Photograph by Julie Glassberg for Fortune Magazine

Can Xiaomi Live Up to Its $45 Billion Hype?

The “Apple of China” gets a reality check as its smartphone sales slump.

January 15, 2015:

Inside a Beijing convention hall big enough to fit a brigade, Chinese tech upstart Xiaomi is rolling out its newest big-screen phone, the Mi Note. The event has the hype of a Hollywood premiere, and $15 tickets have sold out to this crowd of thousands of buzzing fans.

When CEO Lei Jun takes the stage, in distressed jeans, sneakers, and a blue button-down, he’s confident—cocky, even. You can hardly blame him. Xiaomi, the company Lei founded in 2010, has become the world’s fourth-largest smartphone seller, hawking affordable, stylish phones that cater to China’s immense middle class and its youth culture. Xiaomi has just completed a funding round that made it the world’s most valuable private startup, with an astounding valuation of $45 billion—reflecting investor excitement about not only its phones but also its “ecosystem” of online services and smart-home products, which could turn phone buyers into loyal customers for years to come.

Tech journalists have begun calling Xiaomi the “Apple of China.” The name rankles designers at the actual Apple, who grouse that Xiaomi phones are merely cheap iPhone copies. Lei begs to differ. In fact, he tells the Beijing crowd, his phones are better: “The Mi Note is lighter, thinner, narrower, and shorter than the iPhone 6 Plus, but our screen is larger,” he gushes. Over the next few months customers validate his exuberance, as Xiaomi has its best quarter ever for smartphone sales—while monthly users of its games, apps, and services top 100 million.

May 21, 2016:

Beijing again, but this time at a government-sponsored tech conference in an older exhibition center. Smartphones are a topic most attendees would rather avoid, since sales have sputtered. But in an interview with Chinese media, a Xiaomi public affairs official lets slip that Xiaomi’s sales rose just 3% in 2015, to $12.5 billion. A year earlier, Lei Jun had boldly predicted that figure would be $16 billion. As for the much-touted ecosystem, investors say it produced half the services revenue Xiaomi had expected.

Apparently this news wasn’t supposed to go public: Chinese websites quickly delete references to the interview, and Xiaomi declines to comment on the numbers. Still, the setback reinforces what industry watchers already suspect: Xiaomi’s sales have flatlined, and its revolution is in jeopardy.

Xiaomi’s tale may sound like merely another iteration of that now familiar headline, tech unicorn gallops into wall. But Xiaomi (pronounced “SHAO-me,” with the first syllable sounding like the “show” in “shower”) isn’t just any privately held, multibillion-dollar startup. It’s a rising power in a nation eager to prove that its consumer-oriented companies can compete globally. “Xiaomi’s mission is to change the world’s view of Chinese products,” Lei said last year. While Xiaomi no longer wears the most-valuable-startup crown—that now belongs to ride-hailing service Uber—its $45 billion valuation remains a powerful symbol of its aspirations, so much so that Xiaomi proudly includes it in product catalogues. (Some analysts put the figure slightly higher.)

The company didn’t attain that valuation on the strength of its phones, though those get raves in the tech press (and have even made Xiaomi modestly profitable) while selling for half the price of an iPhone. No, private investors judged Xiaomi to be more valuable than FedEx fdx or Caterpillar cat or Delta Air Lines dal because of the promise that it could build a network of products, services, and recurring revenues—an ecosystem like Apple’s—not just in China but around the world.

#CHINA-BEIJING-XIAOMI-NEW PRODUCT(CN) Xiaomi CEO Lei Jun promotes his company’s smartphones at a product-release event in Beijing. Smartphones account for more than 90% of Xiaomi’s revenue.Zhang Jin Xinhua—Eyevine/Redux

If anything, Xiaomi’s idea of an ecosystem is more ambitious than Apple’s. Apple aapl focuses on services like iTunes and a tightly focused suite of tablets, computers, and smartphones. Xiaomi envisions a sprawling Internet of things. The company hopes you will someday control your Xiaomi water purifier, Xiaomi air filter, and Xiaomi mood lighting—an entire Xiaomi smart home, essentially—with a few taps on your phone. Executives and investors say today’s disappointing numbers are merely a stumble en route to this goal. “In terms of the ecosystem build-out and international expansion, Xiaomi’s still at the very early stages,” Richard Ji, the venture capitalist and former Morgan Stanley ms tech analyst whose Hong Kong–based All-Stars Investment led Xiaomi’s big 2014 funding round, tells Fortune.

