Wednesday, September 18, 2013

The Business Model of Xiaomi, China's Answer to Apple

To throngs of cheering fans, the CEO of a cellphone company sauntered onto stage wearing jeans and a black shirt to unveil THE sleek new phone of the season. The scene is . . . familiar. But, to most Americans, the company is not. Xiaomi is often compared to Apple due to its launch parties and its focus on design. However, it takes a distinctly Chinese approach to running its mobile phone business. And this model recently pushed Xiaomi past Apple in the Chinese mobile market share with 5% to Apple’s 4.8%. How does Xiaomi’s business model differ from Apple?
The Phone
Apple’s base business model in China is relatively simple: it sells high-tech, beautiful phones at a high price with high margins. The iPhone 5 retails for $860, and the new “inexpensive” iPhone 5 will retail for $733 in China, and Apple has the highest margins in the business. At similarly high prices, Apple has generated revenues of $19.6 billion from phone sales in China, Hong Kong, and Taiwan through the third quarter (Q3 and Q2Q1).
Xiaomi has a beautiful phone with some good technology, but Xiaomi takes a different approach with their phone’s price. They sell their phone at cost for about $330, and they sell directly to customers in order to keep the price as low as possible. At less than half the price of an iPhone, and in a country where customers are more price sensitive than in America, the lower price of the Xiaomi phone helps build market share. But to what end?
The App Stores
Xiaomi sees themselves as similar to Amazon. Just as Amazon sells its Kindle near cost to drive profitable sales of books, Xiaomi sells its phone at or near cost to drive sales of apps, music, and video through its app store. The Google Play store remains banned in China, but Google’s Android operating system is the dominant mobile operating system. Xiaomi’s snazzy looking phones and slick marketing campaigns convince people to buy their phones, and the phones, of course, direct their users to Xiaomi’s app store. In many ways, this is the classic internet business model of building a user base with a nice product, and then monetizing it later with add-ons. Xiaomi’s monthly revenue from its app store doubled from April 2013 to August 2013, and Tencent, which has the largest app store in China, had $5 billion in revenues from its app store in 2012. Xiaomi’s app store is a big part of why it’s one of the 15 most heavily venture backed mobile startups of all time.
We know that Apple’s iTunes Store is successful with about $11.7 billion in revenue through Q3 of this year (see links to revenue above). But Apple has not published a geographic breakdown on where this revenue is generated. We do know that there is fairly sophisticated piracy of the iTunes store, but we just don’t know how much money Apple is making from iTunes in China.
But each company’s store is probably not what has driven Xiaomi past Apple in market share.
The Software
I’ll admit it. I’m a bit biased against the Apple mobile OS because it lacks the customization options of Android, and the look and feel of the phone is determined by the overlords in Cupertino. Apple makes a great OS, but I enjoy tinkering with how my phone looks and works. Apple is also notorious for how it takes for OS updates. Xiaomi takes a . . . different approach.
Xiaomi releases a new version of its OS, which is based on Android, on a weekly basis in response to users suggestions. Often these updates are based on polls on weibo. This customer interaction could be a big part of the emotional embrace of Xiaomi by the people who buy its handsets.
William Lewis is a tax and business attorney based in the Silicon Valley. He advises domestic and foreign clients on a range of business, tax, and estate planning matters. He can be reached by email at lewistaxlaw[at]gmail[dot]com.

Thursday, September 16, 2010

The Politics of the Anti-China Bill

For the sake of convenience and rabble-rousing I'm going to refer to the Currency Reform for Fair Trade Act as the Anti-China Bill. The bill will essentially allow the US to impose trade sanctions against countries that manipulate their currencies. The best thing written about the bill and Geithner's speech today is from the Economist's Free Exchange:
Pundits have been demanding that Mr Geithner pressure China to allow its currency to appreciate against the dollar, and Mr Geithner (reluctantly, one imagines) is rising to heed the call.
. . .
It was American pressure that led the Chinese to de-peg their currency in the first place; recall that they wanted to avoid heated confrontations at the June G20 summit. And American pressure has likely contributed to the recent sharp rise in the yuan (which has appreciated by 1.25% in just the last fortnight), though signs that the Chinese economy is achieving a smoother landing than previously believed have obviously helped.
Persuasion, in other words, is working.
. . .
My view is that China recognises the need to let its currency rise, and when economic conditions permit it is willing to move toward gradual appreciation.
. . .
Actual trade confrontation, on the other hand, would be very messy. Chinese leaders are explicitly warning that sanctions would be counterproductive. Some American leaders and pundits seem to assume that if persuasion is working, an aggressive policy confrontation would work better.
. . .
But there's an election on, and populism is ascendent, and the trade warriors in Congress will have their day. I just hope the legislature holds to its recent pattern of behaviour—all talk and no action.
A qualitative analysis of why it matters that it's an election year goes something like this: While the Democrats have been in power the US unemployment rate is hovering around historic highs for a historically long time. Democratic policies have either failed or appeared to have failed to fix the unemployment situation. In a bid to deflect blame for the poor state of unemployment from themselves, the Democrats have chosen an external target: China. Simplified, they claim that unemployment is due to the trade imbalance which is due to an under-valued renminbi.

