Jul 17, 2012 · 14 minutes

China's answer to Apple occupies the 12th floor of a staid office tower in a sprawling commercial area of Beijing. It has no signage on the building's exterior, so the only clue that suggests I'm in the right place is a standard directory plaque in the lobby that lists, among other companies, the name "Xiaomi Corporation."

To get up to Xiaomi's reception desk, I first have to wedge myself into an elevator that sags with the weight of all the bodies stuffed into it. A group of about 10 men, all dressed in dark suits, pants and light-blue shirts, all chatty and laughing, disembark on the same floor as I do and disappear into a side room.

A secretary, dressed in shorts and a T-shirt, leads me into an office to meet Xiaomi's president and co-founder, Bin Lin. Over the next two hours, the mild-mannered Lin (pictured above) tells me why his startup's smartphone will defeat an ever-expanding list of competitors, how the company plans to use its hundreds of millions of dollars of early funding, and why it stood up for itself in a public spat with the controversial CEO of software company Qihoo.

These are the very early days for Xiaomi, but the startup has already been an industrial-grade magnet for headlines. The name, by the way, translates to "millet" in English, which is a sly reference to "millet and rifle", a Chinese colloquialism for revolution. (Update: In the first version of this post, I mistakenly translated the name to literally mean "rice and rifle". I misinterpreted Lin's explanation.)

I predict there will be two major stories that define China's mobile Internet era. One will be Tencent's messaging application, Weixin (the English version of which is called WeChat), which has amassed more than 100 million users in a year and has the potential to go global. The other will be Xiaomi, which has matched top-notch hardware with first-rate software to create an outstanding device and a business model that takes its cues from Amazon, Apple, and Dell.

"When people are buying our products, they're not just buying the handsets, and they're not just buying the software," Lin says. "They're buying one product. They are seeing this product as one, no matter if it's software or hardware, or the build and the design."

I cast my eye around Lin's office. Light-colored, faux-wood floorboards. A framed photo of an idyllic beach with the ocean's break lapping over an empty shell. On the floor by a simple standing bookshelf, paper shopping bags overflow with stuffed-toy versions of Xiaomi's cartoon rabbit mascot.

And then there's Lin, dressed in a black T-shirt, blue jeans, and black loafers, looking every bit the Googler he was before he started Xiaomi with his friend Lei Jun, an iconoclastic serial entrepreneur who is emerging as the closest thing China has to Steve Jobs. Given the relaxed setting, it's hard to process the idea that I am sitting in the office of a company that just last month was valued at $4 billion on the strength of a Series C funding round that netted $216 million. That was on top of earlier funding from IDG Capital, Singapore’s Temasek Holdings, and Qualcomm, which totaled $131 million.

Xiaomi hasn't disclosed the C round investors, and Lin refuses to divulge names. But a source close to the company has told me that the major investors are GIC, which, like Temasek, is a sovereign wealth fund controlled by Singapore's government, and the Russian tycoon Yuri Milner, who invested personally. A number of other individuals, says my source, contributed smaller investments.

An Amazonian Apple

While it's over-reaching to suggest Xiaomi is China's Apple, the lead I used for this story is not mere provocation. Almost certainly, Xiaomi will be a major, long-term competitor to Apple's iPhone in China's smartphone market, which has already surpassed the US in number of devices sold and in terms of growth is only just getting started. Xiaomi appears to have hit a sweet spot in the market, selling high-spec devices that compete with the iPhone on quality, but undercut it substantially in price.

Lin doesn't claim to be as strong as Apple when it comes to design – or, more accurately, executing on design – but he says Xiaomi can hold its own on device performance. "We cannot build beautiful designed hardware like Apple," he says. "But then on the other hand, we are really good at making the hardware and the software work together."

Xiaomi's MI-ONE, the sum of its parts

The MI-ONE, Xiaomi's first and so far only model, is priced at US$313 (RMB1,999), which in China is as much as $470 cheaper than the iPhone 4S. It is sold mainly online, direct through Xiaomi's Web site (that's the Dell part of the model). Lin says the direct-to-consumer distribution allows the company to chop 20 to 30 percent off the device's retail price. China Unicom and China Telecom, the country's second- and third-place telcos, also sell subsidized handsets through their retail stores.

Jenny Lee, managing director of venture capital firm GGV's Shanghai office, says an Internet company taking on the traditional mobile sector is novel. "Historically, we've never seen a pure-play Internet company come into this sector, and they're trying to do this with an interesting product."

Lee says Xiaomi is targeting one of the final slots atop China's Internet hierarchy, which is dominated by Baidu, Alibaba, Tencent, and Sina (and, sometimes, Shanda). "It's not easy. It's challenging, but it's also very interesting in that they're trying to attack the mobile sector with their own platform and their own hardware," she says.

Xiaomi also has an unconventional sales strategy. It makes its phones available for purchase only when a large-enough batch of devices is available for distribution. That means its sales come in spikes, which are weeks or even months apart. But those spikes are intense.

