Let the Chinese games begin.The Olympics may not roll into Beijing until 2008, but anyone who can't wait will find that a different type of competition -- the battle to serve the world's largest population via the Internet -- has been heating up this week. The firing gun that started the race was a below-the-radar purchase of a 19.5% stake in Sina ( SINA - Get Report), China's biggest Internet portal, by Shanda Interactive Entertainment China's leader in online games. Shanda acted as Sina's shares lost a quarter of their value earlier this month on substantially lower first-quarter revenue guidance. A key source of Sina's wireless revenue, which accounted for nearly two-thirds of its total revenue, came from selling horoscopes through mobile phones. Chinese regulators banned radio and TV ads for wireless horoscopes in January. Sina responded to Shanda's purchase with two statements, one on Saturday insisting that the stake "has no direct effect on the company or its business and operations" and another on Tuesday outlining a poison pill provision allowing Sina to flood the market with new shares if Shanda boosted its stake above 20% or if another investor bought a stake above 10%. Just what Shanda was thinking as it was quietly digging up its stake in Sina, disclosed in a Friday SEC filing, isn't certain. (Shanda officials didn't respond to a request for an interview.) But it's clear that the impact will be a lot more serious than what Sina suggests. Whether Shanda is planning to become a powerful presence in China's Internet sector or just hoping to turn a quick profit when another suitor buys Sina, the move complicates an exit strategy for Sina's investors. "Shanda is now in a position to play kingmaker at Sina," said Jason Brueschke, an analyst with Pacific Growth Equities, which performs no underwriting for companies. "They can now dictate, if not strongly influence, whether Sina is bought and who it would be sold to."
The battle for Sina might end up coming down to two unlikely rivals: Yahoo! ( YHOO), the American online media giant that analysts say has been quietly courting Sina for a takeover for some time, and Softbank, a Japanese venture capital firm that is Yahoo!'s co-investor in Yahoo! Japan. Softbank is a key backer in the SB Asia Infrastructure Fund, which controls a 15% stake in Shanda. Yahoo! and Softbank have indicated a strong interest in China's Internet industry, which will undoubtedly dominate the Internet in Asia in coming years. Yahoo! has formed partnerships with 12 Chinese Internet-related companies, including Haofang, a game site controlled by Shanda. Softbank's China portfolio includes online travel site CTrip ( CTRP) and CyBizAsia, a Beijing technology incubator. But for both companies -- and for any non-Chinese company seeking a strong foothold in China's Internet sector -- there are few options beyond Sina, which is only 15% owned by Stone Electronic and directors. According to Goldman Sachs analyst James Mitchell, the other major Internet companies in China -- such as Shanda, NetEase ( NTES - Get Report) and Tencent -- are majority-owned by founders and directors. The closest is Sohu.com ( SOHU), which is 40% owned by controlling shareholders. That supply-demand imbalance could trigger a race into China among foreign companies, especially in the high-margin Internet game industry. "Shanda's acquisition of the equity stake is a sign of potential consolidation to come this year," Safa Rashtchy and Aaron Kessler wrote in a Piper Jaffray research note. "The implications of this trend are enormous since the U.S. companies that had taken a more cautious approach to China are now likely to speed up their processes. A competitive bidding for Sina is not necessarily out of the question." Online games have yet to catch on in the U.S., so it's hard to imagine the significance of a gaming company moving to take over a big online giant like America Online in the mid-1990s (on a smaller scale, it's not unlike America Online taking over Time Warner in 1999). Games have become the tail wagging the portal dogs in China, raising a philosophical question -- which won't be answered here -- of what happens when people prefer to spend most of their time online pretending they're someone else.
In China, the Internet gives an exponential enhancement to the immersive nature of role-playing games. Shanda reports an average of 1.1 million gamers are on its servers at any given minute, a number that can rise as high as 1.6 million at times. "For young people in China, there is a dearth of entertainment options," says Brueschke. "American kids go to the mall, and Chinese kids go to Internet cafes, where there are 70 or 80 people there at a time." In a typical Chinese Internet cafe, says Brueschke, three-quarters of people using PCs will be playing online games and the rest will be busy with email or instant messaging. Because of the low penetration of PCs in Chinese offices and homes, those cafes are where most Chinese access the Internet. Also, piracy concerns have prevented the widespread adoption of game consoles, as well as PC-based games. To get a sense of how popular this emerging sector is becoming, take a look at NetEase's earnings released Tuesday. The Beijing-based Internet company posted a profit of $16 million, or 45 cents a share, compared with a profit of $11 million, or 33 cents a share, a year ago. Revenue rose 55% on year to $31.6 million. The interesting part isn't that this is an eight-year-old Internet start-up with fast-growing profits, or that the earnings were in line with expectations. The key is where the growth is coming from. NetEase's traditional lines of business -- wireless services and advertising on its portal site -- were down 24% and 12%, respectively. But revenue from online games jumped 23%. Since June 2003, revenue from online games has gone from about a quarter of NetEase's revenues to three-quarters in the most recent quarter. And while gross margins for wireless and advertising operations dropped to 65.5% and 28.4%, respectively, they rose for the gaming business from 80% to 88.3% as economies of scale kicked in with larger subscribers.
NetEase plans to build on the success of its two main games, Westward Journey Online 2.0 and Fantasy Westward Journey Online, by adding martial arts-themed games and a 3D role-playing game based on Chinese mythology later this year, the company's chief operating officer, Michael Tong, said in a statement. Tong also said NetEase would introduce casual games -- less immersive, more stripped-down online games that appeal to a broader demographic. The gaming industry in China has its share of risks: aggressive government censors, a shortage of talented game developers and technicians and sometimes strained relationships with Internet cafes. But for the moment, the companies with the best games are not only raking in revenue, they are in the best position to influence the development of the Internet in Asia.