Is a second crash on the cards?
China’s digital sector is big news in the investment community. In just one week in April almost half a billion US dollars poured into the sector, mostly from overseas investors. From a marketing angle, what underpins much of this investment is the expectations of China’s digital ad market - just as it was in the West in the last dotcom bubble. The question is: are those expectations misplaced once again?
The big deals include a US$57 million refinancing of online video site Tudou, much of that money coming from Silicon Valley-based venture capitalists. The sum dwarfs the previous funding round of $19 million, with Tudou claiming to have turned down even higher offers. A few days later, Oak Pacific Interactive, owner of university-based social network Xiaonei, secured funding of $430 million, led by Japanese telecoms firm Softbank. The funding gives the investors a 35 per cent share, giving the company a rough valuation of $1.23 billion.
Since then, reports have quoted Zhang Fan, CEO of Zhanzuo (another university-based social network), saying he expects to receive third-round investment of tens of million of dollars by the end of the year. Rumours abound of a $50 million-plus funding for social networking site 51.com.
When the investment in Oak Pacific was announced, the word used on several blogs was ‘bubble’. After all, many of the businesses involved have yet to turn a profit, yet are being given substantial valuations. Could there be a repeat of the dotcom crash?
The US subprime crisis and talk of a Western recession has fuelled speculation that the smart money is heading east. China’s digital market in particular looks a good bet. It boasts the largest online population in the world (recent figures put it ahead of the US with more than 220 million netizens), yet has still only scratched the surface of the overall population.
According to Kaiser Kuo, group director, digital strategy for Ogilvy & Mather, there may be plenty more investment to come. He says that the recent levels of expenditure are part of a longer-term development. A lot of these funds raised their money well before the meltdown [and] long ago earmarked quite a bit of money to be deployed specifically in China, he says. It depends on how deep and how long the US recession is, but my guess is it’s not going to have a huge impact on the amounts of money flowing into China already.
Jeffrey Cole, director of the Center for the Digital Future, a thinktank affiliated with the University of Southern California, believes some investors will get burnt, but that overall the chances of a crash are low. I see some people irrationally throwing money in who may lose their investments, but I don’t see a bubble that’s going to burst, he says. I don’t see business plans written on the back of napkins that try to suspend the rules of business. I see some pretty rounded businesses.
There are good reasons for believing this won’t be a repeat of what happened in the West at the turn of the millennium. For a start, investment in the Chinese media industry is subject to considerable Government control. Ownership caps, for example, prevent overseas firms taking a majority stake in a Chinese web firm, and the authorities in Beijing will be sure to scrutinise foreign investment in such an important area. That, say analysts, may act as an artificial braking mechanism, stopping runaway levels of investment in the tech sector. Foreign direct investment is primarily gated not by foreign interest or demand, but by Government regulation and the speed at which deals are approved, says John Goeres, regional director for Southeast Asia for Deloitte’s telecom, media and technology consulting arm.
David Wolf, CEO of marketing consultancy Wolf Group Asia, agrees that the market has not lost its head just yet. I don’t think you have quite that level of frenzied activity where people are just throwing together business models in an attempt to get on board and people are throwing away decent jobs in order to work for dotcoms - there’s a little more sobriety about this growth; it’s not so much a bubble, but it’s certainly an uplift, he says.
The choice of sector is significant. Recent investment has focused on the upcoming areas of online video and social media. In more established areas of China’s online market, there are already clear leaders hogging the revenues. Baidu dominates search, Tencent instant messaging, and there are plenty of major portals.
There are not many things left to buy; if there were, people would have already bought them. If you look at the business model of online advertising, about one half of it is display brand ads, another third is search ads - and both segments have distinct brand leaders, says SY Lau, Tencent’s executive vice-president of online marketing services and corporate branding.
That view is supported by Kuo, who adds: There’s a lot of money chasing a relatively small number of widely recognised excellent deals.
At the same time, investors remain wary enough to look for companies that have already proved themselves capable of building audiences, especially given the current economic climate in the West. It is true there is a lot of money floating around looking for qualified deals, but I think venture capitalists are cautious, rational and try to talk to the right people to get a sense of whether their targets are viable, argues Shen Hao Yu, vice-president of business operations at Baidu.
