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Tudou and Youku IPOs: A Sucker's Bet?


When something sounds too good to be true, it usually is. Despite their growth and audience size, the two sites face significant headwinds.

The pirating party police have made their way to China. And so far they've been effective -- I'm pretty far behind in several of my favorite prime-time series.

The State Council's newly established crackdown against piracy is a very welcome movement. The level of precision in which the Chinese can "copy and paste" just about anything isn't exactly a desired skill set in a country desiring to develop into a leading global innovator.

That said, from a more micro standpoint, the campaign against counterfeiting will negatively affect all who participate in the act -- including US investors.

Sure it's a pity I haven't viewed the last few episodes of Desperate Housewives, but the real impact falls on the two portals that previously delivered my Sunday night drama fix -- Tudou and Youku -- and the US investors awaiting their upcoming IPO listings on the Nasdaq.

The Tudou website, as viewed in China

At first glance, Tudou and Youku look like cookie-cut versions of Google's (GOOG) Youtube. Browse around for a few minutes and it becomes glaringly evident that's not the case.

China caps the number of foreign films allowed in theaters at 20 per annum, all of which greatly lag Hollywood release dates. I'd be surprised if anyone here ever noticed as most full-length movies are (ahem, were) uploaded and fully viewable on Tudou or Youku before they even made it out of the US theaters. For free.
In China, YouTube is blocked and General Electric's (GE) NBC, Disney's (DIS) ABC, Hulu and other official streaming sites are inaccessible to internet users with a Chinese (or any other foreign) IP address. And the entirely state-run television network airs a very limited and edited selection of Western shows, often with poorly done voiceovers.

From episodes of old school television sitcoms, to the most recent episodes of the hottest current shows (sometimes within 24 hours of the original airing), to box office hits, Tudou and Youku help bring the US entertainment world to China.

Unlike Youtube, which attracts viewers with original user-generated clips, Tudou and Youku earn traffic by offering Chinese residents a detour around the country's highly censored and state-controlled entertainment business. Official figures on how much pirated material exists on these sites are unknown, but it's an easy bet that illegally uploaded content is a driving force for traffic. Especially given how well-versed most young Chinese are with American television.

It's no wonder Tudou and Youku generated 317% and 1,000% revenue growth respectively over the last two years.

But the crackdown on piracy and the fact that these companies have chosen to list and raise capital in the country from which they uplift their copyrighted content has rapidly changed the model. As previously stated, movies and television shows have vanished from the sites and both management teams have announced they are working diligently to adhere to international standard copyright laws as the government pushes its campaign to reduce piracy. To fill the gaping hole, they're moving towards purchasing licenses and self-generated content.

To a US investor, a company cleaning up its act in such a manner sounds appealing. The problem is that Tudou and Youku have been branded as destinations to watch free foreign films and television. Last year, Youku's CEO, Victor Koo, even admitted that only 30% of the site's content was user-generated. (Note the 70% estimate of licensed content stated in the referenced link is VERY questionable). The removal of such material will deter traffic.

Sure, Youku is launching a beta version of a subscription service like Netflix (NFLX), which will allow viewers to watch select movies and videos legally. But the subscription-based model is unlikely to work in a country where free versions are always available, either on lower-profile sites, or dirt cheap DVDs sold via street vendors -- who get away with piracy despite a government crackdown.

Furthermore, the upkeep cost of maintaining a piracy-free site in China will come at a hefty expense, especially as the government pressures companies to diligently remove illegal content. Keeping up with the Chinese users who continue to upload illegal video isn't easy. And the cost of obtaining film licenses is skyrocketing due to the obviously increased value of a license in response to the government's anti-piracy movement, along with lawsuits from producers in recent years. Episodes that cost just a few hundred yuan two years ago are now selling at several hundred thousand yuan.

Selling the idea of producing content may seem like an innovative twist to the traditional online video business model that has, for the most part, proven profitless across global peers. But the costs associated with this activity, not to mention the experience necessary, and the riskiness of whether some unknown video series will be well-received detracts from the potential success some investors may imagine this to be.

The belief that an online video entity can transform itself into a hit film producer in the blink of an eye is laughable. But it's not surprising. All too often, when one business doesn't work, the Chinese jump ship and attempt something completely different.
With just one-third (430 million) of China's population considered internet users, US investors tend to initially gush over the vast untapped market potential Chinese dotcom companies have. Thus, it's very likely that Tudou and Youku (set to be valued at over US$1 billion) will have an initial great run.

But for two companies that remain millions of dollars deep in the red, the story unfolding isn't all that enticing. Before getting into one of these hot dotcom IPOs, consider that both business models have been shaken up, rising expenses are inevitable, and both compete in a very fragmented and evolving industry that could easily leave these two players in the dust.
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