A bet on that build-out is a bet on several transformative trends: the rise of China’s middle class, the incorporation of average Joes and Janes into the Internet of things, and the capacity of consumer-focused Chinese companies to make inroads in Europe and the U.S. But as Xiaomi’s progress slows, there’s growing skepticism that a startup without innovative technology of its own or much success outside of smartphone sales can produce an ecosystem anywhere nearly as big or “sticky” as Apple’s and Google’s googl . “I think the wheels are wobbling,” says Duncan Clark, an Internet consultant based in China and an early adviser to e-commerce giant Alibaba baba . And that makes a bet on Xiaomi look more and more like a long shot.

Xiaomi executives hate it when their company is called a smartphone startup. They much prefer “Internet company.” And Xiaomi hewed to that identity even as it shipped 175 million smartphones over the past five years. The company had no retail locations until recently, selling most of its phones via its website. In China, the phone ships with Xiaomi’s operating system, a heavily tweaked version of Google’s Android, complete with its own online music and app store.

Xiaomi realized a few years ago that phone buyers alone weren’t generating much recurring revenue—nor were they luring return traffic from customers who might be enticed to upgrade to a new phone. The company started selling smartphone batteries in different colors as accessories, and those did well enough to spark an aha moment, says Hugo Barra, Xiaomi’s head of international business: “Why not new products?” Barra, a Brazilian-born MIT grad who once led the Android new products team at Google, had been poached to turn Xiaomi into an international brand. “We don’t care about selling phones, but about getting as many users as we can,” he has said. If devices attract users, Xiaomi brass reasoned, let’s assemble a fleet of devices.

The ecosystem campaign aims to do just that. Its core is a team of 170 people with expertise in product development, supply chain, and design. But unlike, say, Jony Ive and his design hive at Apple, Xiaomi’s team works primarily with outside companies. The company partners with hardware startups (and often creates new ones), providing seed money for ecosystem products. Xiaomi avoids taking full control, encouraging the founders to act like risk-taking entrepreneurs. The company gets an exclusive deal to sell most of the startups’ products, and in turn the startups, now numbering 55, get access to Xiaomi’s supply chain, marketing, and even its industrial engineers.

XIA.07.01.16.ProductsA Xiaomi phone (center) surrounded by some of the products that make up the company’s “ecosystem.”Courtesy of Xiaomi

Liu De, a 43-year-old former dean of industrial design at Beijing University of Technology, leads the ecosystem effort with a blanket approach, in which almost everything fits. Xiaomi sells headphones, Bluetooth speakers, a fitness wristband that doubles as a buzzing alarm clock. So far its bestsellers have been everyday, non-“smart” products: a power strip, a portable smartphone charger. But the bigger goal is to create an entire synced smart home. In April, Xiaomi invited 300 journalists to its Beijing unveiling of its $150 smart rice cooker. (From their phones, users can track rice transforming from the “water absorption” phase to one called “big fire.”)

Xiaomi’s ecosystem sales were about $750 million last year, although most of that flows to its startups through revenue-sharing agreements. Smart homes may be a $15 billion market in China by 2018, according to Juniper Research, and Liu says Xiaomi’s ecosystem revenue might equal its smartphone revenue in less than five years. Last year, 90% of Xiaomi’s $12.5 billion total revenue came from smartphones. So in essence, Liu and Xiaomi hope to catapult a $750 million, mostly domestic business into at least an $11 billion, increasingly global one.

A visit to Yeelight, one of Xiaomi’s startups, suggests how complicated that effort could be. Headquartered in the formerly German-controlled coastal city of Qingdao, the 60-employee company sells a “smart” mood light generating 16 million hues, as well as a Bluetooth-enabled lightbulb—a dead ringer for the Hue lightbulb from Dutch electronics giant Philips phg .

