Tough Times for Portals

In their darkest hour, left for dead after 2001's dotcom bloodbath, Sina, Sohu, Chinadotcom and Netease – China's four NASDAQ-listed Internet portals – found salvation from an unexpected source. They nourished themselves back to health on revenues pulled literally out of thin air, cashing in on a wireless messaging craze that began to sweep China just as the bubble days were ending.

Legions of urban teens and twenty-somethings discovered SMS (Short Messaging System), a simple but powerful feature that comes with most GSM handsets and can also be used to download mobile phone ring tones and screen logos, to send jokes and greetings, to get sports scores or weather forecasts and to play games.

Wireless revenue didn't just resuscitate the portals, it pushed them into the black by Q4 2002, sending stock prices soaring well above bubble-era heights. At the end of Q2 2002, Sina closed at $1.75, while Sohu was at $1.70 and Netease trailed at $1.40; one year later, those stocks closed at $36.40, $20.84 and $43.00 respectively, with all three portals reporting profits and impressive revenue growth, about half of it due to SMS. They finished the year as three of the best-performing stocks on the US markets.

But even as they flourished, analysts queried the portals' dependence on China Mobile's SMS services for so much of their revenue. Some feared that the revenue share terms that the Big Three Chinese portals – dubbed "chortals" – had secured from China Mobile were too good to last. Inspired by the success of Japan's NTT DoCoMo, China Mobile also took a relatively small cut – typically only 15% – of value-added service charges that service providers (SPs) tacked on basic messaging fees. China Mobile's billing platform, called Monternet (short for "mobile Internet") collected a penny for a Cantopop ring tone here, a nickel for a daily horoscope service there, but pretty soon you were talking very serious money.

A question of when
Analysts wondered how long it would be before China Mobile decided it wanted more of the action. Other service providers worried, too: as they prepared new services for the 2.5G GPRS network, including MMS (Multimedia Messaging Service, which allows for color graphics, sound and text files), they expected some reduction in their take. "When MMS came out, the SPs told us to use a higher percentage [share to China Mobile] in our models," said Piper-Jaffray managing director and senior research analyst Safa Rashtchy.

But the concerns proved unfounded: China Mobile has not altered the revenue share agreements for MMS or any other new mobile data offering.

Then, in August 2003 China Mobile banned SPs from using SMS as a billing mechanism for non-mobile content and from forming "SMS unions" – alliances allowing non-Monternet companies to send messages through SP websites. Investors got skittish, especially when Netease reported that its Q3 2003 SMS-related revenues had dipped by 21%. The company's stock tumbled.

A year on, regulatory uncertainties have some analysts fretting again about the chortals and their addiction to wireless revenues. A total of 27 wireless SPs, including portals Sina, Sohu and Chinadotcom, were fined in September this year for offenses including sending WAP push advertisements without China Mobile's approval, providing content "not of high taste" and billing expired users.

Sohu, for instance, was banned from MMS business for a year, and then slapped with a US$500,000 fine for billing dead users. The relative harshness of the punishments affirmed for some analysts what they'd worried about all along: China Mobile not only giveth, China Mobile also taketh away.

Sohu has said that the MMS ban will likely cause a dip in Q3 revenues of between US$1.5 and $1.8 million, and a decline in profits of US$1.0-1.3 million. Ironically, the sanctions don't impact Sohu's more lucrative WAP business, even though it was WAP that got the company in trouble.

In Sina's case, punishment related to IVR content described by China Mobile as being "not of high taste," according to Sina's CFO and co-COO Charles Chao. "IVR is basically a phone sex service," said Dave Carini, a consultant with Norson Telecoms Consulting in Beijing. "The government's not going to allow this."

Sina's offering apparently was relatively mild, but the company was told it would not have any additional wireless services approved for three months. "Unfortunately, this all happened during a sensitive period," said Chao, referring to the government's ongoing crackdown on pornography. Sina's IVR service, which accounted for 4% of the company's Q2 revenues, continues to operate, and Chao said the company has not revised its Q3 projections.

Chinadotcom, meanwhile, may have fared worst: the company had just completed the acquisition of a wireless SP called Go2Joy in July when it was fined US$160,000 for indecent content and banned from SMS services for a year.

But the fines and other punishments meted out by China Mobile are not death sentences. China's portals have done well on the strength of wireless revenues, and while they have fallen off, it doesn't mean the well's gone dry.

"There's still plenty of life left in SMS," said Nathan Midler, a Beijing-based analyst at IDG. "When it comes down to it, SMS wins because of economics: it's cheaper to send an SMS than make a phone call, it's easy to use, and it's entertaining." The chortals, he said, have exploited SMS well. "SMS turned out to be an exceptional opportunity, especially compared to other areas they were active in. Why push the rock uphill when there was this fast growth area?"

