All in + China

Isn’t Chinese market supposed to be very price sensitive and foreign brands should suffocate in the face of the cheap local copycats? How could these stories be true? Even if we rule out Fact 1 using the all-too-convenient “Apple is an exception” excuse, it still doesn’t explain the other two facts about GoPro, a very young brand that didn’t go IPO until 2014, and Misfit, a much smaller startup that was only 4 years old.

The truth is: no consumers make purchase decisions completely out of rationality. In fact, the more developed an economy, the more its consumers make shopping decisions irrationally. And this of course also applies to consumer electronics in China.

There is, both historically and theoretically, a correlation between public market values and private market valuations. This is not just because most successful startups will eventually hit IPO and hence become public companies, but also because in the valuation models of private companies, public comparables are often included despite the obvious differences in growth potential and therefore valuation multiples.

When public market rose in the past couple of years, so did the valuation of private startups. If the market takes a hit in the months to come, it's reasonable to expect a correction on the valuation of startups that are raising new rounds. In the worst case scenario, a startup might be forced to take a down round, which might trigger some embedded rights in the contracts with previous investors, which leads to further dilution or a complete impasse in fundraising.

In the later case, the startup might run out of cash and roll over.

Again, let's go back to the highly simplified Gordon Growth Model. Assuming a certain startup has a discount rate of 30% to reflect all kinds of risks. For Gordon Growth Model to work, we have to assume that the startup is already generating positive free cash flow (FCF) from its operations. This is apparently not true for startups but I'm simplifying the calculation here so that you could see the impact of the growths, which will have similar impacts with a full DCF valuation where most of the value for a promising startup comes from after Year 7~10.

Now assume that this startup generate $10M FCF for this year. In the two following growth scenarios it will have such valuations:

  • Growth of 10%: Valuation = $10M*(1+10%)/(30%-10%) = $55M
  • Growth of 20%: Valuation = $10M*(1+20%)/(30%-20%) = $120M

Note how sensitive valuation is to growth rate: a doubling of growth from 10% to 20% gives $65M more paper value to the entrepreneurs here. It goes without saying that it's much easier to generate such a growth figure of 20% in a country where the macro is growing 7% compared to 3%.

Quartz's latest interview with Hugo Barra, the former head of Google Android that has been leading Xiaomi's engineering ascendance to relevancy, explained more about Xiaomi's strategy of selling the smartphones at cost and going after the long-term service businesses, which I discussed briefly in my previous article. The country here mentioned is India but the strategy applies to all emerging countries in SEAsia that Xiaomi is actively breaking in.

Here I quote some relevant Q&A's...

The fallacy in this argument is that investment is about return, not about GDP growth. Return is basically future exits in relation with current valuations, whether you measure in compound growth rates, cash-on-cash multiples or IRRs. In a high-growth country, current valuations will be high and vice versa. If the market is efficient, the percentage return should be the same after risk and all other relevant factors are adjusted, whether it's in the hyper-growth China or the stagnating Europe.

As China slows down, the old rules of investments will undergo a structural change. It makes perfect sense for Chinese capital which had been enjoying more low-hanging fruit than the other countries to start diversifying beyond its own vast borders, and behave more and more like most giant institutional investors in the West.

There are two distinct characteristcs about Xiaomi's business at this moment:

  1. It generally sells smartphones at cost and often with high specifications
  2. 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!

Uber's idea is ridiculously simple now that it's famous. Any startup can write a similar app and start recruiting drivers like they do. In fact, there are at least one or two Uber copycats in every metropolitan area around the world, in addition to Uber itself!! So why is Uber the one that's getting $1.2B series D at a valuation of $17B from famed investors like Google VenturesKleiner Perkins and even BlackRock, instead of your copycat?

Because they're the one that successfully maxed out the scaling speed given the cash available in addition to be the idea originator. In other words, it's execution that got Uber to where it is today, not the idea.

For Californian or French startups struggling to raise money on Kickstarters or from suspicous angels so that they could pay for the huge prototyping cost, I could testify with my own 10 years of working in Taiwan that you could easily get the prototyping done at a much lower cost.

