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China Internet - Creating Consumer Value in Digital China (118 pages) ;

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Comment
Please see analyst certification and other important disclosures starting on page 113.
Page 1
Industry
Equity Research
Global
Morgan Stanley does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that
the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single
factor in making their investment decision.
Richard Ji (Internet / Media - China) Industry Overview September 12, 2005
+852 2848 6926 – Hong Kong
Richard.Ji@morganstanley.com
Mary Meeker (Internet - US / Global)
+1-212 761 8042 – New York / Menlo Park
Mary.Meeker@morganstanley.com
Creating Consumer Value in
Digital China
Contributors:
Andy Xie (Economics - China)
andy.xie@morganstanley.com
Mark Shuper (Telecom - China)
mark.shuper@morganstanley.com
Hani Abuali (Telecom - China)
hani.abuali@morganstanley.com
Lina Choi (Telecom - China)
lina.choi@morganstanley.com
Viktor Ma (Technology - China)
viktor.ma@morganstanley.com
Brian Fitzgerald (US - Internet)
brian.fitzgerald@morganstanley.com
Ramji Srinivasan (US - Internet)
ramji.srinivasan@morganstanley.com
Jenny Wu (China - Internet / Media)
jenny.wu@morganstanley.com
All of Morgan Stanley’s technology equity research
reports are available on the Internet through Client
Link at https://secure.ms.com. If you wish to receive
this service please contact your institutional sales
representative.
This report and its complementary summary slide
presentation (along with other technology overview
reports and presentations) can also be downloaded
from http://www.morganstanley.com/techresearch/
• We are initiating coverage of the China Internet industry with an attractive
view. We believe Chinese Internet companies that focus on creating consumer
value have the highest potential to create shareholder value. China is No. 1 in
the world in mobile subscribers and No. 1 in Internet users under the age of 30
- this evolving presence on the world stage should not be underestimated.
• We endeavor to find businesses with robust growth potential, high barriers to
entry, scalability, network effects and low regulatory interference. We prefer
management teams who are consumer-centric and innovative, and stocks
whose share prices have overlooked upside plus ‘margins of safety.’
• We believe the ‘click plus brick’ model may dominate ecommerce in China;
content may prove to be king; foreign companies lagging in localization may
lag in market penetration; and local companies may need to become savvy
acquirers to outgrow rivals.
• Online gaming is our favorite segment pick. Local players with selfdevelopment
and distribution capacity may emerge as long-term winners.
• We believe competition is breaking out in online brand advertising, which
faces inventory oversupply and a secular shift toward performance-centric
models. Paid search, on the other hand, is poised for robust expansion.
• We view mobile value-added services as an overlooked opportunity. Despite
regulatory concerns, entry barriers are rising and a segment recovery is in
sight.
• We see rising opportunities in online commerce including travel, instant
messaging-related services and auctions. Emerging payment mechanisms will
be key to more substantive growth.
• Our investment concerns include economic slowdown, regulatory risks, dearth
of innovation, management quality and excessive capital inflow.
• Our top stock picks include Ctrip (Overweight-V), NetEase (Overweight-V),
and Tencent (Overweight-V). See our related reports for these companies,
plus Sina (Equal-weight-V), Sohu (Equal-weight-V), TOM Online (Equalweight-
V) and 51job (Equal-weight-V).
• See page 73 for a slide presentation summarizing this report.
China Internet
China Internet – September 12, 2005
Please see analyst certification and other important disclosures starting on page 113.
Page 2
Table of Contents — Report Roadmap
In this report, a follow up to The China Internet Report http://www.morganstanley.com/institutional/techresearch/pdfs/China_Internet_Report0404.pdf
(4/04), we review key trends for the Internet market in China, relative anomalies (we call them ‘mysteries’), plus key
challenges and risks. We also lay out our investment framework and drill down on four key segments of the market: 1) mobile
value-added services (MVAS); 2) online advertising; 3) online gaming and 4) online commerce. In addition, we highlight
investment ideas. Under separate cover, we have initiated research coverage of Chinese Internet companies Ctrip, NetEase,
Tencent, Sina, Sohu, TOM Online, and 51job. For more detail on the Internet and China, see The China Internet Report.
Investment Thesis - Focus on Consumer Value will Drive Shareholder Value ................................................................... 3
China Internet Trends ............................................................................................................................................................ 4
1 - Growing Faster Than Other Markets…with More Potential.............................................................................................. 4
2 - Internet Brings About Cultural Evolution ......................................................................................................................... 5
3 - Unlike the Rest of the World, China Internet is Mobile-centric Rather Than PC-centric ................................................. 5
4 - Foreign Interests Accelerating ......................................................................................................................................... 6
5 - Hotspot for Mergers and Acquisitions ............................................................................................................................... 7
6 - A League of Big Players…............................................................................................................................................... 8
7 - Leadership Position May Not Necessarily be Secure......................................................................................................... 9
8 - Purer Plays Tend to Have Higher Market Share ................................................................................................................ 9
9 - Regional Focus Can Vary ............................................................................................................................................... 10
10 - Content Becoming King................................................................................................................................................ 11
China Internet Mysteries....................................................................................................................................................... 13
1 - Chinese Internet Players at Valuation Discounts to Global Internet Peers ...................................................................... 14
2 - Real Revenue Perhaps Significantly Higher than the Headline Revenue ....................................................................... 14
3 - Chinese Internet Players Have Much Higher Margins than Global Peers........................................................................ 14
4 - Ecommerce Ready to Take Off? ..................................................................................................................................... 15
5 - Why Can ‘Click Plus Brick’ Outcompete? ...................................................................................................................... 16
6 - State-Owned Enterprises (SOEs) - Referees and Players?............................................................................................... 17
7 - Why Are Foreign Players Especially Challenged in China? ........................................................................................... 18
China Internet Challenges / Risks......................................................................................................................................... 24
1 - Economic Hard landing or Soft Landing?....................................................................................................................... 24
2 - Expect the Unexpected! .................................................................................................................................................. 25
3 - SOE-Friendly versus Entrepreneur-Friendly.................................................................................................................... 25
4 - Too Much Capital, Too Few Good Ideas......................................................................................................................... 26
5 - To Buy or to Build? ........................................................................................................................................................ 27
6 - Long-Term Value versus Short-Term Profit .................................................................................................................... 27
7 - Dearth of Innovation ....................................................................................................................................................... 28
8 - Founder Mentality........................................................................................................................................................... 28
9 - Hollowing of Management Teams.................................................................................................................................. 29
China Internet Investment Framework – Business / Competence / Price.......................................................................... 33
China Internet Industry Analysis - Close to Consumers, Focus on Growth ...................................................................... 34
Mobile Value Added Services (MVAS) - Light at the End of the Tunnel ............................................................................. 37
Online Advertising - A Race for Eyeballs and Performance.................................................................................................. 46
Online Gaming - Pipeline and Distribution Fuel Hypergrowth.............................................................................................. 53
Online Commerce – Solid Outlook… ................................................................................................................................... 62
Global Internet Companies’ Price Performance .................................................................................................................. 72
Summary Slide Presentation ................................................................................................................................................. 73
China Internet – September 12, 2005
Please see analyst certification and other important disclosures starting on page 113.
Page 3
Investment Thesis - Focus on Consumer Value will Drive Shareholder Value
Summary and Investment Conclusion
We are initiating coverage of the China Internet industry
with an Attractive view. China is the world’s fastest
growing economy and the Internet is its fastest growing
industry. China has more consumers than any other country,
and the Internet may reach more Chinese consumers than
any other business. We view the Internet as one of the best
ways for investors to benefit from China’s consumer market
growth. That said, it is key to remember that investing in
emerging markets (the Internet) in emerging markets (like
China) is always fraught with risks and challenges – and a
portfolio approach to investing is crucial.
Key Factors for Long-Term Success
We endeavor to identify and support Chinese Internet
companies that focus on creating consumer value:
First, these companies should regard consumers as their top
priority. To paraphrase a well-known American politician,
they should ‘ask not what consumers can do for them, but
what they can do for consumers.’
Second, they should target markets with enormous
consumer needs and significant growth potential.
Third, they should be innovative in delivering key content,
key services and key products to consumers.
And finally, in our view ill-gotten money will not last. For
companies to be truly successful in the long term, they must
monetize their consumer services in ethical ways.
We firmly believe only those companies focused on
consumer value have the potential to create shareholder
value over the long term. As Meg Whitman, eBay’s CEO,
has said: ‘Whoever wins China will win the world.’
Our View of the China Internet Industries
Four points summarize our view of the China Internet
Industries:
1) Online gaming is our favorite segment pick. We
estimate the industry revenue for online gaming at
$390MM in 2004, growing at a three-year sales CAGR
of 37% to $1B in 2007. Local players with selfdevelopment
and distribution capacity may emerge as
long-term winners.
2) Competition is breaking out in online brand advertising
(industry revenue was $220MM in 2004, and should
expand at a sales CAGR of 24% to $420MM in 2007),
which faces inventory oversupply and a secular shift
toward performance-centric models. Paid search, on the
other hand, is poised for robust expansion.
3) We view mobile value-added services (MVAS;
industry sales for MVAS excluding those for mobile
carriers was $770MM in 2004, and should grow at a
CAGR of 28% to $1.6B in 2007) as an overlooked
opportunity. Despite regulatory concerns, entry barriers
are rising and a segment recovery in is in sight.
4) We see rising opportunities in online commerce,
including travel, instant messaging-related services, and
auctions. Emerging payment mechanisms will be key to
more substantive growth.
Our Top Picks in China Internet
While these companies are still early stage, risky and
volatile, our top China Internet investment ideas are:
1) Ctrip (CTRP, Overweight-V) – A primary beneficiary
of rising consumption power and travel growth in
China. Ctrip’s sharp consumer focus, scalable platform
and superior online and offline operational ability help
make it a dominant player in the service-intensive
travel industry.
2) NetEase (NTES, Overweight-V) – The leading
innovator in the rapidly growing online gaming market
in China. With its market savvy, focus on innovation,
and strong management team, led by William Ding, we
believe NetEase should be able to sustain market
leadership.
3) Tencent (700.HK, Overweight-V) – The powerhouse
in China’s rapidly expanding instant messaging market
with 60%+ user share. Tencent has created a strong
community with networking effects and high barriers to
entry. The company has been successful at growing
profits in Internet value-added services and MVAS and
looks to continue to ramp monetization through Online
Gaming and online advertising.
China Internet – September 12, 2005
Please see analyst certification and other important disclosures starting on page 113.
