Photograph by Julie Glassberg for Fortune Magazine
The “Apple of China” gets a reality check as its smartphone sales slump.
January 15, 2015:
Inside a Beijing
convention hall big enough to fit a brigade, Chinese tech upstart Xiaomi
is rolling out its newest big-screen phone, the Mi Note. The event has
the hype of a Hollywood premiere, and $15 tickets have sold out to this
crowd of thousands of buzzing fans.
When CEO Lei Jun takes
the stage, in distressed jeans, sneakers, and a blue button-down, he’s
confident—cocky, even. You can hardly blame him. Xiaomi, the company Lei
founded in 2010, has become the world’s fourth-largest smartphone
seller, hawking affordable, stylish phones that cater to China’s immense
middle class and its youth culture. Xiaomi has just completed a funding
round that made it the world’s most valuable private startup, with an
astounding valuation of $45 billion—reflecting investor excitement about
not only its phones but also its “ecosystem” of online services and
smart-home products, which could turn phone buyers into loyal customers
for years to come.
Tech
journalists have begun calling Xiaomi the “Apple of China.” The name
rankles designers at the actual Apple, who grouse that Xiaomi phones are
merely cheap iPhone copies. Lei begs to differ. In fact, he tells the
Beijing crowd, his phones are better: “The Mi Note is lighter, thinner,
narrower, and shorter than the iPhone 6 Plus, but our screen is larger,”
he gushes. Over the next few months customers validate his exuberance,
as Xiaomi has its best quarter ever for smartphone sales—while monthly
users of its games, apps, and services top 100 million.
May 21, 2016:
Beijing again, but
this time at a government-sponsored tech conference in an older
exhibition center. Smartphones are a topic most attendees would rather
avoid, since sales have sputtered. But in an interview with Chinese
media, a Xiaomi public affairs official lets slip that Xiaomi’s sales
rose just 3% in 2015, to $12.5 billion. A year earlier, Lei Jun had
boldly predicted that figure would be $16 billion. As for the
much-touted ecosystem, investors say it produced half the services
revenue Xiaomi had expected.
Apparently
this news wasn’t supposed to go public: Chinese websites quickly delete
references to the interview, and Xiaomi declines to comment on the
numbers. Still, the setback reinforces what industry watchers already
suspect: Xiaomi’s sales have flatlined, and its revolution is in
jeopardy.
Xiaomi’s tale may sound like merely
another iteration of that now familiar headline, tech unicorn gallops
into wall. But Xiaomi (pronounced “SHAO-me,” with the first syllable
sounding like the “show” in “shower”) isn’t just any privately held,
multibillion-dollar startup. It’s a rising power in a nation eager to
prove that its consumer-oriented companies can compete globally.
“Xiaomi’s mission is to change the world’s view of Chinese products,”
Lei said last year. While Xiaomi no longer wears the most-valuable-startup crown—that now belongs to ride-hailing service Uber—its
$45 billion valuation remains a powerful symbol of its aspirations, so
much so that Xiaomi proudly includes it in product catalogues. (Some
analysts put the figure slightly higher.)
The company didn’t attain that valuation
on the strength of its phones, though those get raves in the tech press
(and have even made Xiaomi modestly profitable) while selling for half
the price of an iPhone. No, private investors judged Xiaomi to be more
valuable than FedEx
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or Caterpillar
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or Delta Air Lines
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because of the promise that it could build a network of
products, services, and recurring revenues—an ecosystem like Apple’s—not
just in China but around the world.
Zhang Jin Xinhua—Eyevine/Redux
If anything, Xiaomi’s idea of an ecosystem is more ambitious than Apple’s. Apple
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focuses on services like iTunes and a tightly focused suite
of tablets, computers, and smartphones. Xiaomi envisions a sprawling
Internet of things. The company hopes you will someday control your
Xiaomi water purifier, Xiaomi air filter, and Xiaomi mood lighting—an
entire Xiaomi smart home, essentially—with a few taps on your phone.
Executives and investors say today’s disappointing numbers are merely a
stumble en route to this goal. “In terms of the ecosystem build-out and
international expansion, Xiaomi’s still at the very early stages,”
Richard Ji, the venture capitalist and former Morgan Stanley
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tech analyst whose Hong Kong–based All-Stars Investment led Xiaomi’s big 2014 funding round, tells Fortune.
