Xiaomi: Just a Hardware Company?

Whether or not Xiaomi is just a hardware company or is truly an internet company as founder Lei Jun continually emphasizes came into question with last week’s Wall St. Journal report. The statistic that surprised many was the “94% of revenue made in hardware” figure. It was generally believed Xiaomi sold their hardware at cost with little to no margin and made their profits with internet services. However, if the Wall St. Journal report is correct, then that assumption has been flawed, at least up until now.  What’s fascinating, and perhaps enlightening, about what we learned from the report is they have effectively figured out how to still get average OEM net profit margins. Xiaomi’s BOM cost of their popular Red Rice Phone is about $85 and sells for $130. Their popular Mi3 has an estimated BOM cost of $185 and sells for $270. By being able to manage the supply chain and, after other hard costs, I estimated hardware net profits of approximately $23-$26 per phone sold.

What is interesting to ponder with relation to the Wall St. Journal report is why Xiaomi’s profit only increased 85% when handset shipments increased 200% YoY. One would think, given this hardware model they are employing, profits would scale with such a dramatic increase in unit sales. Clearly Xiaomi incurred some significant costs, perhaps in CapEx, or in global expansion efforts, which offset their profit growth.

Another explanation for the discrepancy in growth was a higher mix of products like the RedMi and RedMi Note which, in a BOM cost analysis I did by looking at their suppliers, suggests this product was sold well below the average of $23-$26 estimated margin per phone and may have actually been sold at a slight loss. In fact, non-public reports I have read hint that Xiaomi initially prices their phones at or just below cost but then quickly drives costs down allowing them to begin to yield margins that weren’t there initially. Xiaomi in this case is a lot like Dell, in that they only order the phones to be made once the sales are taken in. Xiaomi manages zero inventory and only builds phones in bulk for the orders they have taken. This is one reason the order availability is capped at a certain level. By managing supply chain tightly, and driving product costs down over time while capturing those margins in real time, they have effectively been able to generate the kind of hardware revenue the Wall St. Journal report indicates. That being said, they can not simply be a hardware company. And ultimately their growth prospects are challenged with just this business model. This is why they are seeking to raise capital. A cash infusion is necessary for Xiaomi to grow and grow quickly, which they’ll need to keep capitalizing on the mind share they currently have.

Ultimately however, I believe Xiaomi is still laying the critical groundwork to be the internet services company they desire to be. Being in the hardware business alone is not a sustainable business for many global OEMs. I have spoken with several high-up execs at Xiaomi and was told that, as of late 2014, they are generating around $21 million USD in revenue from their app stores (game app store, mobile app store, and books app store). Which means it is likely 2014 profits should have quite a bit more balance between hardware and services. Xiaomi is on pace to again increase handset shipments ~200% — yet the WSJ report only estimated a 75% increase in profits this year. The curious variable of why profits are not more closely matching explosive YoY handset shipments is a concerning element of the overall Xiaomi story.

Can Xiaomi go international? That remains to be seen. Their sales in markets outside of China have been nominal to date but there is increasing brand awareness in non-Chinese markets. Scaling internationally will be a challenge and they have to be more than a hardware company to do it sustainably. Xiaomi is in the news a lot but I still have my doubts about their long term fate. If China is the only market they are relevant, this is not a bad thing. Xiaomi can have a strong and profitable regional business and still be successful.

Thoughts on Xiaomi

The Wall Street Journal had a big scoop this week: some numbers on Xiaomi’s business are apparently being shared with potential investors as it looks to raise money for acquisitions and/or expansion. Until now, I’ve held off on writing anything in-depth about Xiaomi precisely because its financial model and key facts such as its profitability were opaque, and I found it difficult to evaluate its likely impact going forward without that understanding. Now that we have at least a few tantalizing glimpses at Xiaomi’s finances, I feel like it’s finally time to share some of my thoughts.

One of the three most interesting companies in smartphones

Xiaomi is on my list of the three most interesting companies in the smartphone space right now, along with Lenovo and LG. Each of the three is very different and interesting for varying reasons. Lenovo is interesting because it’s transformed itself from a provincial player to a global force in PCs and now sits in the top five in smartphones, tablets and PCs, and rising. With the acquisition of Motorola, it promises to do what all the other Chinese OEMs have failed to do: break into the US in a big way. LG is interesting because it seems like the most viable alternative to Samsung for many carriers looking to diversify their Android vendor base, since it’s not as shaky as HTC or Sony and doesn’t come with the baggage of the Chinese vendors. With some really good phones in the last few months, its shipments have been steadily rising and its margins with them. But Xiaomi remains the most mysterious of the three and, in my opinion, actually the least likely to make headway in the US.