In 2014, after Google bought Nest for $3.2 billion, smart-home startups were in vogue, and Yeelight founder Eric Jiang found himself being courted by venture capitalists. Xiaomi’s offer seemed like a godsend, Jiang says. Xiaomi would help with everything from branding to quality control. It also let Yeelight bypass traditional retailers, who typically take a 40% cut of the purchase price. Instead, Yeelight’s products were put in front of what Jiang calls the fire hose of traffic on Xiaomi’s website—which averages more than 140 million unique monthly visitors, according to China Rank.

Yeelight has sold 500,000 lightbulbs and mood lights since last summer, 10 times the rate before Xiaomi invested, says Jiang—at prices 80% lower than the Philips Hue starter kit. That makes Yeelight the kind of symbiotic success story on which Xiaomi wants to build its ecosystem.

But Yeelight is also the kind of company that fuels Xiaomi’s skeptics—and one whose challenges mirror many of its ecosystem startups. Yeelight sells products that aren’t daily necessities, a sticking point for Chinese consumers, who have only about 20% as much discretionary income as Americans. And if Yeelight wants to reach consumers outside China, its rock-bottom prices are bound to rise. Even lightbulbs have intellectual property that needs to be licensed outside China. (China has strong IP laws on paper, but enforcement is lax.) Jiang, a former software engineer at Lucent, speaks frankly: To sell in the U.S. or Europe, Yeelight will have to license patents from other companies, which would boost its retail prices by several percentage points. And since Xiaomi’s e-commerce site has virtually no traction outside China, Yeelight would have to pair up with traditional retailers, raising its prices another 30% to 40%. The bottom line: Unless Yeelight rolls out innovative technology of its own, it loses a lot of its price advantage outside China.

15 June, 2016 -上海 小米之家上海大悦城店西藏北路198号上海大悦城3层302-01Shanghai - Story: Xiaomi -Photo: Xiaomi store, located in a Shanghai mall. The design of the store is really similar to Apple. -Photographer: Julie Glassberg for Fortune. A customer peruses the gear at a Xiaomi store in a Shanghai mall. Xiaomi’s smartphone models won early accolades for offering sleek designs at about half the price of comparable iPhones.Photograph by Julie Glassberg for Fortune Magazine

Xiaomi’s phones have encountered comparable IP headaches abroad. Swedish telecom giant Ericsson for years accused Xiaomi of using Ericsson wireless tech without licensing it—and after Xiaomi began selling smartphones in India in 2014, Ericsson won an injunction against it. (The case is ongoing; Xiaomi declines to discuss pending litigation.) In May, Xiaomi announced a deal with Microsoft that will help address the phone IP problem, buying 1,500 patents. But those patents won’t do much for the lightbulbs and water purifiers. “At least some of the ecosystem companies have this problem” with IP, Liu admits. And without the support of Xiaomi’s website, only a few ecosystem products have made the leap abroad. They aren’t exactly high-margin, statement gear. The Mi Band fitness tracker has been modestly successful in the U.S., for example, but it sells for $15.

Three years ago, Lei Jun told the New York Times, “We’re not just some cheap Chinese company making a cheap phone.” But many Chinese consumers still see Xiaomi that way because of some of its stumbles in making trustworthy products. Its first Mi air purifier was criticized this year by a Shanghai regulator for the amount of clean air it produced. (The company says the purifier has “passed all standards required by regulators in Beijing.”) Complaints about Xiaomi’s $620 4K TVs appear on Xiaomi’s own consumer forums.

Even Xiaomi’s reputation-making phones have been fallible. Though Xiaomi relies on a web of suppliers, including iPhone-maker Foxconn, its products haven’t proved as reliable as those of more mature competitors. Some Mi phone users lament cracked screens and static from earphone slots. Xiaomi’s newest flagship phone, the Mi 5, has attracted complaints since its release in March, with buyers reporting that new handsets often reached a scorching 120˚ F.

Xiaomi says the handset complaints involve “isolated cases” and says, “We do investigate all reasonable complaints.” But the phones’ perceived unreliability has had an impact. Clark, the Internet consultant, recently surveyed phone owners in China. Only 37% of Xiaomi owners said they would buy another Xiaomi phone, while 74% of Apple users said they would get another iPhone. “Xiaomi isn’t sticky,” Clark says. “It’s not what an ecosystem should be.”

