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Last July, Fan Weiping, director of the industrial development department at the General Administration of Press and Publications (GAPP) made an announcement that thrilled investors in China’s exploding digital publishing sector. For the first time, he said, the "economic scale" of the digital publication industry had exceeded that of traditional paper-based publishers. A rash of stories in state media made it clear that the future would be digital.
 
While misleading – the statistic includes figures from video games – Fan’s statement perfectly captured the combination of wishful thinking and justified optimism that defines the publishing sector’s current mood. From the halls of government to corporate boardrooms, everyone, it seems, expects digital publishing to convert the industry from a sedate and often clumsy producer of state-supported propaganda into a lean, market-oriented beast.
 
Despite undeniable potential, however, digital publishing in China is in chaos. In the long run, innovation will unquestionably accomplish just what Beijing – and investors – hope it will: a profit-driven revolution in the way written material is published, distributed, sold and consumed. But the next five years will produce more failure than success as entrepreneurs and established enterprises experiment with untested formats, business models and partnerships in an unstable regulatory environment.
 
From binding to binary
 
The sector’s optimism is justified by solid evidence of market momentum. China’s overall book sales rose about 20% in 2009, and the printing industry’s output value reached over US$80 billion, up 25% year-on-year. Digital versions of books, or "e-books," comprised US$11.8 billion of that output; e-book circulation reached 30 million individual copies of 500,000 titles China published in 2009, up 50% from 2008. Chinese customers purchased 249,500 e-readers in the third quarter of 2010 alone, almost as many as the total figure for 2009.
 
So if Jeff Bezos of Amazon (AMZN.NASDAQ) can move the majority of his customers off of hardbacks onto e-books in 33 months, why can’t China? After all, the government is behind it, industry is behind it, consumers are behind it and money is behind it. Imagine millennia worth of Chinese literature downloaded to machines that can fit in a jacket pocket; textbooks that track reading speed and test comprehension; magazines that deliver interactive ads based on reader identity and physical location. And everyone benefits. Consumers get a richer reading experience. Online publishers can move onto a platform that eliminates printing and distribution costs while (in theory) protecting content through digital rights management (DRM). Authors sell more copies and can more easily promote themselves overseas. Advertisers can precisely measure the effectiveness of print campaigns. And all that served with a dollop of green icing: It saves on trees.
 
Before these benefits can be realized, of course, the calcified remains of the old, state-subsidized system, which was officially weaned from state funding in 2002, must be cleared away. At a September conference held by the Chinese Institute of Publishing Science, state-owned publisher after state-owned publisher stood up to put their reservations on the record.
 
"The gap between China and the US publishing market is very evident," Zhong Jianhua, chairman of the Jiangxi Province Publishing Group Party Committee, told the attendees. "The inability to integrate functions is an industry weakness … Apart from developing isolated content databases, other segments are stagnating. The predicament of the traditional publishers is an undeniable fact."
 
A source in state media who requested to remain anonymous concurred with the diagnosis of stagnation. "I think [the state-owned publishers] are still very much learning how to adapt to the free market. For some of these groups, the mindset is still stuck in the past."
 
The road to listing
 
They are being rapidly dragged into the future. This year, GAPP announced ambitious plans to create a cluster of large-scale, publicly listed national publishing champions operating out of dedicated industrial zones. By 2015, GAPP says, the industry will be dominated by 20 publishing houses, each producing revenues of US$148 million per year, while 10 new industrial zones are expected to produce net revenues of US$1.48 billion each. A quarter of those revenues will come from digital content.
 
But it is unlikely the old publishing danwei will play a leading role, no matter where they are located. "The state-owned publishing houses are state-owned communist dinosaurs. They don’t know how to do business," said Eric Abrahamsen, translator and founder of China-based publishing consulting firm Paper Republic.
 
There are likely to be unpleasant surprises in store for the dinosaurs when they go public. For the most part, their assets are political. For the past decade, their primary source of revenue has been selling the ISBN registration numbers that allow China’s de-facto publishers, the privately owned "culture houses" (so named to distinguish them from official publishers) to sell their titles.
 
"These culture houses do the lion’s share of the publishing work," said Abrahamsen. "[They] know what they are doing and are very savvy, business-wise. A lot of them are quite profitable."
 
The big publishing houses, in contrast, are not profitable, nor are they likely to lead the digital revolution. So why the rush to raise money from the stock market? Industry sources suggest that one reason is that GAPP officials own stakes in many publishers, which they are eager to cash out.
 
