Youku Emerging a Goliath in China Internet

NEW YORK (TheStreet) -- After the all-stock merger between Youku (YOKU) and Tudou (TUDO) a couple of weeks ago, Youku's stock has receded from the $32 levels it hit the day of the deal announcement.

The stock is now back down at the $24 level -- and actually less than where it traded before the deal was publicized.

That seems a bargain considering that Youku's in a much stronger position today than it was then. (Tudou is still trading at $32, which is more than double where it traded before the merger.)

Consider these important facts:
  • China's Internet population just reach 513 million last year according to the government-run China Internet Network Information Center (CNNIC)
  • 56 million Chinese used the Internet for the first time in 2011
  • 60% of China's population remains offline at the moment
  • That means that all Chinese Internet sites are poised to benefit from increased Internet penetration over the next couple of years.

    However, Youku is in a unique position among Chinese Internet stocks.

    Youku was the second-largest video Web site in the world after YouTube with 4.6 billion videos viewed in October. This represented 2.3% of all videos viewed worldwide that month according to ComScore.

    Tudou is the No. 2 video site in China.

    By combining with Tudou, Youku now has a dominant position in the Chinese online video space, although some of the bigger portals like Baidu ( BIDU), Sohu ( SOHU) and Sina ( SINA) could always spend a lot of money to beef up their presence.

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    For the last four months, Youku and Tudou had been engaged in a bitter legal battle over IP rights. They'd also been forced to bid for rights to different types of online content to increase traffic to their sites.

    The fight for content was not unlike what we saw in the world of satellite radio a few years ago with XM and Sirius ( SIRI). Both had paid up handsomely for sports content rights and for on-air talent like Howard Stern, Oprah and Martha Stewart.

    Once the companies merged, however, the hunger for paying up for content went away. The two sides had already locked up a lot of the best content already. And, of course, by merging, they'd taken the No. 2 bidder out of the market for all future content.

    The same thing will happen here. China's Internet space is a lot bigger and more competitive than the U.S. satellite radio space. This isn't a duopoly. However, Youku and Tudou are clearly the two biggest dogs in this fight and the only two pure-plays.

    There's another key difference between the Chinese video space and the U.S. satellite radio players. In the satellite game, there are huge up-front costs of shooting up a satellite into space. In the Chinese online video space, there are huge ongoing costs of running this business. They're called bandwidth costs.

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    The more popular your video service gets, the more videos you play, and the more bandwidth you need to pay for in order to serve them. These costs had both been weighing on Youku and Tudou since they went public and were a big reason why both had yet to show profitability.

    Now, as a combined entity, they will be able share these costs over more videos being served and more ads being played. They will also likely be able to shrink their headcount to trim costs.

    Bandwidth costs as a percentage of total costs shouldn't necessarily drop as a percentage of revenue right away, but the combined companies' costs should indeed drop relatively quickly.

    Looking ahead, the promise of continued growth in the Chinese Internet video sector is still compelling. Youku is less of a "Chinese YouTube" and more like a "Chinese HBO" -- albeit with an ad-supported model right away vs. subscription.

    There is really no equivalent to an HBO or Showtime in China today. Youku is seeking to play that role, but doing it online rather than through cable. It's like they missed the whole pay-TV-cable thing and are going straight to HBO Go.

    As a combined company, Youku and Tudou will have a solid cash pile and be in a strong position to do further stock offerings to further raise cash in the future.

    No pure play has a shot at them in China and it's very likely the Chinese portals won't have the focus to effectively compete.

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    Victor Koo -- Youku's CEO -- is also very well-respected in China and Hollywood. He's built a strong team that will now be supplemented by more talent from Tudou.

    At the time of publication, Eric Jackson was long YOKU and SINA.

    Eric Jackson is founder and Managing Member of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd. In January 2007, Jackson started the world's first Internet-based campaign to increase shareholder value at Yahoo!, leading to a change in CEOs in 2007. He also spoke out in favor of Yahoo!'s accepting Microsoft's buyout offer in 2008. Global Proxy Watch named Jackson as one of its 10 "Stars" who positively influenced international corporate governance and shareowner value in 2007.

    Prior to founding Ironfire Capital, Jackson was President and CEO of Jackson Leadership Systems, Inc., a leadership, strategy, and governance consulting firm. He completed his Ph.D. in the Management Department at the Columbia University Graduate School of Business in New York, with a specialization in Strategic Management and Corporate Governance, and holds a B.A. from McGill University.

    He was previously Vice President of Strategy and Business Development at VoiceGenie Technologies, a software firm now owned by Alcatel-Lucent. In 2004, Jackson founded the Young Patrons' Circle at the Royal Ontario Museum in Toronto, which is now the second-largest social and philanthropic group of its kind in North America, raising $500,000 annually for the museum. You can follow Jackson on Twitter at www.twitter.com/ericjackson or @ericjackson.

    You can contact Eric by emailing him at eric.jackson@thestreet.com.

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