The growing pains would matter less if smartphone sales were soaring. No such luck. Before the Mi Note launch, Lei announced a smartphone sales goal of 100 million units for 2015. The company ultimately shipped only 71 million, according to IDC. In the first quarter of 2016, Xiaomi shipped 10.9 million phones, a 26% year-over-year decline. (Global phone sales were down 0.5% over that stretch.)

These numbers make Xiaomi’s $45 billion valuation look shaky. If Xiaomi delivers a 10% operating margin on its $12.5 billion in revenue, it would be valued at a bubbly 38 times its earnings. Since Xiaomi sells phones at close to cost to gain users, a 5% margin seems more likely (and even generous). After taxes, that would imply a value of 80 times earnings, and four times sales. If Xiaomi were publicly traded, it would need to at least quadruple its revenue to bring that valuation closer to, say, Apple’s.

If Xiaomi were public, it’s also safe to say that distraught investors would have fled the stock. Apple’s shares are down 12% since April, when it reported the impact of slowing smartphone sales on its top line. Apple’s tech ecosystem is the world’s most successful, generating $6 billion in quarterly revenue—roughly 12% of Apple’s total sales. But that revenue is highly influenced by device sales growth. When their phones are new, people spend more on apps and services; when the shine fades, spending plummets.

XIA.07.01.16.chart-longformClick to enlarge.

Xiaomi, of course, is private. And its sales have been strong enough to keep it from needing to raise more money. That has helped the company avoid a headline-grabbing “down round” where it might raise money at a lower valuation than its previous round (although there are reports the company is looking to issue debt). Tuck Lye Koh, an early Xiaomi backer and a co-founder of Shunwei Capital in Beijing, says he and others are confident Xiaomi will dominate China’s Internet of things. They see Xiaomi as both an Internet company, blessed with low costs, and a future Ikea, a maker of high-quality, low-cost goods that sell in mass volumes.

Richard Ji of All-Stars Investment says Xiaomi’s lower smartphone prices mean its potential customer base is much larger than Apple’s. To skeptics, Ji also replies: Just look at Tencent. That Chinese Internet giant was largely dismissed by investors until it introduced WeChat, which has become China’s most popular social network, helping Tencent’s revenue more than quadruple since 2011.

Ji envisions a similar trajectory for Xiaomi. But it hasn’t materialized. Xiaomi’s revenue from apps and games missed its $1 billion sales target last year, hitting $560 million in 2015, according to one current investor. And unlike Tencent and Apple, Xiaomi’s ecosystem growth hinges on making bestsellers out of devices like rice cookers and drones—products for which competition is stiff and margins are low. “These are one-use-type products,” says Neil Shah of Counterpoint Research in Mumbai. “The rice cooker will only cook rice. It won’t consume content. It won’t get you additional revenue.”

If Xiaomi doesn’t live up to its $45 billion valuation, you won’t need to shed a tear for the investors who gave it that status. The Singaporean sovereign wealth fund GIC, Ji’s All-Stars fund, Russian billionaire Yuri Milner’s DST, and Yunfeng Capital, a fund affiliated with Alibaba founder Jack Ma, were among the core investors in late 2014 that raised $1.1 billion for Xiaomi. Though investors would not discuss the deal with Fortune, the fact that the funding came relatively late in Xiaomi’s development makes it likely that it’s a “ratchet” deal—one that will give investors more equity if Xiaomi raises money or goes public at a lower valuation.

Xiaomi could mature into a successful company even if it doesn’t reach the potential its investors foresee. The Mi 5 phone, which Xiaomi unveiled this spring at Barcelona’s Mobile World Congress, could reignite sales, while its Microsoft patent deal could help its phones crack more foreign markets. Thanks to inroads in India and Brazil, the company derives about 9% of revenue outside China—a rare accomplishment for a Chinese company.

There’s also that dream of a smart-home ecosystem—though Xiaomi won’t have that field to itself. Huawei, which sold 108 million phones last year to seize the Chinese market-share lead from Xiaomi, is now advertising its own smart-home suite, with partners including Haier, the appliance maker that paid $5 billion for GE’s ge appliance business this year. “I don’t want to be considered second to anyone,” Lei once told a crowd at a Xiaomi publicity event. But despite a magical few years of growth, first place is looking ever more out of reach.

A version of this article appears in the July 1, 2016 issue of Fortune with the headline “Xiaomi What You’ve Got.”

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