A possible exception is the China Publishing Group, which has both a sophisticated website and a new contract with US enterprise software firm Oracle (ORCL.NASDAQ) to develop a digital publishing platform. It has already announced plans to list this year. However, CPG’s main purpose for listing is to use the proceeds to acquire the provincial publishing houses. The problem is that many provincial publishing houses would be better off closed than acquired – buying out doddering local operations may be politically necessary, but is nevertheless a waste.
 
Publishing gnats
 
At the other end of the scale, the business-savvy culture houses may be profitable, but they are also an uncoordinated mess. Thanks to their foggy legal status and the uncertainty of the overall publishing sector, Chinese culture houses tend to be small, nimble and – with the exception of political censorship – loosely regulated. In the US, five major players control the majority of book volume; in China, there aren’t even accurate statistics as to the number of culture houses, which likely number in the thousands. Those who would negotiate content deals must knock on a lot of doors. 
 
Shanda Literature (owned by Shanda Interactive, SNDA.NASDAQ), the country’s largest online e-publication portal, has been rapidly buying up or contracting with these smaller players, but admitted the difficulty in an email to China Economic Review. "From the standpoint of business negotiation and regulation, to go to 600 different publishers is obviously inconvenient," it said.
 
The difficulty is compounded by overlap. Given Chinese writers’ resistance to signing exclusive contracts, combined with weak intellectual property enforcement, many works are published by multiple publishers.
 
"I can’t imagine [the issue of multiple publishers of the same work] is going to get any simpler with this online content," said Abrahamsen. "The problem is very, very loosely defined copyright laws, and nobody in the industry knows about them, particularly the writers, who have no idea how to protect themselves. That’s starting to change now, but until recently it’s been a disaster."  
 
Partially as a result of this confusion, the bulk of the Chinese literature available online is not, in fact, acquired from print publishing houses – or any publishing houses.
 
"Most of what you are seeing is either internet novels written specifically for that medium, or they are pirated," said Jo Lusby, managing director of Penguin China (owned by media conglomerate Pearson; PLO.NYSE). "For the likes of Shanda or China Mobile’s (CHL.NYSE, 0941.HK) reading platform, the mainstay tends to be these internet novels." Abrahamsen calls these works "disposable writing" of relatively low market value, much less literary significance.
 
Sharing the blame
 
Other parts of the private sector have other problems. Private hardware and software companies, for example, are also busy dividing the market up into tiny technology fiefdoms, at the cost of industrial development.
 
On the hardware front, the market is dominated by Hanwang Technology (branded as Hanvon; 002362.SZ), which claims to have sold 267,000 devices in 2009, and 249,000 in the first half of 2010. As of the third quarter, Hanwang controlled around 77% of the e-reader market, but that ratio is doomed to decline rapidly. Some analysts have predicted that China will have as many as 100 new e-reader brands on the market by 2011, most of them competing on price alone.
 
"There are too many products on the market, and too many Chinese spending 20% of the price for 80% of the functionality," said Torsten Weise, founder of Weise Publishing, who has worked in Chinese publishing since 2004. "So, hardware? Hm. No."
 
Because these hardware providers won’t be able to compete on features, most of which are now generic components, the logical strategy is to develop alternative revenue streams, like selling content.
 
But the base format of any book is text, and text can be read on anything. To make sure their libraries can’t simply be copied to competitors’ devices, Chinese hardware makers are swamping the market with proprietary formats. Thus the works in Hanwang’s library of over 100,000 publications cannot be read on anything but a Hanwang device. Shanda Literature also has a custom format for its Bambook reader.
 
Variants of this strategy have enjoyed a degree of success in the US, but they are unlikely to work in China, where no single company has brand strength comparable to Apple’s (AAPL.NASDAQ) iPad or the product catalog of Amazon. Nor do custom formats prevent an author from simultaneously licensing publication rights to multiple publishers, which can then license the same work out to other e-reader companies.
 
Such a format war can do a lot of damage to sector development: A similar struggle paralyzed the US industry for years. The solution was the decision by a consortium of publishers, and software and hardware developers to standardize around a common format called "e-Pub" – though its adoption is far from universal in the US, and booksellers like Amazon and Barnes & Noble (BKS.NYSE) maintain proprietary formats. In China, there is no sign of even a weak consensus among industry players.
 
