Can Xiaomi’s Operational Excellence Compensate for a Weak Business Model? (Tech Strategy – Daily Update)

Xiaomi is an important company. And it has really important strategy lessons. I think there are 5.

But the big question that cuts across all of them is: Can the company’s operational excellence compensate for its weak business model? 

Here’s my take.

Lesson 1: Xiaomi’s Foundational Asset Was World Class Tech Management.

From its founding in 2010, Xiaomi has been run by experienced and truly talented management. This was the A Team of digital China. They had backgrounds and expertise that matched the best tech founders and executives in Silicon Valley (and anywhere else). And this was something fairly new in digital China.

Digital China began in the 1990’s, which was +30 years behind Silicon Valley. Keep in mind, Hewlett Packard, IBM, Fairchild Semiconductor, Intel and others had been building products and companies in the Silicon Valley since the 1960’s. In fact, Silicon Valley is named after the silicon that these early companies used to make their semiconductors. From there, we saw another wave in the 1970’s, including Atari, Microsoft, and Apple. In the 1980’s, we saw Adobe, Norton, Intuit and many others. And in 1990’s, we saw companies like Netscape, Palm and the first wave of internet companies. And all of the new companies benefited from a pool of executives and engineers who had been trained in existing companies.

But in the 1990’s in digital China, everyone was a first time entrepreneur. And most all the engineers had little experience. There were very few existing companies to work at. And most had existed for only a few years. Many early founders, like Robin Li of Baidu, had gotten their experience in the US before returning to China. And most venture capitalists were raising their first fund (although many were from the USA). The period of 1995—2005 was first wave of digital China. This was when companies like Baidu, Alibaba, Sina, Sohu, and Tencent emerged.

Fast forward to 2008 and two important things had happened.

  • Smartphones were beginning to arrive in China. This was going to be the great opportunity for entrepreneurs and investors. It was a seismic change in the tech paradigm. And it was going to bring the Chinese population online in mass for the first time. It would become the world’s largest ecommerce market within 10 years.
  • A population of seasoned entrepreneurs, venture capitalists and executives was now on the ground. Executives and engineers had been trained at places like Baidu, Alibaba, and Kingsoft. And the entrepreneurs were now second or third time entrepreneurs with both deep experience and big capital.

One of the stars of this new tech demographic was Lei Jun, founder of Xiaomi.

Lei Jun was born in Hubei in 1969. His name in Chinese is 雷军, which the US press has just discovered means “cloud army”. People are discussing this but it doesn’t mean anything.

He attended Wuhan university and graduated in computer science in two years. And he reportedly started his first company while at school. So he clearly had the intellectual horsepower and drive early on. But the really important event was when he joined Kingsoft in 1992, (reportedly) as one of its first ten employees.

Kingsoft is one of those companies that people never remember when talking about digital China. It was founded in 1988 , back in the PC and pre-internet era. And it naturally focused on software and services. Think Microsoft office and similar tools. There is a reason its name (Kingsoft) sounds a lot like Microsoft.

Lei June rose rapidly and became CEO of the company in 1998. Before Alibaba, Tencent and Baidu were founded, Lei Jun was already running one of the leading digital China companies. And before the age of 30. He shepherded Kingsoft to its IPO, became wealthy and held the CEO title until his resignation in 2007. Along the way, he also founded Joyo, an online bookstore that he sold to Amazon. And he did a lot of other stuff.

Post Kingsoft, he became an angel investor. He invested in and became Chairman of both YY and UCWeb. These are also very important digital china companies. UCWeb is one of the most popular browsers in China. And also in India. Well, until it was banned last year.

Which brings us to 2010 and his founding of Xiaomi. But first, think of the massive difference in management expertise at the founding of Xiaomi vs. the founding of, say, Alibaba. Alibaba was founded by an English teacher with little tech knowledge. It was him and 17 others in a small apartment in Hangzhou. In contrast, Xiaomi was founded by a seasoned software CEO and investor. He had been CEO and/or Chairman of multiple successful Chinese software companies. And he brought with him a top-tier team from Kingsoft, Google China and Motorola. As well as from the venture capital community.

So that is lesson #1. Xiaomi was founded with one big asset, a management team that could go head to head with Microsoft, Google, and any other company you could find in Silicon Valley.

Today, this is is more common. Bytedance was built with an outstanding team. And it is not surprising they can run circles around Facebook. Alibaba and Tencent today are better run than most anything in Silicon Valley ecommerce (except maybe Amazon). And Huawei can beat Ericsson and Nokia in a fair fight every day of the week. But Xiaomi was one of the earliest in this trend.

Lesson 2: Xiaomi Identified the Right Tech and Infrastructure Trends.

On the Acquired Podcast, it was mentioned that Lei Jun and his team were looking at three tech trends at the time of founding. Capturing a major tech trend was a very important, if not the most important, factor. The three identified were:

  • Social
  • Gaming
  • Ecommerce

And all on Chinese smartphones.