A unique model, different from Apple’s in important ways

Xiaomi’s model is unique, even though it’s often compared to Apple’s. Apple’s model relies on tightly integrated hardware and software it controls end to end and owns exclusively. Services are another crucial component of Apple’s value proposition, and exclusivity has often been a hallmark of those too, though Apple hasn’t been afraid to buy into data and services when it needs to, though allegiances have shifted over time (Google out, Microsoft and Yahoo in, for example). Xiaomi also differentiates itself through the software and services it brings to bear, but its model is different, in that the core of its software is Android, owned by Google and not Xiaomi. This gives the company less control over its own destiny, but obviously also significantly reduces the cost of going to market and maintaining its OS.

The services Xiaomi provides are a hodgepodge of pieces and parts cobbled together from a variety of sources. I loved this in-depth review of a Xiaomi device from July because it highlighted the patchwork nature of what Xiaomi provides (and what the user adds him or herself through the app store). Baidu’s maps and search are apparently defaults, but many of the other services are local equivalents to Google, whose services of course are famously not available in China. This means a major revenue source for Xiaomi is likely fees from the various partners it signs up to fill these slots. Xiaomi’s own software and services focus on the non-revenue-generating aspects such as the weather app and the voice recorder. Yes, Apple has relied on Google in the past for key features, but that was the past and that relationship quickly changed. Apple has always been strong enough to eventually develop its own global ecosystem to rival Google’s, but Xiaomi is far from having that sort of global clout.

A model that won’t work in the US

All this means a model that works well in China will work far less well in many other markets where the Google services are available and where they are the preferred options for users. To the extent Xiaomi thrives on the first- and third-party software and services it layers onto the operating system, that model breaks down quickly in markets where both users and Google will insist Google services are paramount. Xiaomi can get away with not providing the Google services package in China but, if it wants to be an official Android vendor outside of China, it will have to dial down those customizations.

The WSJ article is tantalizingly short on consistent details, providing a precise number here but only a vague allusion there, hinting at margins here but leaving out the comparable figure from a year earlier, and so on. But there’s enough to establish a few key facts: Xiaomi is profitable, the vast majority of its revenues come from handsets, and it spends very little on marketing. To top it all off, it’s doing all this, with higher margins than all but two other vendors, with an average selling price of somewhere around $200, which is unheard of. The services and software piece is likely critical to those margins, as the revenue from its licensing deals is likely mostly profit, but again that model will break down quickly outside of China and a handful of other markets where local services are prized above Google’s. It will certainly break down in the US.

The question of intellectual property

The other thing that’s been widely discussed with regard to Xiaomi is its liberal borrowing of both hardware and software design from other vendors, notably Apple. Some have suggested it won’t be able to expand into the US because of the intellectual property threat outside of China, but I think this may be overblown. Apple in particular has spent years fighting Samsung over patents and allegations of copying and I just can’t see it repeating this process with Xiaomi. It’s too expensive, too time-consuming and ultimately seems to do little good. By the time the court cases are resolved, the devices in question have long since had their day, and the legal wrangling has caused all sorts of private information to emerge. I suspect Xiaomi may be more careful outside of China with some of its design decisions, but I don’t think the threat of litigation is the biggest barrier to its entry into the US and other major Western markets.

Is there a future without a presence in the US?

The biggest question for me then, is not whether Xiaomi can succeed in the US, but whether it can succeed on a global basis without succeeding in the US. That’s generally been tough: the US remains by far one of the largest markets for premium smartphones, and that’s where the margins have been. Though Xiaomi’s model allows it to generate margin elsewhere, premium phones are critical to future success. But we’re seeing an increasing regionalization in smartphones, with major countries such as China and India fostering their own domestic brands and lending otherwise impossible scale to companies operating in a single market. Lenovo’s success in smartphones has come almost entirely from China itself and Chinese vendors are now able to build scale to match (or even exceed) that of global vendors even before they venture overseas. As a result, there’s no doubt in my mind Xiaomi can continue to grow in both size and influence as a smartphone vendor over the next few years. But I believe its success will come despite its failure to break into the US, not because of success here.

For further analysis of Xiaomi and the offerings they provide beyond hardware, see Ben Bajarin’s video analysis of the company.

Video Analysis: Xiaomi in Focus

I have the ability to record and broadcast presentations I give through my primary presentation tool Perspective. So I thought it would be interesting to try something different and create a quick analysis of some of my data and add make some points around a particular focused topic. To start, I thought I would focus on Xiaomi. I’d love any thoughts or feedback on this as it is something I’d like to do more of, specifically for our subscribers, but wanted to test it out broadly first.

If you have the Perspective app (it’s free) you can use this link and watch this in the app which is a higher quality experience than the video. As I do more of these, it may be a good idea to get the Perspective app (available on iOS for iPhone or iPad) since I may do more of these live and be able to take questions. All of that can only be done in the app. If you use the app, you can also pause these stories and interact with my charts yourself. If you have iOS I encourage you to try it.

The one is 11m long. I’d like to keep them shorter in the future.

[fluidvideo url=”//player.vimeo.com/video/108588142″]