Profitability analysis for a new smartphone start-up company

Smartphone Start-Up

This paper examines the possibility of a new smartphone start-up company. The focus is on understanding the dynamics of the industry, because it is from that understanding that the company can derive strategy. Then, an analysis will be required to understand whether the company will be profitable, or more specifically what it will take to be profitable, and whether that is feasible or not. It is determined through the course of analysis that profitability is possible, though it will be difficult, due to the changing nature of the industry. Key growth markets are entering maturity, something that has resulted in a more challenging environment for a start-up than any other company that has a significant share in the market today. However, there are still some relatively young companies, mostly in China, that are having success in this industry and whose experience can provide insights -- if not hard financial data -- upon which a reasonable analysis of profitability can be based.

Introduction

Starting a new smartphone company -- from scratch -- is probably not the brightest idea in the world. The industry is highly competitive, and the learning curve on the technology side is very high. Your benchmarks are not going to be Apple, Samsung or those sorts of companies. Even well-capitalized companies with high levels of technological skill (HTC, Nokia, Motorola among others) have found it impossible to match the technological leadership of Samsung and Apple. Blackberry is barely even in the industry any more, and they were once the leaders.

Your benchmarks are going to be the companies that are entering the business today, with the business models that make that possible. In essence, the only way into this industry, unless you're playing a child's game of make believe, is to start at the low end, and build share by offering cheap phones to people who cannot afford the world's premium models, but instead are in the value segment. That's usually people in the developing world, which is why these companies come from those same regions. The technology for lower-end models is cheap and easy to acquire. Xiaomi is probably the biggest success story, but there are several other companies in China that have followed this pathway into the business (Chinese Smartphones.com, 2014).

Ethical Worldview

The product will be made under normal conditions for smartphones in China. The job of this company is to make money, and that will be done within the context of whatever laws are in place. That means that while we will not engage in bribery, we are also going to work with the subcontractors that deliver what we need in terms of quality and price. We are not going to be the police of the Chinese labor system -- our job is making and selling phones. The consumers have demonstrated quite clearly that they do not care too much about ethical issues when shopping for phones, so there is no financial advantage to be gained from taking a different ethical stance than our competitors take.

Implications

There are several implications of entering the smartphone business. First, there should be a discussion of the prevailing industry characteristics, as they are critical to understanding the financial ramifications of starting a new smartphone company. First, this is a highly competitive industry. At the high end, you would need to attract the best talent in the world away from Samsung or Apple -- good luck with that. It might have been possible to start at the top, leapfrogging the leaders, back in 2009 or 2010, but today even big money companies that are trying to do this cannot accomplish the task. A start-up with no brand isn't going to get the talent needed to realize that vision, and needs to build itself up, similar to how Huawei has done this over the course of several years. This is what makes the low end attractive. The technology for lower-end models is usually 1-3 years old, available off the shelf. A new company in this segment, therefore, has a relatively flat learning curve, and is mostly in the assembly and marketing business. The design aspects are going to be derivative, and that is simply not the most important part of the value chain for this start-up.

Thus, the focus is on finding two things. The first is an efficient supply chain, and the second is finding a market. More or less, the key to the latter is the former. There are no meaningful gaps in the smartphone market. Consumers generally opt for the best phone that they can afford. Thus, there is a fair bit of room -- and competition -- at the low end, where barriers to entry are low. Low barriers means a high level of competition, and with all companies seeking to succeed with a high volume/low margin strategy at the low end, being able to offer value is essential to success.

