Sales in China Plunged 34.9%. In the End, the Problem Was Xiaomi's Two-Year Offline Strategy

Value for money and hit products — Xiaomi is trying to go back to what it was at the start.

In the last three months of 2018, China's smartphone market carried on the slide that had run through the whole year, with sales down 9.7% from a year earlier.

Most of the attention went to Apple, naturally. iPhone sales fell 26.7%, Tim Cook wrote an open letter admitting the company was in trouble in China, and the new iPhones were selling for 2,000 yuan off less than two months after launch.

But on February 10, a report from the phone-industry research firm IDC came as a surprise. In the fourth quarter of 2018, Xiaomi's crisis in mainland China was worse than Apple's: shipments plunged 34.9% year on year, and its market share dropped to fifth place.

Xiaomi's answer to the slide has been visible over the past two months.

On January 10, Xiaomi made Redmi a separate brand and handed it to Lu Weibing, the former president of Gionee, who had just joined the company. The first model, the Redmi Note 7, sells for 999 yuan. At the launch event, Lei Jun said the Redmi brand would "fight to the death for value for money," put a taunt from Honor's president about the Redmi spin-off up on his slides, and said, waving his arm: "Our rivals are rattled — that shows we're doing it right… value for money has nothing to do with our rivals!"

The Mi 9, which goes on sale on the 20th, has already run six straight days of an "online launch event" on Weibo, one video a day. Lei Jun and brand ambassador Roy Wang have given away every selling point of the new phone: a 48-megapixel camera, three rear cameras, CNC micro-engraving, dual-frequency GPS, "generous use of materials."

By pushing "value for money" and "generous use of materials" to the front again, Xiaomi has lifted its sub-1,000-yuan phones to the same rank as the Mi line. That is a major adjustment: high value for money leaves Xiaomi little profit to hand to offline channel partners, and low prices leave thinner commissions for the salespeople in stores.

Xiaomi is trying to go back to what it was at the start — cheap for the specs, with users comparing components carefully and ordering online. That is exactly the path Xiaomi spent the past two years trying to leave behind by opening up offline channels.

In third-party offline channels, Xiaomi's sales push has clearly weakened

QDaily visited six phone retailers in Beijing and Shanghai: three Gome stores, two Suning stores and one Dazhong Electronics store. All six looked alike. Oppo, Vivo and Huawei held big, prominent stretches of floor; Xiaomi was usually squeezed into a corner, sometimes with no counter at all.

On the east side of Beijing, the Suning store in the Foreign Enterprise Building on Dawang Road sits next to the crowded Hopson One mall. Xiaomi has two 1.5-meter counters there, displaying about 10 phones. The neighboring Vivo and Oppo areas are at least five times bigger, white counters running in a ring around a space with tables, chairs and sofas. One sales assistant told QDaily they barely rested over the Spring Festival: the Vivo area needed four assistants working in shifts, while the Xiaomi counter normally has one.

A Gome store in Tangzhen, Pudong, Shanghai, open for barely a month, had no space for Xiaomi at all. A clerk who said he had sold phones for more than ten years said Xiaomi now puts next to nothing into Suning and Gome; of Shanghai's roughly 50 Gome stores, he guessed, at most five still sell Xiaomi phones.

Sales assistants have little reason to steer customers toward Xiaomi.

The Dazhong Electronics store in the Carrefour in Shuangjing, Beijing, is on the mall's first floor, where an ad for Xiaomi's New Year shopping festival sits beside the orange Xiaomi logo. No Xiaomi assistant was there, and the salespeople at nearby counters knew nothing about the promotion.

A salesperson at a Gome store in Shanghai told QDaily that Xiaomi's rebates to frontline staff are now very low — under 5% in commission. Other brands are much the same, he said, but Xiaomi's is the lowest in the whole store.

Smaller channels get even less. A dealer who runs a phone shop in a county town in Linfen, Shanxi Province, told QDaily he can no longer get any commission out of Xiaomi: "The wholesale price I pay is higher than the promotional price on the official site." Xiaomi phones stay on his counter only because "young people still come in and ask."

In Xiaomi's IPO prospectus, Lei Jun called hardware plus new retail plus internet services the company's "triathlon." The new-retail leg rests mainly on Xiaomi's own stores, not on these third-party channels.

As of the end of September 2018, Xiaomi had 499 full-range Mi Home stores in mainland China, plus 1,100 authorized outlets covering smaller cities and rural areas. Xiaomi built them out fast: from late April to early May it opened 61 stores in four days, a record.

