INTEGRATIVE CASE 1 XIAOMI CHALLENGES GLOBAL SMARTPHONE LEADERS Klaus Meyer and Jianhua (Jenny) Zhu Ivey Business School In 2014, surprised newspaper readers around the world learned that the most valuable start-up com- pany was a Chinese company that most had never heard of: smartphone maker Xiaomi (valued at $45 billion) overtook the worldwide operating taxi-booking company Uber (valued at $40 billion). Within only four years, Xiaomi became number one in China by units sold, ahead of Samsung, Apple and Lenovo. In the second quarter of 2014, Xiaomi had overtaken Samsung to become volume market leader with a 14% market share. Worldwide, Xiaomi rose to sixth place in 2014, behind Samsung, Apple, Lenovo, LG and Huawei (Table 1). What explains the phenomenal success of Xiaomi?Klaus Meyer and Jianhua (Jenny) Zhu Ivey Business School In 2014, surprised newspaper readers around the world learned that the most valuable start-up com- pany was a Chinese company that most had never heard of: smartphone maker Xiaomi (valued at $45 billion) overtook the worldwide operating taxi-booking company Uber (valued at $40 billion). Within only four years, Xiaomi became number one in China by units sold, ahead of Samsung, Apple and Lenovo. In the second quarter of 2014, Xiaomi had overtaken Samsung to become volume market leader with a 14% market share. Worldwide, Xiaomi rose to sixth place in 2014, behind Samsung, Apple, Lenovo, LG and Huawei (Table 1). What explains the phenomenal success of Xiaomi? The Chinese smartphone market has grown to become the largest in the world, overtaking the USA in 2012, with 31.8 million units sold. The industry was driven by the rapid evolution in smartphone technolo gies and the availability of Wi-Fi, cheap components, specialized contract manufacturers and a vast domes- tic market of budget-conscious consumers. Local Chinese companies compete head-on against Apple, Samsung and other major global brands, who still sold about 20% of their global sales in China. Six of the top eight vendors are Chinese firms that compete intensely among themselves: computer maker Lenovo, telecom equipment giants Huawei and ZTE, consumer electronics firms TCL and Coolpad and start-up Xiaomi. Samsung and Apple target the high-end market with handsets for about 6500, while domestic competitors target lower market segments with selling prices set between (100 and (150. Only a few years ago, the hottest brand in town was HTC. Once a manufacturer of phones for Western brands, HTC started its own branded smartphone in 2007 and became the top Android-based smartphone in the USA in 2010. Driven by a fast innovation culture, HTC aimed to launch a new version every month. Yet with an undifferentiated product and a mid-price positioning, HTC soon found itself squeezed betweenINTEGRATIVE CASE 1 XIAOMI CHALLENGES GLOBAL SMARTPHONE LEADERS 501 Apple and Samsung at the high end and Chinese players such as Huawei and ZTE at the low end. HTC's global market share slipped to 2.2% in the third quarter of 2012. In the next two years, IITC launched new high-end phones, but despite awards and rave reviews, sales remained modest. Table 1 Estimated world smartphone market share (units sold] 2011 2013 2014 Samsung 16.8% 32.5% 28.0% Apple 10.2% 16.6% 16.4% Lenovo nva 4.9% 7.9% LG rva 4.3% 6.0% Huawel 9.5% 4,4% 5.9% Xiaomi ni 2.2% 5.2% Cooload na 3.6% 4.2% ZTE 6.9% 3.2% 3.1% Sony na 4.1% 3.9% Nokia 30.1% 3.0% n/a Other 26.6% 21.2% 19.4% Source: Technavio, Gartner, author's estimates. ENTREPRENEURSHIP, CHINESE STYLEENTREPRENEURSHIP, CHINESE STYLE One entrepreneur who observed and learned from HTC was Lei Jun. A graduate from Wuhan University, he spent his early years as a software engineer, later a C.F.O, at Kingsoft, a software company competing with Microsoft in China. His first major success as an entrepreneur was zhuoyue.com, an online book retailer he sold to Amazon in 2004, earning him (10 million. After Kingsoft was listed on the Hong Kong Stock Exchange in 2007, Lei resigned as CEO and started a new career as a venture capitalist, investing in online commerce and social media businesses. In 2011, Lei Jun founded Xiaomi. At this time, the smartphone industry was rapidly maturing, with specialist providers at different stages of the value chain. Upstream were hardware manufacturers (like Qualcomm for chips) and software providers, for operating systems (such as Android) and software appli- cations (like WeChat and Weibo). In the mid-stream, companies like Foxconn integrated the hardware and software to manufacturers of the physical products, smartphones. Further downstream, brand owners like Nokia, Apple, Samsung, HTC, Huawei and Lenovo marketed the products and also led product innova- tion. Smartphones were usually sold via distributors, including telecom operators China Mobile, China Telecom and China Unicom, and retail stores like Gome, Suning, JD.com or Taobao. With a good dozen established smartphone brands, how could Xiaomi differentiate itself? First, Xiaomi only used the suppliers for Apple and Samsung to establish a reputation as a top-tier brand. For