What's the 'deal' with Chinese internet companies?

THE AMOUNT of M&A activity and the increasing value of deals - fuelled by the money making potential in mobile platforms - in the Chinese internet scene makes the sector a very exciting place at the moment. Analysys International, an internet research firm recently reported that the value of China's mobile internet market will rise to 300 billion Yuan (£30 billion) in 2014. It was only worth 150 billion Yuan in 2012. China's internet users stands at 591 million in June 2013, an increase of 41% compared to three years ago.

M&A wise, I believe there will be continued activity here and especially in the mobile internet sector since mobile internet and applications fields are not fully developed in China. There is much scope for growth, organically or by M&A.

I have chosen a few momentous (planned) deals to blog about.

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In the past day, Qihoo, the second most popular search engine by traffic in China (after the almighty Baidu) has announced it is in early talks with Sohu to buy its search engine Sogou (meaning literally 'search dog'). I believe that the acquisition of Sogou, the third most popular search engine by traffic is a well thought out strategic decision for catching up with Baidu who is and still will be (if the acquisition goes ahead), miles ahead in terms of traffic and revenue. Internet research firms CNZZ and Alexa show that Baidu command roughly 69% of search traffic while Qihoo and Sogou only have 15% and 9% respectively. However, Qihoo has still been a serious competitor to Baidu. Their simple interface is more attractive to inexperienced users and at the same time, delivers a better smartphone/tablet experience. Further, Qihoo have an advantage over Baidu in that it is also a software company. This has enabled Qihoo to incorporate search engine bars into their software to boost traffic. 

Market share is important in the internet sector and the fastest way for Qihoo to increase market share is through M&A. With the Sogou buy, Qihoo will reach more than 20% of market share for search engines and can scale it up. This acquisition will also give the company access to the search technologies of music/MP3, videos, maps, shopping, photos, Sogou's online radio station among other features which are popular among younger internet users (who form the bulk of internet users), directly challenging Baidu's products. Further, Qihoo will reap the technology of Sogou's smart input search method which currently has 195 million users. In general, both brands have similar business models and I think there are strong synergies between Sogou and Qihoo search. Not only will they be a dominant challenger to Baidu from a second position, but they will also be dominant in the browser, internet security, software and Chinese language input markets.

Given that it is early days in talks, numbers are unclear. Sogou is valued between $1.2-$1.4 billion. As Qihoo reported $301 million of cash and cash equivalent at year end in March, any offering is more likely to be equity heavy. And since Sogou is in talks with other parties, Qihoo could potentially lose to bidders who can offer more cash, namely Baidu. However, any acquisition by Baidu could be blocked on antittrust grounds. 

The valuation of Sogou is questionable since it was only worth $237 million one year ago. A valuation of over $1 billion only makes sense if Sogou has dramatically optimised and innovated new products in its search and other software in the past year which admittedly it it has done some of...see here and here. Still, a more prudent estimate should be around $800 million maximum.

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The IPO of Alibaba in possibly this year or early next, will be one of the biggest IPOs globally. Alibaba is currently valued at up to $120 billion and could raise $15-$20 billion in this IPO. Alibaba is the biggest e-commerce firm in China and its platforms are the equivalent of eBay, Amazon, Groupon and PayPal. 

I think this IPO is likely to happen sooner than later. Alibaba achieved a profit margin of 48.4% in Q1 2013  - double than that of Apple's in the same period - boosted by the demand for e-commerce services to link businesses and consumers in China. If Alibaba can demonstrate such strong earnings growth again in Q2 2013, an IPO could be ready by the end of 2013. Other financials are also very attractive. Compared to its US counterpart, Amazon, who is the world's largest online retailer, Amazon only achieved a profit margin of 0.51% in the March quarter while it was 18.1% for eBay. Alibaba's net income in Q1 2013 was $669 million compared to only $220 million in Q1 2012. Further, Alibaba constituted 70% of parcel deliveries in China last year and sales alone on its two main platforms reached 1 trillion Yuan in 2012.  

Alibaba is also an attractive company to hold on any investor's portfolio due to the large growth market it operates in. Alibaba is still in its early days also, who has a more vertical growth curve rather than a flatter one. 

Other details of the IPO remain sketchy. But Credit Suisse is expected to take a leading role given its history of working with Alibaba on past transactions. Goldman Sachs and Morgan Stanley are also expected to play a leading role in this prestigious and highly lucrative deal. 