Online video and social networks can certainly pull in the crowds, but converting that into revenue has proved tricky - not just in Asia, but across the world. The rationale behind the high valuations put on these sites is that they can eventually develop distinctive ad formats that can pull in marketers.
As Benjamin Joffe, CEO of Beijing-based consultancy Plus8star, points out, that has yet to happen. At present, the new wave of web properties are just fighting it out with established portals and other players for basic display ad revenue. General portals as well as jobs, real estate and travel verticals are doing well. Others, such as online communities and social networks, are merely gathering users and fighting for a piece of the online advertising pie - worth only $1 billion last year, and that was largely eaten by portals and search engines.
According to Joffe, the bad news for these businesses in the short term is that ad rates on many sites are falling. Online ad inventory is growing at a rapid pace, probably faster than ad spending, generally driving prices down aside from specialised properties such as verticals, he says. All second- and third-tier internet sites are struggling for revenues.
This is not a universally held view. Wolf argues that ad rates on many sites are going up as China’s online population expands apace. However, Goeres believes that online ad price inflation will not really kick in for another four to five years, when the market reaches critical mass. He adds: Unlike Western markets, online gaming and mobile data are the name of the game for interactive digital media in China.
China’s online gaming already surpasses online digital advertising, in revenue and year-on-year growth.
On the surface, the $430 million injection into Oak Pacific is a vote of confidence in the future of social networking. But with even the mighty Facebook yet to turn its market dominance in the West into serious revenue, many still question the viability of the channel. They also point to the fickle nature of netizens, who could leave in droves when a fashionable alternative becomes available.
If you put two key words together, sometimes that’s enough to drive valuations very high, says Wolf.
When people talk about Xiaonei they usually put ‘Facebook’ and ‘China’ in the same sentence - two very hot words that instantly drive interest. Investors refer back to the experience of Baidu - ‘Google’ plus ‘China’ - and the early investors in Baidu have done very well. We may have early-stage investors relying on the ‘greater fool syndrome’. They say to themselves: ‘OK, the site may not be worth that much, but the markets will think it is worth it when we take this to an IPO’. That is what is driving these valuations - speculative opportunism.
Oak Pacific owns more than just Xiaonei - its other assets include entertainment portal mop.com. So its investors are counting on at least one of them proving an advertising draw. That may be a wise move, according to Claus Mortensen, principal at analyst IDC. [Xiaonei on its own] is certainly a risky investment, he says. Social networking is such a burgeoning thing, there’s probably not any risk in investing per se, but it becomes a bit of a risk when you take a chance on one site. Social networking is clearly a web 2.0 trend that is here to stay, but the individual sites may not be.
With a high number of users, social networks can be a good portal for online advertising. But many feel their real potential, and the reason they attract such investor interest, is as platforms for targeted advertising based on their user information.
The only catch is that it is still up in the air whether it can be used, adds Mortensen. The EU, for example, has directives around consumer databases. It’s still early days, but once social networks start using their data in a more targeted way, regulators might start restricting them. That could potentially diminish the value of social networks.
Video-sharing websites have also built up large audiences in a short space of time, but, like social networks, they face growing pains.
We believe that there are significant opportunities to build a large advertising business around large and engaged audiences. However, like other players, we haven’t found the right formula yet, says Jay Chang, president of 56.com, which along with Tudou and Youku makes up the three major video-sharing sites in China.
Recent experiences of both Tudou and 56.com show how uncertain this market can be. Tudou was reportedly threatened with shutdown by the State Administration of Radio, Film and Television (Sarft) over prohibited material uploaded to the site. And 56.com has suffered an extended break in service, again following reports of a Sarft clampdown.
There’s no doubting China’s potential. With so much room for growth, even minor players in the market could deliver substantial returns. But the key word here is ‘could’. The volatility of China’s internet market, not to mention the uncertainty of how the Government will treat it, means that backing a winner remains tricky.
The recent high valuations placed on properties reflect the small number of sites that are seen simultaneously as up-and-coming yet established enough to be decent bets.
For all the promise of web 2.0 companies, most are currently still reliant on selling display ads against audiences. If these sites are to justify the boom-time price tags, marketers have to be convinced they offer something more impressive.