It’s a hot season for China’s online video companies., the country's largest online video company by market share, raised US$203 million in its early-December initial public offering (IPO) on the New York Stock Exchange, and saw its share price surge 166% on the first day of trading, the best performance for an IPO in the U.S. since 2005. Meanwhile rival Tudou Holdings has plans for its own market debutin early 2011.

“What we are looking at [with the IPOs] is not just online sites for videos. We are really looking at the birth of two major, 21st-century international media companies,” says David Wolf, founder and CEO of Wolf Group Asia (WGA), a management advisory firm in Beijing and Los Angeles. “They are going to become large international media companies, [involved in everything] from online delivery to online broadcasting channels.”

But for now, being focused on online video in China is attractive in and of itself. A range of venture capital, for one, has flowed into this media niche since taking off five years ago — as much as US$1 billion in all, according to some estimates. With China’s online population surpassing that of the U.S. to become the largest in the world at the beginning of 2010, online video has been able to ride on the back of the boom. And now, almost three-quarters of the country's 420 million Internet users watch onlinevideo programs. Industry research firm iResearch predicts the number of online video viewers in China will grow at a compound annual rate of 36.3% between 2006 and 2012.

One reason for the popularity online video in China is that unlike traditional broadcasters, online video content is adaptable — viewers can mix and match what they watch more easily and tune in when they want, where they want. Another reason is that these sites are relatively free from state interference to run the content they choose. “They can completely focus on two areas to build a real media company: The audience and the content,” states Wolf, “Unfortunately, most media companies in China focus on content and on the government… the audience is last thing that is thought about.”

However, although the sector hasbeen attracting investors, viewers and – increasingly – advertisers, there's growing impatience for online video companies to prove that they can be profitable by being subscription, pay-per-view or – as is the case with Tudou and Youku – advertising dependent. That must be done while maneuvering their businesses through a rapidly changing, risk-filled environment, andfiguring out whether to be a friend, foe or both of TV broadcasting and which business models can drive the most revenue.

“Many different services will arise, lots of different revenue models are going to compete against each other, and models will continue to evolve,” predicts Peter Fader, a Wharton marketing professor. “There might be a rough ride in the market … but once it settles down, it will do so for the right reasons. The best model willthenemerge.”


Into the Mainstream

At the moment, the ride does indeed look rough in some places. China's independent online video companies face competition from all angles, and not just the state-run media behemoths and major Internet firms with designs on their niche. There's also a rampant black market in pirated material, both online and offline: Bootleg DVDs of the latest movies are on sale at newsstands, occasionally before the films hit the screens; illegal satellite dishes are sold for one-time installation charges, providing unrestricted and inexpensive viewing; and popular international TV programs are quickly subtitled, shared and spread through streaming or peer-to-peer downloads. In this world, content is not just unrestricted — it is free. 

Although Internet video sites have more creative freedom than terrestrial broadcasters, they are still operating in one of the world’s most restrictive environments for media content. While they do not have to seek clearance with authorities for videos, they must respond rapidly to ad hoc content take-down notices issued by the government. They also have put in place relatively strict self-policing measures in terms of handling sensitive user-generated content and copyright.

In other words, they have adeptly navigated their way from the grey market to the mainstream. “For quite some time, everybody in online video was technically operating illegally,” before regulations could be crafted, notes Mark Natkin, managing director of Beijing-based Marbidge Consulting. “But instead of cracking down immediately, the government sat back and observed how things worked because they didn’t want to kill the industry.… They just wanted to ensure that it developed in a way in which they are comfortable.” 

And developed it has. Online video in China was able to grow in leaps and bounds in an era when there was no legally available independent content, "and that’s only really possible where there is no incumbent,” asserted Victor Koo, Youku's CEO, during a presentation at the Foreign Correspondents Club in Shanghai shortlyafter that company’s IPO.

Koo noted that U.S. online video sites – including YouTube and Hulu — have more constraints than their Chinese counterparts in running drama series or other commercial content because it would mean competing head on with the "big six" media conglomerates — General Electric, News Corporation, Time-Warner, Viacom, Walt Disney and CBS. For the time being, he said, China is hugely fragmented, with hundreds of broadcasters owned by provinces and municipalities, much like the U.S. did in the 1940s before its consolidation.


Where the Money Is

Yet reminiscent of the early dotcom startups of the late 1990s in Silicon Valley, China's online video companies might be making lots of money, but are also hemorrhaging cash. With approximately 264 million unique monthly visitors in September, Youku's net loss widened 22.5% to RMB 167 million in the nine months of the year, and Tudou's narrowed 16.6%, to RMB 83.7 million.