A good example of how to enter and grow rapidly in this business is Xiaomi, which is the largest OEM in China, the world's largest smartphone market. The Xiaomi flagship, the Mi4, is derivative of both the iPhone and the Galaxy, but the company undercuts both by half. It has a few specs that are better, but mostly it runs like an older version of those phones -- but not that much older. Essentially, the Mi4 is a very good phone at half the price of the industry-leading phones. This makes it incredibly attractive to buyers. Further, Xiaomi has surrounded its main lines with tablets, an app store and the otherwise full suite of services and products, just like the biggest companies (Amadeo, 2014). This has helped it to market itself as a value premium brand -- something that has allowed it to overcome its poor starting position as a brand nobody had ever heard of. While those ancillary services provide revenue, they also serve to make the entire product offering better, and it is recommended that any company serious about making an impact in the smartphone business have a similar "value premium" approach. Other Chinese upstarts are taking the same pathway to success, recognizing that a large segment of the market wants good features, but does not necessarily need to pay for the full range of premium features. Both Oppo and OnePlus are building on this strategy, for example (Seifert, 2014).

Aside from the phone, there are the service and distribution aspects that need to be paid attention to. How the phones are sold, distributed and serviced are of course all elements of the value chain. These need to be conceptualized in order to cost out those different elements. First, most start-ups are focused on Asia markets. They need to sell volume, quickly, in order to build their business, because margins are slender on derivative, commoditized phones. There's a reason all the new manufacturers come from China -- they make phones cheap and they have a huge market. India has people, but not the same manufacturing capacity. Russia, especially with the weak ruble, might be a place to start, but ultimately China is hard to beat as a proving ground. So the start-up has to look at the cost of assembling a phone, and marketing that phone in China. Why not the U.S. Even the best companies in China have had difficulty breaking into the American market. Apple and Samsung dominate this market -- their shares total 70.9% of the American market together, leaving little room for upstarts, with less than 30% of the market dedicated to anything other than the highest-end phones (Ausick, 2015). This compares with the worldwide market, where those companies hold a collective 42.9%, leaving much more room in lower rungs of the market for new entrants. It is worth noting that the only low-end phone among the top five manufacturers is the oldest and most diversified -- Huawei, with 5.2% of the global market. Xiaomi is the #6, leading a large peloton of smaller brands fighting for 40% of the world's share (IDC, 2015).

The industry is in a state of maturity, which is a condition significantly different from that in which any of the major industry players arose. The history of the industry is one of rapid change. Blackberry and Palm were the initial smartphones, or prototypes thereof, and they were aimed at the corporate market. Apple's first iPhone was really the first smartphone aimed at the consumer market, and it was a tremendous success. Among the followers, HTC first and then Samsung, were able to close the gap on Apple's technological leadership. The smartphone market was a race to the top, with the high-end phones being the big sellers, and sales focused in major economies.

In more recent years, the major markets have remained focused on high-end smartphones, with only around 30% of market share in the U.S. For example available for anything but the latest models. The U.S. market is showing signs of maturing, but short product life cycles are a factor in driving continued strong sales, and new phone introductions are also important demand drivers -- Apple's recent market share resurgence has been on the strength of the iPhone 6. In emerging markets, consumers are either getting their first phones, or are upgrading into mid-range phones. In many nations, there are tens of millions of consumers who can afford some sort of smartphone, but not a high-end one. So there has been tremendous growth in phones in the mid-range. China of course has been the strongest such market, but all major emerging markets have a similar profile. The reality is that this market is now maturing as well. This means slim margins due to competition, and the need to overcome those margins -- which provide relatively little contribution to fixed costs -- through a strategy that features strict cost containment on fixed costs along with a very high sales volumes. For most mid-range and low-end players, these are the keys to success. The optimal positioning is to offer a phone nearly as good as the major brands, but at a much lower price. The major brands have high margins (Luckerson, 2014),so there is room to compete there by accepting lower margins, but also companies tend to take advantage of the short product life cycles to use component technologies that are a year or two old, but at that age would be obsolete in a Samsung or Apple phone, but that are passable for many consumers and come at 30-50% less than the most modern components. This strategy has already been adopted by many firms, who understand that the smartphone market is quite a bit different now than it was even a few years ago, and will be the basis for our company's strategy as well.