When, on September 5, Xiaomi first opened online orders for the MI-ONE, the company sold 300,000 phones in 34 hours. The next batch, of 100,000 phones, went up for sale on December 18. They sold out in three hours. On February 28, it took Xiaomi 25 minutes to sell a further 150,000 phones. And then, on April 6, the company's second birthday, Xiaomi sold 100,000 phones in 6 minutes and 52 seconds. (All these figures come from Lin.)

In total, Xiaomi has sold more than 3 million phones in 10 months. Just over a third of those sales came from China Unicom and China Telecom, but all others were online. Save for a small investment in elevator TV ads – which are abundant in China – the company doesn't spend anything on traditional marketing channels. Instead, it focuses its marketing efforts on social media, and in particular Sina Weibo, which is like a hybrid of Twitter and Facebook.

By April, just seven months after its launch, Baidu's brand awareness billboard ranked Xiaomi as the fifth most-recognized handset brand in China, behind Nokia, the iPhone, Samsung, and HTC, and ahead of Sony Ericsson, Motorola, and domestic players ZTE, Huawei, and Lenovo.

Part of Xiaomi's strength lies in its community. It has a fan club of more than 2 million people, who have the power to vote out features of the phone that are unpopular with the community. Many Xiaomi users have also designed themes for the phone, which can be added for free from an in-built marketplace. Lin shows me one user-designed theme that makes the whole UI look like a pair of jeans, complete with zippers to unlock features and stitched pockets for the apps.

"They're selling an aspirational lifestyle platform that resonates with China's youth," says Robin Chan, an angel investor who splits his time between Beijing and Silicon Valley. Chan founded social game company XPD Media, which in 2010 was acquired by Zynga. Xiaomi was one of his first investments in China. "Everybody else is selling cheap phones with injected Android code. It's really hard to build a community, a consumer brand."

While it takes the Apple approach to integrating software and hardware, Xiaomi's business model has more in common with Amazon, which offers its Kindles for cheap in order to sell more books. Rather than relying on hardware as its main source of revenue, Xiaomi strives to keep the price as low as possible while making money from accessories and software, including its highly customizable user interface "MIUI" and its MiTalk messaging app. The latter bears a striking resemblance to Tencent's Weixin, which came out soon after MiTalk's launch. Coincidence? Nope.

"Absolutely, they copied us," Lin says with a wry smile. But he can’t complain too much. As he freely admits, MiTalk itself was "inspired by" Kik. Lin boasts about the speed with which his team was able to get MiTalk to market after Kik's launch. It took a week. Today, MiTalk has 15 millions users, a number that is growing 10 percent month on month.

MIUI's customized themes

Neither MiTalk nor MIUI are fully monetized yet, but they will be in the future, probably with premium features, such as design themes and, if Korea's KakaoTalk is anything to go by, sponsored listings. MIUI already has a marketplace that offers companies prominent positioning for their apps if they pay for the privilege. The marketplace's default section, however, features apps that have been voted most popular by Xiaomi users.

In the meantime, the company is starting to see substantial margins on its hardware. Initially, Lei told media that Xiaomi made no money from the actual devices. At the time, August, that was true. In its second quarter, however, as suppliers started to drop their prices, the company started to break even on each device. Today, Lin says, it is seeing a margin of 10 to 15 percent, which is healthy by any measure. By my calculations, that means the company earns as much as US$47 (RMB300) per device.

Because its overheads are low, Xiaomi has already managed to become profitable. "Right now with the 10 to 15 percent coming in on profits on hardware, we are already seeing a little profit coming in," says Lin.

That money, however, is being reinvested into the company, specifically on improving customer and after-sales service. The venture capital, meanwhile, will be dedicated to operations and sustaining the hardware business, which is notoriously expensive. Lin estimates Xiaomi will need $300 million to $500 million a year for that purpose.

Dream Team

In China's Internet business, it's hard to top Xiaomi's team. Lin and Lei recruited five other co-founders so they could cover all aspects of their ambitious plan to combine so many disciplines under one umbrella.

Lin himself draws on 11 years of experience with Microsoft, including five years as an engineer at the company's Redmond headquarters. He came back to China in 2000 and helped build the company's research and development center here. In 2006, he jumped to Google, where he became the company's de facto Android guy for China (his words). While there, he worked with Android's manufacturing partners, such as Nokia, Motorola, and HTC.

It was while at Google that he noticed the tremendous shift to mobile. In January 2006, for instance, mobile search traffic in the country topped out at 200,000 users a day. By January 2010, there were 27 million daily mobile searches.

Lei Jun spotted the trend too. As an entrepreneur, Lei had founded leading software company Kingsoft, which later went public, and the ecommerce site Joyo.com, which in 2004 he sold to Amazon for $75 million. He went on to become as an angel investor for several years, during which time he took up the chairmanship of UC Web, China's leading mobile Internet browser. He was in that role in 2009 when he first met Lin, who was then at Google.

