because of these dynamics with consumer spending in emerging markets. They just don't have the money to buy a $1,000 iPhone X.

Lewis: And if you look at worldwide, Xiaomi is gaining on all of these major smartphone manufacturers. I mentioned that this is a name you're going to continue to hear. As of most recent IDC data, Xiaomi was No. 4 by units as of Q1. They're trailing Samsung, Apple, and Huawei. But they are gaining on them pretty quickly. That 28 million units figure during Q1 was good for 88% year over year growth. In that time, Samsung posted declines. Apple and Huawei posted 3% and 14% growth respectively. Xiaomi is blowing them out of the water, in terms of growth rate.

Niu: They've really bounced back. You saw a lot of headlines in 2013, 2014, 2015, as they were growing, and their valuation was going up. But they had a pretty big hit, and it dipped in 2016. They disclosed their unit volumes. They did 66 million in 2015, smartphones. That dipped to 55 million in 2016. Then, I think, when that starts to come down, their valuation came down, too, because that's not something investors like to see. But then, in 2017, they spiked all the way back up to 91 million. So, they were able to rebound and recover, in terms of unit volumes, by quite a bit there. 

Lewis: Thinking about profitability for this business, working with 5% margins and hardware when you have a lot of overhead costs associated with everything you're doing as a business, is going to be difficult. I think long term, when you look at this business, it's that remaining 10% of revenue, the services revenue, which they hope will grow and be a way for them to supplement what they're doing to grow out a big installed base on their hardware side.

Niu: Right. That's one thing where they do share what Apple's trying to do. And not just Apple. Lots of companies like to build these services businesses, because recurring revenue tends to be more profitable, you have more visibility. They have made a lot of progress here, growing their platform. Their platform is called MIUI. At this point, they have about 170 million monthly active users on the platform. That's a pretty strong number. Those are people that are buying stuff, using their services, all sorts of stuff. The more you can grow that number ... And, their average revenue per user on that side is also going up. They are getting good engagement from those users that are increasingly spending a little bit more and more money each year.

Lewis: I mentioned the 9% gross margins on the hardware side. Gross margins for the services is roughly 60%. A little bit more what you'd expect for a platform-type business. That revenue mix is advertising online games and some entertainment content, very similar to the services segment at Apple. All of the segments for Xiaomi are posting huge growth. Actually, services is posting the smallest growth, even though it's the smallest segment, which is interesting. Their hardware businesses are doing very well.

Niu: They're really popular, just because they offer so much stuff. It's kind of insane how much stuff they do.

Lewis: All of this bubbles up to a business that did roughly $17 billion in sales in 2017. I say roughly because we are adjusting to dollars. They don't state their financials in dollars. At a $50 billion valuation, roughly, that means they're trading at somewhere in the neighborhood of 3 to 3.5 times sales. It's a big business. Evan, what do you see as the long-term look for them? Are they going to be able to make up what they're doing on the hardware side with growing out the services segment? Is that the approach here?

Niu: I think that's what they're certainly trying to do. They are making progress. On top of that, they're also trying to expand internationally. We've already talked a little bit about India. They've been eyeing the U.S. market for many years, and I think they might start selling more products this year. But the big challenge is that the U.S. has really strong intellectual property laws. If they come into the U.S. market and something they do copies Apple or anyone else too closely, they have a big risk of getting sued over it; whereas China is notorious for having very weak IP laws. In general, that's why so much counterfeit stuff is made in China across all sorts of industries and markets and products. 

That's one of the big hurdles that's always kept them out of the U.S. It's not clear how they're going to address that, or what they will change to avoid that risk. But beyond that, other than the U.S., they're now in 74 different countries. They are expanding outside of the U.S. internationally quite a bit.

Lewis: Ahead of the show, we actually got a listener question from Colin in the U.K. He wanted to know a little bit about Xiaomi, sent us some questions. He also sent us a video review that featured a Xiaomi vacuum cleaner and his dog Sam. That was awesome. I appreciated getting that. [laughs] You mentioned the 74 countries they're in. He was curious, what does the international plan look like? They seem to be opening a small number of shops in Europe. You look at their financials by geography over the last couple of years. In 2015, 94% of revenue came from mainland China. By 2017, that was down to 70%. Their expansion plans seem to be taking root, they seem to be increasingly less reliant on China. You mentioned that they are the No. 1 provider by units in India, as well. It seems like they're getting outside of their core market.

Niu: They're definitely starting to expand a little bit. I think the challenge is going to be balancing the cost associated with expanding operations. If you try to do too much too fast, you could blow through too much money, and those investments might not pay off. They do need to take a measured approach and be really selective in the markets they expand into and the products they expand into those markets. But so far, they are making progress reducing their reliance on just China as their only market.