So the implications of entering this market are as follows. The strategy has to be low-end, because of the learning curve and general impossibility of catching up to Apple and Samsung. The product has to be manufactured in China. It will be sold in China and adjacent countries initially, to build share. Further, the pricing strategy has to reflect the competitive marketplace. Manufacturers are basically price-takers, and their products are priced in line with the technology that they offer. The more successful companies transcend this -- Apple with its top level pricing and Xiaomi being able to undercut Apple and Samsung with a phone not dissimilar. But for most companies, in terms of pricing strategy they get in where they fit in, unless they can afford to use their phones as a loss leader. If the Mi4 is priced around 2000 kuai, or $320 roughly, a phone that is lower in quality by, say 30%, will need to priced 30% lower. That implies a retail price of $224 unlocked.

Revenues

The first step in the accounting part of this analysis is the revenue side. A phone that retails at $225 unlocked is going to be the starting point for the economics of this. There are several steps remaining at this point to assessing the profitability of the phone. First, the costs have to be known -- all of them. Then, the breakeven point can be established. At that point, the total market size and estimated share available will be determined, at which point the conceivable profitability will be understood. The most important aspect of this analysis is that the numbers need to be realistic. If not, well, garbage in garbage out. Anybody can say that their idea will be profitable, but if that finding is not based on realistic numbers, it isn't worth anything at all. The objective of this exercise, and of this type of managerial accounting exercise in general, is to aid with managerial decision-making, not to serve an agenda. Thus, managerial decision-making should be made on the careful analysis of facts. The next step, as noted, is to determine the cost structure associated with bringing this type of smartphone to market.

Costs

The cost structure is going to consist of a few different elements. The fixed/variable cost dichotomy is sort of awkward, in a sense, because most of the costs are variable. The major cost drivers are the materials, the labor and the marketing costs, and all of these are primarily variable. It is absurd to use Apple or Samsung as a cost base for understanding the fixed costs of a start-up smartphone company -- they are a hundred times larger, run multiple product lines, and have a global presence. When you want a comparable, you need something in the same ballpark. Xiaomi has released some financial information -- not exactly GAAP nor particularly detailed, but enough to provide some insight into the finances of a smartphone start-up. As Jones (2014) notes, the company's financials are not even close to Apple's. As is normal, Xiaomi did not publish managerial accounting figures either -- so no "direct," "indirect," "fixed" or "variable" cost lines. Most companies do not publish those.

For Xiaomi, the operating margin is 1.8%, and the net margin is 1.3%, which supports the above analysis that margins would have to be thin, and the company operating on a high-volume model in order to succeed (Jones, 2014). There is cost information to help break down those operating costs, however, if one looks at the iPhone. The 16Gb iPhone 6 apparently costs $200.10 to make, according to a third-party research report (Luckerson, 2014). The screen is the most expensive component, so naturally our company will need to use a cheaper screen in order to shave some dollars off of that production cost. If the production costs can be shaved by 25%, that could allow the company to arrive at a cost of goods sold of $150.075 per unit. Marketing will need to be a fairly intensive, but will not be in line with the high-end campaigns of the major producers. The marketing expenses are more likely to be in line with smaller companies like Blackberry or Nokia. Those companies spend millions as well -- Nokia's 2013 marketing spend was $13 million, which is still a fairly large number for our company. Xiaomi succeeded with viral campaigns, guerilla marketing and other low-cost strategies, something we will need to do as well. The marketing budget will initially be set for $2 million, with basically no advertising and all promotion done with low-cost strategies (Agomuoh, 2015). This strategy is in line with not only Xiaomi's approach but that of OnePlus as well (Kovach, 2014). This cost can, however, scale up with volume. The company is basically looking at the value of a customer over the lifetime of the phone and seeking to have a very low acquisition cost for each customer.