Supposing that trade tends to be good for the economy and that data shows that manufacturing jobs in the US have been in steady decline since the '50s, one should only be able to make the above argument if they are intellectually dishonest because they arguing for what they should argue for politically even if it is not a real solution. If this is the case, then one would expect that Democrats who sponsored the Anti-China Bill are disproportionately in congressional districts where they are not considered safe in the mid-term elections in November. So I took a look at the congress people who endorsed the Anti-China Bill, and whether or not they are considered to be safe in the November elections according to Real Clear Politics polling.

Of the 146 sponsors of the bill, 103 are Democrats and 43 are Republicans. Of the 43 Republicans, 40 are considered safe, and 3 are in districts that are likely or leaning Republican. Of the 103 Democrats, 47 are in districts considered safe, 23 are in likely/leaning Democrat, 18 are in tossup districts, and 15 are in likely/leaning Republican. The 18 Democratic congressmen in elections that are considered tossups represent half of the total 36 Democratic congressmen in tossup elections, and the 15 Democrats in elections likely/leaning Republican represent half of the 30 total Democrats in those elections.

I think that's some pretty good evidence that quite a few of our elected representatives are being intellectually dishonest with themselves and their constituency. plus ça change, plus c'est la même chose...

Thursday, September 9, 2010

Comment on the NYT China Clean Energy Subsidies

Stan Abrams has a great post up today on this morning's New York Times article by Keith Bradsher about China's various solar subsidies, On Clean Energy, China Skirts Rules. In his post, Stan enumerates the various subsidies discussed in the article, and he discusses their strengths if they were filed in a WTO complaint. One response to Mr. Bradsher's article: I thought the juxtaposition of US industry complaints with a Chinese entrepreneur's responses, or at least the selection of quotes from a Chinese entrepreneur, definitely painted the alleged Chinese subsidies in a poor light. One response to Stan's post: I had to investigate why export restrictions are such difficult items.

Juxtapositions of Complaints and Responses
In response to export subsidies in general, Zhao Feng, a GM at Sunzone, responded that "the world should appreciate the generous assistance of Chinese government agencies to the country’s clean energy industries."

In response to the land use rights, Mr. Zhao responded that "the subsidized land will also help Sunzone afford plans to sell solar panels below cost to poor people in western China."

And in response to official encouragement, Mr. Zhao pointed out that "Our provincial governor has come several times to our plant, just as Gov. Arnold Schwarzenegger has made several visits to solar power companies” in California.

Mr. Zhao is not exactly helping his own case here.

Mr. Bradsher only presents one real defense from the Chinese government: China contends "that it is still a developing country struggling to understand its commitments."

Response to Export Restrictions
Stan's comment on rare earth metal export restrictions:
"Export restrictions on raw materials and currency manipulation are certainly ongoing trade disputes. However, whether either of these practices is a violation on WTO law are hotly debated issues, and if you take a poll of trade lawyers, you would be unlikely to get any sort of consensus opinion. Moreover, proving these allegations in a formal dispute resolution procedure would be quite difficult."
I think he is right that proving the allegations is quite difficult because WTO rules allow for export restrictions in certain circumstances including general revenue and conservation. And, in fact, when Beijing imposed export restrictions on rare earth exports, they claimed it was for conservation after "years of over-exploitation that has damaged the country's environment." Export He is also right that the issue is hotly debated. Let's see what the debate is about.

So what are the WTO legal standards for illegal export restrictions under the General Agreement on Tariffs and Trade (GATT)? Here's a summary of a summary of GATT rules. The main source for what export restrictions are and are not allowed is Article XI:1 of the 1994 GATT. The summary distinguishes between allowed export duties and disallowed quantitative export restrictions:
  • Export Duties: Export duties, taxes, and other charges are generally permitted.
  • Quantitative Export Restrictions (QER): Includes quotas, bans, minimum prices, and non-automatic licensing requirements on the "exportation or sale for export of any product." Could potentially include prohibitively high export duties, but that's highly debatable. There are exceptions:
    • If QERs are applied to relieve temporary shortages;
    • If QERs are necessary to spread supplies over a longer period of time;
    • If QERs are for price stabilization;
    • If QERs reasonably relate to conservation "in conjunction with restrictions on domestic production or consumption." And this exception, which is in Article XX(g), cannot be relied on if they are "designed to protect or promote a domestic processing industry."
    • And there are also a number of security related exceptions.
If a quantitative export restriction causes the price for domestic production to be lower than in the absence of the restriction, then a subsidy could be found to exist. If a subsidy is found to exist, then a countervailing duty or anti-dumping remedy could be appropriate.