Beyond SMS, there's considerable growth potential in 2.5G applications and content. The shift now under way from the 2G SMS technology to more advanced features accounts for part of the decline in wireless revenues, said Sohu president and COO Victor Koo. "We're in a transitional period, when people are converting and familiarizing themselves with a new technology." Even relatively inexpensive new GSM handsets typically come with high-resolution color screens, digital cameras and polyphonic sound, and are Java, WAP and MMS-enabled. SPs are confident that it's only a matter of time before 2.5G content and applications – animated screen savers and picture messages, sophisticated ring tones, downloadable games – eclipse SMS as revenue earners. All the portals, including Hong Kong-based Tom.com – as well dedicated wireless SPs like NASDAQ-listed Kongzhong and Linktone – are banking on a 2.5G mobile data take-off.

No repeating
No one is predicting that the explosive growth in SMS will repeat itself, but analysts do see MMS gaining traction. "I think 2.5G services like MMS are going fine: its growth is still being masked by how big SMS is," said Piper-Jaffray's Rashtchy. "But it will require all of next year to gain critical mass." China Mobile's competitor, Unicom, has an almost identical SMS billing platform called Uni-Info. But a limited subscriber base and early interconnectivity problems left China Mobile with three times the market share in mobile data. That said, a Norson study suggests Unicom's share of WAP revenues may be as much as 60% of China Mobile's, as Unicom subscribers tend to generate much higher per-user revenues for WAP "due in large part to Unicom's superior CDMA network and more developed WAP ecosystem", Norson's Carini said.

China Mobile is not about to let the wireless revenue stream dry up. Its interests are aligned with those of the SPs, and insiders believe China Mobile was not behind the crackdown. "Any time you see restrictions put on communication and content in China, you can assume it's coming from the government," said Midler. "China Mobile is interested in building this business."

Some speculate that China Mobile was responding to pressure from the Ministry of Information Industries (MII), China's IT and telecoms mandarinate, to get the SPs in line.

"In Sohu's case, they may have been genuinely displeased by some of the billing practices," said Rashtchy, "but this is mostly China Mobile trying to show MII they can be tough."

A crackdown originating in MII had long been expected, said Bruce Richardson, head of research at Evolution Securities in Shanghai. "You've got a regulator and operators who didn't know where this was all going," he explained. "Now we're getting to the point where the turf battles are sorted and they're finally coming in and regulating."
Readjustment in the SP revenue picture was inevitable given the way in which the business developed. With little oversight, and SPs leveraging relationships with provincial and municipal mobile operators to blast users with SMS offerings, customer acquisition tactics were aggressive and transparency in pricing and billing was poor. Customer complaints were rampant, but China Mobile needed some prodding to act. "Carriers even in developed markets don't tend to be proactive in addressing billing and other customer problems," said Midler. "In this market, it's going to be even less so." And so it fell to the MII, which in June announced its intention to clean up the SPs.

The portals themselves have tried to make lemonade of the lemons handed them by China Mobile. Rather than fight the sanctions, they've professed to being chastened, and have publicly vowed to reform themselves. On September 15, the heads of the big three chortals – Sina's Wang Yan, Sohu's Charles Zhang, and Netease's Ding Lei – met in Beijing to announce plans for self-discipline, to repair relations with the MII and their reputations with consumers.

"Self policing is usually how it ends up in China. The point has been made, the major companies have been hit, and it's been wrapped up for this round," said Norson's Carini.

Henry Yang, managing director of Shanghai- based IT analysis firm iResearch, is sanguine. "In the aftermath of the punishments, now that things are getting cleaned up, we're looking at healthier development, not an end to development."

That said, the SPs and chortals traditionally booked wireless accounts receivable as revenues. China Mobile's clampdown will see substantial reductions in actual payouts by China Mobile.

"The SPs are tap-dancing around the issue, "said Richardson. "They stopped the growth [in billing of inactive users], but there are still dead users.Now we're going to see receivables go bang in the third quarter, into the fourth quarter." Evolution Securities analyst Jim Sun has estimated that SMS revenues for major SPs will drop by as much as an average of 30% in the second half of the year.

The chortals are aware that they might take a hit. Asked about the dead user issue, Sina's Chao replied, "It's a complex question, and I can't talk too much about this topic. We're collecting data and talking to mobile companies."

While investors have tended to obsess on the vicissitudes of their wireless businesses, the chortals have not neglected other business areas. Ad revenues for the three main portals were up by an average of 55% year on year for Q2 – no surprise to anyone who's logged on to be assaulted by interminable pop-ups, floating ads, banners and buttons. "I'm optimistic about online advertising because it's the most easily advanced of all the services by the portals," said Piper- Jaffray's Rashtchy. Given that China's media is still relatively undeveloped while the chortals are now established media brands, "they don't have to compete to elbow their way in with the other media like the US portals did," Rashtchy added. All three portals are also investing heavily in the red-hot online gaming sector – with Netease showing most success in that area, its gaming revenues having nearly quadrupled even as its wireless revenues have shrunk.

Verticals on the rise
The greatest challenge to the long-term health of the portals isn't fickle telecoms regulators and panicky investors, but a more fundamental change in the topography of the Chinese Internet: the rise of vertical websites offering specific services with an efficiency and focus that the big portals can't match.

