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China had an estimated 513 million internet users as of the end of 2011. The size of the market is impressive, but the internet industry is in its early stages and risky. It is also among the fastest-growing industries in China.

The high speed of growth, in my opinion, is one of the catalysts for takeovers and buyouts among Chinese internet companies. Valuations are favorable, and local strategic buyers are facing less competition from private equity, although that is still an option for Chinese internet companies listed in the U.S. or Hong Kong. Several internet firms including leading search engine Baidu (NASDAQ:BIDU) have expressed interest in delisting abroad and returning to China's A-share market.

Recent LBOs and mergers have provided profitable arbitrage opportunities. The market prices of Chinese companies tend to stay well below the agreed price until the deal completes, as Chinese transactions are sometimes perceived as riskier than they actually are.

E-commerce

I believe the privatization of Alibaba Group's (OTC:ALBCF) Hong Kong-listed unit, of which it owns 73%, will go smoothly. The HKD13.50 price was a 46% premium when the deal was announced on February 21, enough to entice minority shareholders.

Alibaba Group's move could help it retune its operating strategy and add flexibility to ongoing negotiations with Yahoo! (NASDAQ:YHOO). Alibaba might buy back the 39% stake owned by Yahoo, or it might buy Yahoo and expand into the U.S. In the latter case, it could meet with some tough competition from strategic buyers like Microsoft (NASDAQ:MSFT), but also private equity buyers like Bain Capital, Hellman & Friedman, or Providence Equity Partners.

Alibaba, the top B2B player in the Chinese e-commerce market, should also expect to get some more competition at home, and not just from HC360 and Myekoo. Foreign companies like EBAY's PayPal want to get a piece of the $121 billion market. PayPal has applied for a license to process electronic payments, and could soon be in a position to challenge Alibaba's Alipay.

Search engines

An area that might see strategic takeovers is search engines. Due to the restrictive government policies, domestic Chinese internet companies have control of the market. Baidu has 78% of the search market, compared with only 17% for Google China.

I see Baidu as a potential buyer for Sina (NASDAQ:SINA), China's second-largest online media portal, which also provides mobile value-added services, games, enterprise solutions and online shopping. An attractive part of Sina is its fast growing and revenue-generating micro blogging platform Weibo. Sina's revenue grew by 21.30% year-over-yea in the last quarter, compared with 82.50% for Baidu. Sina's profit margin is -62.57%, while Baidu's is 45.78%.

Another possible target for Baidu is Sohu (NASDAQ:SOHU), which owns the third-biggest but rapidly expanding internet search engine in China, Sogou.com. Sohu also provides Chinese online video content, news and other media, gaming, community, and mobile services. Although its results have been dented by its video activities, it is still profitable with a 19.10% margin. Sohu's quarterly earnings growth is 42.20% year-over-year, better than Sina's but still far below that of Baidu. Hower, Sohu's forward P/E is attractive at 11.34, compared with 21.07 for Baidu.

Online video

As demand for online video increases in China, it has become another M&A hot spot. The two largest companies in the space, Youku (NYSE:YOKU) and Tudou Holdings (NASDAQ:TUDO), have recently agreed to merge. Together, they will control over a third of China's online video advertising revenue. Youku has a 22% share and Tudou about 14%, compared with 3% for Sohu, and 7% for Baidu.

I think the merger is a shrewd move for Youku as it takes out two competitors in online video - Tudou of course, but also Sohu. Sohu is now trapped between Baidu's Qiyi, Tencent (OTCPK:TCEHY) and an even bigger Youku. This might help to drive Sohu into the arms of Baidu. If Youku had done a deal with Baidu, which was thought to be more likely, then Tencent would have acquired Tudou, creating an even bigger competitor.

M&A activity in Chinese online video might not stop with the Youku - Tudou tie-up. Neither of the merger partners is currently profitable. Profitability is hard to achieve in the sector because fierce competition drives the cost of content upward. Rivals Xunlei, Sohu Video, and Baidu's Qiyi all have either traffic or resources support. Sohu, Baidu, Sina and Tencent direct traffic from their web portals to cultivate their newly established video sites. I would therefore not rule out a future merger of the new Youku Tudou with Baidu.

Gaming

Shanda Interactive Entertainment's $2.3 billion buyout by management closed in mid-February. Slightly above 30% of Shanda had been in public hands. I believe that Shanda's subsidiary Shanda Games (NASDAQ:GAME) might go the way of its parent. GAME's sales are lagging those of market leaders like Tencent and NetEase (NASDAQ:NTES). The visibility of SNDA's non-game segment - online video, movie and cloud computing - remains low and will continue to generate losses in the near term.

Online gaming companies appear to be the cheapest among Chinese internet companies right now. The9 (NASDAQ:NCTY), Giant Interactive (NYSE:GA), and Changyou (NASDAQ:CYOU) have all seen lackluster performance.

An attractive target is Perfect World (NASDAQ:PWRD), the leading 3D online game developer and operator in China whichis also active in the U.S., Japan, and Southeast Asia. Perfect World operates four main self-developed 3D massive multiplayer online role-playing games, some of which it has licensed to other countries. It is also involved in the production and distribution of films, as well as television advertising. Perfect World has quarterly revenue growth of 30.90%, a profit margin of 32.98%, and a forward earnings multiple of only 0.77.

Social networking

An additional Chinese internet company that might see some buyer interest is Renren (NYSE:RENN). It operates a social networking internet platform, which enables users to connect and communicate with each other; share information and user-generated content; play online games; listen to music; and shop for deals. Renren's market cap is $2.08 billion and its profit margin 34.97%. Renren's stock has fallen over the past year due mounting competition from Sina's Weibo and Tencent's PengYou, as well as persistent concerns about government censorship.

In my opinion, Renren could be a good fit for Sina or Tencent. Either could realize synergies from combining Renren's user base with its own. Major China internet companies with financial resources, including Baidu, Alibaba, Netease and Sohu, could also contemplate an acquisition as a way to obtain an immediate market presence in the social networking space. Even foreign players such as Facebook might be interested in Renren in order to access a user base in China.

Source: Internet Stocks For Aggressive Investors