Beneficiaries Of China’s 518 Million Internet Users

According to the China Internet Network Information Center, China has nearly 384 million Internet users – that is more than the entire U.S. population. However, it is still a mere 29% penetration rate for the country’s 1.3 billion population, compared with near 70% penetration in the United States. But online sales in China are growing. Analysts peg online sales for 2009 at $36.6 billion with an estimated 90% growth in the current year and Internet users to grow to 518 million. Last September, Taobao.com launched an online promotion by offering low prices on brand-name consumer electronics. The promotion attracted 1.8 billion visitors (non-unique).

Amid such positive trends, Alibaba (1688.HK) continues to prosper. Q1 revenues grew 49.3% over the year to RMB1.2 billion (US$178.7 million), driven by strong acquisition of paying members. EPS of HK$7.37 (~US$0.94) grew over the HK$6.28 (~US$0.81) earned last year.

Registered users crossed the 50 million milestone with the addition of 2.5 million users over the quarter and 10 million users over the year. Alibaba reported a total of over 658,700 paying members, recording growth of 36.8% over the year. International Marketplace revenues for the quarter grew 42.2% to RMB718.9 million (~US$105.3 million). In the quarter, the number of registered users in the company’s international marketplace grew 45.9% to over 12.6 million. China Marketplace Q1 revenues of RMB406.1 million (US$59.5 million) grew 34.9% over the year. Registered China members grew 19% over the year to cross 37.6 million uses.

Alibaba announced a number of new initiatives in the Chinese marketplace. It revamped the Chinese site to highlight the online wholesale transaction features of its marketplace. To accelerate member acquisition in the Chinese market, it is working on lowering the barriers to entry for membership: it recently launched a “China TrustPass Basic” membership on the China marketplace, which offers reduced entry-level membership fees and speeds up the migration process of small businesses moving from offline to online. The company also launched more value-added services (VAS) such as Premium Placement advertising to address specific customer needs.

Further, it launched AliExpress, an e-commerce platform which enables smaller-quantity orders, instant online transactions, and an escrow service to protect buyers and sellers. While Alibaba.com focuses on larger quantity orders, AliExpress will focus on addressing the needs of businesses that need smaller quantities for immediate shipment. Alibaba.com is looking to invest over US$100 million in the initiative. It has already tied up with PayPal for AliExpress to enable AliExpress merchants to access the benefits of using PayPal as a payment method. Businesses will now be able to source goods through AliExpress using PayPal in their preferred local currency.

The stock is trading at HK$16.20 (~$2.08), taking its market capitalization to HK$81.7 billion (~$10.5 billion). It touched a 52-week high of HK$22.50 (~$2.89) in September of last year.

However, despite the growth, China continues to be encumbered with government regulations and firewalling on content. Earlier this year, Google was forced to exit China over Internet regulatory issues. The search giant’s retreat has helped the Chinese search engine Baidu (NASDAQ:BIDU) command a quasi-monopoly in China with over 64% of China’s search market share in Q1 compared with 58% a quarter ago. Baidu is targeting to expand its market to 80% by next year.

For the quarter, Baidu reported revenue growth of 60% to $189.6 million. EPS grew 165% to $2.02. The market was looking for revenues of $189.6 million with EPS of $1.50.

Baidu attributes its significant growth to the new online marketing platform, Phoenix Nest. Phoenix Nest offers customers higher quality, more relevant paid links, and wider keyword coverage. Since Phoenix Nest’s launch in December of last year, customers can purchase a greater number of keywords with higher click-through rate over a wider range of queries, thus translating to superior returns for customers and higher online marketing budgets available for Baidu to tap.

Baidu is continuing to invest in growing its market. Earlier this year, it announced a tie-up with Japan-based Rakuten to jointly invest $50 million over three years to build an online B2C shopping mall for Chinese Internet users. Rakuten already operates a popular Japan-based Internet shopping mall, Rakuten Ichiba.

Additionally, Baidu’s independent online video content company, qiyi.com already has $50 million in funding from Hulu investor Providence Equity Partners. According to researchers, China’s online video market was approximately 162 million yuan (US$23.73 million) in Q3 2009, and analysts expect sales to triple in the coming years.

The company projects revenues to grow 67%–70% over the year to $268.1 million–$274 million compared with analyst expectations of $240.1 million for the current quarter. While Baidu has not given its annual projections, the market expects the company to deliver $905.5 million revenues for the year 2010 with EPS of $8.92, a significant growth from previous year’s $651.6 million revenues and EPS of $6.62.

The stock was trading at $76.12 after a 10-for-1 stock split with a market capitalization of $26.5 billion. It touched a 52-week high of $82.29 earlier last month.

At the end of the day, China, like India, is a numbers game. Alibaba and Baidu will share the bulk of the monetization potential of 518 million Internet users this year. Over the next five years, Internet penetration in China will likely continue to soar. For the foreseeable future, I see no end to the growth prospects of either company. While today’s 50%–60% growth rate may slow down to 20%–30% in a few years, it would still make for enviable momentum.