Has the China online video story run its course?

When Youku, China's leading online video site, released its 2011 annual report on April 16, one number took no one by surprise: the company posted a net loss of RMB172.1 million ($27.3 million). Youku is now in its sixth year of existence and has yet to become profitable.

This didn't stop the company, or its closest competitor, Tudou, raising millions of dollars from public investors in the last couple of years. But now the two are set to merge - a move that is supposed to reduce costs and propel the combined entity into the black - questions are being asked of what this means for the prevailing online video business model in China and VC players who participate in the space.

"Investors have been with Tudou for some five years and they have secured pretty good returns through its IPO," says Bill Bishop, an independent consultant and investor who focuses on digital media investments. "Once the lock-up is over, I guarantee that at least Tudou's investors will sell like crazy and I don't think any more venture capital firms will get into online video now because it is suicidal."

Cost conundrum

Youku and Tudou may have become everyday names to millions of young Chinese. An antidote to traditional television channels that must program according to government remit, online video sites have gained a massive following. Youku claims 263 million users per month, a 20% market share, while Tudou has 227 million users.

Offering content ranging from programs by state broadcaster CCTV to Desperate Housewives, these sites are a magnet for advertisers keen to connect with youth. In 2011, ad revenues came to RMB4.8 billion, more than double the level a year ago, according to research firm Analysys International. Youku's net revenues reached RMB897 million for the year, a 131% increase, while Tudou saw its takings jump 78% to RMB512 million.

The serial losses at both companies stem from escalating costs, specifically bandwidth and content. For every user Youku and Tudou add, they must boost online streaming capacity to accommodate the extra traffic and buy content that ensures the user keeps coming back. Revenue costs have grown fourfold and threefold, respectively, since 2008.

The problem is competition. Every Chinese video platform offers some similar material, so content prices and marketing outlay together outstrip advertising income. Last year, content costs were equal to 27% of Youku's revenue and 33% of Tudou's.

"Five years ago, you had close to 100% of streaming television series online coming from illegal uploads; today you can go onto the major online video sites and find a number of them legally provided by the content producers," says Dave Carini, says Dave Carini, co-founder of tech consultancy Maverick China Research. "Viewers will want more of this high-quality content in the future, meaning further cost increases for the video sites."

Top quality content is useless if the site doesn't have sufficient bandwidth to accommodate all the users who want to access it, which means online video sites must pay more to China Telecom and China Unicom, the leading state-owned broadband providers. Escaping this bind is dependent on achieving a critical mass of users, something Youku claims to have done in 2010 and 2011, as net revenues finally exceeded revenue costs.

However, the company stayed in deficit because of a huge increase in its sales and marketing expenditure - if you buy good content, you have to tell people about it.

If the online video business seems like a vicious circle of spiraling costs, M&A as a short-cut to scale appears is a logical step. Once adversaries in the courtroom over alleged copyright infringement as well as online, Youku and Tudou are now engaged in a friendly merger in a 100% stock-to-stock transaction.

"Youku Tudou will represent a differentiated leader in the online video market in China with the largest user base, most comprehensive content library, most advanced bandwidth infrastructure and strongest monetization capability within the sector," Victor Koo, founder, chairman and CEO of Youku, said of the deal. "[We] will have the reach and scale to bring our users high quality content at high speeds."

Koo will serve as chairman and CEO of the combined entity with Tudou CEO Gary Wang joining the board of directors.
Youku shareholders, which include VC firms Brookside Capital Partners, Maverick Funds and Farallon Capital, will own around 71.5% of the new company, with the rest held by Tudou shareholders. The latter's VC backers include IDG Ventures, General Catalyst Group and JAFCO Asia.

They will be aware that a Youku-Tudou merger is no guarantee of long-term success, although it does boost the firms' chances.

The combined entity will control less than half the market, and emerging rivals don't necessarily face the same financial pressures. Tencent and Baidu, for example, can call upon deep cash reserves generated by their core businesses when it comes to bidding for content. Much as YouTube augments Google's existing operations, Tencent and Baidu may regard online video as a route to diversification and cross-fertilization, not an immediate stand-alone profit center.

"When venture capitalists got into the online video sector a few years ago, they foresaw market growth, but few expected content cost competition to be so strong," says Frank Fang, a research analyst at ChinaScope Financial.

Industry participants have every reason to expect that content providers will ask for more money from online video sites as viewers and advertisers shift from television to the web space.

"Both foreign and domestic content providers are still giving these online providers friend prices," says David Wolf, president of Wolf Group Asia, a strategic communications consultant to the creative industries. "But in time, content costs for online video platforms will grow to a level comparable to that which television broadcasters are facing."

Uncertain future

This uncertain future lends credence to Bishop's view that existing investors will exit as soon as the opportunity arises. Hanging on in the hope of a lucrative sale to a strategic investor is another option, but there are no guarantees.

According to Duncan Clark, chairman of BDA, a Beijing-based tech advisory firm, Youku and Tudou's backers may have envisaged a YouTube-style exit, with a big tech conglomerate like Baidu purchasing the combined entity. However, as long as the company remains a giant cost center - Koo expects to turn a profit in 2013 - an acquisition would be difficult to justify, especially given Baidu has its own online video offering.

Some industry participants suggest that the VC story is at an end for online video. Those who don't already have a stake in Youku or Tudou are advised to focus on related businesses that are not yet saturated with investment. These include devices that integrate online video with social networks, or applications that put online video onto mobile devices.

One example is PPStream, a Chinese online video software applicable to a range of devices. The company is profitable despite rising content costs because it is based on peer-to-peer technology. Each computer acts as both a client and a server for the other computers in the network, supporting shared access to files and restricting bandwidth to just 15% of that required by a solely web-based solution. As a result, bandwidth costs are 80% lower.

PPStream last year received $28.6 million in backing from Hong Kong telecom provider PCCW and Vision Knight Capital.

"Web-based video is less meaningful than client solution-driven online video applications - apart from expensive bandwidth costs, online video sites must also advertise the content they buy," an internet-focused GP tells AVCJ. "PPStream just needs to track people's watching behavior and pop up at the right time."

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Greater China
• Technology
• Media
• Venture
• Venture
• China
• TMT
• Growth capital
• Exit