A bet on that build-out is a bet on
several transformative trends: the rise of China’s middle class, the
incorporation of average Joes and Janes into the Internet of things, and
the capacity of consumer-focused Chinese companies to make inroads in
Europe and the U.S. But as Xiaomi’s progress slows, there’s growing
skepticism that a startup without innovative technology of its own or
much success outside of smartphone sales can produce an ecosystem
anywhere nearly as big or “sticky” as Apple’s and Google’s
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. “I think the wheels are wobbling,” says Duncan Clark, an
Internet consultant based in China and an early adviser to e-commerce
giant Alibaba
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1.54%
. And that makes a bet on Xiaomi look more and more like a long shot.
Xiaomi executives hate it when their
company is called a smartphone startup. They much prefer “Internet
company.” And Xiaomi hewed to that identity even as it shipped 175
million smartphones over the past five years. The company had no retail
locations until recently, selling most of its phones via its website. In
China, the phone ships with Xiaomi’s operating system, a heavily
tweaked version of Google’s Android, complete with its own online music
and app store.
Xiaomi realized a few years ago that phone
buyers alone weren’t generating much recurring revenue—nor were they
luring return traffic from customers who might be enticed to upgrade to a
new phone. The company started selling smartphone batteries in
different colors as accessories, and those did well enough to spark an
aha moment, says Hugo Barra, Xiaomi’s head of international business:
“Why not new products?” Barra, a Brazilian-born MIT grad who once led
the Android new products team at Google,
had been poached to turn Xiaomi into an international brand. “We don’t
care about selling phones, but about getting as many users as we can,”
he has said. If devices attract users, Xiaomi brass reasoned, let’s
assemble a fleet of devices.
The ecosystem campaign aims to do just
that. Its core is a team of 170 people with expertise in product
development, supply chain, and design. But unlike, say, Jony Ive and his
design hive at Apple, Xiaomi’s team works primarily with outside
companies. The company partners with hardware startups (and often
creates new ones), providing seed money for ecosystem products. Xiaomi
avoids taking full control, encouraging the founders to act like
risk-taking entrepreneurs. The company gets an exclusive deal to sell
most of the startups’ products, and in turn the startups, now numbering
55, get access to Xiaomi’s supply chain, marketing, and even its
industrial engineers.
Courtesy of Xiaomi
Liu De, a 43-year-old former dean of
industrial design at Beijing University of Technology, leads the
ecosystem effort with a blanket approach, in which almost everything
fits. Xiaomi sells headphones, Bluetooth speakers, a fitness wristband
that doubles as a buzzing alarm clock. So far its bestsellers have been
everyday, non-“smart” products: a power strip, a portable smartphone
charger. But the bigger goal is to create an entire synced smart home.
In April, Xiaomi invited 300 journalists to its Beijing unveiling of its
$150 smart rice cooker. (From their phones, users can track rice transforming from the “water absorption” phase to one called “big fire.”)
Xiaomi’s ecosystem sales were about $750
million last year, although most of that flows to its startups through
revenue-sharing agreements. Smart homes may be a $15 billion market in
China by 2018, according to Juniper Research, and Liu says Xiaomi’s
ecosystem revenue might equal its smartphone revenue in less than five
years. Last year, 90% of Xiaomi’s $12.5 billion total revenue came from
smartphones. So in essence, Liu and Xiaomi hope to catapult a $750
million, mostly domestic business into at least an $11 billion,
increasingly global one.
A visit to Yeelight, one of Xiaomi’s
startups, suggests how complicated that effort could be. Headquartered
in the formerly German-controlled coastal city of Qingdao, the
60-employee company sells a “smart” mood light generating 16 million
hues, as well as a Bluetooth-enabled lightbulb—a dead ringer for the Hue
lightbulb from Dutch electronics giant Philips
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.