example, Xiaomi's chip suppliers were Nvidia and Qualcomm, and its manufacturers were Foxconn and Inventec. Second, Xiaomi developed its own operating system, MIUI, based on Google's Android system, yet using creative designs to make it more user-friendly for Chinese consumers.502 PART SIX INTEGRATIVE CASES Third, Lei Jun developed an innovative business model to reach consumers while reducing costs. Xiaomi spent next to nothing on advertising but sold its phones exclusively through the internet. In this way, it not only saved the margin the retailer would earn but dramatically reduced the need to keep inventories. Building on his experiences in e-commerce and social media from his earlier entrepreneurial ventures, Lei Jun designed innovative online marketing and distribution channels. Initially, Xiaomi targeted technol- ogy-savvy IT engineers and college students via an online Xiaomi forum. Thus Xiaomi's official website is its main sales channel, complemented by online malls, such as Taobao. Lei Jun moreover developed a pre-selling model to reduce expenses for inventory. Xiaomi's cell phones were usually offered with limited supply, and customers had to register online before being able to bid online for a Xiaomi smartphone. As a result, 150 000 units were often sold online within minutes. A Financial Times correspondent observed: Offering sleek, high-spec kit at low prices, Xiaomi has overtaken more venerable rivals to become the country's most popular smartphone brand. Its models sell for hundreds of dollars less than the latest Apple or Samsung phones, yet on the streets of Beijing or Shanghai they have become objects of lust. However, the true source of Xiaomi's success may not be the product but the community of fans that Xiaomi has built. Before launching its products, Xiaomi had already recruited tech enthusiasts to help testing its MIUI operating system. Xiaomi engages directly with its fans both online, for example, through social media communications and early bird offers, and offline, by inviting them to product launches or parties in nightclubs across China. With intensive online communication, Xiaomi developed a fashionable image beyond online geeks. As CEIBS professor Jane Wang observed (source 15): Everyone around us has the iPhone and iPhone6 plus. But Xiaomi stands out as something different. What does this say about its users? It says: I'm experimental, I'm willing to give new ideas a try and I'm really leading the trend.As the brand matured, it also became popular as a gift young people gave to their grandparents: good value for money and easy to use. This market however was less emphasized by Xiaomi, as it added less to its aspired brand image. Xiaomi's innovation strategy focuses on fast prototyping with very short 'launch-test-improve' cycles, a strategy found in many Chinese technology start-ups. Thus products are launched in quick succession, customer feedback is collected via online forums and engineers quickly incorporate new ideas into the next product ideas, especially in software. While every change is small, cumulatively this process generates quite substantive innovations in the operating software, MIUI, and the apps that come with the Xiaomi phone. This business model enables Xiaomi to offer innovative products while undercutting rivals with rock- bottom prices; many Xiaomi models are available online for prices around (100, whereas Samsung's Galaxy smartphones retail for 6500 and more. Thus in 2014, Xiaomi sold 61.1 million smartphones (a 227% increase over 2013) and earned sales revenue of almost 610 billion (135% increase). However, some observers expected Xiaomi to drive smartphones to commoditization - a process of competition by which differentiated products that command high prices and high margins lose their comparative advan- tage. Xiaomi focused on building volume and market share and expected profits to come later once market leadership had been consolidated, thus following a strategy common in boom years in Silicon Valley. How- ever, with thin margins, the business model was also sensitive to disruptions, as Xiaomi had little financial buffer to absorb unexpected shocks. COMPETITION, CHINESE STYLE As Xiaomi became the most popular Android-based smartphone brand, it was recognized as the most 'threatening' competitor for Samsung in China. In the third quarter of 2014, Samsung's mar- ket share in China fell to 24.4%, down from 32.1% a year before, and for five consecutive quartersCOMPETITION, CHINESE STYLE As Xiaomi became the most popular Android-based smartphone brand, it was recognized as the most 'threatening' competitor for Samsung in China. In the third quarter of 2014, Samsung's mar- ket share in China fell to 24.4%, down from 32.1% a year before, and for five consecutive quarters INTEGRATIVE CASE 1 XIAOMI CHALLENGES GLOBAL SMARTPHONE LEADERS 503 Samsung reported falling earnings, because it was squeezed by Apple's iPhone6 and Chinese local rivals like Xiaomi. Moreover, Xiaomi also ate the market share of local players like Huawei and ZTE. In response, Huawei and ZTE launched mobile phones with