This article first appeared in The Edge Malaysia Weekly on May 28, 2018 - June 3, 2018

IN a darkened theatre with just the beam of a spotlight, a man in black T-shirt, jeans and sneakers appears on stage to introduce a smartphone or some other shiny new gadget. You have probably seen the clips on TV or YouTube. As the camera closes up on him and the audience roars, you suddenly realise it is not Steve Jobs, the co-founder of Apple, but Lei Jun, the CEO and founder of Xiaomi — the maker of iPhone-lookalike cheap smartphones for the masses in China and India — unveiling the product. While he admits that the Apple co-founder was “an early inspiration”, Lei “Don’t call me Steve Jobs” insists he is no copy­cat and Xiaomi’s fledgling business model is very different from Apple’s.

Long brushed off as a cheap imitator, Xiaomi, literally “little rice”, is now almost like the real thing. China’s second-biggest unicorn, or private company worth over a billion US dollars, is seeking a listing on the Hong Kong bourse next month by raising over US$10 billion. Though it has quietly ratcheted down its expected initial public offering valuation from the US$100 billion reported in the media earlier this year to an expected range of US$60 billion to US$80 billion, Xiaomi’s listing would be the biggest capital raising for a tech company since the listing of Chinese internet giant Alibaba Group Holding on the New York Stock Exchange four years ago.

Even at the lower end of the range, Xiaomi’s market capitalisation will be larger than some of the long-established global consumer electronics names, including Japan’s Sony Corp (US$59.8 billion) and Panasonic Corp (US$33.8 billion) and Korea’s LG Electronics (US$15.4 billion). Some China tech analysts were surprised that Xiaomi ended up choosing Hong Kong over Nasdaq or the New York Stock Exchange, where its razor-blade model probably would fetch a far better valuation.

Xiaomi an internet company?

At the mid-point of the expected IPO range, or US$70 billion valuation, Xiaomi, dubbed the “Apple of China”, would trade at 39 times 2017 operating profit, or 4.2 times sales. “This would put its valuation in line with internet companies, which trade at 30 to 100 times earnings, compared with consumer electronics or tech hardware companies, which trade at 7 to 16 times earnings,” notes Mark Newman, tech hardware and semiconductor analyst at investment bank Sanford C Bernstein in Hong Kong. “If the new target valuation is higher, Xiaomi is effectively expecting to be valued like an internet stock, not a smartphone or consumer electronics company.” Lei has said he runs Xiaomi as an “internet company” that just happens to produce hardware at low prices.

Xiaomi made an operating profit of US$1.9 billion last year, up nearly 200% from the previous year, although if you were to deduct the cost of redeeming its convertible preference shares, which will automatically convert upon listing, that would become a pre-tax loss of US$6.5 billion. Still, some optimistic analysts are touting operating profit to balloon to US$4 billion next year and nearly US$12 billion in 2021, particularly if the Indian smartphone market explodes — in line with some of the bullish forecasts — and Xiaomi can claw back some of the market share it lost to Oppo Electronics Corp, Vivo Communication Technology Co and Huawei Technologies in China in recent years.

With an 8.4% share of worldwide handset sales, Xiaomi was the fourth-largest smartphone vendor globally in March, behind South Korea’s Samsung Electronics Co, which has 23.4% market share, Apple (15.6%) and Huawei (11.8%), according to IDC. Last year, Xiaomi’s handset sales grew more than 56% in volume terms. Indeed, with a 14% share of the Asian market currently, Xiaomi is now the second-largest smartphone maker in the region, just behind Huawei, but ahead of the two glo-bal giants, Samsung and Apple. It is by far the largest smartphone vendor in India, with more than 31% market share, according to research firm Canalys, way ahead of Samsung and Apple. But in its home market, it has fallen to No 4, behind Huawei, Oppo and Vivo, which are popular in rural China, as well as ZTE Corp and Lenovo Group, which have an urban China focus. Xiaomi has also been growing its footprint in Latin America, the Middle East and Africa as well as Europe, particularly in Eastern European markets. Yet, for all its global expansion, Newman notes that China accounted for 72% of Xiaomi’s revenue last year.  

Founded in 2010 by Hubei-born serial entrepreneur Lei, who had previously set up Chinese software firm Kingsoft and sold Joyo.com, a Chinese online bookstore, to Amazon.com, Xiaomi grew fast, raising US$1 billion in just three years and commanding a US$46 billion valuation. Among the early investors were Singapore’s two sovereign wealth funds, GIC and Temasek Holdings. Even at the lower end of the IPO valuation range, both GIC and Temasek would stand to more than double their original investment in the firm. “Xiaomi is a truly disruptive company,” notes Newman. “Not only is it the world’s fastest-growing smartphone maker, it also has a highly disruptive business model that has potential ramifications for the entire handset and consumer electronics industry.”

Selling an ecosystem

For its part, Xiaomi says it tries to limit its margins on smartphones to just 5% by trying to make money selling services, including software, apps, cloud storage space as well as accessories to its young, tech-savvy customers. Essentially, it is selling an ecosystem, not smartphones. Lei has likened it to the Gillette model of giving away razors almost for free only to make money from razor blades. Xiaomi makes money from internet services, such as selling apps and ads, which have 60% gross margins,” notes Newman.  