If true, they were, in retrospect, exactly right. And not just because these were the major  technology trends of the time. But also because they were supported by the major infrastructure trends in China. This point is important.

In Silicon Valley, companies focus on finding the next tech trend and being innovative and / or disruptive. Find a new blue ocean market. Or disrupt a big existing market. But people don’t think too much about government and infrastructure. Or about the overall development of the country. But in developing economies like China, you need to think about technology, infrastructure and development.

For example, it is harder to do ecommerce in a country that is still developing credit scores and getting credit card adoption (i.e., China). It is harder to do Uber in a country without cars and functioning traffic (i.e., Jakarta). Your ability to capture a tech trend as a small company depends heavily on infrastructure, government and the state of the country’s development.

My favorite example of this is how ecommerce progressed in China vs. South America. The two leading ecommerce companies in these regions are Alibaba and MercadoLibre. And both were founded in the same year (1999). The difference in their trajectories has a lot to do with the difference in the infrastructure and economic development of China vs. Brazil and Argentina. Alibaba has 7x the market cap of MercadoLibre today.

The flip side of these infrastructure and development difficulties is you can have a much more powerful impact with technology in developing economies. If nobody has credit cards, that is a problem for ecommerce. But it also means mobile payment can have a much bigger impact on consumers. Developing economies have more challenges but bigger opportunities with tech.

Looking back at China in 2010, a reasonably well run company capturing any of those trends (social, gaming, ecommerce) on a smartphone would have done spectacularly well. And would have been well supported by the infrastructure and government trends of the time.

Xiaomi identified exactly the right trends to catapult them upwards. Which is what happened.

Lesson 3: Xiaomi Rose Rapidly But With a Weak Strategy.

Xiaomi identified the right trends (ecommerce, gaming, social on smartphones). And you could argue that smartphones (and their operating systems) are the foundation for all of this. So in the gold rush of China smartphone adoption, selling infrastructure to everyone else is not an uncommon strategy. Let everyone else fight for each type of app. Just sell the infrastructure and picks and shovels.

But consumer electronics doesn’t have great economics. They are not great businesses. And while smartphones are not exactly like refrigerators and televisions (difficult businesses), they are definitely like PCs. And everyone wanted to be Microsoft or Adobe – and not HP or Dell. Everyone knew the attractive businesses were operating systems and software. Not making laptops.

Plus, the Xiaomi founders were not hardware people. They were very seasoned software people. They had no history of building devices. But they were outstanding at Kingsoft, UCWeb, Google, etc. So why would they jump to hardware?

I assume they were going after hardware plus software. They wanted to sell both the handsets and the software and services. An integrated device. They wanted to be Apple. And they probably wanted to take down Android in China.

But even if they wanted to do that strategy, the power is still in the semiconductors and the operating system. And then to a lesser degree in a few critical apps like messenger, social, search and mapping. That is where the power and the profits go. Can you launch an integrated devices if you are using someone else’s semiconductors and operating system?

Here is my understanding of their strategy circa 2010.

  1. Take the Android kernel and develop a better and much cooler operating system with their own skin.
  2. Integrate their MIUI operating system with their own hardware and create a superior user experience. This is what Apple does with the iPhone. It is a vertically integrated product (from semiconductor to operating system and some apps) that has a better experience than Android, which is modular.
  3. Sell these smartphones cheap to get adoption in the then wide-open China smartphone market.
  4. Then capture network effects (and profits) as usage grows in software and services. This was to be the ultimate source of their competitive strength and profits.

And steps 1-3 worked beautifully.

They entered the scene in 2011-2012 with their first phones. The entire market was growing fast with Nokia the leader at 45-50% of marketshare. In 2011, China surpassed the US and became the largest smartphone market by volume. Xiaomi executed well against mostly foreign firms. Everyone started calling Lei Jun the Steve Jobs of China. And he would give talks wearing black t-shirts, jeans and sneakers.

Fast forward to 2020 and Xiaomi is still trying to get to step 4. They are still trying to go from being mostly a handset maker to doing software and services. And while much of their operating profit does come from software and services today, that is mostly because they are still selling their smartphones and other smart devices at gross profits under 5%.

So here are my questions:

  • Why didn’t Xiaomi just go into software and services directly? Why take this long walk around the block in smartphone manufacturing in order to get to software?

In 2010-2015, they could have just as easily launched a mobile app for communications (i.e., WeChat). Or for payment (i.e., Alipay). Or for lending (i.e., Lufax). Or for short video (i.e., ByteDance). Or really for anything that runs on a smartphone. They were at the beginning of the smartphone age in China with a top tier team and lots of capital. They could have grabbed any of 20 very attractive strategic locations. Either in 2010 or later in 2015 when it was obvious this was a difficult business.

