Recently I had this interesting debate with an old friend who's a marketing expert for 3M, an important player in the smartphone supply chain given its film technology, in the smartphone market. Specifically we're debating over the potential of Xiaomi, the red-hot Chinese startup that recently become, for a good 8 hours at least, the 3rd largest smartphone manufacturer in volume, shipping 17.3M devices in the past quarter, trailing only the two giants Samsung (78.1M) and Apple (39.3M).
For those of you who don't yet know the company, it's famous enough now that you could google for a lot of articles that cover them. The latest buzz about them, in addition to claiming temporarily the No. 3 spot in smartphone shipments, is the Bloomberg article reporting that Xiaomi is seeking a new round of investment at a valuation of a whopping $50B. Those of you who read my recent article using Peter Thiel's 7 questions to analyze the 9 most valued startups today should vaguely remember that Xiaomi is currently valued at $10B, which supposedly came from its Series D in August 2013. This represents a 5X multiple in valuation within less than 16 months, assuming they close this round by the end of 2014.
Of course, if this happens, it will catapult Xiaomi way ahead of Uber ($18.2B) into the highest valued startup in the world.
$50B sounds like a lot already, until you factor in the required rate of return for this up and coming round.
How so? Assuming that this new round is still funded by VCs, which has a cost of capital of 30%. That means they're expecting Xiaomi to make an exit, very likely an IPO, either in 12 months at a valuation of $65B, or in 24 months with a valuation of $84.5B. Given the Xiaomi growth trajectory though, I think the VCs who will bet on them now will be looking for them to yield an IRR higher than 30% so as to cover their losses in other companies.
How significant is a $84.5B valuation? Turns out it's good enough to put Xiaomi into the Russell Top 50® Mega Cap index, currently with a low-end at around $78B. All this for a company that will be barely 7 years old in two years. (Granted the low-end of Russel Top 50 Mega Cap index will definitely change in two years as well.)
The more likely investor is probably growth capital funds, which in general seek 10% IRR, much lower than the 30% IRR of early-stage VCs to reflect the lowered risk at this stage. Still, that would be a lot of trust put into a company that has yet to make a single dime.
And probably it's the fact that Xiaomi almost aims at not making a single dime NOW that gives them the chance to challenge giants like Apple and Samsung, and this is where my view diverges from my 3M friend's.
There are two distinct characteristcs about Xiaomi's business at this moment:
- It generally sells smartphones at cost and often with high specifications
- It sells through on-line channels, avoiding all usual retail channels
If we project these two distinct characteristics into the exploding middle-class population in emerging Asian countries, we can start to see why some investors are even considering making this bet.
Specifically we're talking about countries like Indonesia (Population: 252m, GDP growth: 5.8%), Vietnam (Population: 90m, GDP growth: 5.4%), Malaysia (Population: 30m, GDP growth: 4.7%), and Thailand (Population: 67m, GDP growth: 1.8%). Note that Xiaomi is also attacking the Indian market but I don't see them having an obvious edge there due to the culture differences so I exclude India for now. On the other hand, Xiaomi definitely has an advantage in trying to capture the rising middle-class in the above 4 SEAsian coutnries with a combination of 439m people in population. That's more than USA (316m) and Canada (35m) combined!
Wait wait wait? Culture? We're talking about smartphones here right?
And that's exactly what most western journalists who accused Xiaomi's as mere copycats have never figured out. Xiaomi does not sell smartphones. It sells a mobile future consisting a bunch of free and (hopefully) paid services. The high-spec shiny devices for Xiaomi are just trojan horses. What Xiaomi is doing is trying to tightly integrate its consumers into its eco-system.
Sounds familiar? Yeh, that's exactly why Apple's iOS system has been so successful! But Apple was already so good at it that Xiaomi had to find other ways.
The way it figured out was selling high-end smartphones at cost and building a lot of services so dear to the Chinese people that they become addicted. And this is the culture aspect that Apple never seems to care about. Anyone who owns an iPhone is essentially living a Californian mobile life. Yes you can install local apps on your iPhones but they face a lot of system limitations as Apple aims for system reliability. As a result, Apple designs its core experiences from California and in California. All of us using iPhones live our virtual Californian life on our mobile devices.
Xiaomi saw that clearly, so when it built its own Android OS, MIUI, it integrated lots and lots of Chinese-friendly features into the system, such as the hospital reservation system and the smart features that show the delivery men's photos when they call you on the mobile phone. All these features, whether originated in-house or simply copied from other Chinese app developers, are built into the OS. As Xiaomi users use their phones more and more to enjoy these services that connect to restaurants, hospitals, shops and department stores, the more and more likely that Xiaomi gain control of the communication channels for these end service providers. That, my friend, is where Xiaomi is gonna eventually make its money to give it a valuation today at $50B.
Given this understanding, namely the cultural aspect, we now see how Xiaomi is relatively well positioned to capture the middle-class population in SE Asia. Despite the obvious language and culture differences, the four SEA countries listed above are still much closer to the Chinese social environment than to the Californian one. Historically there have also been lots of immigrants from China, especially from the Canton Province, into SEA – in fact, there are so many Chinese immigrants in Indonesia that it has historically caused some social frictions. In any case, compared to the Cupertino-based, clean and shiny fruit giant, Xiaomi can definitely customize their MIUI OS for local uses much better than anyone.
And since Xiaomi sells at cost and bypasses all traditional retail channels, it also doesn't have to worry about striking complicated deals with local telecom giants through subsidized packages. It can establish its brand image directly in the middle-class population, rather than suffering the fate of the Taiwanese HTC who went into Europe with telecom-branded phones and eventually struggled to stand on its own legs despite pouring in tons of marketing resources.
All of this, obviously, is just projections right now. But if anyone can realize this game plan, it would be Xiaomi, not Samsung and Apple.
And if it could really capture the SE Asia market and cut out a good piece of India for bonus, who cares about whether they can copycat their way into the more originality-sensitive North American market? Don't forget that despite all the "no presence outside of China" accusation, Alibaba has as of today a $261B market cap, larger than Amazon and eBay combined. In other words, the market has been examing all the data for a while now since it's quoted on NYSE and the market concludes that maybe the Chinese market alone is big enough for this valuation. And that's a good wakeup call for those who claim that US market is a must-have for large companies.
Now imagine Xiaomi that might one day own China – and Indonesia, and Malaysia, and Vietnam and Thailand? Maybe there is indeed some points behind the rumored $50B valuation that is coming up.