Thoughts on Xiaomi

on November 6, 2014

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.