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Is Xiaomi's Smartphone Growth Story Over?

The Motley Fool logo The Motley Fool 14-07-2015 Leo Sun

Xiaomi, China's largest domestic smartphone maker, recently posted slower-than-expected growth in the first half of 2015. The company's smartphone shipments rose 33% annually to 34.7 million units, representing a steep slowdown from the triple-digit growth it posted in previous years. That figure also represents less than half of its prior full-year forecast for 80 million to 100 million shipments.

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Xiaomi's Mi 4i. Source: Xiaomi

Is Xiaomi, which was recently valued at $45 billion in its latest funding round, about to see its growth peak before it can go public? Let's take a look at the challenges the smartphone maker faces over the next few years.

How Xiaomi makes money

Xiaomi, which was founded in 2010, became the fourth largest smartphone maker in the world after Samsung (NASDAQOTH: SSNLF), Apple (NASDAQ: AAPL), and Huawei (in that order) at the end of 2014. Xiaomi also finished the year as the top smartphone in China, with a 12.5% market share, according to research firm IDC. But Apple surpassed Xiaomi in the first quarter of 2015, claiming a 14.7% share compared to Xiaomi's 13.7%.

Xiaomi's rapid growth was fueled by three things. First, it spends very little on advertising, and relies on word of mouth, social media campaigns, and flash sales to generate interest. Second, Xiaomi also avoids distributing its devices through brick-and-mortar retailers, and launches limited batches of its devices periodically through its online store. That strategy eliminates an inventory buildup of unsold phones while inflating consumer demand. Lastly, Xiaomi is willing to sell its devices at much thinner margins than its rivals.

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The combination of those three strategies allows Xiaomi to sell devices with comparable specs as Samsung's flagship devices for a fraction of the price.

But here's the problem ...

For a while, Xiaomi enjoyed a first-mover's advantage in the market for cheap smartphones with high-end specs. But that success inspired other companies to do the same. In addition to smaller challengers like Meizu, Xiaomi now faces bigger and better-funded competitors like Lenovo (NASDAQOTH: LNVGY), which bought Motorola's handset unit from Google last year, and Huawei. 

To make matters worse, chip makers Qualcomm (NASDAQ: QCOM), MediaTek, Rockchip, and Intel introduced "turnkey" designs that reduced development costs and enabled smartphone makers to launch new devices in a matter of weeks. Those cheap phones lowered price expectations and quickly commoditized the market.

Smartphone growth in China is also slowing down. In the first quarter of 2015, IDC reported that the Chinese smartphone market contracted 4% year over year, representing its first annual slowdown in six years. 

How Xiaomi can counter that slowdown

In response to those challenges, Xiaomi is expanding overseas and diversifying its product portfolio. The company has already expanded into India and recently announced plans to launch several smartphones in Brazil. Over the past year, Xiaomi launched new products like fitness bands, smart scales, air purifiers, smart TVs, action cameras, and premium headphones through its online store. It also expanded its online store to Europe and the U.S.

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Yet both strategies have already hit roadblocks. Last December, Xiaomi was partially banned from selling phones in India due to violations of wireless patents owned by Ericsson (NASDAQ: ERIC). Similar patent challenges should prevent Xiaomi from selling its smartphones in developed markets like the United States anytime soon. But I previously speculated that Xiaomi could get around that issue by signing a partnership with Microsoft , which co-owns many of Ericsson's wireless patents, in exchange for producing a limited number of Windows Phones. 

IPO potential

Despite those challenges, there has been plenty of buzz about Xiaomi eventually going public. Xiaomi is currently valued at $45 billion, but Russian billionaire Yuri Milner -- one of the company's top investors -- believes that its valuation could hit $100 billion.

But there are two main problems that Xiaomi must address before going public. First, it needs to show investors that its revenue -- which doubled annually to $12 billion in 2014 -- can keep growing by selling new products and expanding into new markets. Second, it needs to keep it margins positive as it expands. That could be challenging considering Xiaomi had an operating margin of less than 2% last year. By comparison, Samsung's mobile unit had an operating margin of nearly 11% last quarter.

Xiaomi's future

Xiaomi is still growing, but its declining growth rates and low margins indicate that by the time the company finally goes public, most of its momentum will have cooled off. But that slowdown could force Xiaomi to evolve into a well-diversified electronics company that is less dependent on the saturated smartphone market.

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