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BEIJING -- Investors looking for a little relief from the barrage of bad news in China's wireless sector didn't get much help from

Tom Online

( TOMO). Late Thursday, the Beijing-based firm 'fessed up to a massive shortfall in third-quarter sales guidance, predicting sequential revenue could fall by up to 35%. More than one analyst used the word "shocking" to describe it.

Friday morning, Piper Jaffray downgraded Tom to market perform from outperform, but the stock was up fractionally in recent trading.

The sharp slump isn't entirely Tom's fault. It's partially the result of a government regulatory crackdown that is forcing all wireless companies to abruptly switch to flat-fee subscriptions and start offering lengthy trial periods for new services.

Based on Thursday's close of $10.41, Tom shares have lost 39% of their value since the policies were announced on July 6. Peers







Hurray! Holding Co.

( HRAY) have seen similar stock-price plunges.

Granted, the sector's regulatory woes will pass as companies adjust. If that was all executives had to worry about, they might shoulder through a slightly miserable summer and forget about it.

What's worrisome is that the new policies are proving a distraction at a time a much bigger problem has emerged: titan

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China Mobile

( CML), which owns two-thirds of the mainland cell phone market, is moving onto the service providers' turf. And it looms as a giant competitor.

Tom, the biggest of the wireless bunch, delivered 2005 sales of $172.1 million vs. China Mobile's $30.3 billion.

Service providers in China have spent their brief lifetimes sandwiched between powerful carriers at one end and content providers at the other.

When the industry was in its infancy, that worked fine for all sides: Service providers licensed content from record labels and game developers, then distributed it through revenue-sharing deals with China's two mobile carriers, China Mobile and smaller

China Unicom


. The service providers were allowed to keep a generous 85% of the revenue, with carriers satisfied to take the other 15%.

But everything is about to change. The looming transition to 3G networks in China will make it possible to sell higher-margin music and video to consumers -- a big step up from the humdrum fare like short-message service and ringtones that account for most of the current wireless-services market. With 3G expected to become available sometime in the next 18 to 24 months, the stakes are getting higher. Suddenly, carriers (and content providers, too) no longer look so willing to let service providers act as middlemen, taking the biggest cut of revenues.

"The old way of doing business for the

service providers in my view is largely over," says Jason Brueschke, a Hong Kong-based analyst for Citigroup who's negative on the sector. "It's just of question of how it's going to die and when, and who is going to survive."

In a development with terrifying implications for wireless small-fries, China Mobile is expanding its own wireless-services operations. This summer it launched an instant-messaging service and debuted a music club that lets subscribers download songs and ringtones.

China Mobile has also started to work directly with content providers. Instead of merely contracting with service providers to obtain music, as it has in the past, China Mobile has already struck deals with at least one record label. By cutting out the middleman, China Mobile can take 50% of the revenue share instead of 15%.

Overall, China Mobile is aiming to boost the portion of revenues it receives from wireless services to 30% this year, up from 21% in 2005, according to Jacky Yang, an analyst for Beijing-based Norson Telecom Consulting.

The changes under way have left service providers scrambling to reinvent themselves. Tom hopes eventually to diversify its revenues through an alliance with mobile phone payment firm


and generate advertising revenue through a joint venture with Internet calling company Skype, a unit of




A number of wireless firms have pursued M&A, aiming to lay claim to high-quality content that will increase their bargaining power with the carriers.



has been especially aggressive on that front, making some half a dozen acquisitions over the past few years to bulk up its portal and search-engine business. It's bought web sites focused on online games, real estate and mapping services.

In one of the more fascinating industry gambits, over the past year Hurray has acquired two Chinese record labels and a local game developer. "I think it's going to be inevitable that a lot of service providers will have to get into content, whether it's music or original video production or films or what have you," says Ran Wang, CEO of China eCapital, an investment bank that advised Hurray! on the two music deals.

In the biggest deal yet, Tom paid $75 million in June for a wireless firm that offered

an exclusive deal with a major television channel in China.

But the sudden imposition of new regulations will likely complicate deal-making, if not quash it for a while. "Policy changes will kill their revenues and their market cap, and that really limits their maneuverability," points out Citigroup's Brueschke.

With stock prices reeling and revenues sinking fast, wireless firms will be hard-pressed to find currency for more M&A. As recently as this spring, Tom boasted a market cap of $1.2 billion. As of Thursday's close, its market value had dwindled to $553 million.