In 2014, after Google bought Nest for $3.2
billion, smart-home startups were in vogue, and Yeelight founder Eric
Jiang found himself being courted by venture capitalists. Xiaomi’s offer
seemed like a godsend, Jiang says. Xiaomi would help with everything
from branding to quality control. It also let Yeelight bypass
traditional retailers, who typically take a 40% cut of the purchase
price. Instead, Yeelight’s products were put in front of what Jiang
calls the fire hose of traffic on Xiaomi’s website—which averages more
than 140 million unique monthly visitors, according to China Rank.
Yeelight has sold 500,000 lightbulbs and
mood lights since last summer, 10 times the rate before Xiaomi invested,
says Jiang—at prices 80% lower than the Philips Hue starter kit. That
makes Yeelight the kind of symbiotic success story on which Xiaomi wants
to build its ecosystem.
But Yeelight is also the kind of company
that fuels Xiaomi’s skeptics—and one whose challenges mirror many of its
ecosystem startups. Yeelight sells products that aren’t daily
necessities, a sticking point for Chinese consumers, who have only about
20% as much discretionary income as Americans. And if Yeelight wants to
reach consumers outside China, its rock-bottom prices are bound to
rise. Even lightbulbs have intellectual property that needs to be
licensed outside China. (China has strong IP laws on paper, but
enforcement is lax.) Jiang, a former software engineer at Lucent, speaks
frankly: To sell in the U.S. or Europe, Yeelight will have to license
patents from other companies, which would boost its retail prices by
several percentage points. And since Xiaomi’s e-commerce site has
virtually no traction outside China, Yeelight would have to pair up with
traditional retailers, raising its prices another 30% to 40%. The
bottom line: Unless Yeelight rolls out innovative technology of its own,
it loses a lot of its price advantage outside China.
Photograph by Julie Glassberg for Fortune Magazine
Xiaomi’s phones have encountered comparable IP headaches abroad. Swedish telecom giant Ericsson for years accused Xiaomi
of using Ericsson wireless tech without licensing it—and after Xiaomi
began selling smartphones in India in 2014, Ericsson won an injunction
against it. (The case is ongoing; Xiaomi declines to discuss pending
litigation.) In May, Xiaomi announced a deal with Microsoft
that will help address the phone IP problem, buying 1,500 patents. But
those patents won’t do much for the lightbulbs and water purifiers. “At
least some of the ecosystem companies have this problem” with IP, Liu
admits. And without the support of Xiaomi’s website, only a few
ecosystem products have made the leap abroad. They aren’t exactly
high-margin, statement gear. The Mi Band fitness tracker has been
modestly successful in the U.S., for example, but it sells for $15.
Three years ago, Lei Jun told the New York Times,
“We’re not just some cheap Chinese company making a cheap phone.” But
many Chinese consumers still see Xiaomi that way because of some of its
stumbles in making trustworthy products. Its first Mi air purifier was criticized
this year by a Shanghai regulator for the amount of clean air it
produced. (The company says the purifier has “passed all standards
required by regulators in Beijing.”) Complaints about Xiaomi’s $620 4K
TVs appear on Xiaomi’s own consumer forums.
Even Xiaomi’s reputation-making phones
have been fallible. Though Xiaomi relies on a web of suppliers,
including iPhone-maker Foxconn, its products haven’t proved as reliable
as those of more mature competitors. Some Mi phone users lament cracked
screens and static from earphone slots. Xiaomi’s newest flagship phone,
the Mi 5, has attracted complaints since its release in March, with
buyers reporting that new handsets often reached a scorching 120˚ F.
Xiaomi says the handset complaints involve
“isolated cases” and says, “We do investigate all reasonable
complaints.” But the phones’ perceived unreliability has had an impact.
Clark, the Internet consultant, recently surveyed phone owners in China.
Only 37% of Xiaomi owners said they would buy another Xiaomi phone,
while 74% of Apple users said they would get another iPhone. “Xiaomi
isn’t sticky,” Clark says. “It’s not what an ecosystem should be.”
The growing pains would matter less if
smartphone sales were soaring. No such luck. Before the Mi Note launch,
Lei announced a smartphone sales goal of 100 million units for 2015. The
company ultimately shipped only 71 million,
according to IDC. In the first quarter of 2016, Xiaomi shipped 10.9
million phones, a 26% year-over-year decline. (Global phone sales were
down 0.5% over that stretch.)