Selling direct guarantees service and focus, but next to its rivals Xiaomi's fewer than 2,000 offline outlets are nowhere near enough. Back in 2015 Oppo already had more than 250,000 offline stores. Richard Yu, CEO of Huawei's consumer business, said Huawei had 53,000 stores by the middle of 2018.

On sales efficiency, Xiaomi's own stores are far less nimble than the phone distributors entrenched across the provinces. Many of those distributors were built up by Nokia in the mid-2000s, when Nokia paid retailers rebates large enough to make them push Nokia phones.

In March 2016, Xiaomi struck a deal to sell its phones through 1,200 Suning stores — a courtship of a big offline channel that was read as an important step toward taking share from the traditional manufacturers. Xiaomi followed up with a Redmi phone made with Suning, updated in 2018 to the Redmi 2S and sold only in Suning stores.

Even so, Xiaomi never got much better at offline distribution — or rather, it paid too much to try.

In two years Xiaomi succeeded in raising phone prices, but not in making more profit

A sudden one-third drop: Xiaomi has been through a crisis like this before.

By 2016, online phone sales were nearing saturation and growth was coming mainly from offline channels. That year Xiaomi shipped only 41.5 million phones — fewer than the 60 million of 2014, and down 36% from 2015.

Competing offline means paying commissions to distributors, often rebates of 10-plus and sometimes 20-plus percentage points. That is before advertising and brand ambassadors, which cost money too. Xiaomi has never been the kind of internet company that burns cash without limit or consequence, so the only way to open up offline channels without losing money was to sell more expensive phones.

In 2016 Xiaomi launched pricier models. The sub-1,000-yuan Redmi line was cut to three new phones, and the Redmi Pro went up to 1,499 yuan. The flagship Mi 5s broke through the iconic 1,999-yuan price point for the first time. Then came the Redmi Note 2, with an OLED screen curved on both edges like the Samsung Galaxy Note 7, which pushed the price up again, to 2,800 yuan.

Xiaomi gave up margin to sell through big offline chains like Suning and Gome, signed brand ambassadors and shot television commercials; large Xiaomi ads appeared at bus stops and in waiting rooms.

In 2018 Xiaomi trimmed the product line further and raised prices across the board. The Mi Note series vanished after three generations, and the flagship Mi line's signature 1,999-yuan price rose to 2,699 yuan.

At the same time, the average revenue Xiaomi got from each phone it sold — the price it charges distributors — rose from 807 yuan in 2015 to 1,052 yuan now.

The point of raising prices was to raise the profit on each phone. Every major phone maker, Apple included, has done the same thing since the market stalled.

By the figures in its financial reports, Xiaomi's average gross profit per phone reached 100 yuan in 2017, three times the 2016 level and equal to a gross margin of 11.7%.

The gains did not hold. By the third quarter of 2018, Xiaomi was making an average of 64 yuan in gross profit per phone. Its phone business produced 2.135 billion yuan in gross profit that quarter, 30% less than a year earlier.

The IoT business, which includes products from Xiaomi's ecosystem companies, has healthier margins — its gross profit had doubled from 2017 — but even that could not fill the 870-million-yuan hole the phones left.

In other words, over the past year Xiaomi's phones sold for more and its hardware profit shrank.

For comparison: the much-criticized iPhone price rises brought Apple problems of their own, but Apple's hardware margin has held at around 35%. Xiaomi's phones got more expensive, and most of the extra revenue went to advertising and sales channels; the profit each phone brought the company fell.

Xiaomi's operating efficiency has slipped as well. One trip through production, sales, shipping and collecting payment counts as an operating cycle; in the third quarter of 2018 Xiaomi took an average of 65.24 days to finish one, 10 days longer than at the time of its 2017 annual report.

More serious still: since the price increases, Xiaomi's user base in China has been shrinking.

Xiaomi's user base at home is shrinking, which threatens its internet services revenue directly

Lei Jun opened Xiaomi's IPO letter to shareholders by insisting that "Xiaomi is not simply a hardware company, but an innovation-driven internet company." High growth and high profit are what make internet services attractive; the gross margin on this part of Xiaomi's business runs as high as 68%.

Seventy percent of Xiaomi's internet revenue comes from online advertising — ad slots in the app store, ads placed inside the MIUI system. Both make money.

But internet ad revenue rests on the number of users, and over the past year Xiaomi's user base has started to fall.

The Mi App Store comes pre-installed on every Xiaomi phone, so how much it is used reflects how many Xiaomi phones are in people's hands.

