“We pioneered an amazing, innovative business model underpinned by courage and trust,” founder Lei Jun said in an open letter accompanying its offer document Thursday in which he reiterated a pledge to cap hardware margins in favour of making money via services.
Reading through its 597-page prospectus, it’s apparent that in Xiaomi-speak, “services” means “serving ads.”
Xiaomi has done quite a job of monetizing device buyers beyond the initial transaction, tripling sales from the services segment over the past two years. Smartphones accounted for 70 percent of revenue last year and 46 percent of gross profit. Internet services, on the other hand, accounted for 8.6 percent of revenue but an outsized 39 percent of gross profit.
What surprised me most is how dependent this business is on advertising, which accounted for 57 percent of the category’s revenue last year. (Online games is the other major component.)
“We use our proprietary technologies and big data analytical capabilities to offer comprehensive and innovative services to our business partners and users.”
Here’s how it works: Xiaomi sells a smartphone at near-cost, including its MIUI mobile interface. Through that, Xiaomi tracks your usage and learns what you might be interested in. It then starts suggesting apps, some of which will be Xiaomi-developed. Once installed, the company then has an ad-serving platform right in front of your eyes.
Xiaomi can also make money by pushing third-party apps. In some cases, it’ll split the revenue if a customer upgrades from a free to a paid app, or signs up for a subscription such as iQiyi’s video content service.
For a hardware company, that’s quite innovative. It also pits Xiaomi against Baidu, Alibaba Group Holding and Tencent Holdings in China, and even Facebook and Amazon.com Inc. in international markets such as India.
In its prospectus, Xiaomi talks up the fact that competitors must spend money to acquire users. Xiaomi believes it doesn’t face that problem because users actually pay for the privilege of being connected to its ad network, and crowed about this in its prospectus.
“Selected leading internet companies all have acquisition costs, which differs from Xiaomi who profitably acquires users through hardware sales.”
But this is misleading.
Growth in sales and marketing costs outstripped revenue since 2015, as the company expanded into physical retail and shipped cheap smartphones to build market share. But if every smartphone purchaser is also a platform user (as Xiaomi asserts), then the expense of selling those devices needs to be considered an acquisition cost. Sales and marketing expense per handset sold doubled from CNY 28.7 ($4.52) per phone in 2015 to CNY 57.2 last year, according to my calculations.
So not only does Xiaomi have user acquisition costs, these expenses are rising. Offsetting the expenditure is its markup per device – the gross profit – less other operating costs such as admin and R&D. Accounting for all these, smartphones were sold at a loss in 2015, and it’s difficult to discern any profit in 2016 and 2017.
Only once that’s all settled can Xiaomi hope to make money from services. It had 171 million monthly active MIUI users in December – think of this like Apple’s iOS install base – and garnered 57.9 yuan in revenue from each of them last year. (Notice that services ARPU and marketing cost per phone track each other closely.)
The big risk to this model is that it depends on consumers continuing to buy Xiaomi’s hardware, and use its MIUI interface, and use the firm’s apps and allow their usage to be tracked, and convince advertisers that price-sensitive buyers of low-end devices are a compelling market to target. We already saw from Xiaomi’s sales slump in 2016 that Mi fans aren’t that loyal, while being built around the Android operating system means there’s not much stopping customers from switching to Huawei or Oppo, or Samsung phones.
“Courage and trust,” Lei Jun said. Yup, that’s exactly what both consumers and investors will need.