Joyo.com, recently acquired by US-based retail giant Amazon in a US$75 million deal, and rival Dangdang.com (which turned Amazon down) have emerged as leaders in Mainland B2C e-commerce. Industry insiders remain divided on the question of whether China is ready for e-commerce. "In China, e-commerce is still at a nascent stage. Until China has a viable way of resolving payment, delivery and credit [issues], I don't see e-commerce growing too fast in China," argues Sina's Chao.

IDG's Midler disagrees: "COD [cash on delivery] works in China," he said. "Payments are not the inhibitor. With the cost of couriers so cheap, and with populations so centralized, it's not a big problem." But he agrees the market is restricted to the main urban areas.

In online auctions, B2B heavyweight Alibaba.com is confident that its recently launched site Taobao.com will beat out e- Bay-invested Eachnet.com as the preeminent auction website. The 9.com and NASDAQ-listed Shanda.com are cashing in on robust growth in online games. And Baidu.com – in which Google recently acquired a US$10 million stake – has passed all the portals to become the search engine of choice for Chinese web surfers – and so stands to earn substantial revenues, as Google and Yahoo have, from paid search. Travel service websites like C-Trip, which listed last year on NASDAQ, and its arch-rival E-Long, which has filed for a NASDAQ listing after receiving a US$60 million investment from US investment guru Barry Diller's InterActive Group, have capitalized on the booming domestic travel industry.

The surge of the vertical niche players has led at least one Chinese Internet commentator – Fang Xingdong – to proclaim "the end of the era of the portals."

Fang argues that the popularization of the Internet in China – the Mainland now boasts well over 100 million Internet users with no sign of slowdown – has meant that Netizens are no longer an elite class, and that the average "cultural level" of users is falling. The portals, for whom user numbers are everything, will have to dumb down and pander to the lowest common denominator to stay in business, while many will go to Shanda and not Netease to play the latest Massively Multiplayer Online Role-Playing Game; will use Dangdang over Sina to buy the new Haiyan cop thriller, and will search for Jay Chow fan sites on Baidu rather than Sohu.

The chortals now look to their US counterparts for strategic inspiration. "The situation we're facing is similar to the situation that Yahoo faced some years ago," says Sina's Chao, noting that the global megaportal parlayed its huge user numbers into success in many areas while remaining relevant in core areas like search. He's confident that Sina can do the same: "Each [of the vertical sites] occupies a niche market but nobody is as comprehensive. We had 15 million [dollars] in revenues last quarter. No one's getting close to us in size. You have to look at size, at scale – the Internet is about scale."

Opportunities for US players
If size matters, then opportunities in the Chinese Internet still abound for the gargantuan US-based companies, who have in recent months made significant inroads into China. Earlier efforts to enter China focused on building portal business, but few companies met with success.

AOL's joint efforts with PC maker Legend ended in failure, and other portals like Lycos never really got their Chinese efforts off the ground. Yahoo China is one exception; though its portal lags behind the Big Three in user numbers, Yahoo has partnered aggressively with Chinese companies and made key acquisitions: in June, it launched an auction site called 1pai.com in partnership with Sina to challenge Taobao and Eachnet/e-Bay China. "The auction space is still a shootout," Rashtchy said. "It may turn out that in China, unlike other markets, there's not one single dominant player."

It isn't just US companies that stand to profit from the shifting Internet landscape. In particular, South Korea's game developers – world leaders in online gaming – have done terrific business in China. According to the government-run Korea Game Development and Promotion Institute, Korean companies controlled more than 70% of the online game market in China in terms of revenue, with almost half the titles offered by Chinese game companies originating in Korea. Webzen's "Mu", NCSoft's "Lineage" and Actoz Soft's "The Legend of Mir" – the game that put game portal Shanda on the map – have all been wildly popular. Total online games revenues are expected to pass the US$1 billion mark by 2006, according to industry analysts. But like the wireless content business, the online game business is subject to government oversight, and periodically suffers when Beijing decides to crack down – by closing the Internet caf?s used by many gamers, for example. All games are now vetted by the Ministry of Culture, which has imposed content restrictions for graphic violence, explicit sexual content or anything else deemed unhealthy. In the last year, Beijing has drastically reduced the numbers of licenses granted to Korean companies; only two licenses were issued between September 2003 and May 2004. Many suspect protectionism: Beijing openly desires to foster its own game industry's development either by excluding imported games or by compelling them to form JVs with Chinese partners.

The portals have been eager to grab a piece of the online game market, too: Sohu launched a beta version of a game called "Blade 2," a multiplayer online version of a Chinese martial arts-themed PC game. Sina partnered with leading Korean game developer NCSoft and is now testing its game "Lineage 2"; it is also launching a casual game portal called iGame in partnership with Korean casual game developer Netmarble.

Auctions, games, e-commerce, travel, search – there's more to the web in China these days than the chortals. But that doesn't necessarily mean that the portals are out. As Midler pointed out: "This so-called 'end of the age of the portal' is really just a function of the maturation of the Internet in China." Fair enough. But for China's listed portals, whose shareholders punish them for the slightest slowing in growth, some adjustment in strategy is nonetheless necessary. "We're definitely reinvesting in core competencies and business like advertising and search," said Sohu's Koo. "That's not to say we're not picking new growth areas: we're just not going crazy picking new businesses."