But no. They stuck with their smartphone business. Hoping it would one day get them to software and profits. When they went public, they described themselves as an internet company.

Lesson 4: Operational Excellence Can Compensate for (or at Least Hide) a Weak Business Model.

Here’s the irony. If Xiaomi management was not so outstanding, if they had not executed so well, they probably would have changed their strategy long ago. They would have realized that what they were doing was too difficult. That the ongoing competition was too hard. And that the rewards of winning were too small. A weaker management would have failed or given up.

Top tier management and operational excellence can hide a weak strategy and business model.

And Xiaomi’s operational performance from its founding was outstanding.

  • Xiaomi raised a lot of money (+20M?) before they even had a product. Based on their reputations.
  • They built very good smartphones and a cool operating system.
  • They sold them cheap (at <5% GP) which fueled adoption.
  • They built a unique brand. Xiaomi quickly developed a big fan base (MiFans) with lots of evangelizers. They did hunger marketing where they would sell out a limited stock of phones in hours.
  • They iterated at an amazing pace. They got feedback from their fans and released new versions of their software every week.

And they ran circles around their competitors, especially the foreign smartphone makers that dominated China in the 2010-2014 period. By 2014, they were called the “Chinese phoenix”.

However, I argued at the time that they were going to get hit hard soon. That their success had a lot to do with catching a wave. They were in a window of time where demand was growing but local competitors had not yet arrived. Soon another company would arrive and do to Xiaomi what Xiaomi did to Apple. Domestic competitors like Huawei, Oppo and Vivo were on the way. And they were in a business with few competitive advantages.

And, sure enough, Oppo, Vivo and Huawei burst on the scene and crushed Xiaomi’s market share in China. In 2015-2016, the company fell from 1st to 5th in smartphone sales in China.

That would have put down a lesser management team. But, again, Xiaomi management was outstanding and did a couple of important moves to right the ship:

  • They focused on the point of sale. Oppo and Vivo were very effective at working with local retailers and getting people to switch their purchase at the point of sale. So Xiaomi, which had relied on online sales, began working more with local retailers. And they opened their own retail outlets.
  • They continued their international expansion. And they successfully caught smartphone adoption waves in other countries. They grew in India, SE Asia, Latin America and Europe. This was wildly successful. The other Chinese smartphone companies followed suit.

But by 2018, the smartphone adoption wave of China had peaked. It was a more stable market. That’s when you discover who has competitive advantages and who doesn’t. When a market is growing fast, there is room for everyone. Having powerful advantages doesn’t matter as much. But when growth slows, the competitors all turn their guns on each other. You then grow by mostly taking from others. This is when we see who is strongest. And who has competitive advantages and who doesn’t.

As mentioned, consumer electronics in a mature market is a difficult business. Take a look at washing machines. Televisions. Refrigerators. And PCs. You are constantly struggling to release a new hit model every year. And to grind your competitors away with scale and efficiency.

The powerful positions are mostly in the software. In the operating system. In certain apps. And in certain hardware components (like camera lenses and semiconductors).

But Xiaomi’s management was too good. Even after their crash in 2015, they fought their way back to the top of a still not terribly attractive business. A lesser management team would have failed or given up. And that would have been the right strategic move.

Final Lesson: You Have to Win at Both Levels: Business Model and Operating Model.

 

 

I keep arguing you need to compete at the business model and operating model level. The operating model is what you have to do every week. It is all the tactics and back-and-forth responses to your competitors and with your customers. It is a race. A marathon. Xiaomi was outstanding at this.

But you also need a business model with structural advantages. Or you need to be building towards one. You want protected and profitable positions. Even if they decay over time.

  • Google and Alibaba are outstanding at both levels.
  • Facebook and Airbnb are great business models but relatively poor at execution.

Xiaomi is the opposite, which is quite strange. Can their operational excellence compensate enough for their weak business model? Can that be enough in this business to generate significant economic returns?

I don’t think so. But I’m watching closely.

Thanks for reading, – Jeff

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Get my new book Moats and Marathons (Part 1): How to Build and Measure Competitive Advantage in Digital Businesses

Related articles:

From the Concept Library, concepts for this article are:

  • Digital Competition Pyramid

From the Company Library, companies for this article are:

  • Xiaomi
This is part of Learning Goals: Level 3, with a focus on:
  • #9: The basics of smartphones, ecosystems and endless bundling.

Photo by Zana Latif on Unsplash

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I write, speak and consult about digital strategy and transformation.

My book Moats and Marathons details how to measure competitive advantage in digital businesses.

I also host Tech Strategy, a podcast and subscription newsletter on the strategies of the best digital companies in the US, China and Asia.

This content (articles, podcasts, website info) is not investment, legal or tax advice. The information and opinions from me and any guests may be incorrect. The numbers and information may be wrong. The views expressed may no longer be relevant or accurate. This is not investment advice. Investing is risky. Do your own research.

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