The reason is exactly the success of OEM and semiconductor industries. Due to decades of hardware focus, there are a mountain of 3rd-party vendors in Taiwan providing hardware services such as module prototyping and crafting. We're talking about family firms of 5~10 employees with molding machines in their small workhouses, taking your order individually at a reasonable contract price and even allowing for back-and-forth modification free of charge or with limited extra cost — to many Cali startups, this sounds like heaven and it truly should be.

And for more complicated designs, sourcing the necessary semiconductor components such as processors, memories, networking chips and even digital camera modules is probably even easier than in California, and surely than in France. You find market leaders of different components within the 100 km of diameter from Taipei to HsinChu. And if you have the right connections, eager and talented engineers in those companies are always happy to help you in debugging your system so long as your projects provide the good old engineering satisfaction of problem solving for them — heck! I personally am open to help startups solve issues with their HDMI or USB interfaces as well as WiFi connectivity, even just for fun!

Last but not the least, if you successfully build your networks through working with component vendors and 3rd party hardware service providers, it's much easier for you to find the small OEM who might be willing to manufacture that 1,000 pilot devices that you need to distribute to your impatient supporters from Kickstarter and test the response of a larger market!

This article, brain-stormed and co-written by Mark and me, is also simultaneously published on Mark's website: The article also appeared in Japanese translation on THE BRIDGE: アジア発メッセージ・アプリ対決談義——LINE vs. WeChat(微信)vs. カカオトーク.

MB:  Well, LINE clearly dominates in its ingenious sticker strategy. I know you’re going to argue that WeChat also offers stickers, which makes sense. Stickers are of tremendous importance in cultures where communication involves layers of honorifics and deep context. I’ve even witnessed passengers on the train in Japan exercise careful deliberation in choosing just the right sticker to convey the proper tone and mood in their chat. But I think LINE wins in the sticker battle. Not only do they generate significant revenues from sales of sticker packs (which seem to have drawn inspiration from the old record album model (i.e. two tracks of ‘killer’ and 8 tracks of ‘filler’), but stickers also create switching costs among users who have invested in sticker sets and would not be able to carry them over to another messenger app. LINE admirably employs sticker campaigns to raise funds for charitable causes. They have also wisely opened up the creation of stickers to outside illustrators in the form of a creators marketplace, which will foster an army of ambassadors for sticker promotion, and hence promotion of LINE.

JY:  Okay, that one I agree. As a heavy LINE sticker user and client — I counted 13 paid stickers in my arsenal — let me just say it’s amazing how a company can generate so much potential from something so simple. And I also see the potential of the LINE bear-rabbit couple to spin off into a standalone franchise. It will be fun to see how a company from a country that gave birth to successful character sans histoire like Hello Kitty plans this one out.

Due to the capital control of Government of China, historically money flowing out of China was stigmatized as rich people moving their money of dubious origin to developed countries or tax havens. But over the past few years things have been changing.

While oversea investments by giant corporates in China are no news at all, we're now seeing Chinese funds, piles of cash in hand, seeking exposures to geographies other than their own country. It's probably inspired by the expected slow down of GDP growth, the discussion of which had first surfaced a couple of years back and is now a fact. More importantly, I believe as the investment environment in China become more and more mature, geographical diversification becomes one of the objectives for the super big funds especially. While it might have already happened in mutual funds, now the Private Equity people are also extending their reach west-ward.

For the overall analysis, it's important to recognize the fact: chat app is a social networking service, not just a messenger replacement. What separates a quintessential social networking service from a mere tool is the network deepens its stickiness once it gets to critical mass. Put it simply, as more of your friends use a certain service, you will be more inclined to use the same. Chat app fits perfectly in this definition, and more. To name just one among the surprisingly numerous factors that add to the chat app stickiness: keeping mulitple chat apps on your smartphones drains the power very quickly. Before long you realize you only want to keep one, at most two of them alive. 

The force of exclusion seems to be confirmed as one inspects the geography column of the table above: despite the acclaimed reliability and efficiency of the network of Whatsapp, in different geographies different chat apps dominate. LINE dominates in eastern Asian countries such as Japan, Taiwan, Thailand and Indonesia. KakaoTalk pratically monopolizes the South Korean market, just like Wechat in China. On the other hand, the supposedly most dominant of all, Whatsapp, chose not to disclose its user number in the United States while disclosing for the other countries. Viber also did not specifically break down its constituency.