These numbers make Xiaomi’s $45 billion
valuation look shaky. If Xiaomi delivers a 10% operating margin on its
$12.5 billion in revenue, it would be valued at a bubbly 38 times its
earnings. Since Xiaomi sells phones at close to cost to gain users, a 5%
margin seems more likely (and even generous). After taxes, that would
imply a value of 80 times earnings, and four times sales. If Xiaomi were
publicly traded, it would need to at least quadruple its revenue to
bring that valuation closer to, say, Apple’s.
If Xiaomi were public, it’s also safe to
say that distraught investors would have fled the stock. Apple’s shares
are down 12% since April, when it reported the impact of slowing
smartphone sales on its top line. Apple’s tech ecosystem is the world’s
most successful, generating $6 billion in quarterly revenue—roughly 12%
of Apple’s total sales. But that revenue is highly influenced by device
sales growth. When their phones are new, people spend more on apps and
services; when the shine fades, spending plummets.
Xiaomi, of course, is private. And its
sales have been strong enough to keep it from needing to raise more
money. That has helped the company avoid a headline-grabbing “down
round” where it might raise money at a lower valuation than its previous
round (although there are reports the company is looking to issue
debt). Tuck Lye Koh, an early Xiaomi backer and a co-founder of Shunwei
Capital in Beijing, says he and others are confident Xiaomi will
dominate China’s Internet of things. They see Xiaomi as both an Internet
company, blessed with low costs, and a future Ikea, a maker of
high-quality, low-cost goods that sell in mass volumes.
Richard Ji of All-Stars Investment says
Xiaomi’s lower smartphone prices mean its potential customer base is
much larger than Apple’s. To skeptics, Ji also replies: Just look at
Tencent. That Chinese Internet giant was largely dismissed by investors
until it introduced WeChat, which has become China’s most popular social
network, helping Tencent’s revenue more than quadruple since 2011.
Ji envisions a similar trajectory for
Xiaomi. But it hasn’t materialized. Xiaomi’s revenue from apps and games
missed its $1 billion sales target last year, hitting $560 million in
2015, according to one current investor. And unlike Tencent and Apple,
Xiaomi’s ecosystem growth hinges on making bestsellers out of devices
like rice cookers and drones—products for which competition is stiff and
margins are low. “These are one-use-type products,” says Neil Shah of
Counterpoint Research in Mumbai. “The rice cooker will only cook rice.
It won’t consume content. It won’t get you additional revenue.”
If Xiaomi doesn’t live up to its $45
billion valuation, you won’t need to shed a tear for the investors who
gave it that status. The Singaporean sovereign wealth fund GIC, Ji’s
All-Stars fund, Russian billionaire Yuri Milner’s DST, and Yunfeng
Capital, a fund affiliated with Alibaba founder Jack Ma, were among the
core investors in late 2014 that raised $1.1 billion for Xiaomi. Though
investors would not discuss the deal with Fortune,
the fact that the funding came relatively late in Xiaomi’s development
makes it likely that it’s a “ratchet” deal—one that will give investors
more equity if Xiaomi raises money or goes public at a lower valuation.
Xiaomi could mature into a successful
company even if it doesn’t reach the potential its investors foresee.
The Mi 5 phone, which Xiaomi unveiled this spring at Barcelona’s Mobile
World Congress, could reignite sales, while its Microsoft
patent deal could help its phones crack more foreign markets. Thanks to
inroads in India and Brazil, the company derives about 9% of revenue
outside China—a rare accomplishment for a Chinese company.
There’s also that dream of a smart-home
ecosystem—though Xiaomi won’t have that field to itself. Huawei, which
sold 108 million phones last year to seize the Chinese market-share lead
from Xiaomi, is now advertising its own smart-home suite, with partners
including Haier, the appliance maker that paid $5 billion for GE’s
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appliance business this year. “I don’t want to be considered
second to anyone,” Lei once told a crowd at a Xiaomi publicity event.
But despite a magical few years of growth, first place is looking ever
more out of reach.
A version of this article appears in the July 1, 2016 issue of Fortune with the headline “Xiaomi What You’ve Got.”
Ref:http://fortune.com/xiaomi-business-china/
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