Page 4
China Internet Trends
1 - Growing Faster Than Other Markets…with More Potential
2 - Internet Brings About Cultural Evolution
3 - Unlike the Rest of the World, China Internet is Mobile-centric Rather Than PC-centric
4 - Foreign Interests Accelerating
5 - Hotspot for Mergers and Acquisitions
6 - A League of Big Players…
7 - Leadership Position May Not Necessarily be Secure
8 - Purer Plays Tend to Have Higher Market Share
9 - Regional Focus Can Vary
10 - Content Becoming King
1 - Growing Faster Than Other Markets…with More
Potential
The China Internet Network Information Center (CNNIC)
reports that, as of June 2005, China’s Internet users
surpassed 100MM and rank No. 2 in the world, behind
211MM users in the US. Notably, we estimate that China
has more Internet users under the age of 30 (70MM+ or
71% of total Internet users) than any other nation in the
world. This is especially relevant as the evolution of
computing technology has shown that innovation is often
most active in markets with the largest number of younger
users.
Exhibit 1
China Leads the World in Mobile Subscribers and Ranks
No. 2 in Internet Users
Mobile Phones Internet Users Mobile Phone to Installed PCs
Country (MM) (MM) Internet User Ratio (MM)
China 363 100 3.6:1 53
US 177 211 0.8:1 207
Japan 88 78 1.1:1 55
Germany 69 51 1.4:1 39
UK 54 37 1.5:1 26
Italy 54 32 1.7:1 16
S. Korea 37 32 1.2:1 27
Source: Euromonitor, CNNIC, Morgan Stanley Research (July 2005).
Second, China leads the world in mobile phone users
(363MM, in June 2005). We estimate that the mobile valueadded
services (MVAS) industry contributed around $5-6B
in revenue, including sales generated by both Internet
Service Providers (ISPs) and telecom carriers, in 2004, with
revenue from short messaging services (SMS) contributing
the bulk of the total (Note that, when we refer to ISPs
throughout this report, we refer to companies as defined in
the section “What Models Shall We Focus On — ISP or
ICP?” on page 39 rather than the ISPs that western investors
are likely familiar with, such as EarthLink.).
Third, CNNIC reported that the number of China’s
broadband users hit 53MM in June 2005, up 71% year-overyear
(Y/Y). We forecast that China’s broadband users may
grow 53% Y/Y to 66MM by the end of 2005.
Fourth, the major drivers for China’s Internet services are
robust. We project the industry revenues for MVAS, Online
Gaming, and online advertising may expand at mid-20-40%
compound annual growth rates (CAGR) for the next three
years.
Exhibit 2
Major Drivers for Chinese Internet Are Trending Up
By the End of 2004 CAGR for next 3 years
Volume
Internet users 94MM (18% Y/Y; <7% of population) 13%
Broadband users 43MM (146% Y/Y; <3% of population) 32%
Mobile users 335MM (24% Y/Y; 26% of population) 12%
ARPU
Internet users $5-$6 per month
Broadband users $10-$15 subscription fee per month
Industry revenue
MVAS $770MM (89% Y/Y) 28%
Online Gaming $390MM (90% Y/Y) 37%
Online advertising $220MM (78% Y/Y) 24%
Note: ARPU- average revenue per user.
Source: CNNIC, Morgan Stanley Research
Last, but not least, the China Internet space has increasingly
captured the attention of global investors and Internet
companies. Note that in August, the share price of Baidu,
the sponsored search leader in China, jumped 350% on its
first day of trading. Also in August, Yahoo! purchased a
China Internet – September 12, 2005
Please see analyst certification and other important disclosures starting on page 113.
Page 5
40% stake (with 35% voting rights) in Alibaba for $1B in
cash. The deal created a combined entity, with Jack Ma a
the helm, which comprises Alibaba properties (Alibaba
International, Alibaba China, AliPay, and Taobao) and
Yahoo! properties (Yahoo! China portal with its
communications / advertising services, Yahoo! Search
Technology and 3721). The deal also created a new
template for doing business in China: Yahoo! contributed its
Yahoo! China business to Alibaba.com, effectively
outsourcing Yahoo!’s China business.
2 - Internet Brings About Cultural Evolution
We believe the Internet delivers many things that Chinese
consumers have long been craving, such as:
Free-floating information. Compared to content on
traditional media, Internet content is less regulated in China.
To date, the top ten newspapers and the top ten TV
operators (except Phoenix TV) in China are state-owned
and state-regulated. The Internet offers Chinese consumers
an alternative source of information. For instance, Sina and
Phoenix TV were the only two Chinese media companies
that reported the terrorist attacks in the US on September 11,
2001 within five minutes of the tragedy–other sources were
delayed by hours. For 2004, Sina reported a daily average of
30MM unique readers for its portal content, more than the
combined total for China’s top ten newspapers.
Interactivity. The Internet allows consumers to
communicate more openly with one another. Open
communication has been lacking in China due partly to the
legacy of the Cultural Revolution and partly due to the
country’s one-child per family policy. In 4Q2004, Tencent
reported peak concurrent users for its instant messaging
(IM) services of 13MM, a figure comparable to New York’s
population.
Entertainment. Over the 10-year span of the Cultural
Revolution (from 1966 to 1976), the primary source of
entertainment for Chinese people was eight ‘model movies,’
including ‘Hong-se-niang-zi-jun (The Red Army Girls),’
‘Hong-deng-ji (Tale of The Red Lantern),’ and ‘Bai-maoneeu
(The White-haired Girl).’ Over the past decade, we
have witnessed the significant development of China’s
entertainment business, including domestic production of
blockbuster movies, music and TV dramas. However, even
to date, quality entertainment is still scarce, especially in the
second-tier cities in China. We believe there is a significant
opportunity, particularly among those younger people with
access to computers, for online entertainment to fill in the
gaps and draw large numbers of followers. For instance,
Shanda’s leading online game, Legend of Mir 2, attracted
average concurrent users of 300,000-400,000 in 2004. In
another words, if you access Shanda’s top game at any
given moment, you may have a virtual audience equivalent
in size to all the students from 20 to 30 US colleges.
Exhibit 3
China — Internet User Age Demographics
Ages
31-35
10%
Ages
60+
1%
Ages 18-24
38%
Ages
36-40
7%
Ages
41-50
7%
Ages
51-60
3% Under 18
16%
Ages 25-30
17% 71% under 30
54% under 24
Source: CNNIC 16th Statistical Survey Report on the Internet Development in
China, July 2005.
3 - Unlike the Rest of the World, China Internet is
Mobile-centric Rather Than PC-centric
Unlike most other regions of the world, China’s Internet
market centers on mobile handsets rather than personal
computers (PCs):
• China has over 360MM mobile phone users, 3.6
times more than its Internet users.
• The total number of China’s mobile users is equal
to the total of the next three nations combined. In
the US, it is the reverse: the total number of
Internet users in the US is equal to the total of the
next three nations combined.
• We estimate ISPs (or Internet Service providers,
including Sina, TOM Online, and Tencent)
generated around $700-800MM from MVAS for
2004, two times more than Online Gaming and
three times more than online advertising.
• There are six publicly traded companies (Sina,
TOM Online, Tencent, KongZhong, Linktone and
Hurray!) that generated the majority of their 2004
revenues from MVAS, versus three (Shanda,
NetEase and The9) from Online Gaming and two
(Sohu and Baidu) from online advertising / search.
China Internet – September 12, 2005
Please see analyst certification and other important disclosures starting on page 113.
Page 6
• China’s people are heavier users of mobile data
services, relative to other countries. This trend is
exemplified by SMS (short message service; a
service that allows brief text messages to be sent
and received on mobile phones) usage: there were
652 SMS per mobile phone sent in China vs. 139
SMS per mobile phone sent in the US, in 2004
(where China SMS data is from the Ministry of
Information Industry, US SMS data is from
SMS.ac, and mobile data is from Morgan Stanley
Research). We believe this China trend is due to
the immediacy and cost-effectiveness of phones.
When we say cost-effectiveness, we don’t mean on
a per MB basis, but on an absolute dollar basis, as
noted in section #4, since the cost of a computer
and Internet connection outweighs that of a mobile
phone and a text message in the short term. To
make the convenience of mobiles relative to PCs
concrete, consider the experience of Wang Yi, a
19-year-old bartender in Beijing, quoted in the
7/21/04 Wall Street Journal. She noted that, she
infrequently uses a PC to communicate with her
parents in rural China; instead she asks, “My
parents have e-mail, but why go online when I can
just send them an SMS?”
• China, in many ways, is leading the development
and monetization of mobile content (i.e.
KongZhong, TOM Online) in ways that are still
nascent in the US; we believe investors
underappreciate the secular trend at work within
mobile computing, and the value, both in terms of
wealth and consumer satisfaction, that mobile
value-added services can contribute.
4 - Foreign Interests Accelerating
In response to China’s potential market opportunity, over
the past two years…
• Leading global Internet players, including eBay,
and Amazon.com, have acquired leading China
Internet companies.
• InterActive and Monster.com purchased sizeable
stakes in their Chinese counterparts.
• Google opened its own operations in China, and
launched Google Local in China
(bendi.google.com)
• Yahoo! acquired a 40% economic (35% voting)
stake in Alibaba, while folding its Yahoo! China
unit into Alibaba
• Alliances between foreign companies and
domestic players are abundant, such as Skype-
TOM Online (In September 2005, Skype formed
its first joint venture in the world with TOM
Online to promote Skype services in Chinese
domestic market.), NCsoft-Sina (joint venture for
online game operations), and Disney-Sohu (for
online content distribution).
• We believe that, if it were not for governmental
restrictions or the potential withdrawal of news
supply by the Chinese government, foreign
companies might have purchased stakes in Sina by
now, given its high level of free-floating shares.
Exhibit 4
Examples of Foreign Entries into China’s Internet
Market
Foreign
Entrant
Local
Target Date
Type of
Transaction Market Position of Target*
eBay Eachnet Jul-03 Acquisition No. 1 in online auction
Yahoo! 3721.com Nov-03 Acquisition No. 2 in paid search
Alibaba Aug-05 40% stake No. 1 in B2B marketplace
Amazon.com Joyo Aug-04 Acquisition A leading e-commerce provider
InterActive elong Jul-04 30% stake No. 2 in online traveling
Monster.com ChinaHR Feb-05 40% stake No. 2 in online recruiting
Google Baidu Jun-04 3% stake No. 1 in paid search
* Refers to the market position at the time of transaction.
Source: Company data, Morgan Stanley Research
China Internet – September 12, 2005
Please see analyst certification and other important disclosures starting on page 113.
Page 7
Exhibit 5
Alexa — Global Web Site Traffic Rankings
Rank Site Name Country
1 Yahoo! USA
2 MSN USA
3 Google USA
4 Yahoo! Japan Japan
5 baidu.com China
6 Sina China
7 Passport.net USA
8 eBay USA
9 163.com (NetEase.com) China
10 Sohu China
11 Microsoft USA
12 QQ / Tencent China
13 Amazon.com USA
14 3271 (Yahoo!) / Alibaba China
15 Naver.com Korea
16 Myspace.com USA
17 Google Japan Japan
18 Google UK UK
19 Nate Korea
20 Allyes.com China
21 AOL USA
22 BBC Online UK
23 Daum.net Korea
24 Tom.com China
25 CNN USA
Source: Alexa.com, September 6, 2005. Alexa data may be somewhat skewed
given that its statistics are based on the usage patterns of users of its Alexa
toolbar. Users are not randomly selected to receive the toolbar: they opt-in.