According to tracking data Aurora Mobile supplied to QDaily, the number of people opening the Mi App Store each month stopped growing after May 2018, and fell in the most recent month.

Over the same stretch, active-user numbers for the Huawei, Oppo and Vivo app stores all grew to varying degrees, and each was more than twice Xiaomi's size.

The app-store number runs a little below Xiaomi's actual user base, since Xiaomi owners may use third-party stores from Baidu, Tencent and others. But users who skip the Mi App Store bring it no ad revenue either.

Data tracked by another research firm, Quest Mobile, shows a similar downward curve: in the year to September 2018, Xiaomi's share of the smartphones used by China's internet users fell from 12% to 9%. Measured against the size of China's internet population over that period, that works out to roughly 70 million Xiaomi users.

Xiaomi has a good number of users abroad, but 96% of its internet revenue currently comes from China. A shrinking Chinese user base means a shrinking base to make money from.

Xiaomi's internet revenue is still growing because each user is worth more to the company. Its financial report put average internet revenue per user at 21.1 yuan in the third quarter of 2018, up 34% year on year. Since 70% of that is advertising, if the number of active users at home does not recover, the only way to keep revenue growing is to show still more ads on Xiaomi phones.

Too many ads damages the experience, and Xiaomi has been questioned over this before. A side-by-side test by FView concluded that with no new apps installed at all, Xiaomi ranked third among domestic Android systems for notification-bar ad pop-ups, pushing 17 ads in four days. The advertising has hit the brand directly. In 2018, as P2P lending platforms collapsed one after another, Xiaomi pushed P2P ads to users, which set off a controversy.

There is also the wider climate. A research note published by Sinolink Securities early this year points out that the industries spending most on internet advertising in recent years — gaming, e-commerce, internet finance, cars, fast-moving consumer goods, real estate and others — include many whose demand was weak in 2018, hit by everything from regulation to the macroeconomic cycle. What advertisers do with their budgets is the biggest uncertainty facing Xiaomi's internet business at home.

The overseas business is Xiaomi's biggest bright spot, but it creates a new contradiction

IDC's reports on China and India show that, in absolute shipments, by the end of 2018 India had passed mainland China to become Xiaomi's largest market in the world.

That is why, even with China down 34.9%, Xiaomi still managed 1.4% growth globally. It has held the top market share in India for four straight quarters.

Xiaomi's shipments in Indonesia grew 337% year on year, second in market share; in Western Europe they grew 386%, though that has a lot to do with a small base.

In 2015, only 6% of Xiaomi's revenue came from outside China; by 2018 it was more than 40%. Set against the enormous manpower Oppo and Vivo have poured into India, Xiaomi took a bigger market at a fraction of the scale — a startling performance.

The catch is that abroad, and especially in India, which accounts for the bulk of its overseas sales, Xiaomi still does not make much profit.

What Xiaomi mainly sells in India are cheap phones: of the models on its Indian site, only two are Mi phones, and the other six are Redmis priced between 500 and 1,300 yuan. You could read it as Xiaomi using overseas markets to keep selling 1,000-yuan phones and make up for the decline at home.

The bigger problem is that outside China, Android phone makers struggle to earn internet revenue at all. Google requires phone makers to install its own app store, Play Store, which takes away the largest source of internet revenue on an Android phone.

Video and music are sizable sources too, but Netflix and Spotify hold those. Netflix alone is worth more than four times as much as Xiaomi.

That is why Xiaomi now sells more phones abroad than in China, yet overseas produces only 4.4% of its internet revenue.

This is a problem all Chinese phone companies share abroad. Internet revenue is not something to count on; in the end they still have to make money by selling expensive phones.

And expensive phones have become harder to sell. Apple raised prices with every model from the iPhone X on, leaving the 4,000-yuan band to Chinese companies. But after the XS and XR flopped, Apple started cutting prices on its new phones too — the XR now goes for as little as 4,500-odd yuan. All of that squeezes the room Chinese Android companies have to grow. Even Huawei, the best performer among them, has begun cutting prices in response.

Redmi's new Note 7 is being called the "little powerhouse," and the Mi 9 has been thoroughly teased on social media before it goes on sale, its features and selling points all disclosed, with only the price left as a surprise. If you remember, Xiaomi phones followed much the same script eight years ago.

The Chinese market still matters most. How Xiaomi's phones do in China determines the sales of its smart home appliances and 96% of its internet services revenue. Value for money and hit products: Xiaomi has doubled back to the road it was on two years ago.

Graphics: Luo Cong

Cover image from Pixabay and Visual China Group