How Xiaomi's Hip, Inexpensive Smart Phones Conquered China

But can they succeed overseas?

Lei Jun, the CEO of Xiaomi, has drawn comparisons to Steve Jobs. (Jason Lee/Reuters)

For years, the Chinese cell phone market offered consumers an unappetizing choice: You could either buy a high-quality, imported phone (such as an iPhone or a Samsung Galaxy), or settle for a cheap, inferior domestic equivalent. Given how few people in the country can afford an iPhone, there's little wonder that China's knock-off, or shanzhai, market is so strong.

Enter Xiaomi. Named after the Chinese word for “millet,” the three-year-old company has manufactured a sleek, attractive smart phone that functions much like an iPhone—for a fraction of the price. The popular Mi3 model, for instance, costs only $327; in comparison, Apple's iPhone 5s retails for $866.

Customers are responding. Xiaomi sold 7 million phones in 2012, and are projected to triple that amount this year. Its market share in China stands at roughly 5 percent, eclipsing Apple's. And a recent valuation of the company put its worth at $10 billion—roughly twice that of Blackberry. All in all, not bad for a company that few people outside of China has even heard of.

How has Xiaomi done it?

The simplest explanation is clever pricing: Xiaomi's phones are affordable, but not too cheap. And that's a good thing. “The price is right in the sweet spot—it's cheap enough that it's still affordable to most people in their target demographic, but expensive enough that people know it's not garbage,” says Charlie Custer, a writer who blogs about the Chinese tech industry.  Indeed, in a country where defective, substandard products are common, Xiaomi phones are noted for being well-made. “Feature for feature, you would likely pay 40 to 60 percent more for a similar phone from Samsung, and Xiaomi's quality is consistently acceptable,” says David Wolf, a public relations professional who has written extensively on the industry.

How has Xiaomi managed to achieve this balance? Though the company is often compared to Apple, its business model actually resembles another Internet phenomenon: Amazon.  Like the retail giant, which deliberately loses money with each sale of its signature Kindle products, Xiaomi makes little to no profit from the physical phone itself. Instead, it makes its money through selling apps and movies through its software, which is based on Google's Android operating system.

But perhaps the real secret to Xiaomi's success is its marketing strategy; which, oddly, is to avoid any marketing at all. Most Chinese cell phone companies rent space in the country's ubiquitous multi-story shopping centers, but Xiaomi sells its devices online only. In addition to cutting down on costs, this strategy gave the company an edgy, exclusive factor that other cell phone manufacturers lacked. As Custer says, “The gold iPhone 5s is the phone your corrupt official uncle and all his rich friends will buy, while the Xiaomi is the phone your cool hipster cousin has.” In a country where criticizing—and mocking—the rich has become something of a national sport, Xiaomi's “cool and cheap” message has a powerful resonance.

Lei Jun, Xiaomi's CEO, personifies this hip image. Wiry and bespectacled, with a penchant for wearing blue jeans, Lei resembles a Chinese Steve Jobs, a comparison he has publicly deflected. But however modest he may be, Lei Jun has big ambitions for his company. In August, Xiaomi hired Hugo Barra, a former vice president at Google, to help broaden the company's appeal in foreign markets, particularly the United States, a task for which Barra has expressed great enthusiasm.

Will Xiaomi's global expansion work? Though there is certainly a market for an inexpensive, decent smart phone everywhere in the world, Xiaomi faces fundamental obstacles. In the United States, for example, cell phone companies must negotiate with carriers (such as Verizon or AT&T), a barrier that doesn't exist in the Chinese market and one that may exclude up-and-comers. And even if Xiaomi does break into foreign markets, it will lose its cache as a cool, hip, Chinese company—a source of pride in a country which has traditionally lacked internationally known brands. Finally, there's the name (pronounced “sheow me”), which is difficult for non-Chinese speakers to say.

Even if Xiaomi never achieves a huge market share outside of China, however, its potential to grow remains enormous. Smart phones are ubiquitous in wealthy, urban neighborhoods, but in much of the country people are still too poor to own them. “There's still a big percentage of the Chinese population that isn't going to spend $300 on a phone, period, no matter how much bang for their buck they're getting,” says Custer. But as economic growth will lift millions of people into China's middle-class each year, Xiaomi's target demographic will expand, hooking more people into the company's range of apps, games, and other services. Tellingly, makers of shanzhai phones have begun to complain of lousy sales.

Lei Jun, for all his ambitions, may never achieve the international profile of a Steve Jobs, Jeff Bezos, or Bill Gates. But he has possibly achieved something far more important. For much of the past three decades, foreign observers have sneered that while China can mass-produce cheap goods efficiently, they lack the ability to innovate. Xiaomi seems poised to prove them wrong—whether people can pronounce its name correctly or not.