Nevertheless, we believe Alexa’s data does have some directional significance
for site traffic and interest.
Exhibit 6
Alexa — Chinese Web Site Traffic Rankings
Rank Site Name Major Business
1 Baidu Paid search
2 Sina Portal (MVAS and online advertising)
3 NetEase Portal (online games)
4 Sohu Portal (online advertising)
5 QQ / Tencent Instant Messaging
6 3271 (Yahoo!) / Alibaba Paid search
7 Allyes.com Online advertising
8 Tom.com Portal (MVAS)
9 TaoBao (Alibaba) Online auction
10 Google Paid search
11 Yisou (Yahoo!) / Alibaba Paid search
12 ChinaRen / Sohu Online community
13 SoGou / Sohu Paid search
14 China.com Portal
15 21CN Portal
16 eBay EachNet Online auction
17 Xinghuanet Portal
18 Hao123 Portal
19 126.com email community
20 mop.com Entertainment portal
21 hc360.com Industry Portal
22 pconline Online commerce
23 265.com Portal
24 cmfu.com Literature portal
25 poptang.com Online game portal
Source: Alexa.com, September 6, 2005. Alexa data may be somewhat skewed
given that its statistics are based on the usage patterns of users of its Alexa
toolbar. Users are not randomly selected to receive the toolbar: they opt-in.
Nevertheless, we believe Alexa’s data does have some directional significance
for site traffic and interest.
5 - Hotspot for Mergers and Acquisitions
Internet-related merger and acquisition (M&A) activity in
China has been robust:
• Horizontal integration. Sohu ramped its total
web traffic by acquiring ChinaRen (the No. 1
online alumni club), 17173.com (the No. 1 online
game portal), and Focus.net (the No. 1 real estate
portal). Shanda acquired Bianfeng (casual games),
Haofang (LAN-based PC games), and Digital Red
(mobile games) to solidify its leadership in the
gaming business.
• Vertical integration. Sina jumpstarted its MVAS
business via the acquisitions of Memestar and
Crillion, which contributed around 30% of Sina’s
revenue in 2003 (Memestar alone) and in 2004
(Memestar plus Crillion). TOM Online secured its
leading position in the interactive voice response
(IVR) business by purchasing Puccini.
• ‘Hostile’ effort. In February 2005, we witnessed
the first hostile share purchase in China as Shanda
acquired a 19.5% stake in Sina in the open market.
Following Shanda’s share purchase, we saw
probably the most publicized ‘poison pill’ in China
as Sina adopted a defense strategy against Shanda.
Note that Sohu adopted China’s first ‘poison pill’
in 2001 to fend off an intended hostile takeover by
Jade Bird, although at a much smaller scale
relative to the Shanda-Sina encounter.
China Internet – September 12, 2005
Please see analyst certification and other important disclosures starting on page 113.
Page 8
Bull Case for Combination of Shanda and Sina
• Sina is the best online content provider, based on its topranked
portal traffic, in our view. This could broaden
Shanda’s product offering beyond Online Gaming and fuel
content growth for Shanda’s home entertainment strategy.
• Sina’s management depth may help Shanda venture into new
business territories.
• The consumer demographics of the two parties may
complement each other. ACNielsen estimates around 52% of
Sina’s users have an annual income of Rmb25,000 (or
US$3,000) or above, versus around 19% for general Internet
users. IDC assesses that 73% of Chinese online gamers are
below the age of 25 and likely have low spending power.
• Shanda could help NC-Sina expand the distribution of
Lineage 2, while NC-Sina could add some potential hits to
Shanda’s pipeline.
• The transaction could transform Shanda’s public image from
an online game operator into a mainstream digital media
player.
Bear Case for Combination of Shanda and Sina
• Shanda’s core competence is in Online Gaming, not MVAS or
online advertising. Shanda thus needs the buy-in of Sina’s
management to operate businesses outside of online gaming.
Unfortunately, the ‘poison pill’ put in place by Sina suggests
the combination may start off on the wrong foot. This could
make it hard for Shanda to increase its holdings without
incurring significant share dilution.
• There is little business overlap between the two companies,
thus resulting in low cost-saving synergies.
• Shanda’s balance sheet is stretched. ‘Poison pill’ aside,
Shanda could only add 8-10% of Sina’s stock at a price range
of $28-30 (with its current cash and cash equivalents).
Moreover, Shanda may need to pay a premium above Sina’s
market price to further increase its stake.
• Shanda’s online game operation has relatively high barriers to
entry and relatively low industry risks. If the combination
goes through, Shanda may inevitably be exposed to the
regulatory risks and the earnings volatility in MVAS.
• Shanda’s business model is undergoing a major
transformation. In its core gaming business, rivals such as
NetEase and The9 are closing the gaps. Shanda’s interactive
TV initiatives may prove more thorny than rosy as Shanda
needs to collaborate with state-owned local media groups for
content and China Telecom/Netcom for broadband access.
Will such alliances turn into partnerships similar to that
between the MVAS providers and China Mobile? We could
not rule out the possibility as telecom carriers and local media
companies control the billing relationship with customers. In
that case, Shanda’s prepaid cards may no longer work for the
payment of the interactive TV content.
• Sina and Shanda have different business cultures. Sina is the
oldest Internet company in China, with a team of professional
managers running a diverse spectrum of business operations.
Shanda, on the other hand, is a relatively new entity on the
block and focuses on a single business line. Like a merger
between an incumbent supermarket and an upcoming specialty
store, a cultural clash could jeopardize their integration.
6 - A League of Big Players…
In China’s online markets, industry leaders, such as Sina
and Sohu in online advertising and Shanda and NetEase in
Online Gaming, accounted for 50%+ of total industry
revenues in 2004. Tencent has 60%+ share of users in
instant messaging (IM). We believe larger players have
achieved their dominance through scale, brand awareness
(Sina and Sohu), networking effects (Tencent, Shanda, and
NetEase), and abundant financial resources to acquire key
targets and develop key technologies. MVAS represents an
interesting case as the top three players, including Sina,
TOM Online, and Tencent, assumed relatively small market
share of 41%, which we attribute to quickly expanding new
services (2.5G) and new players such as KongZhong,
Linktone, and Hurray!, seizing market share.
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Exhibit 7
Online Leaders Have Lion’s Share of Chinese Market
Industry Companies Industry Rank Market Share
MVAS Sina No. 1 16%
TOM Online No. 2 15%
Tencent No. 3 10%
Total share =41% of industry rev
Online Advertising Sina No. 1 30%
Sohu No. 2 25%
Total share =55% of industry rev
Online Gaming Shanda No. 1 39%
NetEase No. 2 18%
Total share =58% of industry rev
e-commerce eBay EachNet No. 1 65%
Alibaba/ Taobao No. 2 29%
Total share =94% of GMV
Instant Messaging Tencent No. 1 63% of IM users
Note: Estimates are based on 2004 results. GMV- gross merchandise value.
Source: Company data, iResearch, Morgan Stanley Research.
7 - Leadership Position May Not Necessarily be Secure
Unlike the Internet business in the US, where there are
established leaders, such as Google, eBay, and Yahoo!, we
are witnessing leadership changes and the narrowing gaps
between the incumbent leaders and the runner-ups. We
believe there are several contributing factors:
• China’s Internet market is relatively new but
expanding rapidly. Today’s leaders may face new and
different competition in the coming years and may
suffer from shrinking market share as a result. For
instance, eBay EachNet saw its market share in gross
merchandise volume (GMV) erode within one year
primarily due to aggressive competition from Taobao.
• Chinese Internet companies are still early stage entities
with fluid cultures. Like any growing entity, they may
make mistakes and thus fall behind.
• Regulatory uncertainties, such as those in MVAS, add
complications to competition. By the end of 1Q2005,
TOM Online overtook Sina, which suffered from a
series of regulatory crackdowns, to become the sales
leader in MVAS.
• Innovation (which is far from guaranteed) is key to
outperformance. To date, NetEase’s Fantasy Westward
Journey, a self-developed game, has replaced Shanda’s
Mir 2, a licensed game from South Korea, as the most
popular online game in China.
Exhibit 8
Gaps Are Closing Between the Market Leaders and the
Runner-Ups
(Revenue, $MM) 2Q2003 2Q2004 2Q2005
MVAS
Sina 14 31 23
TOM Online - 29 41
as % of Sina - 93% 180%
Online Advertising
Sina 10 16 20
Sohu 7 13 17
as % of Sina 72% 86% 83%
Online Gaming
Shanda 17 35 56
NetEase 4 16 40
as % of Shanda 24% 46% 70%
Source: Company data, Morgan Stanley Research.
8 - Purer Plays Tend to Have Higher Market Share
Online leaders typically derive the bulk of their revenue
from one single business line. By being relatively ‘purer’
players, these companies can have more dedicated resources
for technology development, customer service, and
marketing, thus forming a virtuous cycle.
Exhibit 9
Pure Plays Tend to Dominate the Internet Market
Industry Companies Rank in the industry As % of the company's revenue
MVAS
TOM Online No. 1 95%
Online Advertising
Sohu No. 2 66%
Online Gaming
Shanda No. 1 87%
NetEase No. 2 83%
Note: Data are based on the company results in 2Q2005.
Source: Company data, Morgan Stanley Research.
One exception is Sina, which has a diversified business mix
but still led in MVAS and online advertising (based on 2004
results). We attribute such ‘abnormality’ to:
• Sina’s competitive advantages in news content, making
it the preferred portal destination for white-collar
readers and advertisers.
• Sina’s acquisitions of MVAS companies Memestar and
Crillion, which in aggregate contributed 30% of its
2004 revenue. However, in 1Q2005, Sina lost its
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leadership in MVAS to TOM Online, a much ‘purer’
MVAS player.
9 - Regional Focus Can Vary
It is notable that advertising customers are highly
concentrated in top-tier cities (or the top four cities with the
highest GDP contribution in China, including Shanghai,
Beijing, Guangzhou, and Shenzhen), which contributed
roughly 50% of total advertising spending. As noted in
Exhibit 10, China’s Internet users are also concentrated in
these areas. Ctrip estimates that the top five cities accounted
for 60% of its hotel sales volume and 80% of its air ticket
sales volume for 2004. In contrast, IDC assesses that 85%
of the online gamers came from non-top tier cities (or the
cities other than the top four cities in GDP contribution) in
2003.
We believe top-tier cities may continue to dominate online
brand advertising because:
• Top tier cities have more Internet users.
• Residents of top tier cities have more spending power.
• Most corporate headquarters and top advertising
agencies are located in top tier cities.
However, as paid search gradually grabs market share, we
may see an increasing advertising contribution from secondtier
cities as paid search services are tailored toward small
and medium enterprises (SMEs), which are typically located
in regions outside top-tier cities. It is thus important for
investors to focus on top-tier cities for banner advertising
sales and non-top-tier regions for paid search growth.
