China and the internet

How easy is it to make money on internet stocks from China?

If the trading pattern of Chinese search engine Baidu is anything to go by, investors clearly think you would have to be brain dead not to make money on China's internet related stocks. During its first day trading on the Nasdaq on Friday August 5, the stock leapt a record 354% from its issue price to a lofty 2,000 times forward earnings.

For investors it was clearly a simple decision. Just look at the facts and figures. There were 80 million internet users in 2003; penetration rates are rising rapidly on the back or rising incomes, and government support across the spectrum of Internet and tech affairs. That support extends to an ambitious 3G mobile phone roll out and a specific commitment in the latest five-year plan to use the internet as the means to continue China's drive to economic superpower status.

Technology and business plan? Simple. Just look across the Pacific and copy the models that have been developed in the US. And hey presto, in a few years time you too could be owning the stock of the next Yahoo! Ebay or Google.

Well, forget all that. The internet in China is actually a heaving mass of ideas, money, expensive failures and spectacular triumphs. If you are trying to stock pick your way to fortune, you would need the predictive powers of Nostradamus.

"The evolution of the Internet is like nothing you have ever seen before," comments Fritz Demopoulos, co-founder of qunar.com, a Chinese language site, which enables users to search and compare hotels and airline prices. "You would imagine the Nasdaq-listed portals Netease, Sina and Sohu would have a lock, but that's not happening - They are being outflanked by nimbler players, who themselves are being left in the dust by even more innovative businesses."

The upside of this dynamism is that business models are being minted, and technologies being put to use in ways that have never been experienced in the US, Europe or even Japan and South Korea, at the cutting edge of Internet cool.

The internet revolution in China exploded with the listings of the portals during the global dotcom boom in 2000, themselves straightforward rip-offs of US business models. But whereas at one point these stocks represented almost 100% of the stock market cap of the Chinese internet, their influence is shrinking, even as they scramble to re-invent themselves.

The second wave was the wireless internet player. To many observers' surprise, it was not the established portals, which took the lead in the booming, mobile phone based technology.

"Everybody was aware that wireless internet services were going to be big, but it took a company like Kongzhong to put the idea into practice, show it could grow fast and then secure a listing," comments Demopoulos.

Since then, some 500 smaller companies have got into the game, but the market is dominated by the early movers - Tomonline, Linktone and Kongzhong, all of which are listed in the US.

Hot on the heels of the wireless service providers came the 'verticals'. Verticals are the opposite of portals in that they focus on one business. US and Hong Kong investors greedily snapped up job search specialists 51job.com and online booking agent C-trip - one of the first and still the most successful of China's internet-related stocks.

A third hot point has been search engines, with 3721.com acquired by Yahoo! in 2003 for $120 million - a sum which stunned the domestic industry. That was swiftly followed by Google's acquisition of a 2.6%stake in Baidu for $10 million, and Sina's move this year to upgrade search function with iAsk.

As the number of search companies shows, one of the problems of the internet in China is the rapid way companies copy each other. Search technology is especially difficult to monetize, according to some experts because the rate of technological progress has slowed since the breakthrough days of Google.

"Once you lose your technological edge, it becomes easy for companies to catch up, which is why you are getting so many Chinese search players," says one. But despite these convenient categorizations, they should not hide the fact that companies are constantly re-inventing themselves - and the ones that are doing it properly are reaping the rewards.

Take Netease. This player, founded by William Ding, who topped China's Rich List last year, has seen more ups and downs than an Alpine ski lift. Listing as a bog-standard, me-too, made-in-China imitation of Yahoo! in 2000 at $15.50, the counter dropped to below one dollar in 2002, but had risen 10,000% by late 2003.

The story behind the reversal is revealing. In 2002, Ding came under intense pressure to sell. But instead of giving up, he went about re-inventing the company, not once but twice over.

Firstly, he gave up on the portal model. The reason is simple. Online advertising (the bedrock of portal revenue in the US) follows e-commerce and online transactions.

For a country with one of the worst banking and financial systems in the Pacific, that was a tall order for China. Online transactions are slowly climbing, but with credit cards still way off Western levels, there is a way to go. It is also the case that a phone call can relay an order faster, in many cases, than an order of the internet (Most households use ADSL, rather than broadband in China, and connections can be patchy).