Lewis: Colin has another question. He noted that he bought a device sold as a Xiaomi vacuum cleaner, but it had no Mi or Xiaomi branding on it. This is a product that came from one of their third-party hardware relationships. He was curious how these worked.

Niu: They don't develop all of these products in-house. Certainly, they focus primarily on their tech gadgets, like smartphones, laptops, tablets, etc. For most of the other stuff that they sell, it's done through this ecosystem of partners. They basically invest in and collaborate with a bunch of third-party manufacturers to create and develop these devices. Some of them share branding, some of them don't. They do have a wide spectrum of these relationships. That's where most of these other products actually come from. Again, it's hard to imagine them putting a bunch of money into an air purifier or a scooter. But they are investing in these other companies. They have a stake in them. It's not just a traditional distribution wholesale relationship where you're buying it from them and selling it to someone else. They're investing in these other companies, and then some of those are being co-branded under their Mi brand. 

Lewis: And this is something that gives them ubiquity as a consumer hardware brand in these markets. I have to imagine, though, that at a certain point, if they don't become a meaningful portion of sales and continue to grow, then it turns into a distraction for a business that's primarily a smartphone business.

Niu: Exactly. They're putting quite a bit of money into these things. There's something like over 200-210 ecosystem partners that they have invested in, of which 90 are focused on IOT, smart hardware, lifestyle products. As you mentioned before, that's about 20% of revenue. It's a decent chunk of the business, but you don't want to put too much in. There is a good brand benefit, because like you said, they're ubiquitous in China because they have so much stuff and their brand is instantly recognizable, even though other companies are doing some of the leg work with some of the smaller, niche products that not everyone is buying. They don't want to spend too much money on it, but they seem to be doing alright with this strategy so far.

Lewis: Evan, the natural question any time we do a show that looks at a company's prospectus, because shares just started trading, is, is this something that's worth looking at as an investment? Is this something I should have on my watch list? There are some hurdles to that with Xiaomi before we even get into business viability because of the way that they have listed and the exchange that they're on.

Niu: They're only trading on the Hong Kong exchange right now. It's not clear yet if they'll offer an ADR, which is an American depository receipt, which is where a U.S. financial institution will buy a bunch of shares, hold on to the shares, and issue receipts for those shares, and the receipts are what's traded. That's one of the easiest ways for U.S. investors to invest in international companies, is through ADRs. But, as of right now, it's not clear if there's going to be one.

If you wanted to buy it, you'd have to talk to your broker, to actually go to an international trading desk and place an order on the international exchange. That typically comes with much greater fees; you can have delays in order execution, you can have liquidity issues. There are a bunch of different little things that make international trading a little tricky. 

Also, on the reporting side, it's worth noting that international companies don't use U.S. GAAP; they use IFRS, which is international financial reporting standards. The way they report the numbers is also slightly different. A lot of different things that U.S. investors should be mindful of if they're interested in this company.

Lewis: Are you interested in this company, having gone through their prospectus, Evan?

Niu: I didn't go through all 600 pages of it. [laughs] But, no, I'm not really too into it. They don't really have the kind of things I personally look for in a company. I prefer a company that's a little more profitable. And there are some corporate governance things that we didn't get too deeply into. Lei Jun has a pretty big stake in the company; he has a lot of controlling interest, and I never really like those issues. We've talked about those before in the past. So, there are a couple of things that are keeping me away, but I don't think it's a terrible business. 

Lewis: Yeah, I think that this is a company that has a lot of things going for it that maybe a GoPro (NASDAQ:GPRO) or Fitbit (NYSE:FIT) wouldn't in the hardware space. They have ubiquity and seemingly a very strong brand attachment with their offering. I think that there's really something there on the services side. But, when they're capping margins to make their prices more accessible, that only gives them so much cash to operate with. You see the precedent that Apple has set with commanding really good margins and creating a cash cow business with their iPhone segment. I worry that Xiaomi might struggle to do that, particularly because services is such a tiny portion of the overall business. If that starts to change, then I think the interest level for me is a little higher.

Niu: Yeah, that would definitely change the investing narrative, for sure, if they could build up this profitable services business.

Lewis: Anything else before I let you go, Evan?

Niu: No, I think we're OK.

Lewis: Enjoy your weekend off! [laughs] Listeners, that does it for this episode of Industry Focus. If you have any questions, or if you want to reach out and say hey, you can shoot us an email at industryfocus@fool.com, or you can tweet us at @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts.

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Anne Henry for her work behind the glass today. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!

Dylan Lewis owns shares of Apple. Evan Niu, CFA owns shares of Alibaba Group Holding Ltd. and Apple. The Motley Fool owns shares of and recommends Apple, Fitbit, and GoPro. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.