He Sijia, executive general manager of the Founder Group’s (600601.SH) digital publishing subsidiary Apabi, described the Chinese situation: "In addition to unique product specifications, all the library formats are unique [and] everybody is designing every product to be proprietary. It’s extremely complicated," she said. "Such confusion of standards is not conducive to the industry’s development."
 
Apabi has already suggested a self-interested solution: It has developed a new file format called CEBX, which is an alternative to both e-Pub and Adobe’s (ADBE.NASDAQ) widespread Portable Document Format (PDF). "Only a unified format … will help expand the space for the overall development of e-book industry [in China]," said He. But even a unified format won’t solve two major remaining problems: piracy and payment.
 
Avast, an e-book!
 
Unsurprisingly, there are some who say that Chinese pirates will sink the digital publishing ship in the piers. Even if a content provider gets the right contract, and protects the file with strong DRM, a nation of hackers and copiers can figure out a way to get around the protections – just as they have with print. Walter Chan, general manager of Beijing Classic & Wise Culture Development, recently went on a book tour to promote a new bestseller and was horrified by the number of pirated copies he encountered on the way. "The collection [of pirated copies] is now big enough for its own book fair," he complained.
 
The experience has made him skeptical about digitization. "With print piracy, all you have to do is find the source [printing the pirated books]. But digital piracy is uncontainable. A single text file can be stored as a cloud document and viewed and downloaded on countless websites."
 
"Piracy is impossible to defend against; there’s not much you can do about it," agreed a Shanda Literature spokesperson. "[Our] prevention method is to uphold the legal rights of authors and companies and spare no efforts to resist piracy, so as to establish the idea of respect for genuine content in people’s hearts." In Shanda’s case, this has meant instilling the fear of lawsuits in people’s hearts; the company has been to court multiple times.
 
Following the skeptic’s logic, piracy will do to Chinese books and magazines what it did to Chinese music and movies. Worse, where musicians can still earn from performances and movies from theater screenings, there is no comparable revenue generator for books.
 
It’s not quite so simple, however: If this logic were true, the traditional print market would not be profitable either – and yet books can turn a profit even given rampant piracy.
 
The first line of defense is quality. Unlike copying a song file, pirating a book is usually a low-fidelity process. "Pirates tend to use poor quality paper, and usually it’s full of mistakes because someone sat in front of the computer and typed out the novel," noted Abrahamsen. Of course, a simple digital text file can be copied perfectly and instantly – but making digital publications richer and more difficult to replicate is an area of opportunity, not risk, for e-publishers.
 
"No matter what type of content you have, you can’t be sure it won’t be pirated," said Weise of Weise Publishing. "But there are other ways to keep people attached to you." He noted that multimedia interactivity has the potential to make the e-book even more difficult to duplicate than print, especially if content can be made interactive or streamed from web servers.
 
"Even when that book is pirated, due to all the different kinds of media, if you pirate part of it, it won’t be the same," he said. This is similar in many ways to the way the video game industry protects itself, and it works.
 
The quality of the text itself can also be turned against pirates. Dave Gould, director of product marketing at font technology company Monotype Imaging (TYPE.NASDAQ), said his company is betting that publishers, authors and readers in China will ultimately be willing to pay more for better character-based fonts that are easier to read on smaller screens. While font files can be copied, the software that controls text layout according to screen dimensions and simplifies character forms so they remain legible at small sizes is more difficult to steal.
 
"We’re not too worried about it," said Gould. "We have customers in China already, and it hasn’t been a problem."
 
The second issue is simple marketing. Pirates tend to steal best sellers, and therefore by definition books have to sell well before they attract pirates. This is even true of China’s "disposable" internet novels.
 
"Take a look at Shanda Literature," said Weise. "They are a single company that owns the whole value chain … They’ve got their portal, their audio book company, their own reader, their own digital magazine platform. In every step of that value chain, Shanda only needs to make a little bit of money to make a lot of money out of the whole chain. Even if there’s piracy, there’s still plenty left over."
 
Pirates have another problem: Getting a book into a more readable format than simple text takes a lot more work than ripping a CD does. Thus, unlike those who upload songs, book pirates usually upload for profit, not to be sociable. Unfortunately for them, selling works online is much more publicly visible than selling from a street-side cart.
 
"Even a pirate needs to reach his target market, and in China they go through Taobao and Baidu (BIDU.NASDAQ)," said Penguin’s Lusby, referring to the Chinese auction and search websites. "Every time, we go to the parent platform, show them our copyright certificate, and the content disappears … especially if those sites are publicly listed or want to work with us."
 