The remaining cost is for management, as well as research & development. Those are the fixed costs. These, based on the fixed costs for Blackberry less the R&D (which will be significantly lower) are going to be around 15% of revenue. The R&D cost will be around 5% of revenue. The following is a pro forma income statement:

Pro Forma Income Statement

Revenue/unit

COGS

Operating Profit

74.925

Fixed Costs

Marketing Costs

11.25

Administrative

33.75

R&D

11.25

Net Profit

18.675

Operating Margin

33.30%

Net Margin

8.30%

If the company assumes a target of 20 million units in the first year, that will allow it to dial in the sort of fixed costs it can expect, and this will allow for the calculation of a breakeven point:

Breakeven Analysis

Revenue/unit

COGS

Contribution to FC

74.925

Fixed Costs

Marketing Costs

225,000,000

Administrative

675,000,000

R&D

225,000,000

Total Fixed Costs

900,000,000

Breakeven point

12,012,012

So the company will need around 12 million units sold in order to break even. This needs to be sustainable, however, and there needs to be potential for growth. Starting this type of business is risky, so an investor will want a rate of return commensurate with that risk. The hurdle rate that an investor might look for is upwards of 20% on a start-up, depending on what the expected rate of return on more established companies like Xiaomi might be. Earning the breakeven will not be good enough. So the company needs not only to know that it can breakeven, but that it can grow from there. A caveat to this is that the more successful companies in the industry are not able to maintain margins like these. A more realistic view would be that the company might actually struggle to break even in the first few years, and would need to be capitalized to account for that.

A Note on Cash Flow

Most of this business is going to be conducted in China initially. The Chinese market places more emphasis on cash than may be the case in the U.S. Thus, the operation would be financed entirely with equity. With fixed costs of $900 million covering these costs will require a tremendous amount of money, even on a fairly healthy margin. If market forces cut into that margin, the breakeven point will only become that much higher. Thus, it is essential to limit costs on the administrative side. The breakeven analysis had these at $675 million, which was based on Blackberry, which is based in Canada. If Chinese costs are applied, and the administrative overhead is cut in a third, the breakeven point improves:

Breakeven Analysis

Revenue/unit

COGS

Contribution to FC

74.925

Fixed Costs

Marketing Costs

225,000,000

Administrative

222,750,000

R&D

225,000,000

Total Fixed Costs

447,750,000

Breakeven point

5,975,976

Thus, there is a significant impetus for cost control, as this will substantially affect the breakeven point, allowing the company to turn a profit at the sort of sales levels that might be more realistic for an upstart company in a highly-competitive market.

Market Potential

The market potential of the start-up smartphone company has to be evaluated in the context of what other start-ups have been able to accomplish. The Chinese smartphone market is large and there are many competitors. Xiaomi does 61 million units per year, basically all in China (Reuters, 2015). That is believed to be only around 15.4% of the total market in that country, though it should be noted that the market in China is maturing, which will challenge our new company, shrinking by 8% last year (Alba, 2015). If the market shrinks the same next year, it will be 363.5 million units. Our projected breakeven point is thus

12,012,000 / 363,584,000 = 3.3% share.

Is 3.3% share in the first year a reasonable expectation? Probably not. However, the bigger question is whether this sort of share is achievable in subsequent years, as the company will need to be profitable over the long run. Can we sell 50-60 million units in the first 4 years, which is what is needed just to be marginally profitable? That's debatable -- Xiaomi took as many years, in a rapidly growing market where it had notable competitive advantages. Our company could succeed, therefore, if it has competitive advantages, but the market is more mature now, and with greater competition, so the success is less likely. The company would almost certainly need to sell in at least one other major market in order to achieve long-run breakeven sales. Either that or cut costs further, scrape the bottom of the barrel, but that approach is not recommended because consumers will not typically trade down in their phones -- if their first phone is decent, they will not be in the market for a low-end phone subsequently. Most consumers prefer to trade up, a fact that Xiaomi leveraged beautifully by positioning itself between the low-end phones and the top of the market.