Moreover, we believe a nationwide sales presence is
instrumental for online gaming operations and MVAS
because:
• A nationwide distribution platform is key for the sales
of pre-paid point cards to online game players.
• ISPs need to have local sales forces work closely with
regional mobile carriers to promote new MVAS
products.
• Local sales forces may help identify local consumer
needs, which vary from region to region given China’s
cultural diversity. For instance, Shanghai and
Guangdong are two of the most prosperous regions in
China. But the people there speak different dialects
(Shanghaiese versus Cantonese) and the two regions
have distinctively different local cultures.
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Exhibit 10
China — Internet Users Concentrated in Costal Regions and Major Metropolitan Areas
1.3%
Tianjin 2.1%
West China
19%
Coastal China
56%
1.0 %
0.1 %
0.2%
5.6%
2.2% 3.0% 12.6%
3.5%
5.7%
Shanghai
4.7%
7.0%
9.0%
3.4%
1.9%
2.9%
1.0%
3.3% 1.7%
4.6%
3.2%
2.6%
1.3%
2.2%
3.6%
2.8%
0.5%
Beijing
4.3%
0.3%
Source: CNNIC 15th Statistical Survey Report on the Internet Development in China, Jan 2005.
10 - Content Becoming King
As telecom carriers start to roll out broadband and 3G
services, we may see escalating demand for quality content
by ISPs and consumers. The value of differentiated / quality
content may rise. Note the following…
• TOM Online pays out 40-50% of revenue to music
providers, such as Sony Music, for the wireless
revenue generated on such content.
• KongZhong paid five times more for the wireless
distribution rights for the leading blockbuster
movie in 2005 than it did two years earlier.
• Foreign online game developers command ten
games higher payments for game licensing fee now
than just a couple years ago. For instance, to
license The World of Warcraft, The9 needs to pay
Blizzard a $3MM upfront licensing fee plus 22%
of revenue sharing on the face value of prepaid
card sales with $51MM minimal guarantee over
the four-year licensing term.
• In 2004, the most popular song, ‘Mouse Loves
Rice,’ had 5MM downloads, with potential profits
comparable to the best-selling CDs in China.
• We estimate that content providers, such as MTV,
may generate more revenue from mobile phones
than from pay-TV in China in a few years.
We believe several approaches may help ISPs counter these
trends:
• User-generated content. Tencent’s IM services
center on communication and interaction. As a
result, we estimate nearly 70-80% of Tencent’s
content is generated by its IM users. In addition,
blog operators such as BlogChina, allow a user to
post their thoughts on personal, publicly accessible
website (weblog), free of charge.
• In-house development. NetEase has been
focusing on internal development, resulting in
minimal licensing fee to third-party game
developers and a high operating margin.
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• Scale / distribution. TOM Online aims to be a
content aggregator. Its scale in distribution may
help it to gain bargaining power over content
providers.
Exhibit 11
China — Most Frequently Used Online Services
% of Survey
Online Service Respondents
Email 91%
News 79%
Search engine 65%
Browsing, other than news 57%
Online Music 46%
Instant Messanging 45%
BBS (community and forum) 41%
Online Film & TV 38%
School/classmate BBS 29%
File uploads/downloads 26%
Internet games 23%
Online chatroom 21%
Online shopping 20%
Personal websites 17%
Online banking 14%
Online recruiting 12%
Online education 11%
Blog 11%
E-magazine 10%
Online sales (including promotion and auction) 7%
IP telephone 5%
SMS and MSM 5%
Stock trading online 5%
Ticket / hotel reservation 3%
Others 1%
Source: CNNIC 16th Statistical Survey Report on the Internet Development in
China, July 2005. Includes data gathered on 15 previous surveys. The survey
uses multiple survey methods including automatic searching with computer, an
online component, an offline sampling component, and data reported from
relevant organizations. Respondents were allowed to reply with multiple
answers.
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China Internet Mysteries
1 - Chinese Internet Players at Valuation Discounts to Global Internet Peers
2 - Real Revenue Perhaps Significantly Higher than the Headline Revenue
3 - Chinese Internet Players Have Much Higher Margins than Global Peers
4 - Ecommerce Ready to Take Off?
5 - Why Can ‘Click Plus Brick’ Outcompete?
6 - State-Owned Enterprises (SOEs) - Referees and Players?
7 - Why Are Foreign Players Especially Challenged in China?
1 - Chinese Internet Players at Valuation Discounts to
Global Internet Peers
China Internet companies are currently trading at 40-60%
discounts to their global counterparts. Interestingly, their
EPS growth rates, based on our forecasts and consensus
estimates, are higher than their US comparables.
Exhibit 12
Price Discount of China Internet Firms versus US Peers
China US
Average P/E multiple 15-25x 40-50x
Average earnings growth 25-30% 25-30%
Average operating margin 30-40% 15-20%
Top 5 Internet Companies
Source: Morgan Stanley Research (Excluding stock-based compensation costs,
the average operating margin for the top 5 US companies is 20-30%).
We believe there are several plausible reasons for such a
valuation gap. First, the competitive dynamics may change
faster in China than in other Internet economies. Global
comparables, such as eBay, Google, Yahoo! and Yahoo!
Japan, achieved their dominance in their respective areas
with formidable barriers to entry and powerful core
competencies. These companies are rewarded with
‘leadership premiums’ by the stock market as they are
measurably ahead of the competition. By comparison, it is
still too early to call the final winners in China’s Internet
space as the competition is still fierce and the rankings of
the leaders are still in flux (See ‘Leadership Position May
Not Necessarily Be Secure’).
Second, policy risk is higher for China’s Internet players
than for their global counterparts. For instance, in 2H2004,
based on a sudden government mandate, the heads of the
top three telecom carriers shuffled among one another. This
decree is comparable to the US government mandating that
the CEOs of Verizon Wireless, Sprint-Nextel, and AT&T
exchange jobs. There has also been speculation that mobile
carriers may potentially change their revenue sharing
scheme with ISPs.
Third, China Internet companies have been troubled by
operational risks. NetEase was at one point nearly delisted
due to accounting missteps. Sohu’s multimedia messaging
service (MMS) business was suspended for a year due to
billing malpractice. Sina’s interactive voice response (IVR)
business was sanctioned due to improper content.
Fourth, the business models for China Internet companies
are still unfamiliar to global investors. China leads the
world in MVAS and Online Gaming in terms of volume and
growth. Yet these businesses are not as prevalent in the US
and have hardly any listed comparables. Anecdotally, few
people stateside have heard of a color ringback tone, while
in China, there are 44MM ring back tone subscribers alone
on China Mobile. (A color ringback tone is the sound that
callers hear instead of a normal ring when they dial your
number.)
These uncertainties increase the risk premium and hence the
discounts of China Internet stocks. In the long run, we
believe these risk premiums may trend downward because:
• Government and SOEs may learn from their past
mistakes to make their policies more favorable to
Internet companies.
• China Internet companies may optimize their
operations and solidify their leadership.
• Overseas investors may gain more knowledge of
Chinese Internet economy.
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2 - Real Revenue Perhaps Significantly Higher than the
Headline Revenue
For 2004, we estimate the industry revenue for ISPs was
around $770MM for MVAS (up 89% Y/Y), $390MM for
online gaming (up 90% Y/Y) and $220MM for online
advertising (up 78% Y/Y) (Please see Exhibit 2 for details).
We assume the total 2004 headline revenue for Chinese
Internet companies approximated $1.5-2.0B (also including
ecommerce, search, and other Internet services), relative to
$3.3B 2004 revenue for eBay, $3.2B for Google, and $3.6B
for Yahoo!. However, we believe these headline figures
may be misleading:
• Morgan Stanley economists estimate the difference
between the US and China in purchasing power
parity (PPP) is around 4.4x. China’s total 2004
Internet industry revenue should thus be equivalent
to $6.5-9B in terms of PPP.
• IDC estimates that for every $1 of online game
revenue in 2003, the revenue multiplier, or the
revenue that the entire industry value chain may
generate, should be 11x (telecommunication
industry – 6x, IT industry- 3x, and media and
publishing – 2x). Based on such a ratio, the online
game-related revenue could be around $3.5-4.5B
for 2004.
• We estimate person-to-person (P-to-P) MVAS
accounted for around 80% of total MVAS volume
in 2004 and the revenue multiplier for MVAS
should be around 5-6x (including hardware,
software, bandwidth, transmissions, and content
spending, etc.). The 2004 MVAS-related revenue
should thus exceed $4-5B. In comparison, China
Mobile generated around $3.8B revenue from
wireless data and other new services in 2004.
• The bottom line figures for China Internet
companies are more impressive than their top line
numbers. Their operating margins typically range
between 30-40%, nearly twice higher than those
for their US counterparts (See Exhibit 13).
• We believe investors should focus on the growth
potential of China Internet as MVAS, Online
Gaming and online advertising may expand at 25-
40% revenue CAGR for next three years.
• It is of note that the combined market
capitalizations for Amazon.com, eBay, Google,
Yahoo! and Yahoo! Japan were around $2B pre-
2000 IPO. We make this calculation as follows –
we take the initial offering price times the shares
outstanding after the offering (from the IPO
prospectus). For Google, we include $100MM in
post-money valuation. Currently the combined
market capitalizations of these companies have
climbed to over $230B as of August 2005.
3 - Chinese Internet Players Have Much Higher Margins
than Global Peers
We estimate that listed China Internet companies typically
have average operating margins of around 30-40% for 2004,
nearly two times higher than their US counterparts.
Exhibit 13
Comparison of Operating Margins Between Selected
Chinese and the US Internet Companies
FY2004
Reported
Operating
Margin
FY2004
Reported
Operating
Margin
China US
China Finance 65% eBay 32%
NetEase 50% Google 20%
KongZhong 41% Yahoo! 19%
Tencent 40% InterActive* 17%
Shanda 39% VeriSign 11%
Ctrip 38% Amazon.com 6%
Sina 35%
Sohu 33%
Linktone 25%
TOM Online 25%
51job 20%
Average 37% Average 18%
Note: All data are based on the reported results for fiscal year 2004.
* InterActive’s operating income excludes amortization expenses. Note that
excluding share-based compensation costs, the average operating margins for
the above Chinese Internet companies and the US companies would be 39% and
27%, respectively)
Source: Company data.
Lower labor cost is the key to the high China margins. We
estimate that 2004 operating expenses (opex) were $8,000
per employee for Ctrip and $27,000 for NetEase, versus
$7,000 for Chinese companies listed in the Hang Seng index,
$73,000 for S&P 500 companies and around $300,000 for
Microsoft (based on FactSet data). We believe labor costs
may remain low because:
• There is abundant supply of labor in China. For
instance, the Ministry of Personnel reported that
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there were 3MM job openings for 7MM job
seekers in China for 1Q2005 in selected regional
markets that it monitored.
