Why Chinese Web Video Is Like the Steel Business

Victor Koo, chief executive officer of Youku.com, speaks during an interview at the company's offices in Beijing Photograph by Keith Bedford/Bloomberg

As they cheer the proposed marriage of China’s two largest online video companies, investors in Youku and Tudou Holdings should make sure to thank the Chinese government’s censors. Because of the policy preventing Web surfers in China from visiting Google’s YouTube, the country’s cybercops created an opening for Made-in-China alternatives. Youku and Tudou have taken advantage of YouTube’s absence and now account for 52 percent of China’s total Web video traffic, according to Mirae Asset Securities analysts Eric Wen and Nancy Yang.  On March 12, the two companies announced that Youku would acquire Tudou, its smaller, Shanghai-based rival, in a stock-only deal worth $1 billion.

The purchase is just the latest sign of the powerful growth of China’s Internet sector. There are more than 500 million Chinese online, according to the official Xinhua news agency, an Internet penetration rate of close to 40 percent. With the country’s traditional media dominated by clunky, state-owned companies that are hard-pressed to create entertaining programming, that huge Internet user base helps provide companies like Youku and Tudou with a foundation for future growth. “In the long run, all television will be Internet television,” write Wen and Yang in a March 13 analysis of the acquisition. “Television’s user interface will merge with the Internet, giving online video companies a much larger market to play with.”

For now, though, Youku, Tudou, and online video rivals such as Sohu.com and Qiyi, backed by Chinese search engine Baidu, are struggling to turn popularity into profits. Youku’s fourth-quarter sales more than doubled to 309.3 million yuan ($48.6 million), the Beijing-based company announced yesterday. The torrid growth isn’t showing signs of slowing: Youku forecasts that revenue will likely double again in the first quarter of 2012. Yet in the fourth quarter of 2011, Youku lost 49.6 million yuan ($7.8 million). Analysts had expected a loss of 43.8 million yuan, according to the average of five analysts’ estimates compiled by Bloomberg.

With at least 10 major players trying to become the YouTube of China, too many companies are competing for the same viewers, says Michael Clendenin, managing director of Shanghai-based market research firm RedTech Advisors. Companies try to outdo one another by creating original programming, which means costs are soaring and profit margins are terrible. “These look more like steel companies than Chinese Internet companies,” Clendenin says. “The costs for online TV companies are very high—and you can’t reuse the inputs.”

That’s one reason some venture capital investors are looking to other parts of China’s cyberspace for opportunities. Even with hundreds of millions of Internet users, China until recently has lagged in e-commerce because of problems dealing with such matters as logistics and online payments. Those obstacles are now disappearing, putting China on track to surpass the U.S. in the next few years to become the world’s biggest e-commerce market, according to a recent report by Bain & Co. “It’s taking off more quickly here than in the U.S.,” says Clendenin of RedTech.

Confidence in Chinese e-commerce is opening up a flood of money from Silicon Valley venture capitalists and other investors. For instance, Warburg Pincus and Kleiner Perkins last August invested a combined $100 million in Xiu.com, a Shenzhen-based retailer that sells Dolce & Gabbana watches and other high-end brands. 360Buy, an Amazon-like retailer, raised $1.5 billion last April from investors such as DST and Tiger Fund. (DST alone put in $500 million.) And last month, Wal-Mart took a majority stake in a fast-growing online retailer that sells everything from clothing to food to consumer electronics, Shanghai-based Yihaodian. (The name means No. 1 Store.) Discount retailer VIPShop, a Guangzhou-based company backed by Sequoia that specializes in flash sales of Adidas (ADS:GR), Nine West, and other brands, last month filed to sell shares on the New York Stock Exchange.

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