Xiaomi Stood Where the Wind Should Blow — But in 2015 No Wind Came | Top 15 Annual Report

Smartphone sales fell short of expectations, and the smart-hardware bets failed to become the next big trend. What does 2016 hold for Xiaomi?

"After we suddenly became the market leader, we couldn't adjust to it — and every gun was trained on me." That is what Xiaomi CEO Lei Jun told the Wall Street Journal in October 2015.

Early this year, Xiaomi used its annual conference to announce its smartphone sales for the past twelve months: more than 70 million units, below the 80–100 million target it had set at the start of the year. By comparison, Huawei — which Xiaomi had overtaken in 2014 — came roaring back and sold more than 100 million smartphones over the year.

Xiaomi versus Huawei shipments over the past eight quarters

By 2015, 90.1% of China's 620 million internet users were already on smartphones, and quarterly smartphone sales had begun to slide. That meant smartphone brands could only fight over each other's users; there was no longer a pool of feature-phone holdouts, or people with no phone at all, left to convert. The job had grown much harder.

Against that backdrop, Xiaomi's rivals kept growing fast. OPPO, which had always run a dense network of physical stores, saw its sales climb from under a third of Xiaomi's to roughly half. Meizu, which had sold just 4.4 million phones in 2014, drew 20 million buyers in 2015 through aggressive marketing and a faster release cadence.

As its rivals surged, the internet-marketing approach Xiaomi had always prided itself on weakened in 2015 too. After Li Wanqiang — the vice president in charge of marketing and the Xiaomi online store — left at the end of 2014, the divisive but widely shared campaigns like "the art of a steel plate" and "austenitic 304" simply disappeared.

Waiting at the New Wind Gap — and No Wind Came

After the Xiaomi 2 sold big in 2012, Lei Jun delivered a line that would be quoted again and again: "Where the wind blows, even a pig can fly."

The remark was cited many times afterward, and Li Wanqiang — then Xiaomi's vice president for the online store — wrote it into his book on Xiaomi's marketing methods, Participation. "Find the wind gap," meaning seize the trend and find the opening, became one of the central tenets of the Xiaomi success story.

Lei Jun has always had a sharp nose for the next "wind gap." But in 2015, neither of the two he picked produced any wind.

Starting in the second half of 2014, he announced loudly that he had invested in 60 Xiaomi ecosystem companies, concentrated in four areas: smart hardware, software, internet services, and content. Lei Jun's logic was that Xiaomi could not divide its attention by making hardware beyond phones, routers, and televisions, so he wanted to wire all these portfolio companies into Xiaomi's software and hardware, its e-commerce channel, or its services — a wall around the core hardware products, or, put another way, a vast network linking back to them:

"Xiaomi has several networks. First, Xiaomi is not just a phone company but a mobile-internet company, so our first platform is the mobile-internet platform. The second platform is e-commerce — by revenue and by scale, especially in smart hardware, we rank among the top three nationally. One reason we care so much about the smart-hardware supply chain is to round out Xiaomi's product line. The third platform is cloud services.

Within our ecosystem there are also three layers. The first is the smart-hardware ecosystem; the second is the content-industry ecosystem; the third is cloud services. In the hardware ecosystem we invest in hardware startups; in the content ecosystem we brought in Chen Tong and invested in Youku and iQiyi; in cloud services we invested in Kingsoft and 21Vianet."

So from the second half of 2014, a wave of ecosystem companies whose names ended in "mi" (米) surfaced one after another, and reports that "Xiaomi is also moving into apartments / home renovation / O2O" appeared more and more often. In return for an equity stake, Xiaomi gave these companies promotional exposure and channel access, with their hardware listed directly for sale on the Xiaomi online store.

In 2015, the investing went on. But among the hardware companies Xiaomi backed, the only one to raise a further round so far is Huami Technology, maker of the Mi Band. Another Xiaomi ecosystem company, Misfit, was bought by the Fossil Group at a price not far from the valuation it carried when it first took investment — hardly a success.

Globally, too, the "smart-hardware wind" Lei Jun was waiting for never blew. Fitbit, the largest wearables startup, saw its share price fall to a third of its peak within six months of its IPO — even 20% below the offering price.

Jawbone, the other big name in wearables, cut its valuation by 50% after its latest funding round and announced layoffs. For all the companies charging into smart home and wearables, none has yet found a single product form on track for wide adoption.

The second bet Lei Jun placed in 2015 was that Xiaomi could move upmarket.

In January 2015, Xiaomi launched the Mi Note at 2,299 yuan. At the event, Lei Jun spoke at length about how finely the phone was made; he even held up an iPhone 6 Plus for comparison and argued that his phone was expensive for good reason. The top-tier Mi Note, fitted with Qualcomm's top phone chip, the Snapdragon 810, cost even more, at 3,299 yuan.

This was the first time in five years that Xiaomi had broken its own 1,999 yuan price ceiling. But the high price did not hold for long. Because of the Snapdragon 810's many problems with overheating and compatibility, Xiaomi did not actually start selling the top-tier Mi Note until four months after the announcement — and by then its price had already dropped to 2,999 yuan. Soon after, the standard Mi Note was cut back to 1,999 yuan, the comfort zone Xiaomi fans were used to.