In addition, free delivery is common from any offline business premise to anywhere in town, with the customer paying cash on delivery. Finally, most Chinese still prefer face-to-face payments in cash, even if they use the internet for all the steps prior to payment.

Ding initially managed to revive the popularity of Netease through wireless added services. This is a fancy expression for providing a short messaging service to mobile phone users, who sign up for regular delivery of an SMS detailing the day's weather, stock price, news, or horoscope. That may sound simple and low tech, but SMSs are practically free to send and they lend themselves to bulk mailing: Perfect for economies of scale, aided by some fancy marketing. MMS (Multimedia Services) have been used to add graphics to SMSs but they are an interim step to the launch of 3G services.

They do have one major cost: Content does not come free, and content providers get a big slice of the revenue.

According to executives close to Ding, he was never convinced that wireless added services were sustainable and thus took his next big gamble, online gaming, which had already shown itself a huge money spinner in South Korea.

"Online gaming, as opposed to single player gaming was especially attractive because it makes piracy almost impossible," Netease's COO Michael Tong told FinanceAsia, referring to the huge problem Web entrepreneurs have with the country's lack of intellectual property rights.

Let's pause to reflect the nature of these changes. They were essentially huge bets, and it is not surprising that many internet entrepreneurs view Ding as having 'cojones' of steel.

In the US and Europe, there is also a base of SMS users and gamers. But the latter are a subgroup, almost a sect, while the texting by phone as opposed to speaking has not caught on with the same rapidity as in Asia, for reasons that will keep sociologists entertained for years to come.

Netease's figures for the second quarter this year, by common consent, were extraordinary, with net profits after tax up 147% year-on-year, and 57.8% up on the previous quarter, to $29.3 million.

Revenues stood at $50 million, up 90.2% year-on-year. Some 80% of that revenue came from online gaming, confirming Netease's third identity since listing.

In contrast, Sina (China's top portal and often described as China's Time magazine, offering news and finance) has stuck with trying to monetize its portal identity. This has had mixed results.

Second quarter figures show that its net profits fell by almost half year-on-year to $10 million and were down 3% on the previous quarter. Revenue fell by 6% year-on-year to $46 million.

Sina is in a transition whereby it is trying to decrease its reliance on wireless and pump up its online advertising. The problem is that online advertising is growing more slowly than the decline in wireless services.

Sohu (sometimes described as the equivalent of Rolling Stone Magazine because of its younger audience and young, Chinese American founder Charles Zhang) has made better progress. Some 66% of its revenue comes from online advertising, compared to 44% for Sina. Sohu's revenues improved to $26 million in Q2, better than the $23.7 million in Q1, but down from the $27 million of Q2 2004.

Tomonline is another player that started up as a portal but has since moved into wireless services, recently focusing on music downloads, with the portal relegated to the marketing and download site.

"There's no point providing the I-music model in China (downloading from the Web to the PC) because there are too many sites providing it for free," says one source close to the management at Tomonline. But he adds that the company foresees a promising niche providing music to mobile phones, whether in the form of ringback tones (which substitute the sound you hear when waiting for the called party to pick up), ring tones or IVR (Interactive Voice Response, which experts describe as a menu-operated 'electronic magazine' from which callers can download music, stories, articles and jokes)."

Music could save a sector that was crucified last year. China Mobile, for example, saw its share price fall after news surfaced about problems with over-billing and adult content.

The sectors' share price performance was further compounded by concerns about low entry barriers and saturation of the SMS business model. Richard Robinson, a long-term internet observer in China, says investors should keep their heads about the sector.

"Last year, there was very little coverage of the sector, and people over-reacted," he says. "Stock prices (in the wireless sector) plummeted, but if you look at earnings, they were not so heavily affected."

Robinson points out that with mobile phone penetration rates leaping ahead of PC penetration rates, prospects for mobile services remain good.

"Many of those mobile subscribers can't afford a PC, but are desperate to get online," he argues. "This means 2.5G mobile phone services, such as WAP (which bombed in developed markets because they were perceived as laughably slow compared to PCs with broadband) have much greater potential in China."

The interesting thing about the wireless phone sector is that it is moving away from games and leisure into business, with companies such as Beijing-based Emay offering to put critical data collection processes small enterprises struggle with, onto a mobile phone platform.

