From Internet Phone to Hardware Company: Xiaomi's Eight Years From Startup to IPO

The first and only company to go public on the strength of smartphones.

Lei Jun, who coined the phrase "stand at the vent and even a pig can fly," is standing at the vent again.

On May 1, the Hong Kong Stock Exchange changed its rules to let companies with weighted voting rights list, opening the door to China's internet companies.

At 9 a.m. on May 3, Xiaomi published its prospectus and announced it would go public in Hong Kong. Word that had leaked earlier put its target valuation at $100 billion, with a listing as soon as June.

Meanwhile, China's smartphone market fell 21% in the first quarter. Smartphones, the industry that drove global tech growth for more than a decade, are past their peak — and when growth stops, competition gets fiercer, which takes money. For a phone company, there may never be a better time to go public.

The last time Lei Jun stood at the vent, it was because smartphones were exploding.

In 2010 he started a company to build a customized phone operating system, and began making phones a year later. He arrived just as Apple and Google were sweeping away the old rulers — Nokia, BlackBerry, Microsoft — like so much dead wood, and clearing room for new companies.

Xiaomi's "internet phone" entered the right market at the right time and reached number one in Chinese sales in under three years. Honor, Lenovo, Meizu, Smartisan, OnePlus and a crowd of brands now blurred in memory all became followers of the "internet phone." Those were the best years for Xiaomi and for the whole Chinese phone industry — Tim Cook came to China and said Apple's sales had just passed Xiaomi's, and Jony Ive pointed at Xiaomi and said copying is theft.

Then growth across the industry hit its ceiling, and Xiaomi ran into a crisis of its own, falling behind Huawei, then OPPO, then vivo. It changed executives, opened offline stores, built an "ecosystem chain" and a MUJI of its own. After two or three unsteady years, Xiaomi was a different company.

Xiaomi became a traditional phone company. It sold 91.4 million handsets last year, and internet services brought in only 8.6% of its revenue — internet revenue is 15% of Apple's, and nobody calls Apple an internet company.

Offline stores, celebrity endorsers, bigger cuts for Suning and Gome: Xiaomi's phone business in China looks more traditional every year. Its growth in phones now comes mostly from India, where, once a phone is sold, the money that follows goes to Google, which requires the Play Store to be preinstalled. That isn't an internet business either.

At the same time Xiaomi got more efficient and became a profitable hardware company. Operating profit last year was 12.2 billion yuan, most of it from selling phones, and its smart-hardware and home-goods business runs more efficiently than comparable companies and has started to make money. All of this took eight years and 9.2 billion yuan of funding — less than a rounding error next to what Didi or Meituan have raised.

In eight years Xiaomi went from a company that broke with tradition to one that rode the smartphone market through its best years. By the time it went to the market for money, that market had peaked and turned down, and Xiaomi was locked in traditional, brutal competition with OPPO, vivo and Huawei.

Xiaomi had released total phone sales before, along with selected profit figures and product-line numbers, but there was no way to judge how the company as a whole was running.

This prospectus is the first time we can see it.

Starting a Company at the Best Possible Moment for Smartphones

Apple and Google both entered the phone market in 2007. iPhone sales doubled in 2009, the year Samsung and Motorola put out their first Android phones and began to threaten Nokia, BlackBerry and the other traditional brands. By 2010 the smartphone industry was growing more than 70% a year worldwide.

In 2009, two years after quitting Kingsoft, Lei Jun brought together six people to found Xiaomi with him: Lin Bin, vice president of Google China's engineering institute; Huang Jiangji, development director at Microsoft China's engineering institute; Hong Feng, a senior product manager at Google China; Zhou Guangping, senior director at Motorola's R&D center; Liu De, chair of the industrial design department at the University of Science and Technology Beijing; and Li Wanqiang, general manager of Kingsoft PowerWord.

In the early days of smartphones, Android had a great deal of room to improve. Xiaomi's first step with the "internet phone" wasn't selling phones over the internet; it was collecting feedback over the internet. Traditional phone makers spent more than a year building their software and shipped it and were done. Xiaomi rewrote its version of Android every week.

Fast iteration on system builds and phone apps looks unremarkable now, but no phone company did it before Xiaomi. Meizu gathered feedback through forums, but its pace and its choice of operating system meant it missed the best window.