The two got talking, and over the course of about a year they struck upon a plan for Xiaomi. They knew they would need help, so they built a team of Internet stars who brought complementary skills to the company. Between them, the seven co-founders have expertise in mobile software, ecommerce, hardware, industrial design, and software user experience, all from major companies, including Google, Microsoft, Kingsoft, and Motorola.

These are guys who didn't need the money. They are driven by passion. GGV's Lee recalls attending a meeting at their office one night at 11pm. Everyone was still at work.

Prepared to fight

Despite their talent advantage, however, Xiaomi faces major challenges. The company has built its product on an open platform that it doesn't own, Lee points out, and it has had to develop a new business model as a young company that is taking on not only entrenched players, but the entire mobile ecosystem. That's a lot of risk to take on from a very early stage, says Lee, with a fair degree of understatement.

The company will also have to fend off attacks from every side. While Xiaomi hopes to capture users by picking them up from the device purchase stage, other powerful Internet players are releasing their own smartphones in the hope of cornering a larger part of the market. Baidu, for instance, has a search-oriented device, Shanda has a gaming-focusing smartphone in the works, and rumor has it that Tencent will soon launch its own handset.

Lin says his company will fend off the challengers by focusing squarely on one model per year and out-performing them on specs. "We want these handsets to be a super powerhouse as it comes to performance and also performance metrics," he says.

And then there's Qihoo. The company's CEO, Zhou Hongyi, has earned a reputation in the industry as a shit stirrer of the highest order, picking fights with big companies in order to get attention. In April, he sued Tencent for unfair competition. His latest target is Xiaomi. Recently, he took to Sina Weibo to disparage the quality of the MI-ONE and accuse Xiaomi of dishonesty over its hardware profit margins.

Zhou has also taken aim at Lei. “Just because he is wearing a black T-shirt and blue jeans, that does not make him a second Steve Jobs,” the China Daily reported him as saying. “The malfunctioning Xiaomi smartphone is nothing compared with the iPhone.”

Xiaomi CEO and co-founder Lei Jun

Lei eventually responded to Zhou, defending the quality of Xiaomi’s phone and denying that the company was making huge margins on the handsets. “A lie told a thousand times becomes the truth,” Lei told China’s Southern Metropolis newspaper.

It probably comes as no surprise that Qihoo has just released a smartphone that competes with Xiaomi. Lin, for one, smells a rat. “Zhou has a pattern of picking a fight with anybody who is successful and big,” he says. While he speaks about Zhou, the otherwise-relaxed Lin occasionally kneads his hands together.

“Either from the angle of being jealous or from the angle of trying to get famous, I don't know. I cannot read from that from my angle. But the way that Zhou picks fight with individuals, and also the way that he never shies away from using some really nasty words against other people personally, I just see this as being very unhealthy.”

Competition is good, says Lin, but it should remain professional. “I think Zhou does it as a plan. By doing this, he attracts a lot of publicity, a lot of eyeballs from the users here in China. And in return, he's trying  to use those eyeballs and publicity to try and promote his product.”

Despite knowing it would stoke the controversy, Lei decided to respond because Zhou was misleading users, Lin says. In support of his claim that Xiaomi makes as much as $US126 (RMB800) on each device, Zhou used math that seemed reasonable but vastly underestimated the investors’ price-earnings ratio assessments, Lin says. Because its investors see Xiaomi as a mix between a hardware and an Internet company, its price-earnings ratio is much higher than the hardware industry standard on which Zhou based his calculations.

Lin is also at pains to respond to Zhou’s accusation that the MI-ONE is a shoddy product. Xiaomi uses only top-of-the-line components, made by the likes of Qualcomm, Texas Instruments, Sharp, Samsung, and Honeywell, he says. A few phones have failed, but the model has only a 2 percent repair rate, which Lin says is very low by industry standards.

Still, with 3 million users, that means there are 60,000 unhappy Xiaomi customers. “If even one-tenth of them – 6,000 – started posting on Weibo, that would create a massive perception of quality issues with Xiaomi handsets,” Lin says. On the other hand, they’re real customers with real problems, which means the company needs to lift its game. “We are very open to those issues, and we are working very hard to improve those issues."

Perhaps the most successful outcome of Zhou’s mischievous attacks is that they have focused the public’s attention on Xiaomi’s performance as a manufacturer, drawing attention to profits per handset and calling into question the veracity of the device. Lin and Lei won’t like that. They started Xiaomi with the vision of it being an Internet company that is supported by hardware. “If ever Xiaomi becomes a handset company,” Lin tells me, “it's not what Lei Jun and I wanted to do.”

The problem is, they now find themselves fighting a negative rather than affirming a positive. They are playing defense, in other words, when they should be on the offense.

GGV’s Jenny Lee sums up their challenge in one easy sentence. Asked if she thinks of Xiaomi as a hardware company or an Internet company, her response is immediate: “Their aspiration is to be an internet company, but they are currently a hardware company.”

Xiaomi’s second phone is due to launch in a matter of months. Let the revolution continue.