The way forward for the portals is a fascinating question, and one might even wonder what a portal stands for these days. Take the cases of Google and Yahoo! both of which appear to be quite different entities, but which in many respects are converging.

Latecomer Google deliberately designed a very pure, uncluttered interface compared to Yahoo! and emphasized its superb search function. But Google also now offers email (Gmail) and a sophisticated news services as well as extras such as desktop search and Google Earth.

So in some ways it is out-Yahooing Yahoo! in the breadth of its offering. Yahoo! for its part is pouring billions into Internet search.

The two have become mortal enemies, not least because Google's search based advertising structure has proven to be a formidable business model compared to Yahoo!'s portal-based advertising, which was, for many years, haunted by the failure of techniques such as 'banners'.

"The portals are seeing a shakeout in China," comments Chris Reitermann, managing director of Ogilvy in Beijing. "Three major portals and many second tier portals in one country is unheard of, so we'll definitely see some consolidation."

Reitermann believes Sina and Sohu will probably continue to try to remain portals, while the others, led by Netease and Tomonline will find their niche in games and wireless added services respectively.

But Sina and Sohu need to position themselves by re-positioning their brand. In practice that means thinking carefully about what role they want to play in consumers' lives rather than just increasing their name recognition, believes Reitermann.

"At the moment, everybody knows them, but nobody really knows what they stand for!" he says. For a company like Netease the solution to that problem was to become a clearly branded games provider, but that does not appear to be an option for Sina and Sohu given their determination to battle it out as portals.

Branding is important for a portal because it cannot rely on being an expert in a particular area as the verticals. But it can combine a positive image with a raft of conveniently packaged services to attract browsers and the advertising dollars that follow them.

Google has built loyalty through basing its portal model on a great search engine, while Yahoo! has focused on clever bundling: Thus somebody checking their email can almost simultaneously view the news, leisure listings or dating services.

In pursuit of the perfect portal, Sina and Sohu are trying desperately to stop earning so much money from wireless and SMS, which contributes around 60% of their total revenue.

"Analysts want to see the online advertising share of revenue going up. Sina and Sohu have been too dependent on non-core business and investors don't like that," says one observer.

Online advertising is sure to be huge in China, but not for a couple of years, Reitermann estimates.

Advertising on the Web has striking advantages over offline advertising especially in terms of the measurability it provides. Channels such Google get paid at different rates depending on how close the browser comes to committing him or herself to a buying action. That made the Web especially popular with banks, insurance companies, phone companies, IT and real estate agents who used to rely on telemarketing.

"These players want to push the browser to act (to refinance his house, change phone company or buy insurance) so they only want to pay if that works," says Reitermann.

Unfortunately for the portals, this is not a huge stream of revenue since the target market could be very specific and rather small. The winners are rather the advertising companies such as Ogilvy, which have the expertise to plan such campaigns.

But with the 'online experience' becoming ever more rooted in peoples' daily lives, the prospects of the big consumer good companies such as Proctor and Gamble becoming clients becomes every more likely.

"Once companies like P&Gs Unilever and Coke seriously start to spend online, then online advertising will become an important contributor to the portals' revenues," Reitermann concludes.

One final question is how the Chinese internet sector will impact the world, given that Chinese could become the most prevalent online language.

Content-wise, it is not likely foreign youngsters will become transfixed by the Chinese myths and legends which form the basis of games like 'Journey to the West' and 'Tang Dynasty'.

But domestic game development is stimulating a homegrown game industry just as it did in Japan, and pioneering work in the mobile phone sector could well spread across borders. Perhaps sadly, it is likely that China's homegrown portals could become part of the growing interstellar empire of Google or Yahoo! (assuming one does not buy the other by then).

Both these giants have made small acquisitions in China, but experts especially criticize Yahoo! as being arrogant and out of touch. Yet given that Yahoo!'s revenues of $4 billion last year were several times higher than the whole of the Chinese internet sector put together, buying out the whole sector would be all too easy.

Yahoo and Google's market caps, for example, fluctuate around $50 billion mark, while in 2004, the combined market cap of the three pure internet plays - Sina, Sohu and netease - was just $5 billion.

Under such a scenario, stockpicking your way to fortune could become considerably simpler - if substantially less exciting.