MIUI won Xiaomi the earliest users, the ones who most enjoyed tinkering with a smartphone — also China's first generation of smartphone owners. At the end of 2010 Xiaomi closed a $41 million Series A, and the next summer its first phone went on sale: around 2,000 yuan for specs that matched the far more expensive Android phones from Samsung and HTC.

The low price came from a change in sales channels. Xiaomi sold entirely online and kept its selling costs under 3%. It also used flash sales to gauge demand and gave its factories production targets week by week.

A product priced unlike anyone else's, plus software iteration, hardware production and sales channels all moved onto the internet, made Xiaomi a success quickly. The next three years were mostly the story of a fast-growing company working out how to grow faster.

The rest of China's phone industry moved onto the internet with it. OPPO signed Leonardo DiCaprio to endorse its new Find phone; BBK Electronics, which shares some of OPPO's bloodline, set up the vivo brand and shipped its first phone the following year; Huawei launched a sub-brand, Honor; and Meizu, turning itself from an MP3 company into a smartphone company, released its first Android phone, the M9. All of it happened in 2011.

The Xiaomi model became the template for all of them.

"This is a permanent change," said Clay Shirky, the New York University professor who wrote Little Rice: Smartphones, Xiaomi, and the Chinese Dream, describing Xiaomi's effect on the industry. "What you show users is what people can do with this phone, not just the phone itself. When Huawei, Meizu and OnePlus launch a phone now, they stress what you can do with the hardware — they learned that from Xiaomi."

Racing Toward the Ceiling With the Whole Industry

The Xiaomi model grew fast, and by 2014 the company looked nothing like the one that had been founded four years earlier.

That year it sold more than 60 million phones; three years before, the number had been under 300,000. Xiaomi took market share quickly. By the third quarter of 2014, IDC put it ahead of Huawei, Lenovo and LG as the world's third-largest smartphone maker, behind Samsung and Apple.

Xiaomi also closed a new $1 billion round. Less than three years after it was founded, its valuation had risen to $45 billion — more than $10 billion above JD.com's market cap at the time.

The fast growth had to do with low prices. Redmi and Redmi Note, mid- and low-end phones under 1,000 yuan, took Xiaomi beyond its base of "enthusiasts." The Redmi Note went on sale in March 2014 and passed 10 million units in eight months.

2014 was also the peak year for smartphone growth worldwide. Shipments topped 1.3 billion, up nearly 30% on the year before and almost double the 2012 figure. That rate has never returned.

That year Apple released the big-screen iPhone 6 and pushed its own growth to a new high. In 2015 the iPhone sold 230 million units, its record.

That burst of growth rested on the last group of people who had never owned a smartphone, plus everyone who wanted a bigger screen.

It turned out to be the last engine of the smartphone boom. Makers have pitched one new technology after another since, and none has rekindled that kind of enthusiasm.

Growing fast made Xiaomi a much larger company. Even Tim Cook, talking about how well the iPhone 6 was selling in China, called passing Xiaomi "great news."

Selling cheap and selling a lot, Lei Jun defined Xiaomi as an internet company: Mi.com, China's third-largest e-commerce site; MIUI, a phone operating system with 85 million users; and 66 "ecosystem chain" companies making smart hardware, content and internet services.

Apart from OPPO and vivo, essentially all of China's phone industry followed Xiaomi into selling phones cheap and hoping to make its profit from internet services, smart hardware and the rest of an ecosystem. LeEco, which pushed the ecosystem story furthest of anyone, also set up its company and started preparing a phone in 2014.

But the growth stopped soon after.

Online Sales Hit Their Ceiling, and the Whole Industry Went Back to the Oldest Kind of Competition

At the end of 2014, Lei Jun expected Xiaomi to sell 100 million phones in 2015. The target was later cut to a range of 80 million to 100 million.

Xiaomi sold 70 million. The whole Android market had turned saturated and cheap — under 2,000 yuan a phone on average — growth slowed, and the number of competitors rose.

Every one of Xiaomi's rivals had worked out how young people shop. By the first quarter of 2016 Xiaomi had dropped out of IDC's global top five, and it shipped only 41.5 million units for the year, fewer than the 60 million of 2014.

This was what a falling smartphone market did. Global shipments in 2015 barely grew at all; once most of the world owns a smartphone, growth can only come from replacements.