Of particular note by analogy for rare earth metals is that quantitative export restrictions apply to the saleor sale for export. The OPEC countries and their oil quotas have not been tested, but it is argued that OPEC quotas are production quotas and not sale or export quotas. But China's quotas are explicitly export quotas.

So, yeah, this sounds like one difficult situation...

Wednesday, September 8, 2010

Debt for Equity Swaps by FIEs in China

[The meat's a few paragraphs down under "In China" header. I just wanted to do the comparative law thing first.]

Given the prevailing gloomy economic climate in the developed world, and market volatility in the developing world, debt for equity swaps have received a lot of coverage over the past couple of years. Debt for equity swaps can be by contract or under a bankruptcy statute, and if in bankruptcy then they can be voluntary or involuntary. The possibility of debt for equity swaps can encourage creditors to lend to riskier borrowers, and involuntary debt for equity swaps in bankruptcy can theoretically help keep interest rates down by allowing creditors the opportunity to take control of, or at least a significant stake in a company if it is forced into bankruptcy.

The most famous debt for equity swap is GM's reorganization in bankruptcy. GM was nudged into filing for chapter 11 bankruptcy which allows for the restructuring of a company's debt-holder's interests into equity interests. And if the most senior creditor of a debtor corporation has at least a 33% or higher equity interest in that company following the chapter 11 reorganization, then the reorganization is tax free to the company, shareholders, and creditors. In GM's case, secured creditors received the requisite amount of equity to keep the reorganization tax free. Chapter 11 is a useful mechanism for a debt to equity swap because it allows for a corporation to receive a fresh start while giving the creditors a judicial forum to protect their interests.

In China
Cagman Palmer of Shanghai Nan Guang Law Firm recently wrote an interesting paper on debt for equity swaps in China, Debt-for-Equity Swap and Reorganisation Law in the People's Republic of China. As in the US, there are three types of situations where there might be a debt for equity swap: 1) contractual, out-of-court swaps; 2) voluntary reorganizations in bankruptcy; and 3) involuntary reorganizations in bankruptcy. Mr. Palmer explains each in extreme detail. I'd like to briefly summarize his description of contractual, out-of-court debt for equity swaps by foreign invested enterprises in China.

Contractual Debt for Equity Swaps by FIEs in China
The key component of these swaps is that 1) they must comply with any laws, regulations and administrative rules of the PRC, and 2) they must be registered and approved by the SAIC in Beijing, or the SAIC's "local or provincial counterpart at the debtor company's domicile." The swaps must be registered and approved because the swap increases a company's level of registered capital. And since this is Chinese law, you should be asking where is the catch-22? It is in enforcement.

Provisions on restructuring say that contractual debt for equity swaps will be recognized in civil disputes if 1) they are purely consensual, and 2) in compliance with compulsory laws and administrative rules. However, the Supreme Court of the PRC has also ruled that the recognition provisions only apply to domestic enterprises, and not to FIEs. This means that since the laws, regulations and administrative rules do not explicitly allow for debt to equity swaps in FIEs, the approving bodies may not approve them. In effect, an FIE debt to equity swap may not be forced because regulations may not cover them because they may not be able to be enforced. D'oh!

Enter Shanghai. Last year Shanghai introduced measures allowing for debt to equity swaps by FIEs, which should, as long as Shanghai is the domicile of the FIE debtor, make debt to equity swaps in FIEs enforceable in a civil dispute. The Shanghai Department of Commerce should approve a debt to equity swap if the following elements are satisfied:
  1. The swap is a conversion of a registered foreign shareholder loan into the registered capital of the same FIE;
  2. The registered capital of the FIE has been paid in full and on schedule;
  3. It has been unanimously approved by all shareholders;
  4. It meets the requirements of the State Administration of Foreign Exchange (SAFE);
  5. The swap agreement state the amount of debt to be canceled in exchange for equity;
  6. The proper documents proving that the debt meets SAFE requirements has been attached; and
  7. The change in registered and paid-in capital were processed at the same time.
I think the comparative aspects are interesting. And I'm sure we'll see a national expansion of these rules over time.