• We have observed that the average salary for
college graduates remained flattish or even
declined over the past five years, likely due to the
oversupply of recent college graduates. We
estimate there will be around 3.4MM college
graduates for 2005, up 35% Y/Y.
However, we are concerned about potential cost inflation in
certain areas:
• Competition may boost compensation costs. For
instance, Electronic Arts indicated in early 2005
that it planned to hire around 500 game
developers/programmers in China. NetEase pays
out around 500,000 Rmb per year (or around
$60,000) per head to retain its key game
development talents.
• Property prices in selected regions, especially in
Shanghai, have skyrocketed over the past three
years. Our survey indicated that it may become
increasingly costly for Internet companies to
recruit and retain talents in these areas as Chinese
people often prefer to own property in their
working cities.
• Marketing expenses are on the rise. The9 has
committed no less than $13MM in marketing
expenses over the next four years to promote
World of Warcraft, nearly ten times more than the
typical marketing costs for one online game.
• Content costs may continue its climb (See ‘Content
Becoming the King’).
• R&D expenses are trending upward as Internet
companies beef up their in-house development for
Online Gaming (such as is the case with Shanda,
NetEase, and Tencent) and the new 2.5G / 3G
MVAS products.
4 - Ecommerce Ready to Take Off?
We consider trust, GDP per capita, payment, delivery /
logistics, and credit / settlement as bottlenecks for China’s
ecommerce development. We notice some significant
developments since our April 2004 China Internet Report:
Trust. Despite a centuries-old merchant culture, the
Chinese have not arrived at a level of comfort with buying
goods sight unseen. Unlike a physical store, the web allows
for only limited visual interaction with pictures or other
representations of actual goods. While this observation is
not new, it is especially valid in China, where consumers
are conditioned to see and touch goods before buying them.
GDP per capita. China’s nominal GDP was $1,649B in
2004, vs. $11,733B for the US, according to Morgan
Stanley economists, while China’s nominal GDP per capita
was $1,269 vs. $39,934 for the US. People with lower
incomes will purchase less, all else equal. We estimate the
average salary for residents in top-tier cities, such as
Shanghai and Beijing, is around $180 per month. Given that
the “entry ticket” to ecommerce in China is the price of a
computer ($400-$600 for average desktop PC) and an
Internet connection ($15 to $20 per month) — or, in the
case of Internet café users, hourly café charges of $0.3 to
$0.7 — it is reasonable to assume that the average consumer
in China may not have much disposable income remaining
to spend on ecommerce. That said, we believe this factor is
potentially the easiest to reverse as China’s economy
continues to grow, and as population growth remains low,
per capita GDP levels could continue to rise.
Payment. CNNIC reported that 42% of online consumers
used online payment in 2004, up from 16% in 2001.
• Shanda and NetEase developed direct billing
relationships with online gamers through prepaid
card system and e-sales.
• In China, mobile carriers currently control the
billing relationship with 360MM+ Chinese mobile
users. Most MVAS providers use such mobile
payment channels for bill collection and are thus
subject to the regulatory measures by mobile
carriers.
• Companies specializing in online payment have
mushroomed. For instance, YeePay plans to roll
out three new payment methods, including SMS
payment, fixed line phone payment, and mobile
prepayment. SmartPay, a payment startup based in
Shanghai, works by linking users’ bank accounts to
their mobile phone number, thus allowing them to
pay for products and services electronically.
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• Tencent reports that close to 45% of its sales come
from non-mobile channels such as credit card and
prepaid point card sales.
• Alibaba / Taobao developed Alipay, an escrowbased
payment system, in collaboration with
leading domestic banks, including Industry and
Commerce Bank of China (leading commercial
bank) and China Merchant Bank (pioneer in online
banking). To date, over 60% of the number of
transactions on Taobao clear payment through
Alipay.
• eBay launched PayPal in China in July 2005.
PayPal has over 70MM users worldwide and may
offer a massive online trading opportunity between
Chinese Internet users and the global Internet user
base. Presently, PayPal China is only used for
payments in China by Chinese users due to the
government restrictions on Rmb from leaving the
country. However, as restrictions ease over the
long run, PayPal may enable foreign customers to
take advantages of the low-cost merchandisers in
China and help eBay EachNet’s sellers, mostly
SMEs, to sell goods to overseas customers.
Logistics. There are two emerging camps of logistics
systems for online commerce in China:
• Merchant models which integrate inventory and
distribution systems. One example is Joyo.com,
now a wholly owned online commerce subsidiary
of Amazon.com. The company developed a threetier
logistics/distribution system: 1) In the key
cities, Joyo has its own distribution team to ensure
timely and orderly delivery of goods; 2) it also
hires express mail services to complement its
delivery; 3) in the second-tier regions, it mails
goods through post offices. Joyo plans to open a
30,000 square meters-sized warehouse for
inventory storage.
• Agency models which control delivery without
owing any inventory. For example, Ctrip sells
hotel room nights and air tickets without owning
any inventory, which substantially reduces its
inventory risks given the volatility and seasonality
of traveling business. For air ticket booking, Ctrip
uses its ground delivery people to hand tickets over
to customers at airports and collect cash on
delivery (COD).
Credit/settlement. Historically, due to potential cost and
liability exposure, online commerce providers offload credit
risks to online buyers and sellers. This has resulted in fraud
including leakage of personal information, misinformation
of listed goods, buyers canceling orders without proper
causes, and sellers selling substandard products. The
‘Online Signature Law,’ which was released in April 2005,
grants online signatures similar legal authority and liability
as printed signatures. We believe this may help reduce
online fraud and facilitate the development of credit systems
in China. Alibaba / Taobao’s Alipay and eBay EachNet’s
An Fu Tong are two escrow-based payment systems that
help to reduce settlement risks (they typically receive
payment from buyers first and then inform sellers to send
out goods to buyers. Once the buyers confirm the reception
of goods, Alipay or Au Fu Tong will release the payment to
sellers).
iResearch estimates that online shopping market expanded
2.6x Y/Y to $544MM in 2004 and may grow 93% Y/Y to
$1B in 2005. We believe 2005 will be an important year for
ecommerce providers to develop payment, credit and
logistics systems before ecommerce truly breaks out in 2006.
5 - Why Can ‘Click Plus Brick’ Outcompete?
Taking a microscopic view of China’s Internet companies,
one finds that they tend to be hybrids between online and
offline operations rather than pure-breed online entities. We
believe such ‘click plus brick’ model is and will be, at least
for the medium term, the best way to thrive in China’s
unique and fast-moving business environment, for several
reasons.
1) An offline presence facilitates customer acquisition:
• Ctrip has around 2,000 call center staff to sell
tickets and hotel room nights. We estimate the
company generated 70% plus of its sales from its
offline operations.
• We assess that three quarters of 51job’s clients are
SMEs with less than 50 employees. They typically
lack dedicated human resource functions and thus
require close sales coverage. As a result, 51job
doubled its sales force Y/Y in 2005 to acquire and
service these SMEs.
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2) An offline presence is important for product promotion:
• Online game operators, such as Shanda, NetEase,
and The9, frequently organize on-site
informational sessions and contests at Internet
cafes to promote their new games.
• Ctrip deploys its sales team at airports to promote
its services.
3) Offline channels are important for product distribution:
• Shanda currently distributes its physical prepaid
cards, which gamers use to pay for online playing
time, through over 180,000 retail sales points (and
electronic prepaid cards through 130,000 e-sales
systems).
• Dangdang has a well-known bicycle courier
service to deliver many of its goods to buyers.
• Ctrip delivers air tickets to customers at airports
and collect bills on delivery.
4) Close relationships with business partners often require a
local offline presence:
• ISPs like Sina and TOM Online have deployed
local sales teams in nearly all the 30 provinces to
tighten their relationship with regional offices of
mobile carriers.
• 51job uses its local sales forces to build rapport
with local media partners in over 20 cities.
• Baidu, 3721.com, and Alibaba have nationwide
sales networks to market their listing services to
customers, mostly SMEs who may have never
used Internet before.
5) Offline services are pivotal for customer retention:
• Shanda reports that it has over 280 dedicated
customer service representatives who account for
around 20% of its total staff and handle an average
6,000 plus calls, 1,500 emails, 800 faxes, and 200
plus visitors per day.
• NetEase has one of the top 10 customer service
centers in China’s IT industry.
• We have found that when calling Ctrip we can talk
to a contact person within five to ten seconds of
the first phone ring. In service-intensive and
highly competitive businesses, these offline efforts
are crucial to enhancing user experience and
reducing the churn rate of a customer base.
6) Labor costs are and may continue to be inexpensive
given the abundant labor supply in China:
• We estimate average monthly compensation for
customer service staff typically ranges between
$200 to $300, or about 10% of US peers.
• Ctrip estimates that its labor cost per booking is
around $0.36, only 8% of the commissions per
airline ticket and 5% of the commission per room
night.
• China Finance generated an operating margin of
65% for 2004. For the year, we estimate the
company’s net revenue per employee was around
$67,000, 3.5 times higher than its operating cost
per employee.
We believe that it is important for investors to focus more
on offline operations of Chinese Internet companies.
6 - State-Owned Enterprises (SOEs) - Referees and
Players?
In China, the role of state-owned enterprises (SOEs) should
not be underestimated. On most occasions, they are both
rule-makers and major players. To date, the government is
still the largest shareholder of a majority of listed Chinese
companies and it is thus important for investors to
understand that, like most SOEs in other nations, the service
priorities for China’s SOEs are as follows:
• Government, which appoints the heads of SOEs.
Thus investors should pay close attention to the
propaganda and policy swings of the Chinese
government, such as the anti-pornography
campaign in 2H2004 that led to the crackdown on
MVAS.
• Consumers, who bring bread and butter to SOEs’
tables.
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• Business partners, such as ISPs, who are
important but have little bargaining power for the
time being.
China Mobile’s Mood Swing
China Mobile (0941.HK, Equal-weight; covered by
Mark Shuper, Hani Abuali, Lina Choi and team) is the
largest mobile carrier in the world in terms of mobile
subscribers (around 220MM to date). We estimate
MVAS contributed around 16% of its 2004 revenue. In
2004, China Mobile mandated a MVAS content cleanup,
termination of inactive accounts, migration of short
messaging service (SMS) to a new billing platform, and
sanctions on billing malpractice by ISPs. Over 1H2005,
there had been circulating rumors that China Mobile
may raise its revenue share with ISPs, which partially
explains the share price declines for MVAS operators.
We do not believe China Mobile’s intention is to
handicap the MVAS industry, which has already
become its most robust growth engine. While we are
supportive of China Mobile’s initiatives to discipline
the malpractice of ISPs, we believe the company could
handle the cases in a more transparent and more
cooperative way to minimize the damage to the budding
MVAS industry. In July 2005, China Mobile made a
positive move to make its revenue sharing scheme with
ISPs transparent, which removed a lot of uncertainties
in the space. In fact, we estimate mobile carriers have
collected a majority of MVAS revenue because the bulk
of MVAS are person-to-person (P-to-P), which ISPs,
such as TOM Online and Sina, cannot benefit from. In
the long term, it will be in China Mobile’s best interest
to tighten the partnership with ISPs and incentivize
them to work hard.
