China’s sluggish economy, battered by strict pandemic restrictions and an imploding housing market, has squeezed consumers. Smartphone shipments in China fell 12% year over year for the quarter ended September, according to industry tracker IDC. 

Though Xiaomi is China’s biggest smartphone maker overall, it isn’t the local market leader. Apple’s new iPhone 14 is popular there and it was the only major manufacturer that reported year-over-year shipment growth in China last quarter. Honor, which was spun off from Huawei after the Chinese company got hit by U.S. sanctions, has roared back to the top ranks. It was the second top-selling brand in China last quarter, according to IDC, with 18% market share—higher than Xiaomi’s 13%.

India’s smartphone market, where Xiaomi is the market leader, isn’t looking much better: Shipments last quarter dropped 11% from a year earlier, according to Counterpoint Research. Chinese companies, including Xiaomi, are also facing increasing regulatory scrutiny from the Indian government.

Xiaomi’s internet services business, which accounted for 43% of its gross profit during the quarter, also was hurt by China’s economic slowdown and regulatory crackdown on the internet industry. Revenue in the segment last quarter fell 4% from a year earlier, while margins narrowed. The company subsidizes its smartphones to sell customers advertisements, videogames or other services. Gross margins at the segment were 72% versus 9% for smartphones themselves. While Xiaomi makes around half of its revenue outside China, its home market makes up about three-quarters of its sales at the internet services segment. Overseas internet services were a bright spot, at least, with revenue growth of 17% year on year.

Like other Chinese stocks, Xiaomi’s shares have rebounded this month on hopes that China will ease both its zero-Covid policies and property crackdown. Its shares are down more than 70% from their peak in early 2021, though they still fetch around 30 times prospective earnings, according to FactSet.

Xiaomi’s prospects rest to some extent on factors beyond management’s control—especially measures around China’s zero-Covid policy. While Beijing will eventually roll back some of its strict pandemic restrictions, the process will likely take some time. Recent surges in Covid cases have sent many parts of the country back into lockdowns. 

Investors hoping to get a stronger signal from Xiaomi may need to wait a while.

Write to Jacky Wong at jacky.wong@wsj.com