While Internet startups do tend to burn through a lot of cash, video sites face a problem that is somewhat unique: The more viewers they gain, the more they have to invest in bandwidthand content. Youku had a 40% market share in terms of total user time spent viewing online videos during the second quarter of 2010 and Tudou had 23% during the same period.

Can revenue generated from selling ads help fill the void? Group M, a global media investment company, says that of the estimated US$44.9 billion of advertising spending in China in 2010, the Internet will account for slightly less than US$4 billion. Online video takes an increasing percentage of that, at roughly US$300 million, says Gong Yu, CEO of, a video streaming service for commercial content backed by China’s dominant search engine Baidu and Providence Equity Partners. Andhe adds “simple math” shows why advertising will be a cornerstone of online video revenue.

“The total revenue of online video ads is around RMB 2 billion, and we have a dozen players in the market to share this revenue,“ he says. Online video companies "normally get 60% of the ad revenue in the value chain," with the rest going to the ad agencies and other services. “Next year, ad revenue is expected to double to RMB 4 billion and assuming there will still be a dozen players … optimistically, there will be five companies making a profit; less optimistically, there will be around three companies breaking even.”

Lv Wensheng, founder of online video company and CEO and chairman of digital media investment group Corporation, is equally bullish. “As the online video market consolidates – with the investment barrier rising further and fewer players active in the market — alongside advertisers' growing budget, advertising revenue will increase significantly,” he predicts.

As advertising grows, there are questions about the viability of relying on subscription or pay-per-view revenue in a country like China. “I'm not betting big on a subscription model in the short term because pirated content in China still dominates the Internet," says Gong of QiYi, which — like Hulu — does not offer user-generated content as Youku and YouTube do. "If my web site were to charge users to view content but other sites have free content, users wouldn’t be willing to pay.”

But online video companies don't want to rule out subscription and pay-per-view models just yet.’s Lv says while China is still largely a cash-based economy, mobile and online payment technology will become more user-friendly. “Subscriptions will start from mobile channels, and then be driven by state-owned forces in combining'three-in-one'– telecoms, internet and broadcasting,” he says. Eventually, users in China will have two choices — view content for free but with ads and pay for high-quality content.


A Future with TV

Although online media might now seem like the inevitable usurper of terrestrial broadcasting, it would be unwise to write off China’s government-owned broadcasters. Although they have been losing viewers, they still have robust support from advertisers. In November, when it ran its annual auction of prime-time ad slots for 2011, party-controlled China Central Television (CCTV) pulled in US$1.86 billion, a 17-year high and a 15.5% increase over 2009.

“Marketers in China are very conservative," says WGA's Wolf. "Nobody will get fired for buying too many ads on CCTV [and] a lot of advertising [decisions] are not based on efficiency but on relationships and kickbacks.”

But a precipitous decline in viewership for state broadcasters may invite unwanted attention. “Realistically, I don’t think the Party is going to lose control of media,” says Wolf. “And when CCTV and [Shanghai Media Group] start to say, ‘These guys are stealing our ads and viewership and making it impossible for us to fill our political role as broadcasters,’ it will be a challenge. There is a considerable amount of risk in the system, particularly for the [online] companies because they are a long-term threat to the broadcasters.”

QiYi’s Gong Yu is more optimistic. He expects online video channels and traditional broadcasters to converge. “The future will be a combination of computers, TV and mobiles…. Some companies are better with this model, some are better with that model. We are not replacing each other,” says Gong.In the near term, “TV stations might have a small share of the online video market, and we might have a small market share of TV. I estimate that in 10 years, it will not be necessary to separate online video companies and TV stations.”

Youku's Koo reckons change will happen even faster. “In five years, television is just going to be an Internet-enabled screen,” he told the audience in Shanghai. And he dismissed concerns that the relationship between traditional media and online video sites will become adversarial, noting that sites such as his own are already cooperating with television broadcasters in promotion, distribution sales and production. “We don’t see that we are going to be competing with TV… and TV is not suffering,” Koo said, citing the high demand during CCTV’s recent auction and increasing viewership for regional channels, such as Hunan Satellite TV.

The deeper transformation will be in bringing an unprecedented level of media choice to Chinese consumers.For the likes of Youku to achieve that, says Wolf, “they are going to need much more investment, even more than what was raised by the IPOs. They are going to need the government to continue to be tolerant andmuch better ads salesmen.”

However, says Wharton’s Fader, “whatever the winning modelis, it's going to be chosen by consumers.”