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Part 4: Internet and Software

The following is part four of a ten part report evaluating the progress of key Chinese industries as they expand overseas (see the introduction to this series, part 1, part 2 and part 3). CMR interviewed several hundred key executives in each of ten industries to better understand the extent of their globalization thus far, their goals and plans going forward, and the major challenges they are meeting along the way. This section describes the opportunities and challenges facing China's internet and software industry.

Chinese' increasing access to personal computers and the internet combined with domestic companies' increasing use of complex software in day-to-day business operations have spurred significant growth of China's internet and software companies. Sales in China's software industry have increased nearly tenfold since 2000 from 59.3 billion RMB to 580 billion RMB in 2007. China's online population surpassed the United States' in February 2008, making it the world's largest with approximately 300 million. The fact that around 20% of China's total population is online, versus 71.4% of the US's, suggests the remarkable growth opportunities still present at home.

While many Chinese internet and software companies have decided to focus on skyrocketing demand at home as their main source of growth in the near future, a majority of companies interviewed by CMR have established or plan to establish presence abroad within the next five years, and consider overseas expansion an important part of their strategic growth plans going forward. The internet sector especially will be able to handle the financial downturn better than most sectors as younger, middle class consumers who populate most of the Chinese internet community have indicated to us that they expect to spend the same if not more in 2009 on online games sites like Netease (NASDAQ:NTES) or QQ.

Motivations

For those respondents choosing to go abroad, the majority have done so due to demand for their products and services in overseas markets. B2B website Alibaba (HKG:1688) for example, launched a Japanese language version of its website back in 2002 to tap into the enormous growing trade volume between Japan and China--China surpassed the United States to become Japan's largest trading partner in 2006. Baidu (NASDAQ:BIDU) announced plans to move its search engine capabilities into Japan to take advantage of similarities in written Chinese and Japanese while firms like news portal Sina (NASDAQ:SINA) long have had operations in the US, originally to cater to overseas Chinese.

Software companies in particular also consider brand building a top motivator in the move overseas. Respondents feel developing an international brand image will help them gain the reputation for high end technology and high value-added products that will enable them to charge higher premiums and grow faster at home. They also feel that they won't run into the same piracy problems abroad that they face in China where piracy remains rampant despite an increase in recent years of prosecution by the Chinese Government, such as the recent long-term jail sentences handed out to a group pirating Microsoft's (NASDAQ:MSFT) products where their production facilities were larger than Microsoft's own.

Current and Future Operations

Software companies' strategies for going abroad vary by technology and focus area. For example, those producing high-tech, cutting edge software are prioritizing the American and European markets where demand is higher, and clients are willing to pay more for top products. Many companies producing enterprise management software target mainly the Southeast Asian market due to strong demand from the region's manufacturing industry.

Software respondents often choose partnerships and/ or M&A to build their presence abroad. Langchao, for example, formed a joint venture with Japanese software company Shinwa in 2006 to expand its outsourcing market in Japan, and tap into Shinwa's experience in industries including transportation, finance, manufacturing, and education. Global expansion is a top priority for Langchao, which changed its name to Inspur (600756) in April 2006 to make its name easier for foreign clients to pronounce. Inspur hopes to increase sales from overseas markets by as much as 30% by 2010.

The vast majority of internet companies have chosen to target overseas markets via local partnership or M&A. In May 2008 Alibaba announced operations of its Japanese language website would be taken over by a joint venture between Alibaba and Japan's Softbank, a telecommunications and media corporation with operations in broadband, fixed-line telecom, finance, media, e-commerce, and other businesses. Cooperation with Softbank greatly helps Alibaba in all aspects of management and business operations on the ground in Japan, and allows Alibaba direct access to local talent and knowledge of the target market. As explained by Alibaba, "Softbank just knows Japanese people and culture that much better than we do."

Thus far, internet company respondents have typically chosen countries which they believe, rightly or wrongly, have a similar culture to China, such as Japan and Southeast Asian countries. Social networking respondents in particular target countries with large overseas Chinese communities. Understanding local cultures will be especially critical for internet companies.

Challenges

Both internet and software company respondents consider finding the right talent mix the biggest challenge in overseas expansion. Most Chinese software companies are still in the stage of doing low value-added processing jobs and producing lower end products, and cannot easily find the talent at home to lead competition with cutting edge international companies. These companies are also having problems finding team members who can liaise between their home and target markets, have the management skills to lead the company in a foreign business environment, or the ability to spearhead marketing efforts abroad.

Many companies look to directly hire foreign talent to help overcome the need for technical skill and gain understanding of the new business environment. One company explained how they recruit heavily from Japan, the USA, and Canada to improve software development capabilities and program management expertise. Another respondent told us, "Right now we hire Chinese people who live or have studied abroad, but that's not enough to really open the main stream market."

Cultural differences are also a major challenge for Chinese software and internet companies, due to varying local needs and tastes, and language barriers in particular. Chinese companies have a hard time competing with Indian companies for language reasons, for example, and while roughly one in five of China's registered software companies have engaged in exporting or outsourcing partnerships, a full 60% of outsourcing business is from Japan, where cultural and language similarities make cooperation much easier.

Going Forward

Finding and keeping the talent necessary to develop localized products and services, and lead companies as they expand in a cross cultural environment will be the top priority as their globalization continues. Chinese companies also cannot make the same mistakes that Ebay (NASDAQ:EBAY) and Google (NASDAQ:GOOG) made in China, where they were slow to delegate power and localize services for the local communities. This failure to localize and react quickly to local wants is why most foreign internet companies have failed in China. Chinese companies will face the same problems as they move into overseas markets.

Companies should also invest in improving their understanding of the local market and culture, both to facilitate smooth business operations and better tailor products and services to local needs. Overcoming these challenges may require a large initial investment outlay, especially as companies look to increase number of foreign hires while cost of recruiting and retaining labor is increasing dramatically. However, given China's increasingly integrated role in the global market and the consequent demand for products to facilitate communication and trade, such as Alibaba's Japanese website, software and internet companies that make this investment wisely can expect to be rewarded as they expand overseas. But certainly not at Chinese software and internet companies should move abroad -- the difficulty in moving abroad is considerable and the China market might remain the best avenue for growth.

The next several sections of this report will be published on Seeking Alpha by product category. For more information about this report and accompanying charts and graphs, please contact CMR directly at cmrconsulting.com.cn/services/technology.html

CMR Senior Analyst Ben Cavender, Analysts Natalie Zhu, Meredith Sun, and Charlotte MacAusland, and Summer Intern Christie Sze Contributed to this report.

Source: Chinese Companies Go Abroad: (Part 4: The Internet and Software Sector)