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Why China’s Xiaomi and Microsoft Are Teaming Up

Xiaomi Corp. Vice President of Global Operations Hugo Barra Launches The Mi 4i SmartphoneXiaomi Corp. Vice President of Global Operations Hugo Barra Launches The Mi 4i Smartphone
Xiaomi, maker of the Mi 4i phone, is hoping a partnership with Microsoft could boost sales.Lam Yik Fei — Bloomberg via Getty Images

A just-announced partnership between Xiaomi and Microsoft represents a potentially promising collaboration between two struggling smartphone businesses.

Starting in September, Xiaomi’s smartphones will ship with Microsoft’s Office apps and Skype, while Xiaomi will receive some much needed patents from the Redmond, Wash., giant. Xiaomi said the cross-license and patent-transfer agreement, which the two companies announced Wednesday morning in China, helps it meet its goal of building relationships with global tech leaders. Microsoft, meanwhile, gets a new platform for its services.

Neither company is approaching this deal from a place of strength. Microsoft is all but irrelevant in smartphones—the global market share for its mobile operating system dropped below 2% last year, says IDC— while Xiaomi’s once ascendant path has stalled.

The deal is most important for Xiaomi’s ambitions of becoming a global consumer brand. Xiaomi’s smartphone growth was down 9% year-over-year in the first quarter, according to Counterpoint Research, while growth last year was around 23%, just a hair better than much bigger Apple. For comparison: Xiaomi sold 71 million smartphones in 2015; Apple sold 232 million iPhones. Xiaomi, which a little over a year ago enjoyed the third largest global market share for smartphones, has fallen outside the top 5.

Xiaomi’s smartphones haven’t been able to match the quality of Apple’s or, increasingly, Huawei’s in China, and growth is now coming from lower-priced models it sells, in India, Brazil and China. That explains why Xiaomi’s total revenues were nearly flat last year compared with the year before, as Fortune reported this month.

The deal for Microsoft’s intellectual property is bound to help Xiaomi, which understandably suffers from an IP deficit, being a five-year-old smartphone maker. Because of this deficit, analysts note, Xiaomi was the last of the major Chinese smartphone makers to add a fingerprint sensor to its phones late last year. IP weaknesses have also made Xiaomi wary of entering developed markets where litigation risk is high.

But patents alone won’t help Xiaomi successfully expand in the U.S. or Europe.

Xiaomi’s core business model—selling phones online at cutthroat prices for no margin, or nearly no margin, in hopes of attracting users to spend on its services—is difficult to replicate outside China. Shoppers in the U.S., for instance, prefer to buy phones in stores. In India, Xiaomi has turned to brick-and-mortar partners. Moreover, Xiaomi’s services aren’t offered anywhere outside China. Its current operating system is built off of Google’s Android platform. Since Google’s services are blocked inside China, Google allows Xiaomi to offer its services in place of Google’s inside that country. But outside of China, Xiaomi’s phones run with Google’s App store and other services.

Xiaomi’s head of international, Hugo Barra, and other executives say the startup is an internet company, not a smartphone seller. They say this because Xiaomi’s services in music, video and games are driving revenue per user in China, albeit from very low levels.

However, smartphone sales growth remains key to its business. Smartphones sales drive spending on services like music and video. Apple analyst Toni Sacconaghi has pointed out Apple’s own services are highly correlated with smartphone growth. When people buy new phones, they buy new services; with older phones, less so. Xiaomi faces the same dilemma.

The hope for Xiaomi must be that Microsoft can put its smartphone on better footing. “Xiaomi gets IP protected with possibly a special price,” says Neil Shah, a director at Counterpoint Research in India. “But in return Microsoft locks in Xiaomi as a serious partner to drive its own ecosystem.”

Still, this is the same Microsoft that has had recent misadventures in smartphones. Last week Microsoft said it was laying off more than 1,800 workers and writing down the value of its smartphone business by $950 million. Analysts noted that this amount, along with other past writedowns, add up to more than the $7.2 billion Microsoft paid to acquire Nokia in a blockbuster 2014 deal. Its smartphone operating system market share has dwindled to a couple percentage points.

Observers must wait to see how each company approaches the partnership. But objectively, there isn’t overwhelming reason for optimism.