I believe that one problem Alibaba has however, and which could be reflected in valuations, is that Alibaba does not have a strong position in China's social media/mobile market. It is has been unable to monetise on mobile users thus far unlike other Chinese internet giants of Tencent and Baidu among others who all operate rather strong e-commerce platforms or capabilities. The other challenge is choosing which stock market to float on. With many foreign backers, Alibaba may have to float outside of Hong Kong. 

Overall, internet companies are inherently volatile, as are their valuations. I believe any valuation up to $100-120 billion of Alibaba is fair. High performers in this sector are attractive to fierce competitors and creative destruction (in the Schumperterian spirit) is not uncommon, whereby new technologies uproot even the most established ones. It therefore makes sense for Alibaba to take imminent action for an IPO. 

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A few days ago, Baidu, China's Google, has announced it will acquire 91 wireless from NetDragon Websoft for $1.9 billion to further penetrate the mobile applications market. 91 wireless is a platform that distributes Android applications and connects over 90,000 application developers. Baidu is behind the other giant internet companies, namely Tencent and Sina, in terms of targeting mobile internet. So strategically, this acquisition is the correct one for Baidu. Baidu, as a search engine, is really for desktops but since consumers are devoting more time to mobiles/tablets, Baidu cannot continue to rely on online search for revenues. Baidu really needs this acquisition as location based and real-time applications (for maps, business nearby, SatNav for traffic data) are growing popular and consumers no longer need search to find what they're looking for. Using Baidu on smartphones is not particularity user friendly either.  

This acquisition will allow Baidu to generate more traffic from mobile users. Tencent's WeChat has 400 million mobile users and Alibaba is also starting to make headway in mobile applications by investing in Sina Weibo, AutoNavi among others. It is safe to say that Baidu is falling behind in traffic from smartphones. Unlike Google, it also has few applications for smartphones but this acquisition can help Baidu to boost usage experience in mobile apps and help the company to build a mobile ecosystem faster than developing organically. As well as catching up with Alibaba among others, the 91 Wireless acquisition can also shrug off competition from Qihoo who is the market leader in mobile application distribution. 

Although Tencent is a big player in developing, operating and marketing mobile gaming applications, I believe that Baidu and also Alibaba could look into targeting gaming apps in the near future as these are hugely popular with younger Chinese users, who are willing to pay for add-ons within games. 

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All this got me thinking why Chinese internet companies are hugely successful in China but nowhere else. And why, the likes of Google, Yahoo!, eBay or Amazon are hugely successful everywhere else but not in China. So, what is the deal with these Chinese internet companies? There are several answers to my question:

• A large internet/mobile internet market (due to China's population) has been an underlying factor to all Chinese internet companies' success. 

• The rise, growth and later dominance of the main Chinese companies we know today can be attributed to first mover advantage. The companies were founded in circa 1999, a period of mass internet adoption within China. This not only provided the opportunity to enter the internet content market but internet companies also capitalised by emerging as the first movers. Later entrants fail to be as successful since the first movers capture the benefits of dynamic increasing returns, which cause rise and growth. This is true for Baidu for example, as later entrants, whether indigenous firms or foreign firms who enter the search engine market hold significantly less market share.

• Joseph Schumpeter argued that innovation drives economic growth and an organisation forward. Innovation allowed Chinese internet companies to emerge and achieve first mover status but importantly, innovation facilitated their development of new combinations, leading to rise and growth. Baidu contributed little to the general search engine technology having modelled/imitated itself after Google, but the company innovated China’s first Chinese language search engine. Similarly, Tencent QQ is imitated after Mirabilis’ ICQ but Tencent innovated the first Chinese language instant messenger and also technology to send offline messages and store chat history, rapidly increasing QQ’s popularity. Sina’s main innovation lies in being the first to provide comprehensive news and entertainment and lifestyle portals, allowing Sina to diminish its direct competitor Sohu’s market share. Innovating Chinese language platforms in particular, immediately improves ease of use for Chinese users, leading to customer loyalty, brand recognition, other dynamic increasing returns and in turn, rise and growth. Weak IP laws within China have allowed internet firms to do so without much consequence and then reap the benefits of imitating an already successful model.  Just compare: 

Or:

Spot the similarity: Facebook v RenRen; Baidu v Google v Qihoo

• Chinese internet companies' success within China can also be attributed to possessing an excellent understanding of the Chinese market. Chinese search engines' MP3 downloads and games searches are of interest to young Chinese users and Tencent’s QQ and games allow users to purchase items for customising virtual characters, meeting their entertainment needs. Sina provides region-focussed news, relevant adverts and infotainment channels such as automobile information and luxury goods which appeal to China’s ever-growing middle class. The companies also brand themselves strongly as indigenous Chinese firms, further appealing to users.

