For a man who lost his company approximately US$100 million in the last three years, Youku (YOKU.NYSE) CEO Victor Koo had a spring in his step as he strode into a luncheon talk in Shanghai in December. Dressed in Silicon Valley business casual, the 44-year-old Koo engaged confidently with a swarm of skeptical journalists, many of whom had questions about Youku’s dubious financial track record.
But Koo wasn’t defensive. Only days before, his company’s shares in New York closed up 161% on their first day of trading, making him China’s newest billionaire. When cornered by China Economic Review, he was friendly but dismissive of questions about the viability of the online video business model. “Actually, the way to profitability is quite clear,” he said.
The fate of China’s budding online video economy rests on Koo being right, but few would agree with him that the road is clear. Misunderstandings abound. The foreign press frequently refers to Youku (and its competitors Ku6 (KUTV.NASDAQ) and Tudou) as “the Chinese YouTube,” and the analogy clearly excited retail investors in New York. But in fact Chinese online video companies are very different from their Western equivalents – and that’s a good thing. Online video has far better prospects in China than it does in the West.
It is ironic that Youku investors got excited by comparisons to YouTube, which is hardly inspirational as a business model. Google (GOOG.NASDAQ) paid US$1.65 billion for YouTube in 2006; most analysts believe it has lost money ever since due to trouble generating revenues. Western viewers remain unwilling to pay much, if anything, for online video, especially for the user-uploaded content that dominates Western online video sites. Nor is such content considered valuable property by most advertisers. “You cannot build a serious business around cat videos,” scoffed Koo.
In fact, hosting cat videos – or any videos – is a great way to incinerate cash. Online video websites don’t go out of business despite triple-digit annual viewer growth, but because of it. “Online video is such a capital-intensive business. It will continue to be very challenging for companies to make the kind of money people are used to from internet companies,” said Michael Clendenin, managing director of RedTech Advisors.
Indeed, it will be difficult for them to break even at all. The heart of the problem is the cost structure. For traditional TV networks, there is minimal marginal expense in adding viewers, and new viewers attract advertising revenues. But for online video, each new viewer adds costs – more bandwidth, more server space and more content licenses – without necessarily producing any revenue at all.
Unfortunately, opportunities for cost control are limited. Technology innovation can ameliorate bandwidth costs, but it is not a panacea. Clendenin says companies are getting better with how they distribute their technology: In addition to switching to more efficient video formats, some have experimented with “load balancing,” which intelligently allocates bandwidth among users.
“Is there a limit to how much they can cut back? Certainly. Tudou did that, and there’s an argument that it hurt them. Speed is critical to the customer experience,” he said.
And even as per unit bandwidth costs decline, content licenses are getting more expensive. Youku’s SEC filing claims that content costs increased 100% year-on-year in 2010, and it led off 2011 by buying the rights to broadcast the popular American movie Inception (owned by Time Warner; TWX.NYSE).
But China does have one significant advantage. In the US, an entrenched US$85 billion clique of giant corporations is working to cripple online video’s development. To these companies, online video is far more threat than opportunity; it means less advertising on conventional networks, fewer DVD sales, and more user-uploaded piracy.
Even the transmission infrastructure operators are resistant: Cable companies such as Comcast (CMCSA.NASDAQ) have noticed that companies like Net¬flix (NFLX.NASDAQ) are using their bandwidth to sell streamed movies at deep discounts, cannibalizing sales from cable TV subscriptions. Not even network-backed video services like Hulu are immune from trouble in licensing content.
In China, by contrast, there is no premium cable. The national television network is fragmented, and the same goes for the studio system. This immaturity suits online video just fine: Advertisers are more open-minded to online video here, said Jonathan Hsia, general manager for digital marketing at Starcom China (owned by the Publicis Group; PUB.Euronext).
“The relationship between advertisers and TV in the US is a 50- to 60-year relationship,” he said. “In China, the history isn’t as long. More advertisers are just now coming into the market and spending more money than they ever have before. When you haven’t been doing something for a long time, you’re more willing to experiment.”
In addition, traditional TV advertising in China is less effective than it is in the West. For one, most programming is decided at the local level. Apart from shows commemorating national holidays, the most popular programs are not broadcast on a national schedule, complicating national ad campaigns.
In some cases, advertising online is superior to TV advertising in both content and cost. Consider Chongqing Satellite Television’s recent move to replace its popular programming with “revolutionary programs to restore fading red morals,” in response to a directive from the local government. The channel simultaneously jacked up advertising rates by 25%, to US$18,156 per 10 seconds. Suffice it to say that advertisers are unexcited about paying top dollar to reach out to an audience of elderly, nostalgic Communists.
At the same time, content creators in China are unafraid of online video, said Clendenin of RedTech. For them, it’s a potential new channel to sell content into. Online video in China also cannibalizes from DVD pirates’ revenues, and studios have no problem with that either.
“This is a country that requires a lot of brand building, and it’s why television gets an inordinate percentage of the advertising spend in China – some estimate as much as 63%,” said Youku’s Koo.
“Storytelling, which is so important for brand building, cannot be delivered through a banner or a text ad,” he said. Online video, however, can also tell stories about brands, and in a way that is less financially risky.
“Advertisers can invest in a scalable manner,” said Starcom’s Hsia. “Unlike TV, they don’t have to invest RMB30 million (US$4.55 million) to run an online video campaign. It can be a lot more targeted.”
The advertiser preference for online video is supported by the data. Tang Yizhi, an analyst an Analysys International, pointed out that spending on online video advertising is growing faster than overall growth in online advertising – which is in turn out-growing television advertising.
Still, while the Chinese online video industry as a whole is likely to succeed, the pure-play business model is not. The most likely scenario is that the current market leaders will be displaced by bigger fish. Search engine Baidu (BIDU.NASDAQ), for example, has launched a popular and sophisticated online video site called Qiyi, which Clendenin of RedTech believes may already be taking share from Tudou and Youku. Most of the other major web portals have also launched sites, as has CCTV.
For these companies, the capital intensity of online video isn’t such a problem, and they can more easily leverage economies of scale when it comes to servers and bandwidth. They can also afford to take strategic losses from video, offset by other revenue streams, and they already have large viewer bases to sell into. None is likely to pay stratospheric multiple
s to acquire companies like Youku when they can simply price them into the ground.
Koo is right: There is a way to profitability, and to high investment returns in online video. Unfortunately, his most dangerous competitors are already on it.