7 - Why Are Foreign Players Especially Challenged in
China?
Despite the escalating presence of foreign interests in China,
no foreign Internet company has thus far achieved runaway
success in China. eBay EachNet has suffered market share
loss to Alibaba / Taobao. Before its acquisition by Amazon
in August 2004, Joyo was the traffic leader in online
shopping but as of September 2005, its site traffic only
accounts for 60% of Dangdang’s (according to Alexa.com).
Over the past six months, as per Alexa.com, Baidu’s traffic
nearly doubled whilst 3721, which was purchased by
Yahoo! China in November 2003, remained flattish (note
that the original founder of 3721 left Yahoo! China in
August). Ourgame.com lost its market leadership to Tencent
in concurrent game players within one year after its
acquisition by NHN, a Korean Internet company. We
believe there are several roadblocks that account for these
shortfalls:
1) Regulatory barriers are high in China:
• Foreign companies are not allowed to directly
operate online gaming in China. They thus need to
partner with domestic players for online game
offerings, which partially explains the alliance
between NCsoft and Sina as well as Universal /
Blizzard and The9.
• Foreign companies are restricted from providing
news and online advertising by Chinese
government. Even in traditional media business, no
overseas TV company, except for Phoenix TV,
offers any Chinese news programs.
• Google, a supposedly non-content provider, has
been suspended several times in China for
‘improper content’ in its search results.
2) Uncertainties in the operating environment, especially in
terms of working relationships with SOEs, can deter foreign
entry. For instance, until recently, we have not seen any
foreign penetration into MVAS, which is by far the largest
revenue contributor to China’s Internet services. We
attribute this abnormality to concerns related to regulatory
crackdowns and the perceived difficulties in dealing with
mobile carriers by foreign players.
3) Local content is another key factor. For instance, other
than South Korean / Japanese online games that can have
similar cultural origins, no other foreign games ranked
within top 10 in China in 2004 (according to The News &
Publishing Bureau of China). Other popular Internet
applications, such as music content, also require local flavor.
If history ever repeats itself, we believe foreign entrants,
similar to the founders of the Qing Dynasty (which lasted
from 1644 to 1911) need to transform themselves to fit
Chinese local culture instead of the other way around. In
traditional media business, MTV has achieved popularity in
China in part because it produces half of its music programs
using local content.
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4) Localized salesforces and distribution networks are key
(See ‘Why Can ‘Click Plus Brick’ Outcompete?’).
5) After selling their stakes to foreign partners, most local
founders have achieved financial independence. It is
conceivable that they lose their sense of urgency due to their
financial comfort and status change from owners to
employees.
6) The complex corporate structure can slows down the
responsiveness of the foreign subsidiaries in China. It may
take days or even weeks for the shuffling of correspondence
between the local subsidiaries in China and their US
headquarters while their domestic competitors need only a
few hours to make a similar business decision. It is of note
that the chiefs of foreign companies are typically not
frequent visitors to China per year, which can limit their
engagement and understanding of China’s market.
7) When entering into China, most foreign players send
their sales and marketing teams first and their R&D teams
last. In a tech-heavy industry, such as the Internet, R&D
support is critical to optimize products and services to make
marketing and sales more effective. For instance, when
using the Internet in China one typically finds noticeable
latency (relative slowness) in the US-based sites (like
Google) when compared with local rivals, such as Baidu
and Sohu.
8) Few foreign Internet players seem to appreciate that they
are competing against some of the brightest folks, who we
consider the Yao Ming’s of the Internet.
Battle Between eBay EachNet and Alibaba / Taobao
In 2004, eBay completed its acquisition of EachNet,
then the dominant leader in online auctions, for a total
consideration estimated at $180MM. In 2005, eBay
announced it would commit an additional $100MM
investment (including marketing, promotion, R&D,
capex etc.) in China for 2005.
During 2004, we estimate eBay EachNet’s market share
in gross merchandise value (GMV) shrank to around
50% in 4Q2004 from 90% in 1Q2004. Taobao reported
its share expanded to over 40% in 4Q2004 from 9% in
1Q2004. For 1Q2005, eBay EachNet reported
US$100MM in GMV while Taobao reported
US$120MM. For 2Q2005, Taobao reported
US$200MM in GMV while eBay EachNet did not
disclose more details. That said, it is of note that
Taobao's listings makeup is around 10% auctions, while
eBay EachNet reports that its makeup is 40% auctions,
20% combined auction / fixed price, and 40% fixed
price. With an early May listing fee reduction by eBay
EachNet, we believe the market share shift has
stabilized between the 2 ecommerce players and the gap
in new listings between eBay and Alibaba may have
narrowed.
Here are some (6) of our observations regarding eBay’s
investment in China and its recent performance:
1) After the acquisition, one of EachNet’s two original
Chinese founders, Haiyi Tan, retired. Bo Shao, another
founder, became chairman in November 2004 (the COO –
James Zheng – has been running the site since Bo’s move to
chairman). We believe their managerial talents, savvy in
customer service, and insights into competition were the
key attributes for EachNet’s early success. eBay ‘imported’
overseas managers to oversee its China operation, who, in
our view, need to climb a steep learning curve before
zooming ahead of the curve. However, of note on August
26, 2005, eBay EachNet announced that the former Chief
Marketing Officer of Microsoft’s Greater China Region –
Wu Shixiong – would become eBay EachNet’s new CEO.
The position had been vacant since Bo’s change.
2) Unlike eBay EachNet, Taobao offers free listings and had
10MM listings, more than 10x eBay EachNet as of this
writing. Taobao only had 20,000 listings two years ago and
around 3MM half year ago. That said, it is important to note
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that Taobao listings have longer expiration date (Typically,
sellers can choose between 7-14 day listing periods; at the
expiry of the period, the listing is automatically extended
for one more period, after which it is taken off), whereas a
given eBay EachNet listing expires in 7-10 days.
Furthermore, eBay EachNet’s conversion rate is running at
roughly 7 days, so listings turn over much faster than with
Taobao. We believe this improves the “vibrancy”of eBay
EachNet, making the inventory for sale on eBay EachNet
fresher than that of Taobao, in our view. We believe that
Taobao may eventually convert to the eBay EachNet format.
3) Taobao offers a more user-friendly interface:
• Taobao’s listings are organized into several major
categories, such as ‘Men,’ ‘Women,’ and ‘Home.’ In
our view, such an arrangement makes it easier for
buyers to find their preferred shopping destination
and sellers to find their target customers. In contrast,
eBay EachNet simply groups customers into ‘Buyers.
and ‘Sellers.’ Note that Internet users only account
for 8% of the total Chinese population. Most of the
online shoppers are early adopters and any little help
to them may determine who wins these customers.
• Taobao’s listings appear to be more customer-centric
whilst eBay EachNet’s appears to be more productcentric.
For instance, in Taobao’s ‘Men’ section, a
male customer may get the instant feel that Taobao
really wants to make you look ‘cool’ and ‘stylish.’ Its
listed goods are typically organized around such
attention-grabbing topics as ‘Elegant Men,’ ‘Tasteful
Men,’ and ‘Fun-seeking Men.’ To us, by doing so,
Taobao is trying to convey a strong message: ‘You
are my customer, I care about you. What can I do to
better serve you?’ In contrast, eBay EachNet has a
‘Men’s Clothes and Accessories’ section with a long
textual list of various men’s products. To us, the
message from eBay EachNet seems to be: ‘We have
some great products here, so be our customers.’ Note
that most of the Chinese Internet users are likely the
only children of their families, and are accustomed to
being the center of attention.
• Taobao emphasizes community experiences by
allowing its customers to share knowledge through its
IM service, ‘Taobao Wang-Wang.’ We believe such
services may create stickiness for Taobao’s
community and enhance the chances for online
transactions — as customers share their knowledge,
buyers and sellers may get into each other’s mind in
more depth (although some users are turned off by
constantly being under pressure from users who want
to buy off-site or want to negotiate a lower price).
• It is our experience that Taobao’s web site tends to be
graphically richer than that of eBay EachNet. Note
that close to 70% of Chinese Internet users are under
the age of 30. They are trendy, fun-seeking and are
typically short in attention span. As you compare the
web sites in Exhibits 14 and 15 (for an apples-toapples
comparison, we selected the screen shots from
the same book / audio / video channels from the two
sites), it is not be difficult to figure out which site
may be more eye-catching and more appealing to
young Chinese online consumers.
More importantly, it is less appealing to sellers if a
web site has too much text and too few graphics as
they most likely want to see their products standing
out graphically rather than being buried within
mundane text. Note that the front page placement of
sellers / items on Taobao are not purchased, but
chosen by Taobao, whereas eBay EachNet (similar to
all eBay sites) doesn’t assign one listing / seller top
priority. Finally, the user satisfaction level was 77%
for Taobao versus 62% for eBay EachNet for 2004
(according to iResearch).
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Exhibit 14
Screenshots for the Homepages of Taobao and eBay EachNet
Source: eBay EachNet, Taobao.
Exhibit 15
Taobao’s Web Designs Tend to Be Graphically Richer Than Those of eBay EachNet
Source: eBay EachNet, Taobao (The screenshots were taken from the front pages of the book/ audio/ video channels from the websites for Taobao and eBay EachNet).
4) Taobao adopted AliPay, an escrow-based payment
system. To date, Taobao reported 90%+ of its customers
have accepted AliPay and 60%+ of the number of Taobao’s
transactions are done using the system. eBay EachNet also
has an escrow-based payment system – An Fu Tong –
which has been in place since October 2004. Additionally,
eBay EachNet just rolled out the PayPal payment system.
In our view, AliPay may continue its lead in the domestic
payment market as it helps to resolve the settlement risks
among buyers and sellers through its escrow mechanism,
whilst PayPal is a pure play online payment system (which
may not resolve the settlement issues). However, in the long
term, we believe PayPal may enable international trading as
it could help Chinese online customers tap into overseas
markets by leveraging PayPal’s large global user base (over
70MM users to date). PayPal China offers payments in the
local currency and integration with 15 local banks and more
than 20 different debit cards, and PayPal China also offers
buyer protection off eBay, such as with the popular portals
NetEase and TOM Online.
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5) The corporate reporting structure between eBay EachNet
and its headquarters may, at the margin, slow down the
decision-making process. An industry as dynamic as the
Internet demands prompt responses to market changes. For
instance, Taobao can typically turn around a decision within
hours.
6) Alibaba, the parent company of Taobao and AliPay, is
the largest B2B online marketplace operator in China. It
also targets SMEs as Taobao. We believe Alibaba adds
value to Taobao given its similar customer focus and
extensive nationwide sales network. Additionally, the
sellers on Taobao can source their products from
wholesalers listed in the Alibaba marketplace.