And Xiaomi's earlier pursuit of selling efficiency had cost it an enormous group of buyers — people who don't follow information online closely and aren't especially sensitive to price either.

Their business went to Huawei and to OPPO and vivo, which share a parent in BBK Electronics. They had more offline stores, they were willing to hand offline partners a share of the profit, and they were willing to spend hundreds of millions of yuan on billboards and endorsers. They were not as efficient as Xiaomi, but they reached more people, and the brands they built appealed to buyers who cared less about value for money. All three passed Xiaomi between 2015 and 2016, and between them sold phones to more than 200 million people in China.

OPPO's chief marketing officer, Liu Lei, said in 2016 that less than 5% of the company's sales went through Tmall, JD.com and other e-commerce sites: 95% of its phones were sold offline. Add vivo and the two brands together sold 97% of their phones offline. Xiaomi, which had put more than 80% of its channel online, was starting to feel the limits of selling online only.

"We spent a long time solving the supply chain, and products could finally be supplied at scale," Lei Jun said in one interview. "Then we found we'd hit a ceiling. Supply wasn't the problem anymore; the channel was. We underestimated how fast the phone market would change. The market gave us less time than we thought it would."

Having hit bottom, Lei Jun started making changes.

In the phone business itself, he took the supply chain back under his own management, with the phone R&D and supply-chain teams reporting to him directly. Once he took over, relations with suppliers eased and Xiaomi gave up more of its margin to them.

At the same time Xiaomi raised its prices across the board. Of the 11 phones it released in 2016, only three were budget Redmis at around 1,000 yuan. That year, for the first time, a Xiaomi phone was priced above 2,000 yuan.

Higher prices let Xiaomi give up margin in order to sell through big offline channels like Suning and Gome, and to hire endorsers and shoot television commercials. Large Xiaomi ads appeared at bus stops and in waiting halls across the country.

There were new businesses beyond phones too. In 2016 Xiaomi introduced the Mi Home brand and put everything other than phones, routers, televisions and tablets under it. In Lei Jun's words, it was a new MUJI. Coming from Xiaomi, naturally, a cheap one.

After all these changes, Xiaomi was back in fifth place in the second quarter of 2017, with annual growth of 58% — in a year when global phone shipments fell 1.3%.

The Market Is Shrinking and Competition Is Rising. What Kind of Company Is the Xiaomi That Is Going Public Now?

Xiaomi posted a net loss of 43.9 billion yuan in 2017, but it is in fact a profitable company, mainly on phone sales

The prospectus puts Xiaomi's 2017 revenue at 114.6 billion yuan and operating profit at 12.2 billion yuan. Its income statement shows a net loss for the year of 43.9 billion yuan.

That is a product of the Hong Kong Stock Exchange's rules for valuing preferred-share equity.

Since 2010 Xiaomi has raised about 9.7 billion yuan by issuing preferred shares of various classes. The largest single round, 4.59 billion yuan, closed in December 2014.

Set against other Chinese internet companies, which raise billions of dollars at a time, Xiaomi's total is already modest.

Every time a new round closes, those preferred shares are revalued, and the increase is booked for the time being as a liability. Once the company lists, it converts to shareholder equity and the corresponding loss disappears.

Strip that effect out and Xiaomi's 2017 net profit was about 5.3 billion yuan.

Xiaomi issues Class A and Class B shares: one Class A share carries 10 votes, one Class B share carries one. Together they give Lei Jun, with about 34% of the shares, more than 50% of the voting power in the listed entity, and absolute control of the company.

At an IPO valuation of $80 billion to $100 billion, Lei Jun could be worth $27 billion to $34 billion after listing. At $34 billion he would rank behind Jack Ma, Pony Ma and Xu Jiayin as the fourth-richest person in China.

Xiaomi wants to be the MUJI of technology, and it really does sell appliances more efficiently than traditional appliance makers

Ecosystem-chain products have grown from 13% of Xiaomi's revenue in 2015 to 20.5% in 2017, or 23.4 billion yuan a year — about 2.5 times its internet-services revenue.

A traditional appliance maker sells through third-party platforms online and off, which means settlement periods and the cost of building its brand on someone else's shelf. Xiaomi's ecosystem-chain products go from the customer's order to the warehouse system, which sends a courier; because they ship straight to the customer under Xiaomi's own brand, the money goes straight to Xiaomi, and its capital turns over much faster.

