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In my article on Tudou's (TUDO) flawed strategy, I pointed out that Tudou’s core business model of providing user generated content to online viewers is unsustainable in China because Chinese viewers prefer professional produced content (PPC), such as movies and soap operas, over videos created by non-professionals.

To address this weakness, Tudou set out a strategy of content acquisition to defend its declining market share from market leading Youku (YOKU) and emerging threat Sohu (SOHU). However, such strategy is also flawed because Tudou lacks capital or the brand recognition to leverage when acquiring content. Furthermore, monetization of paid content through subscription-based model, such as that of Netflix (NFLX), is impossible due to abundance of pirated contents in China. The only viable way to monetize PPC is by delivering superior user experience and leveraging a company’s brand to attract viewers, but Tudou lacks both attributes.

Tudou’s shareholder value is uncertain at best. In my opinion, aside from upgrading platform and acquiring contents, the other reason behind Tudou’s IPO is to simply survive long enough for the stakeholders to exit. However, just because Tudou has an unprofitable business model, executes a flawed business strategy, operates in an unfavorable market, and, according to some industry observers, has enough cash to sustain for two more quarters, it does not mean that the company has no value.

Tudou’s value to shareholders can be realized if it is acquired by a large domestic player that looks to expand its presence in the online video ad market. Baidu (BIDU), Youku, or Sina (SINA) could possibly acquire Tudou.

Of the three, Baidu stands out as the most likely acquirer because Baidu has sufficient capital, and Tudou has an established platform. Such acquisition will instantly make Baidu a serious player in online video advertising.

Baidu has approximately $1.2 billion in cash. Tudou is currently valued at approximately $654 million and the addition of 30% premium values the company at $850 million. The acquisition will place Baidu as the second largest online video site behind Youku. In addition, Baidu’s superior cash flow generating ability gives the company sufficient capital to acquire contents and compete against Youku and Sohu. The combined operation would also be leaner after getting rid of content overlaps, thereby lowering content cost.

Because mostly all of the online video sites feature similar PPC contents, user experience ultimately decides the amount of traffic that the site will generate. Baidu could deliver superior user experience by modifying its recommendation engine that is comparable to that of Netflix. One of the underlying success factors behind Netflix is its recommendation engine that suggests movies and shows based on a user's viewing history.

The relevant recommendations increased user stickiness, resulting in impressive user growth rate. Baidu can leverage its Phoenix Nest algorithm to constantly seek relevant contents according to viewers’ history. The recommendation generated by Baidu could result in greater user stickiness, gradual erosion of Youku’s market share, and increased advertising revenue.

After Tudou’s IPO, Sina paid $66.4 million for a 9% stake in Tudou to expand its presence in online video advertising. This strategic stake has two implications. The first implication is that this could be a precursor to an acquisition. The other implication is that such an investment is simply a financial investment in that Sina looks to profit as Tudou’s shareholder. The 9% stake is currently used to gauge the viability of Tudou’s business model before making further investment in the company. Because Tudou’s near-term profitability is questionable, it is likely that Sina’s strategic stake is a precursor to an acquisition.

However, acquiring Tudou could be problematic. Sina is currently investing $100 million on its microblogging service, Weibo, which currently has over 200 million users but still has not been monetized. Tudou’s acquisition places Sina in two risky fronts in which the it is required to use scarce cash reserve ($826 million as of last quarter) to monetize Weibo and to acquire video content for Tudou. Such a strategy could be risky and capital intensive, and it is doubtful whether Sina would be successful in undertaking two monetization projects simultaneously.

Youku was rumored to acquire Tudou. However, I believe that Youku is least likely to acquire Tudou because Youku does not have sufficient capital to acquire and such acquisition delivers no value other than taking out a competitor. Currently, Youku has $434 million in cash and cash equivalents, and is unlikely to acquire Tudou without issuing additional equity or debt, or both. Furthermore, Youku’s strategy of acquiring brand name contents from foreign providers, such as Warner Brother and Dreamworks Animation, is helping the company gaining market share from Tudou and establishing itself as the top online video site in China among the eyes of foreign content providers. Therefore, it makes more sense for Youku to utilize its capital on acquiring contents rather than acquiring an ailing company.

As mentioned earlier, some industry observers noted that Tudou’s cash flow is sufficient for the firm to survive for another two quarters. If Tudou is determined to be unsustainable in the long term, its valuation could plummet further and could generate interest from domestic players that are looking for market expansion, private equity investors who are looking to turn the company around, or even international players, such as Google (GOOG), Netflix, and Time Warner (TWX), as they look to enter China’s online video market.

Source: Tudou's Future Lies In Its Acquisition