You might have recently seen headlines like this, declaring Xiaomi some sort of communistic

charity club for voluntarily voluntarily giving up all of its profits above 5%.

And if anything in you went like wait a second, that's not how anything in capitalism works, then congratulations,

your bullshit detectors are working.

I'm Marton from TechAltar, you are watching the 34th episode of The Story Behind series

and let me untangle this fascinating PR campaign.

Because that's what this actually is.

Okay so the first question is: Why does Xiaomi voluntarily limit its profits to just 5%?

The answer is, to make more money.

Sounds confusing, but it isn't.

There are really three pillars of the Xiaomi business model.

70% of their revenues come from phones, a bit over 20 % from the rest of their hardware

stuff, like air purifiers, power banks and internet routers, and the final 9% come from

what the company calls internet services.

These include things like a music subscription service, a cloud storage service, a Xiaomi

App store, advertisements on their phones, and so on.

Xiaomi's CEO only vowed to keep net profits of the first two categories below 5%, but

not the third one.

Now you might be saying that, given their weight, that's kind of the same thing, but

it's not.

See, Xiaomi calls itself primarily an internet company.

They said so in their IPO documents, in fact, they have consistently said so since their

launch, and they even claim that one of the meanings of their name is mobile internet.

So why would they choose to focus on this small part of their business?

Because they are a for-profit company, not a charity club.

See, here is a comparison between the gross margins of hardware and services in Xiaomi.

And gross margins don't even include things like marketing expenses, taxes, overhead costs,

and so on.

Xiaomi probably actively loses money on hardware, while margins on internet services are pretty

healthy.

Making smartphone hardware is a pretty lousy business, because still only

Apple or Samsung have figured out how to make a proper profit out of it.

But making internet services is a fantastic business, as Amazon, Facebook, Google, Microsoft, Alibaba,

Tencent, and a million other very profitable companies have proven.

So Xiaomi desperately wants investors to think that their main business is making internet services.

The difference is that traditional phone companies try to make their profits when the customer

buys the hardware, and then largely leave customers alone when they use their phone,

while Xiaomi accepts basically zero profits from the hardware purchase, but then tries

to make money from their customers during the usage period.

Now, this to me sounds like the hardware equivalent of freemium software.

We used to pay for software outright, but then companies figured out that giving it

away for free at first, and then making money from the users later, by making them pay for

a subscription, or loot boxes, or showing them ads, is great business.

Xiaomi making no profits on hardware is essentially the same as Facebook and Google making their

services free, or Amazon discounting phones that have lock screen ads on them.

It's not charity or communis. It's a business model.

Okay, question two, why do I think this was a brilliant PR campaign?

Well, I hope it's pretty clear by now that Xiaomi never really made or wanted to make

money from their hardware anyway, because higher phone profits means fewer users, less

money from services, and finally, lower profits overall.

So, the 5% limit is artificial and wouldn't have been meaningfully passed anyway.

This was just a statement, not a change to their business model.

But, with this statement, they convinced consumers, who never read past the flashy headline, that

Xiaomi is just a benign, trustworthy company that just doesn't want high profits, but also

investors, who totally get the business model, that Xiaomi is an internet company with much

better profit potential than simple hardware makers.

One statement that in reality didn't change anything makes consumers more likely to buy

Xiaomi phones and investors more likely to invest in Xiaomi.

Good PR can create value out of seemingly thin air.

And the third question then is how low hardware profits work in practice.

Well, internet services and freemium apps have kind of shown us the blueprint already.

This kind of business has two goals: acquiring as many new customers as possible, and then

making sure that those customers spend as much time and money on the platform as possible.

Obviously low hardware prices do the magic for step 1, but step 2 is all about software.

Namely MIUI, the company's own version of Android, and it's no wonder that Xiaomi takes

its software so seriously.

People must love this UI, become loyal to it, and spend as much time with it as possible

for Xiaomi to be able to sell them their services, or serve them ads.

And this business model has good and bad sides for consumers.

The good stuff means that Xiaomi, unlike most Android phone makers, actually has financial

incentives to frequently update their phones and give them relatively long software support.

Xiaomi has also built a large, engaged online community around MIUI, where people can do

things like vote on features to be put into MIUI.

On the bad side though, Xiaomi is also incentivized to push its own software even if it means

duplicating apps or creating bloatware, and like any other freemium software player, Xiaomi

has incentives to invade your privacy and to lock you into their ecosystem.

Cause you have to keep paying those subscription fees and seeing those ads for as long as possible

for this model to work.

Aaand last question is: will this work?

And while I find Xiaomi's business model new and genuinely exciting, I also think that

from a purely business perspective, there are a few weaknesses here.

First of all, at 9%, the profitable part of Xiaomi is very small, which means that right

now, Xiaomi's strategy isn't really working.

People are happy to buy cheap Xiaomi hardware, but most of them don't want to pay for Xiaomi

services.

Even the company itself admitted that they have to increase this rate, but last quarter

the opposite happened, where hardware grew significantly faster than services at Xiaomi.

Not a good sign.

The services business is also relatively small.

Just for scale, Xiaomi made 1.5 billion dollars from services last year, while Apple made

over 9 billion in just the last quarter.

And that's on top of the massive revenue and profits Apple has made from hardware!

So, Xiaomi has to grow their services business significantly to reach a truly global scale.

Second, Xiaomi's business model has only been proven in China.

It sort of works there, because Google services, including the Google Play store are blocked

in China, so people are often happy to use services form their smartphone maker, even

alternative app stores.

But as Xiaomi is becoming increasingly international, it will have to compete against Google.

Google Apps are installed on nearly all international phones, which instantly makes Xiaomi apps

less useful, so there will be lower engagement and lower income per user, and customers might

even be annoyed by duplicate apps, instead preferring a phone with clean, stock Android.

It's kind of enough to have Google spying on you and filling your phone with crap apps

you've never asked to use, but getting this treatment from two companies at once is not

a great experience.

In fact, Xiaomi did ask their users in a poll what they preferred, and embarrassingly enough,

their own fans voted for stock Android.

Aaaand then Xiaomi deleted the poll.

Ouch.

And the third problem is that people who buy cheap phones, also tend to use cheap, or even

free software, which is not what Xiaomi needs.

So in order for Xiaomi's business model to work, Xiaomi will need to invest a lot more

into making really premium phones like the MiMix, and attract more wealthy consumers, and then

also make internet services that truly outclass those of Google.

Not an easy task for a company on such tight margins as Xiaomi.

But none of that makes Xiaomi's fantastic PR move any less impressive.

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