That said, it is of note that eBay has high standards for its
operation. For instance, eBay EachNet focuses on a level
playing field, similar to all eBay sites, and does not grant
any one listing/seller top priority. In comparison, the front
page placement of sellers/items on Taobao is not purchased
but chosen by Taobao.
We also note that on May 1, 2005, eBay EachNet lowered
both its fixed price and auction listings fees while leaving
final value fees unchanged, making the platform more
attractive to users vis-à-vis Taobao free listings. (See
Exhibit 16).
And since that time, we believe the listings on eBay /
EachNet’s web site have rebounded. Note, while not an
apples-to apples comparison, we look at both eBay EachNet
listings (P2P) and (as Taobao does not make its listings
count available on its site) Alibaba’s listings (B2B) as rough
indicators of the health of each platform with general
directional significance. We believe that eBay EachNet
listings have responded favorably since that price change
(see Exhibits 17-18). We will continue to focus here as the
China online auction market develops, and the initial signs
of listings improvement for eBay EachNet could point to
more than just the near-term impacts of the pricing change.
More specifically, in the 50 days since eBay EachNet
reduced its fees, we estimate that daily listings increased
42% to an average of 554K vs. 390K in the 50 days prior to
the change.
Exhibit 16
eBay EachNet Fee Reduction in 2Q2005 (05/01) (Rmb)
Listing Price
Original
Listing Fee
New Fixed Price
Listing Fee
New Auction
Listing Fee
0.01 - 1.00 0.80 0.10 0.05
1.01 - 99.99 1.00 0.50 0.25
100 - 499.99 2.00 1.00 0.50
500 - 1999.99 4.00 3.00 1.50
2,000 + 8.00 6.00 3.00
Motor Vehicles 8.00 6.00 3.00
Source: eBay EachNet, Morgan Stanley
Exhibit 17
Weekly Listings in China – eBay EachNet (P2P)
eBay EachNet (P2P)
0
100,000
200,000
300,000
400,000
500,000
600,000
11/09 /04
12/09/04
01/09/05
02/09/05
03/09/05
04/09/05
05/09/05
06/09 /05
07/09 /05
08/09/05
Listings
eBay EachNet
trendline
Source: eBay EachNet, Morgan Stanley Research
Exhibit 18
Weekly Listings in China – Alibaba (B2B)
Alibaba Listings (B2B)
0
100,000
200,000
300,000
400,000
500,000
600,000
11/09/04
12/09/04
01/09/05
02/09/05
03/09/05
04/09/05
05/09/05
06/09/05
07/09/05
08/09/05
Listings
Alibaba
trendline
Source: Alibaba, Morgan Stanley Research; Taobao does not make its
listings count available on its site
China Internet – September 12, 2005
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Page 23
We believe the ongoing battle between Alibaba and eBay
underscores the key challenges faced by foreign Internet
companies in China, and reinforces our view that foreign
companies that rely less on local elements or could better
leverage local elements may have better odds for success in
China:
• Over time, Google may have a strong chance to
outperform in China because successful search
results are especially technology and scale driven.
While the majority of results for China searches
today are endemic to China, this may evolve over
time to become more global as Chinese people
may increasingly want the best information instead
of the best Chinese information. It is notable that
Google spent $319MM in capital expenditures in
2004 (vs. $3MM for Baidu) in its quest to
‘organize all the world’s information and make it
universally accessible and useful’ and develop
universal language translation on the fly and
leverage its global base of distributed computers.
• eBay may be able to increase its market share if it
tailors its global services toward the local needs
rather than ‘delocalizing’ its services to meet its
global standard. In the long run, eBay may add
value to Chinese consumers through its global
trading platform (As of 1Q2005, 15% of eBay’s
transactions are across-border).
• In our view, Yahoo!’s recent alliance with Alibaba
should add several positives: 1) It may create
cross-selling synergy among sponsored search
(3721/Yisou), e-commerce (Taobao/1pai), and
B2B marketplace (Alibaba) as they mostly target
small and medium enterprises (SMEs); 2) AliPay
may offer the much-needed payment channels for
Yahoo!’s China operation; 3) Yahoo! may help
Alibaba (now the world’s largest online exporter)
and Taobao to expand overseas trading
opportunities; 4) Alibaba’s veteran management
team, including Jack Ma and his crew, would be a
huge plus for Yahoo! to penetrate China’s local
market given their managerial experience and local
consumer knowledge. Despite these areas for
upside, to date nearly all of the foreign Internet
companies have lost momentum after they bought
their ways into China. We need to emphasize here
that integration would be the key for Alibaba and
Yahoo! to unlock the hidden value, each with the
help of the other.
• It may be challenging for other foreign companies
to outcompete independently Chinese domestic
rivals for local content, local services, or local
logistics.
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China Internet Challenges / Risks
1 - Economic Hard landing or Soft Landing?
2 - Expect the Unexpected!
3 - SOE-Friendly versus Entrepreneur-Friendly
4 - Too Much Capital, Too Few Good Ideas
5 - To Buy or to Build?
6 - Long-Term Value versus Short-Term Profit
7 - Dearth of Innovation
8 - Founder Mentality
9 - Hollowing of Management Teams
1 - Economic Hard landing or Soft Landing?
We are concerned about the potential slowdown in China’s
economy because:
• Property bubbles in areas such as Shanghai may
scare away investment fund inflows. In 2004,
investment accounted for 44% of China’s GDP
(versus 20% for the US), the highest in the world
and the highest in China’s history.
Exhibit 19
Comparison of GDP Compositions between China And
the US
China US Differential
Personal consumption 42% 70% -28%
Government consumption 12% 15% -3%
Investment 44% 20% 24%
Net export 2% -5% 7%
Export 36% 7% 29%
Total 100% 100% 0%
As % of GDP
Source: CEIC.
• Morgan Stanley analysts believe that baseline
crude oil prices for 2006 may rise from $45 to $64.
Morgan Stanley Global Economist Stephen Roach
notes that China could be especially vulnerable in
an energy-shocked climate. The energy intensity of
Chinese GDP is double the global norm, and there
is no other economy in the world as highly levered
to the over-extended American consumer.
• The trade wars between China and the
US/European Union may drag down China’s
exports, which approximated 36% of China’s 2004
GDP (versus 7% for the US).
• China’s domestic consumption is low, which
contributed 42% of China’s GDP in 2004, versus
70% for the US. In a time of economic downturn,
consumption may likely be tighter.
• Non-performing loans (NPLs) could become a
severe burden on China’s economy and banking
system. Morgan Stanley Asia/Pacific banking
analysts estimate NPLs approximated 18% of
China’s GDP in 2004 after adding back NPL
transfer, versus around 5% for Japan in 2004 and
8% in 2001, the highest level in a decade. If the
economy decelerates, NPLs may accelerate.
In our view, a market deceleration may have different
impacts on various online businesses:
• Online advertising is cyclical and parallels
economic development. For instance, over the past
two years, China’s automobile sector saw
declining advertising sales following severe price
wars and a sales draught.
• Basic MVAS, such as SMS, may be less affected
by economic volatility due to their inexpensive
price. We argue that more people may choose to
select such low-cost communication means when
they become pocket shy during an economic
downturn. On the other hand, high-end offerings,
such as some MMS and wireless application
protocol (WAP) products, may be hurt as
consumers may become more price-sensitive.
• Online Gaming may be the least affected by a
downward spiral of the market due to the
addictive nature of Online Gaming and their
inexpensive price relative to other entertainment
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formats (for instance, a ticket for a two-hour
movie may cost five times more than playing two
hours of a game online at an Internet cafe).
2 - Expect the Unexpected!
In China, there have been relatively sudden policy and
operational uncertainties that adversely affected company
growth. For instance…
• In 2H2004, owing to the sudden government
mandates, the leaders of the top three telecom
operators, including China Mobile, China Telecom,
and China Unicom, shuffled among one another,
which was equivalent to the exchanges of the
CEOs among Verizon Wireless, Sprint-Nextel, and
Cingular and unlikely to occur elsewhere in the
world.
• Tencent announced that, starting from June 2005,
China Mobile would cease to remit any revenue to
Tencent for their joint venture, 161chat. In other
words, China Mobile ‘confiscated’ 161chat from
mid-2005 onward.
• Cheating tools and private servers are widely
publicized and offered online for popular
massively multiplayer role-playing online games
(MMORPGs). Illegal private servers caused
The9’s revenue to decline by 47% within a quarter
in 1Q2004.
• MP3 search and music downloading, which may
be perceived as a copyright violation in advanced
markets, are among the most popular online
applications in China. We estimate that MP3
accounts for around 20% of Baidu’s traffic. It is
notable that NetEase terminated its MP3 search in
August due to copyright concerns.
3 - SOE-Friendly versus Entrepreneur-Friendly
We believe China’s current business environment is more
favorable to state-owned enterprises (SOEs) than to startups.
• Government is the largest shareholder of SOEs.
We estimate government holdings account for 60-
70% of total shares outstanding for the listed SOEs.
• SOEs accounted for 44% of urban employment
(CEIC 2003). The overarching priority for Chinese
government is to minimize the unemployment rate
and social unrest.
• The heads of SOEs are appointed by government
and typically have better relationships with policy
makers than entrepreneurs.
• Beijing Media Corp., the first overseas listed stateowned
media company, has received a five-year
tax exemption, versus two-year tax exemptions and
three-year tax deductions (typically 50%) granted
to private Internet companies. The company also
secured the government endorsement for crossmedia
ownership, which is typically restricted for
private media companies.
In our opinion, while selected areas, such as Zhong
Guangcun high-tech village in Beijing and Zhangjiang hightech
zone in Shanghai, offer a favorable local policy to the
domiciled startup companies, the overall policy
environment still needs improvement to expedite
entrepreneurship and the shaping up of the ‘Silicon Valley’
in China. That said, as noted in the following Exhibit
(Exhibit 20), the Internet is one of the industries most
opened up, and affected by the entry of China into the WTO.
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Exhibit 20
Effect of China's WTO Membership for Selected Industries Relative to Historical Degree of Protectionism
Internet Services Banking
Chemicals
Distribution / Retailing
Insurance
Agriculture and
Agribusiness
Securities
Telecom Services
Energy
Autos
Processed Foods,
Consumer Goods
Pharmaceuticals
Electrical Equipment,
Electronics
0
50
100
150
0 Low 50 Medium 100 High
150
Historical Degree of Protectionism
Negligible
Effect of WTO Membership
Moderate
Dramatic
Source: United States-China Business Council, McKinsey Analysis.