Xiaomi collects its receivables in 12 days and pays its own bills in 95. By China Merchants Securities' estimate, a traditional appliance maker waits 6 to 12 months after a sale for an e-commerce platform to hand over the money. Gree Electric, one of the industry's leaders, turns its receivables in about 16 days.

The phone business, competitive as it is, is also enormous, and the competitive position and supplier relationships Xiaomi has built there give its Mi Home business lower supply-chain costs.

Xiaomi calls itself an internet company, but internet revenue is a far smaller share of its business than of Apple's

Since 2011 the story Xiaomi has told the world is that it captures users with high-spec, low-price smartphones and then makes its money on internet services. At the time, Lei Jun said outright that Xiaomi was a mobile internet company.

According to the prospectus, MIUI had 190 million monthly active users at the end of March 2018, each contributing an average of 55 yuan in revenue.

By revenue, though, Xiaomi is still a hardware company. Of its more than 110 billion yuan in revenue last year, about 90.8% came from Xiaomi phones and the hardware made inside its ecosystem chain. Internet services were 8.6%, down from 9.6% a year earlier. Apple, by comparison, took 15% of last quarter's revenue ($9.1 billion) from internet services — and that on top of the healthy profit it already makes on expensive hardware.

What internet services do for Xiaomi is lift its overall margin. Against a gross margin of 8.6% on phones, internet services carry a gross margin of 60%. They include the app store, ads built into the system and its software, and revenue-sharing deals on games.

The outlook for that growth isn't especially bright either.

For one thing, Apple has drawn off, through the iPhone, the users most willing to pay for software and services: with about 11% of the phone market, it takes more than half of all app-store revenue.

For another, Xiaomi has to fight for the revenue on its own phones. The main opponent is Tencent, whose Yingyongbao and WeChat both pull users past phone makers' app stores to download games directly, and take a cut. No phone maker dares take a hard line with WeChat.

And that is only China. Overseas revenue reached 28% of Xiaomi's total in 2017, more than triple the 2015 share. But abroad, Android app-store revenue goes entirely to Google. Chinese Android makers not only get no share of the Play Store, they pay Google roughly $1 per device.

Selling more phones abroad and earning a larger share of revenue abroad, in other words, does nothing for Xiaomi's internet-services revenue in those markets.

With the phone market falling, Xiaomi, like other Chinese companies, is paying higher operating costs to hold on to scale

In 2016 Xiaomi squeezed its inventory costs hard, pushing the risk of inventory writedowns onto its supply chain and its distributors. Inventory at the end of that year came to just 8.3 billion yuan, 300 million less than in 2015.

It also drew complaints from channel partners and suppliers, and it left the new Mi Note 2 out of stock for a long stretch, wasting the heavy marketing money spent in advance.

In 2017 Xiaomi clearly changed course: year-end inventory doubled to 16.3 billion yuan. The receivables used to settle with suppliers jumped from 2 billion yuan to 5.4 billion.

Whether that rebound is good for Xiaomi isn't clear yet. More inventory avoids a repeat of the Mi Note 2, with nothing to sell for want of parts. But a large pile of stock also ties up cash Xiaomi doesn't have much of.

Xiaomi's operating cash flow in 2017 was negative 1 billion yuan: it showed a profit on paper, but 1 billion yuan more went out than came in. For a company that sells hardware and holds 11.5 billion yuan in cash, that is pressure.

Chinese smartphone sales, meanwhile, have fallen for several quarters running. Fighting for share, China's four largest phone makers are all raising the cut they hand offline channels, Suning, Gome and Dixintong among them; running more advertising; and using better hardware. All of it squeezes the profit in the phone itself.

Smaller companies simply cannot compete in a market like this. Meizu and Gionee, both in dire straits lately, are the examples.

In the prospectus released today, Xiaomi did not disclose how much it intends to raise or what valuation it is aiming for. But financial media including The Wall Street Journal and CNBC generally expect a target of $100 billion and a raise of $10 billion, 30% of it going directly into R&D on phones and other hardware.

In a phone business that has stopped growing, Xiaomi is raising an enormous amount of capital by going public. Ahead of it lies traditional, brutal competition.

Cover image / Xiaomi