In a way, Xiaomi’s ecosystem strategy is similar to that of Apple, which has also been refocusing on selling services such as apps, music, cloud storage, ApplePay and, more recently, videos. Apple, which currently derives just under 15% of its revenue from services, has a stated goal of growing its services revenue to 20% of its total sales. Xiaomi’s take from services already exceeds 30%, with hardware making up the remainder. Lei has said his ultimate goal is to make services the core of Xiaomi’s revenue, amounting to about half of total sales.

Xiaomi successfully changed the narrative that it is just a smartphone hardware firm by being a major player that builds an “aspirational” and affordable lifestyle brand for China’s and Asia’s upwardly mobile young middle class, with services at the apex of its sprawling ecosystem. Having established its cheap smartphones, Xiaomi wasted little time to expand its product portfolio, selling everything from internet-connected rice cookers to WiFi-enabled air purifiers. It has since extended its product range to smart TVs, artificial intelligence-powered home speakers and, more recently, electric scooters.

Unlike many other Chinese tech giants that try to do everything with homegrown talent, Xiaomi recruited top talent from the US to help it grow. Four years ago, it hired a key Google executive — Brazilian-born Hugo Barra — as vice-president of its global operations to help lead its expansion in emerging markets such as India, Indonesia and Brazil, where there is real demand for sleek-looking smartphones that sell at a fraction of what an Apple iPhone or a Samsung Galaxy costs. Barra left Xiaomi last year and now leads the Virtual Reality unit at Facebook.

Xiaomi’s long-awaited IPO comes just a year after it was almost written off for dead as sales plunged in 2016, losses widened and it fell to the No 4 spot in its home market. Media commentators wondered aloud if its US$46 billion valuation in 2014 was pure hubris.

Like many upstarts, Xiaomi became a victim of its own initial success. One unique part of its business model was that it had minimal marketing costs because it relied mainly on  social media to spread the word rather than advertising heavily. Another key was it copied iPhone models even before they were unveiled by religiously following media reports on what exactly Apple was going to introduce next, right down to the shape and size of the handset.  Not long after Apple unveiled its rose-gold iPhone, Xiaomi’s low-end Redmi was being sold in Mumbai and Shanghai. Indeed, it often went one up on the iPhone maker by introducing several new models every few months while Apple stuck to one or two models each year. It cut costs by using cheaper materials and using the e-commerce model to avoid paying commissions to resellers.   

But rivals such as Vivo, Oppo and Huawei quickly copied Xiaomi’s sales tactics and then outmanoeuvred Xiaomi by actually having a large marketing and advertising budget as well as investing in physical stores, where people could touch and feel the smartphones. Xiaomi sales also suffered after missteps such as glitches in some models that were introduced too quickly before they had been tested.

But Lei and his team doubled down on the company’s expansion in India with several iPhone-lookalike models that matched the specifications of the top-end phone but sold for just a third or less. While it retained its mostly e-commerce sales strategy, Xiaomi also opened its own stores and pushed to have its phones in retail locations across China and India because many older Indians and Chinese want to touch and feel a phone before buying it.

By being laser-focused on services, Xiaomi is positioning itself for the post-smartphone era. The global smartphone market peaked a year ago and has been declining ever since. Handset sales worldwide fell 2.9% in the first three months of this year, weighed down by slowing sales in China as well as in developed markets, where smartphone users prefer holding on to their phones for two, three or even four years instead of replacing them with new models every two years as they once did. As people hold on to their handsets longer, smartphone makers are working hard to extract more value from their existing user base by selling them more services and accessories or higher-end models.

Xiaomi has also invested in more than 90 start-ups that work on apps, services, software and accessories over the last five years. Though not all are likely to succeed, even mediocre success from its venture capital investments is likely to help the so-called Apple of China.

Expansion plans

What’s next for Xiaomi? More international expansion to cut its reliance on China. But don’t look for Xiaomi to enter the lucrative North American market anytime soon. Apple, which is seeking US$1 billion from Samsung for intellectual property violations, has promised to go after Xiaomi in the US courts if it were to start selling its copycat handsets in the US or Canada.  

US President Donald Trump’s recent decision to give Chinese state-owned tech giant ZTE a reprieve to carve out a broader trade deal with Beijing also does not bode well for Xiaomi. If Trump had not stepped in, ZTE’s phone business, which depends on US components and patents, would have collapsed, allowing Xiaomi to pick up more Chinese customers.

So, should investors buy Xiaomi shares in the IPO next month? Or soon after the listing if they can’t get a slice of the IPO? Unfortunately, the track record of recent high-profile China IPOs is not that great. Several are underwater or trading 30% to 40% below their recent highs.

A predominantly hardware play like Xiaomi, despite its focus on services, is likely to struggle in a market worried about US interest rates and valuation concerns. But if Xiaomi lists at the bottom end of its expected valuation range and global markets shake off macro concerns, investors might want to give the iPhone imitator a second look.

Assif Shameen is a technology writer based in North America

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