One new exception to the standard pirate model may be rather more difficult to tame: Some domestic publications have discovered their printed works being sold online by entrepreneurial government censorship departments.
 
The price is wrong
 
Government-sponsored piracy is another headache to consider – but assuming that IP infringement can be controlled, it pales in comparison to the challenges of pricing and payment.
 
On the pricing front, the US example is again instructive. Opportunities in digital publishing in the US attracted new service providers and product manufacturers, many with divergent business interests. Balancing the ecosystem took some time.
 
Amazon, for example, began with a strategy that immediately alienated its publishing partners: It sold all books, from out-of-copyright classics to new best sellers, for US$9.99, taking a loss in some cases. This created customer loyalty for Amazon but depressed prices across the wider market and cannibalized sales from the publishers’ other customers.
 
The issue caused the publishers to redefine themselves in a fundamental way: They became direct agents of the authors, reasserted control over the pricing of digital editions (while allowing traditional bookstores latitude to grant discounts), and converted the online platforms into a sales force earning commission. The resulting compact allowed authors, publishers and content platforms to split revenues in a way that didn’t cripple the overall industry.
 
In China, such intra-industry cooperation is unlikely to emerge naturally, and certainly hasn’t done so yet.
 
"We insist on a minimum key price for publishers – a key point," said Penguin’s Lusby. "We tell our counterparts in China, this is not negotiable … But the Chinese digital community is not yet where international standards are. E-book prices are very low, and e-book revenue splits are not in line with other countries in terms of platforms, publishing, or authors." Unfortunately, Penguin has to date only identified one Chinese partner, Apabi, willing to comply with its terms.
 
Jin Rui, who works in the digital publications department at Chinese publisher Wanrong, agrees that prices are too low: "Currently, profit margins of e-books are no comparison with that of paper books. For example, the monthly profit split we gained from China Mobile for e-books was about RMB40,000 [US$6,032] in the past few months. It is quite a decent profit for e-books, but still dwarfed by that of print."
 
This is not simple greed on the part of the platform providers: They have a problem on the consumer end. The prevalence of piracy has conditioned those most inclined to read books online or on reading devices to resist paying for the experience.
 
"Online readers lack a paying mentality," said successful Chinese author Ge Hongbing, who has published multiple books both in print and through Baidu’s (BIDU.NASDAQ) content platform. "They want everything for free."
 
Even if they are willing to pay, how do they do it? Online payment is an enduring issue in China, aggravated by another format war, that between bank transaction service monopoly UnionPay, telecom provider China Mobile – which is promoting its own electronic payment solution – and foreign credit and debit card transaction services. Like the struggle over content format, this battle is far from settled.
 
Winning on volume
 
Nevertheless, there are a few clear winners who will benefit in the short term, regardless of how long it takes to sort out the rest. The current route to profitability is through transaction volume. Software infrastructure providers like Oracle and software component providers like Monotype make money regardless of regulation. "We make a royalty off of each device sold, so if the content is pirated, it doesn’t matter to us," said Monotype’s Gould.
 
This also applies to the mobile telecom providers, which make money off subscriptions and downloads. At present, given the lack of alternative methods, the primary way in which e-books are purchased is through mobile phone accounts – the cost of the title is simply added to a user’s bill, and no change in user behavior is required. The bigger the book file is, the more it drives demand for 3G connectivity, the holy grail of the Chinese telecom sector.
 
Most hope regulation will sort out the remaining problems. Unfortunately, no one seems to have a clear suggestion for what such regulation would entail, and different players with conflicting interests are lobbying for different policies. Even with widespread agreement that copyright enforcement should improve, conversations about licensing requirements, file formats, DRM, and appropriate contract structures are just beginning.
 
Then there is censorship, which historically has been much more enthusiastically enforced than copyright. Publishing houses that make most of their money on politically indifferent material don’t find censorship to be a business problem. Industry consolidation, however, could be used as an excuse by GAPP and others to reassert ideological control in a way that favors state-owned publishing houses and the officials that would profit from their listings.
 
Until the situation clarifies, most market players are condemned to wander about in the outer darkness for a little while longer. Even in the US, considered the world’s first mature digital publication market, only 10% of written works were sold in digital format in 2009, up from 2% in 2008. It is a very unstable kind of maturity, and there is much the Chinese – and especially the regulators at GAPP – will have to figure out for themselves.
 
"This is new in America, this is new in China," said Penguin’s Lusby. "I don’t see China as an exceptional market. This is new for everyone."