Xiaomi's Killer App Is Its Business Model

Leonid Bershidsky is a Bloomberg View columnist. He was the founding editor of the Russian business daily Vedomosti and founded the opinion website Slon.ru.
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Xiaomi Corp., the private company that sells the most smartphones in China, was until recently shrouded in mystery: It wasn't clear how it could make money by selling top-of-the-line products at rock-bottom prices. Xiaomi has revealed its 2013 financials, and they show a handsome profit, which means smartphones from Apple, Samsung and even LG and HTC may be grossly overpriced.

Xiaomi's flagship phone, the Mi4, sells for a minimum of $327. Its specifications are largely the same as, say, the Samsung Galaxy S5's, which costs at least $150 more. The Chinese maker doesn't skimp on component quality to drive down the price: It uses the same Sony battery and optical sensors, Qualcomm processor, Wi-Fi and audio chip, Samsung RAM chip and other parts found in premium smartphones. Xiaomi phones don't look or feel cheap, though their design is minimalistic. The Mi interface, with its highly intuitive, native-feeling and iOS-like Android flavor, doesn't display the bloatware that characterizes the phones of other manufacturers.

It's a good piece of equipment that reviewers can't fault. It could compete on its own merits, not just on price, so why sell it cheaply?

One possible answer is that Xiaomi sees the phones as just delivery devices for software, which the company also develops.

"We are an Internet and a software company much more than a hardware company," Hugo Barra, Xiaomi's vice president for global operations, said at a recent tech conference.

Barra repeats this disorienting mantra every chance he gets, but the financial data, published in The Wall Street Journal, show it either reflects wishful thinking or plans for a distant future. The company made 94 percent of its $4.3 billion in revenue from selling mobile phones. Even Apple is more of an "Internet and software company": hardware accounts for 90 percent of its sales.

Xiaomi is a late entrant to the market, so it has avoided the hassle of going head-to-head with established players in its price category. Instead, it has chosen to keep down both costs and margins, and to concentrate on the product.

The company is spending very little on conventional marketing. Instead, it provides forums and communicates with users on social networks. In 2013, it only spent 3.2 percent of revenue on sales and marketing. Apple's sales and marketing efforts consume twice as big a share of revenue, which is 40 times greater than Xiaomi's. Samsung's selling and marketing expenses account for 16.3 percent of sales.

Even though it saves on everything except quality parts, Xiaomi still has a gross margin only half as high as Apple's or Samsung's. It did, however, make a net profit of $566 million last year, 12.8 percent of revenue. That's high: Samsung's net profit last year was 13.3 percent of revenue.

That may explain why Xiaomi is attempting to attract its latest round of financing at a higher valuation relative to sales than Apple commands. The Chinese company may be more valuable than any other mobile phone manufacturer because its business model is a killer app. Xiaomi founder Lei Jun described it this way:

When I was with Kingsoft, I had the opportunity to work with Nokia and Motorola, 2 mobile phone giants of their time. One day, I pointed out to their R&D boss, some inadequacies. After that, they merely acknowledged my input, but never acted upon what I had said. So I thought to myself, if I make a phone, you can tell me anything you wish for it or what's wrong. If it is justifiable, we will work on it immediately. I'll give you an update every week and you may even see your wishes come true within a week.

In this era of marketing-driven business, "build it and they will come" isn't a popular approach. It is effective, however. When Xiaomi phones become more readily available in Europe and the U.S., there will be no reason to pay more for competing products whose specifications and build quality are practically the same. Chinese consumers have already reached this conclusion.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Leonid Bershidsky at lbershidsky@bloomberg.net

To contact the editor on this story:
Max Berley at mberley@bloomberg.net