Surf's up in China, where millions are going online
By David J. Lynch, USA TODAY
BEIJING — Ted Sun's silver eyeglasses match the ample gray in his neatly trimmed hair. His crisp white shirt is complemented by a tasteful blue tie. As he speaks, the former investment banker sits perfectly straight, hands folded in his lap.
Men surf the Net in Beijing. China is the No. 2 user of the Internet after the USA.
By Ng Han Guan, AP
He may not look like a digital revolutionary. But Sun, 35, is at the helm of investor darling NetEase, one of three Chinese Internet companies blistering the Nasdaq charts. Over the past year, NetEase shares have rocketed from a 52-week low of $1.80 to Tuesday's close of $65.84. The spike, together with similar jumps by rivals Sohu and Sina, suggests that China — like the USA before it — may be flirting with an Internet bubble. "The lessons of the Internet mania in the United States certainly apply to China," says Roger McNamee, a veteran Silicon Valley technology stock picker. "These stocks are rising on momentum and scarcity as much as anything else."
China's Internet portals — Web pages that offer e-mail, news, search, games and dating services — insist this is different. And three years after the U.S. dot-com collapse erased $3 trillion from investor portfolios, they may be right. Unlike their U.S. predecessors, all three companies are profitable. NetEase earned $9.2 million on revenue of $16.5 million in the quarter ending June 30. "If you look at the fundamentals, we are all making money and also achieving consistent growth in profitability," Sun, the company's acting CEO, says in his 19th floor headquarters just east of Tiananmen Square.
Just two years ago, NetEase narrowly avoided being delisted by Nasdaq after improperly booking $4.3 million in revenue and then failing to meet a deadline for filing an amended annual report. Sohu started making money only in the third quarter of 2002, one quarter earlier than Sina.
But lessons from the U.S. Internet meltdown helped the Chinese companies claw their way into the black. U.S. portals soared on a wave of online advertising revenue from short-lived dot-com start-ups — then crashed. The Chinese portals are far less dependent on any single revenue source, and most ad revenue comes from old-economy mainstays such as Volvo and Procter & Gamble. Almost none is from start-ups.
Watching costs
The Chinese companies also shun the excesses of the American model. Forget rooftop parties and free workplace massages. These companies are all about cost control. More manager than missionary, Wall Street veteran Sun embodies the buttoned-down, bottom-line focus. Unlike Silicon Valley's first generation of Internet enthusiasts, he doesn't talk much about changing life as we know it.
Even Sohu.com CEO Charles Zhang, perhaps the most messianic of the bunch, parrots Intel founder Andy Grove's motto, "Only the paranoid survive." China's No. 2 portal in quarterly revenue and profits, Sohu boasts an operating margin of 38%. That compares with 22% for U.S. titan Yahoo and 8% for the average Internet company. One reason: Chinese software engineers are paid a fraction of what their U.S. counterparts receive.
"The cost structure in China is significantly less than in the United States," says Hurst Lin, chief operating officer of Sina. "So, it does seem that these companies are going to be profit-making machines."
For the quarter ended June 30, Sohu and Sina converted more than 50 cents of each dollar of revenue growth into profit. NetEase did even better. Three-quarters of its revenue increase over the year ago quarter, or $9.1 million, dropped straight to the bottom line as profit.
In their swift rise, the Chinese companies are outpacing the foreign companies that virtually invented the portal business. Yahoo China is a distant fourth among Chinese consumers, with just 4.9% of the market, according to a September survey by the Chinese Academy of Social Sciences. Foreign Web sites often take longer to appear on Chinese computers and seem to lack an intuitive feel for the Chinese market.
"I go online to find local information most of the time. So why would I use a foreign Web site?" asks Zhou Lei, 24, a marketing manager for a Beijing record company.