• Cooperation with the Chinese government’s censorship regulations enabled the companies to emerge and rise. Cooperation is key; Google’s refusal to censor instigated its exits from China in 2010 and several Google services became blocked, allowing Baidu’s market share to increase from 60% to 75.9%. Following Wikipedia’s block in 2005, Baidu also capitalised by developing a Chinese version of Wikipedia, Baiduknows. Sina used the opportunity to launch Weibo in 2009, after the closure of micro-blog Fanfou due to censorship disputes. Thus, censorship regulations and blocks on the main foreign internet companies from Facebook to Youtube to Google reduces competition, grants indigenous companies who comply opportunities to replicate such foreign websites and space to thrive in the Chinese market. 

• Chinese internet companies have been and will be unable to compete globally, I believe. Chinese internet companies cater only to the Chinese market and their niche models cannot succeed abroad. . Mastering an understanding of international markets can also be difficult if management have little experience of the target country. Further, competing abroad is unlikely as well-established or indigenous firms may already operate in the market; Google, Yahoo!, eBay and Amazon serve many regions outside of China. For example, Baidu, who entered the Japanese market in 2008 holds only 0.2% of the market share; the market is divided between first-movers Google and Yahoo!. Moreover, as Chinese internet companies generally will offer no markedly new products, entering foreign markets will generate little success. Similarly for these same reasons, foreign internet brands cannot be successful in China so easily. However, Baidu and Tencent currently operate small-scale foreign ventures - includes multi-language products and establishing partnerships with foreign counterparts - in emerging markets such as Brazil, India and Vietnam. Expanding into developing markets offers Chinese firms an increased chance of success as they benefit from first mover advantage and will experience little competition . Such companies will continue to expand into emerging markets, as their management have expressed a desire to invest in, or acquire foreign firms. For example, Tencent have invested substantially in FAB and KakaoTalk and Qihoo 360 have partnered with Line. 

JH

M&A: a quick deal review

THIS POST is a bit different from my previous posts as I comment on and analyse a few recent M&A deals across various sectors that I've found interesting.

• June 11 2013: Google acquires Waze Inc., beating off competition from Facebook but now faces regulatory investigation.

Like a sporty kid who adds yet another trophy to their cabinet, Waze has become the latest high value internet brand to join the Google family. Waze, an Israeli real time traffic data service start-up has been acquired by Google for a cool $1.1 billion (which I think is slightly overvalued if you benchmark to something like Foursquare), beating off rival competition from Facebook. For the non-tech people among us, Waze's is an app that connects and allows its 47 million users to share information whilst on the road to alert other drivers of traffic congestion or road hazards. By doing so, Waze suggests alternative routes. But users need not to actively contribute as Waze picks up road conditions (driver speed, routes, location etc.) and alters i's maps to guide the whole Waze 'community', all in real time. There are also some social media functions on Waze, allowing users to track locations of Facebook friends or other colleagues. All-in-all, it is a GPS navigator, at the frontier of map app technology with extra frills. 

And what's in it for Google? Well, at the basic level, I would say that the acquisition of Waze and therefore its technology can help Google to enhance its already advanced mapping products with real traffic data time data. The acquisition means that Waze's services can be incorporated into Google Maps and perhaps other Google products, which do not currently have real time user traffic data. As well as this, Waze's social media functions can help Google make a stronger mark in this area; combining Google + functions into Waze is a plausible idea. Of course, Google is also an advertising company and Waze provides a huge stage for generating advertising revenues by attracting local businesses to market themselves on the map. Google's long term plans with Waze are unknown but for now, Google has stated that the two will be kept as separate units, amid regulator probing (see below). Given that consumers are increasingly adopting mobile devices and with the rise of 'phablets', location services/applications have become a primary area of focus for Google as well as other tech giants. 

Of course, the acquisition of Waze also gives Google a good wedge of the millions of consumers who already use Waze on iOS. More importantly for Google, the acquisition means that it can block competitors' use of Waze's data. For example, Facebook who is looking to develop its own mobile apps will have to use 3rd party data for any location based apps. To me, the value of this to Google is huge; maps form an integral component of the mobile ecosystem and mobile mapping heavily influences revenue generation by bringing in advertising and other social tools/apps. Google, with its huge cash reserves is playing a clever game by buying and blocking, rather than building upon Waze's technology to create its own real time mapping product. 