similar configurations at competitive prices. Thus Xiaomi launched Redmi Note at the price of (110, which was in direct competition with Huawei's Honor 3X, priced at (130. The intense competition between Chinese brands raises the question whether or not Xiaomi has sustainable competitive advantages. Some commentators suggest that the loyal fan base and the associated online platforms are rare and hard to imitate resources. However, CEIBS Strategy professor Sam Park has his doubts (source 15): There is nothing that warrants any type of sustained advantage for Xiaomi even in the local market... Given the lack of unique competences, Xiaomi is, and will continue to be, easily challenged by other local companies. Most of these, including Lenovo and Huawei, already launched a similar business model in part of their operations. For local companies, once competition heats up, and the margins become thin, it becomes difficult to survive.Moreover, the lack of patents has become Xiaomi's Achilles Heel. Huawei has built a portfolio of 22 169 patents, one of the largest number, not just in China but worldwide. Likewise, Lenovo has accumulated 14 493 patents, including 2300 patents acquired with the takeover of Motorola Mobility. In contrast, Xiaomi had only seven patents, quite literally a technology dwarf among the giants of the telecom industry. This lack of patents came to haunt Xiaomi as it challenged the leaders. In November 2014, lawyers for Huawei and ZTE sent letters to Xiaomi about the latter's patent infringements. Yet neither Huawei nor Z.TE. actually sued Xiaomi in court. The reason was twofold. Xiaomi's hardware supplier Qualcomm owned 80% of the patents for CDMA communications. Qualcomm also signed reverse patent authoriza tions whenever it worked for a different mobile phone vendor, which meant that Qualcomm was able to integrate all kinds of patents on one smartphone chip. As a result, the Xiaomi chip provided by Qualcomm was safe. On the other hand, due to the IP protection environment in China, even if Huawei or ZTE were to win the lawsuit, the reimbursement fee for each patent was only (10 000, which would hardly dent Xiaomi. INTERNATIONAL AMBITIONS Focused on the vast and fast-growing Chinese market, Xiaomi sold only 3% of its smartphones outside of China, compared to Lenovo's 16% and Huawei's 41%. Following the example of its Chinese peers, Xiaomi decided to first focus on other emerging economies, starting in India and then Brazil and Russia. Xiaomi's first major international venture was in India, where its (90-a-piece smartphones undercut key competitors including global players Samsung and Apple, as well as local start-ups Micromax, Karbonn and Spice. However, Xiaomi found India more difficult to penetrate than China. While both are emerging economies, the Chinese experience was only of limited use in India. In particular, the online sales channels have been - so far - less effective: first, Xiaomi does not enjoy the same attention in online tech circles and hence did not gather the same extent of buzz. In part, this was because many Chinese like Xiaomi because it represents the Chinese entrepreneurial spirit, an appreciation that is difficult to replicate abroad. Second, online retailing was still in its infancy in India, mainly because the physical infrastructure to bring online ordered products to consumers is not in place. Thus Xiaomi adapted its business models by collaborating with phone operator Bharti Airtel and electronics retailer MobileStore to develop more traditional distribu- tion channels - but this increases its costs.A different challenge of internationalization is the possibility of global competitors claiming intellectual property rights (IPR) infringement. IPR disputes are common among smartphone giants; Apple and Sam- sung have been fighting court battles in several countries for years. While the nature of IPR is often dis- puted, claims of IP infringement have become an effective, if costly, weapon of competition. In China, many 504 PART SIX INTEGRATIVE CASES IPR that are not specifically registered in China cannot be enforced. Yet once companies operate outside of China and become big enough to be able to pay large fees, they become the targets of IPR lawyers. Thus Xiaomi and other Chinese smartphone makers have armed themselves with Google executives and Silicon Valley lawyers seasoned in navigating the perilous waters between war and peace in IPR. Xiaomi experienced its first foreign IPR conflict in India. In December 2014, Ericsson sued Xiaomi in an Indian court for IPR infringement, and the Delhi High Court ordered Xiaomi to suspend its sales in India. A few days later, the ban was reduced to a specific product with a specific chip made by Media Tek of Taiwan. Yet the ban was reintroduced a few months later when that particular phone was found to still be on sale in India through an online retailer that Xiaomi claimed was not an authorized retailer. While sorting out this specific legal battle, Xiaomi had to prepare itself for bigger battles to be expected when it entered other markets around the world