Lots of people online
An explosion of Internet usage in China is behind the domestic portals' ascent. Two-thirds of China's 1.3 billion people may be impoverished farmers who covet livestock, not laptops. But the 300 million to 400 million people in the coastal band from Beijing in the north to Guangzhou in the south are flocking to the Internet. The number of people online already has doubled to 68 million just since 2001. That gives China the second-largest Internet population in the world, behind only the USA. By the end of 2005, at least 200 million Chinese are expected to be online.
But the portals aren't just attracting computer users. They've also targeted China's far greater number of mobile phone users — now more than 230 million (vs. 1 million in 1994).
Sending ring tones, jokes and horoscopes over cell phones — called short message service (SMS) — has emerged as the surprise killer application for the Chinese portals. The calls show up on monthly cell phone bills, and telecom operator China Mobile funnels a cut to the Web sites.
The sites' SMS traffic amounts to only about 10% of text messages sent, but in a market as large as China, that amounts to real cash. In the second quarter, it accounted for almost 60% of Sohu's revenue. By itself, the existence of this business is enough to distinguish the Chinese market from the bubbly American version.
"Of course, there are worries. But it's different from the bubble that burst in 2000," says Zhang, Sohu.com CEO. "The U.S. companies didn't have real revenues. People were buying a dream."
The irony is that the Internet, which symbolizes the free flow of information, is becoming a genuine profit engine in a one-party state where the government strictly controls what people read and write. The Chinese Web sites know there are topics — calls for political reform or information on the outlawed Falun Gong religious group — that they are forbidden to explore online.
Sometimes, Communist Party officials go beyond telling the sites what they can't publish and tell them what they must publish. During a high-level political gathering in November 2002, officials demanded, and received, free banner advertising space on Sohu. "The important thing is they see the Internet as a very important means of communication," says CFO Derek Palaschuk.
Still not a sure bet
That doesn't happen every day. But the Chinese portals still face significant challenges. The SMS business is vulnerable to new competition, perhaps including that from the telecom carriers themselves. China Mobile, the largest wireless operator, is happy to have the portals steering all that extra message traffic onto its cellular network.
But in August, irked at heavy user demand for sexy Web sites, the carrier said it was reviewing its relationship with the portals. Some analysts think the telecom operator might decide to jump into the content business.
As the Internet economy matures, executives also are expected to have difficulty differentiating their sites from those of rivals. For now, NetEase is known for online games; Sina's top news offerings make it the thinking man's site; and Sohu skews toward a younger demographic. But preserving those distinct identities will be tough. Once one posts a new feature, the others can soon enough field "me-too" versions.
"The three portals operate all the same. They can copy each other," says Lu Weigang, a Beijing-based consultant.
There are other potential pitfalls. Developing e-commerce into a viable business is difficult in a country where credit card usage remains a rarity. And foreign players, such as Yahoo or AOL, may yet decide to make a renewed run at the Chinese market.
Even managing basic infrastructure can be tricky. All of Sohu's computer servers and routers, for example, are housed in a single Beijing Telecom Administration facility.
The company has no backup servers outside the city, no "disaster recovery plan" in the event that a fire, power loss or break-in crashes the system. And Sohu carries no business interruption insurance. "It's a risk we're willing to take," Palaschuk says.
After the past year's share price run-up, some money managers say the portals seem pricey. Portfolio manager Martin Yokosawa, 43, bought shares of Sohu and NetEase for his Oberweis Emerging Growth Fund last year. At today's prices, he is standing pat.
"You have to look out your window, not in the rearview mirror," he says. "At some point, these companies will become a utility, just like Internet companies in the U.S. And these crazy (price-to-earnings ratios) are going to come back to Earth."
The companies are warning that the easy growth is over. Third-quarter financial results, expected in a few weeks, will likely show continued revenue and earnings increases. But the rate of growth will be well below that recorded earlier this year. Steven Tuen, manager of Kinetics Internet fund, says in the past month he started selling shares of the three portals.
Yokosawa isn't bailing out yet. But if he thinks — like most others here — there is no bubble in China's Internet market, he also knows there are no guarantees.
"Everybody thought AOL was going to take over the world," he says. "They didn't."
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