The markdown came unusually fast. Xiaomi's usual practice is to cut the price of a device only when the next-generation model in the series arrives, at which point the previous generation gets discounted. Cutting early is a sign of sales pressure.

The "internet smartphone sales model" Xiaomi pioneered was, in recent years, seen as the cost-saving future of handset distribution. But the rivals that caught up last year were all companies with some grounding in physical channels: OPPO itself had a large number of stores, and Meizu's offline-to-online sales ratio was 7:3. Huawei, which built its business on carrier channels, opened a large number of stores even as it added online exposure.

Xiaomi, which put more than 80% of its distribution online, was beginning to feel the limits of a purely online approach.

The Vicious Cycle of Cheap Phones

From the launch of its first smartphone in 2011, Xiaomi positioned its prices in the mid-range and went up against Samsung on software experience and specs.

Before Xiaomi, most products from China's smartphone makers were cheap, few-hundred-yuan handsets — the low end that brands like Motorola and Nokia had no wish to enter at scale. (Remember Birdie?) Xiaomi seized on a crowd of geeks who wanted a capable phone that did not cost as much as a Samsung or an Apple.

But in 2015, Xiaomi moved that battle down into the sub-1,000-yuan budget market. This was clearest after its first-half sales came in at 33 million units — less than half the annual target, which gave the handsets launched later a whiff of moving volume to prop up the numbers. The budget Redmi Note line, in particular, refreshed its product line twice in the second half of 2015 alone:

• January 2015: Redmi 2, 699 yuan
• January 2015: Mi Note, 2,299 yuan; Mi Note top-tier, 3,299 yuan
• April 2015: Mi 4i, about 1,272 yuan
• August 2015: Redmi Note 2, 799 yuan
• September 2015: Mi 4c, 1,299 yuan
• November 2015: Redmi Note 3, 899 yuan

Because the flagship "Mi 5" missed 2015, Xiaomi's new phones this year came in cheaper than ever — which can certainly help it find more users. But low prices brought a vicious cycle:

A user willing to spend less than 1,000 yuan on a smartphone — a tool that sits at hand twenty-four hours a day — is unlikely to spend much on content and software later on.

Xiaomi's reliance on online sales magnifies the problem: people who buy a cheap phone online rather than in a store are more sensitive to specs and simply want the most processor and memory for the least money.

To serve these users, Xiaomi has no choice but to speed up its refresh cycle and push out one generation of budget phones after another.

It is a vicious cycle. Kept up, it leaves Xiaomi burning down its own brand to attract more users.

Meanwhile, Huawei's higher-priced domestic models, the Mate 7 and P8, still found a market. Its China sales doubled in 2015, and its average product price doubled too.

"Over the years they've held on to their physical-store channel and their carrier channel, and combined them well with an online e-commerce channel," Gartner analyst CK Lu told QDaily. He saw Huawei's strong results as the product of several factors, with balancing its channels an important one.

In 2015, Xiaomi walked a road of ever-lower prices. For a company that has openly declared its aim of making money through software and services, this vicious cycle is deeply unhelpful.

A counterexample is Apple. On the recent Apple earnings call, CEO Tim Cook said the company would not expand its user base by launching cheap products. Independent analyst Neil Cybart argues that what Apple does not want to lose is the willingness of premium users to pay for Apple apps and services. By staying focused on the high end, Apple can keep finding the people most willing to pay more for good hardware — and those same people are the guarantee of future spending on apps, games, music, and video.

Xiaomi and Lei Jun's 2016

Aware of the problem, Xiaomi is already preparing some changes for this year. Reuters recently cited sources saying Xiaomi's 2016 goal is to double its offline sales over 2015, with an ultimate target of 58 million handsets sold through offline channels such as Gome and Dixintong.

To date, Xiaomi has invested in many startups spanning smart home, wearables, robotics, and other fields. And Lei Jun's search for the "next wind gap" has not stopped. At Xiaomi's annual conference this year, he announced two new directions for the company: a push into robotics and into virtual reality.

Since founding Xiaomi in 2010, Lei Jun has shown a foresight far ahead of his Chinese peers:

• 2010: Xiaomi began building a phone operating system, using the internet for the first time to gather and act on product feedback, and started building an internet fan economy;
• 2011: Xiaomi launched its first smartphone, joining software and hardware and using online sales channels to cut offline costs;
• 2012: The Mi 2 became a hit and scaled up without leaning on the old carrier channel;
• 2013: The Mi 3 showed that a cheap smartphone could have a bit of design; the lower-priced Redmi pushed Xiaomi's reach beyond geek users;
• 2014: Xiaomi's app store began generating real revenue, with sales topping 200 million yuan in its best single month;

But can Lei Jun, who waited for a wind in 2015 that never came, still catch his rivals? China may be the most fiercely contested smartphone market there is. Xiaomi has won little ground overseas, and 90% of China's mobile users have already made the switch from feature phones to smartphones — which means this year Xiaomi will have to take market share straight from other handset makers.

That is no small challenge.

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