Waze's chief executive Noam Bardin noted that the firm explored many options (acquirers including Facebook and Apple) but found Google to be the winning choice. I would say that Google's weapon is likely to be cash, (who have a $50 billion spending power) whereas Facebook was offering stock. Terms of the transaction mean that $1.03 billion will be transferred in cash directly to Waze and its stockholders; an additional $100 million will be awarded to employees based on performance. These figures are something Facebook can probably not afford to afford. I think that Google is also a better fit for the company given that it has a large presence in Israel and therefore would not require Waze to relocate its R&D to California, as Facebook had wanted. 

This deal however is not all sweet for Google. In the last week of June, the US Federal Trade Commission (FTC) confirmed that the acquisition will be investigated to ascertain whether the deal will restrict consumer choice. It follows pressure from consumer groups that the deal should be blocked on antitrust grounds. Consumer Watchdog had raised the concern with the Department of Justice of Google becoming essentially a mapping and data monopoly.  The ruling will be made in due course but a block on the deal will be unlikely I feel since Waze and Google will remain as separate units (at least for now). The market share of Google Maps even merged with Waze is also unlikely to be astronomically high. 

All in all, both parties have got themselves a pretty good deal. Whatever Google's long term plans with Waze are, there is no doubt that into the near future, Google will add real time traffic technology onto its maps.

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• June 5 2013, Xerox buys LearnSomething Inc., expanding into health care.

Xerox, a company that is typically known for its photocopying machines, printers, publishing and other related equipment and consulting services, acquired LearnSomething at the beginning of the month for an undisclosed sum. LearnSomething, based in Florida, is an e-learning service provider of industry information, training and educational programs to food, drug and health care industries. I have not heard of LearnSomething previously and was surprised to find that they supply industry information and educational programs to 110,000 retail pharmacists in the US (equivalent to 85% of US retail pharmacists). The Learner Community e-learning platform is used to deliver regulatory compliance courses for food and drug retailers. 

Whilst the terms of the deal weren't disclosed, a few interesting points can still be made. 

Xerox in recent years have been working to restructure and re-brand itself as a customer focused services business providing services such as document management, bill processing and IT outsourcing in the backdrop of decreasing sales of its traditional products of copiers and printers. This deal effectively allows Xerox to build on its mark and broaden its services in the healthcare industry following the purchase of TMS Health in 2010. 

Given that 500 new over-the counter medications and health/beauty products are introduced every year, and with LearnSomething being a leading provider of educational, training and regulatory services, it seems to me that there will be no shortage of business for Xerox in this area. In turn, this will contribute to an easier re-structuring as Xerox turns away from its traditional business into a more lucrative asset-lite business of customer services. 

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• June 2013, Billabong troubles rumbles on. 

I am no surfer and have never lived near a surfing community but Billabong and other surfing brands like Quiksilver, Rip Curl and O'Neill managed to merge itself into the mass fashion market when I was a kid. Not only were these brands hugely popular, but they were seen as the coolest, trendiest and the most 'it' thing to have. Bus fashions of course fade and go, as do businesses. The whole Billabong trouble is something I've been following fairly closely over the past few month due to my acquaintance with the brand when I was younger. 

In developments this month, Billabong is now looking to sell its retail units separately after 2 private equity firms and Billabong did not reach an agreement to buy the company outright. The three units to sell are DaKine Hawaii Inc., RVCA, and West49, and this could be a means of raising enough capital to repay the company's $350 million syndicated debt facility. 

Billabong rejected a $903.5 million bid from TPG Capital Management in Feb 2012 but the value of the company has really plummeted: Billabong's shares closed at $0.90 on Jan. 11, when Altamont submitted a $556 million bid. By April, Billabong received a bid of $284 million from Sycamore.  

Hindsight is a wonderful thing but Billabong is not a lost cause. I feel that still at the end of the day, Billabong is a nice brand image for surfers and beachwear. What it needs to do is lower prices and appeal to the mass market once again especially for its beachwear and accessories to reverse its revenue situation since management changes and any strategic restructurings have not turned fortunes around so far. Of course, the flip side of this may be that Billabong will lose appeal to surfers as they wish sport more obscure brands to differentiate themselves from mass culture, enforcing their own sub-culture. However, since nothing else is working, and if Billabong is desperate, clever global marketing campaigns to attract the brand once again to non-surfers is the best path to boost revenue. 

Billabong: not so cool for school anymore 

JH