4 - Too Much Capital, Too Few Good Ideas
In 2004, around 44% of China’s GDP came from
investment, the highest in the world and the highest in
Chinese history. In our view, what happens in the pre-IPO
market mirrors China’s macro picture — too much capital
inflow, not enough good projects — which may jeopardize
the future returns for direct investment:
• Increasingly we have witnessed that: 1) Private
equity or venture capital firms easily raise Chinarelated
funds exceeding a couple hundred million
dollars while Chinese start-ups seldom consume
more than $1-2MM in funding per company in
early rounds; 2) foreign investors who have rarely
been to China have begun to pour money into
China; 3) global executives who seldom visit
China more than once or twice a year start to
execute their ‘China strategies.’ As the listed
MVAS companies are trading at mid- to low-teens
earnings multiples, the pre-IPO investment is
converging with the public market valuation.
When money becomes a commodity, prices rarely
become cheap.
• New ventures take time to develop. The current
Chinese Internet IPOs mostly began their
operations 4-5 years ago. Among the hundreds of
MVAS providers, only six are publicly traded.
Recently, companies that have not fully developed
their core strengths have been pushed into the
public markets with high expectations for
impressive execution — before they are ready.
• Baidu’s 4x share price jump on the first day of its
IPO was a vivid example of a supply and demand
imbalance for the shares.
Despite these challenges, we still see opportunities:
• Other than financing, venture capitalists may add
more value through their industry insights,
networks, and their abilities to coach the young
entrepreneurs through ups and downs. Moreover,
venture capitalists with solid track records also add
credibility to the company.
• It is our observation that pure-play domestic
startups still have difficulty raising money because
they typically do not have returnees (who were
born in China but trained overseas) as management
and are not as polished in presenting their stories to
investors. However, they may be close to the local
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market and offer services that consumers crave. It
is thus important for venture capitalists to examine
more closely what these entrepreneurs do instead
of what they say in order to identify the investable
opportunities. Industry leaders, such as TCL and
Broad Air Conditioning, were self-financed in their
early stage.
• Venture capitalists in Silicon Valley have the
advantage of being close to new business models
and new technologies both physically and
intellectually. Their counterparts in China may not
yet have that luxury. Thus being proactive in
identifying future trends and being willing to
endure extensive ground work would be crucial for
long term investment returns in China.
5 - To Buy or to Build?
Chinese Internet companies are split into two camps in
terms of growth through buying or building. One is
represented by NetEase and Tencent, which have
historically been focusing on building organic growth. The
other is exemplified by Shanda (which bought Haofang,
Bianfeng, and Digital Red, as well as stakes in Sina and
Actoz), TOM Online (Puccini, Treasure Base, and
Indiagame), Sohu (ChinaRen, 17173.com, and Focus.net),
and Sina (Memestar and Crillion).
In China’s current business environment, we believe the
biggest hurdle for acquisition is integration, during which
problems may arise due to cultural conflicts and the ego
issues of founders and key management. We believe it is
key to focus on organic growth first.
When making acquisitions, it is key for an acquirer to go
through a Business School 101 checklist:
• Can we build the business on our own? If so, how
long and how much money / time will it take?
• Can we achieve similar market leadership through
self-development relative to potential acquisition?
Will the cost be substantially different?
• If we have to buy, does our target address a sizable
market with high growth potential? Is the business
model irreplaceable, with high entry barriers?
• Will the acquisition help us to better service our
customers?
• Is there synergy between the target and our
existing business, such as complementation in
services or demographics, cross-selling and costsaving?
• What is the core competence of the target, R&D,
marketing, or relationship? Will its leadership be
sustainable?
• Is the management capable and trustworthy? Can
we work with them seamlessly once we convert
them from bosses to employees? Do we have the
right incentive structure in place to keep the
existing management motivated?
• Is the price for the acquisition right? If there is a
premium to prior acquisitions or other comparables,
does the target deserve it? Is the acquisition
earnings-accretive?
Sina’s M&A Savvy
Sina is a company built upon M&A (see our initiation
report on Sina). In our view, its management team is
among the most financially savvy in China. In 2003,
Sina jumpstarted its MVAS business via the acquisition
of Memestar, a leader in MVAS, for $24MM (including
both cash and stocks).
We estimate the face value for the acquisition was only
2-3X of Memestar’s 2003 operating profit and yet
Memestar contributed 30% of Sina’s total sales in 2003.
In 2004, Sina purchased Crillion, a quasi-monopoly in
wireless job search, for an initial consideration of
$19MM plus two contingent payments of around 1.5-
2.0X Crillion’s 2004 and 2005 earnings. We calculate
the acquisition price was only around 3-4X of Crillion’s
2004 operating profit. Sina reported that Crillion and
Memestar accounted for 30% of its 2004 sales. We note
that integration and sustainable growth following
acquisitions may remain a challenge for Sina.
6 - Long-Term Value versus Short-Term Profit
In our view, some Chinese Internet companies are too
focused on delivering short-term profits, especially for the
purpose of passing the ‘quarterly earning test’ set by many
on Wall Street. They may thus attempt to extract extra
dollars from consumers, usually through irrational and
erroneous sales and marketing tactics. This is a direct
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Page 28
violation of our overarching investment thesis — consumers
always come first, share price follows.
ISPs Mishap in MVAS
In 2004, literally all the listed MVAS providers were
sanctioned by mobile carriers for billing malpractice
(such as erroneously charging customers who have been
inactive), marketing manipulation (such as push
marketing to sign on customers without their consent),
and improper content (see Exhibit 21 below). Such
behavior of ISPs in boosting short-term profits ended
up hurting their share prices, which have to date not
recovered to pre-sanction levels.
Exhibit 21
Sanction List for MVAS Providers for 2004
Services Selected Companies Reasons for Sanctions
That Were Sanctioned
SMS Most listed ISPs Inactive accounts
Billing malpractice
Sina Fortune-telling-related SMS
MMS Sohu Push marketing without
mobile carriers' approval
WAP Linktone Billing malpractice
IVR KongZhong/ Sina/ Improper content
Tencent/ TOM Online
Source: Company data.
7 - Dearth of Innovation
We believe ‘genuine’ innovation is still lagging in China’s
Internet industry:
• In the late 1990s, the first-generation Chinese
Internet entrepreneurs saw what happened in the
US and imported the US Internet models, such as
portals, online auction, and paid search, into China.
• MVAS, which is the most popular Internet-related
service in China, was pioneered by Japanese and
South Korean Internet companies.
• In the online game space, Electronic Arts started
the first MMORPG, Ultima Online, in the US in
1997 and NCSoft launched Lineage in South
Korea in 1998. To date, other than a selected few,
such as NetEase, most online game companies lack
in-house development capability.
• New Internet applications, such as VoIP and blogs,
are typically created elsewhere in the world and,
after gaining popularity, are then adopted by
Chinese companies.
• When a new online service becomes popular, you
could expect the mushrooming of dozens or
sometimes hundreds of Chinese copycats within a
short timeframe.
We believe Chinese Internet companies need to beef up
their efforts in innovation to stay competitive and to sustain
their leadership as foreign competition tries to enter China’s
market aggressively.
8 - Founder Mentality
Most Chinese Internet companies are founded by young
entrepreneurs. They are talented, energetic, and resilient.
However, we also observed that they appear to have some
inherent limitations:
Tight fists. Some founders tend not to delegate their
responsibilities as they view the companies as their own
creations. Their tight-fisted controls often create tension for
professional managers hired to exercise their independent
judgment and to add value with their own perspectives.
Some founders also tend to empower their old aides, whose
skill sets and managerial expertise may be limited as the
companies reach a certain size.
Limited vision. Some young entrepreneurs view IPOs as
their endgame. Once they raise IPO proceeds, they are
typically escalated to the richest class in China (our
empirical formula is that if you multiply a Chinese person’s
wealth by a factor of 10, you will get someone’s personal
wealth equivalent in the US). They may lose their sense of
urgency and start to enjoy the fruits of wealth creation.
Unfortunately, we believe if their vision is limited to IPO
and personal gains, their business may fail to be a long-term
winner.
Lost focus. Unlike the fierce competition among US
entrepreneurs Bill Gates (Microsoft), Steve Jobs (Apple)
and Larry Ellison (Oracle), we seldom observe the ‘fear
factor’ for competition among Chinese Internet
entrepreneurs. Given its robust expansion, China’s Internet
market could accommodate multiple winners at the present
stage. However, the market may eventually slow down and
may be consolidated by the most capable players.
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The William Ding Premium
We consider William Ding, the founder of NetEase, to
be one exceptional case among Chinese Internet
entrepreneurs. He is focused on creating consumer
value and willing to delegate his duties to professional
managers (unlike other founders, Mr. Ding no longer
assumes the CEO title).
We believe he has the vision (the first to get into mobile
messaging business, the first to steer away from it, and
the first to focus on game development) and the
leadership abilities to build his company to last.
Moreover, Mr. Ding and his team are among the most
innovative in the industry in R&D, marketing, and
customer services, which altogether made NetEase’s
Fantasy Westward Journey the most played MMORPG
in China (see ‘The William Ding Premium’ in our
NetEase initiation report).
9 - Hollowing of Management Teams
It is a worrisome sign that some China Internet companies
keep losing their key talent, who are either lured away by
competitors or start their own ventures. We believe there are
several negative implications:
• Their departure causes disruptions of company
operation and their roles not easily replaceable.
• Their insights about corporate operations could
help them to out-execute their former employers
in their new competing roles.
• China Internet is still a budding industry with
most companies having five years or less of
history (considering that Sina and Sohu went
public only in 2000). Experienced management is
thus a scare resource. Given the fast pace of
growth of China’s Internet industry, a shallow
management bench could inevitably derail
company’s future development.
Sohu’s Talent Exodus
Would Sohu be a different company if these people
were still there? Over the years, Sohu saw an exodus of
senior management, who in our view comprises an
impressive ‘All-Star’ cast.
Exhibit 22
Who Is Who Among the Ex-Sohu Executives
Name of Sohu’s
Former Executive
Positions at Sohu Positions After
Sohu
Victor Koo President Plans to start own
venture
Sam Qian Vice President President, China
Finance
Lee Zhang Director Co-founder, eLong
Derek Palaschuk CFO CFO, eLong
Yufan Zhou Founder of
ChinaRen, now a
Sohu subsidiary
CEO, KongZhong
Elaine Feng Vice President EVP, TOM Online
Source: Company data, Morgan Stanley Research.
China Internet – September 12, 2005
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Page 30
China Internet Investment Framework – Business / Competence / Price
Business Model - Large Market, Robust Growth, and
High Barriers
When looking at business models, we prefer companies that
target large markets with significant growth potential. This
helps to explain why Shanda has become the No. 1 Chinese
Internet company in market capitalization within four years
and why there are more listed companies in MVAS than any
other Internet sector.
We prefer businesses that have achieved or may achieve
clear market leadership, such as Sina in news content and
Tencent in IM service. We believe their ‘toll booth’ status
may grant them pricing power (e.g., Sina raised its
advertising price by around 20-30% per annum over the
past few years except for 2005, while Tencent increased its
advertising price by 50% in 1Q2005), which may enhance
their bottom lines without incurring much incremental costs.
We prefer businesses with high barri