NETSCRAPE
Sina, Sohu.com and NetEase have seen it all: boardroom coups, investor lawsuits, trading suspensions, a crashed-out stock market and smothering regulations. But against the odds, they grew smartly in 2002 and have now taken their place among a mere handful of profitable portals worldwide.
By Jasper Moiseiwitsch

If you think your 2001 was bad, consider the trials of NetEase, one of China's feisty handful of Nasdaq-listed internet portals. NetEase began the year with the departure of CFO Helen He, who complained of health problems. In August, a possible source of her affliction was revealed: the company's financial statements had overstated its 2000 revenue by US$4.3 million. NetEase's CEO, COO and sales director soon followed He out the door. As NetEase sorted through its accounting mess, it delayed filing its 2000 annual report, prompting Nasdaq officials to threaten to delist it in July 2001. It dodged delisting but, in September, Nasdaq suspended trading of the stock and, the following month, investors launched a class action against the company.

So far, all according to plan. NetEase had all the appearances of being another dotcom dud that was dragging investors and their dollars into the lowest circles of New Economy hell. But here's the twist. NetEase has since turned itself into a high-growth, profitable company. Its revenues spurted 722 percent in 2002 and, in its most recent results announcement, it reported a US$8.3 million quarterly net income on revenues of US$14.2 million. Its share price has risen 1,650 percent in the past 12 months.

NetEase's turnaround has been mirrored by China's other two Nasdaq-listed portals, Sina and Sohu.com. These companies also had a miserable 2001 - big losses, slim revenue, share price slide - but are now likewise reporting sharply rising profits. Their staying power has been a largely ignored phenomenon in this graveyard season of dotcom duds. Asia's other listed dotcoms, which generally came to market earlier and executed much richer IPOs, have not fared as well.

Tom.com (listed March 2000) raised US$174 million in its IPO and follow-on and has yet to report a profit. Chinadotcom (listed July 1999), raised US$495 million in its IPO and follow-on, but only reported a meager US$1.2 million in profits in its Q4, 2002 results - its first since 2000, which were wiped away by year-end writedowns. Hongkong.com is profitable but makes most of its money from interest earned off its IPO proceeds. All three have largely given up on the portal business, diversifying into other areas such as software distribution, publishing and advertising.

And does anyone remember asiacontent.com, asia.com, cwow.com, looks.com, onewoman.com, asiangames.com, myrice .com, yeah.net, kimo.com, cninfo.net or elong.com? Like place names on an ancient map, they're gone with few traces.

Yet China's Nasdaq three have survived thanks to a combination of grit, cleverness and the good sense to understand the needs of China's internet-savvy end-users. Given the disasters that have struck them in Asia and elsewhere, dotcoms were assumed to be capital-raising vehicles with airy business plans that few - apart from some credulous investors - took seriously. In fact, the China portals have hung in long enough to take a crack at making them work. And they are - just.

"It was amazing," says Duncan Clark, the Beijing-based managing director for consulting group BDA China. "These companies ran through minefields. And, in a sense, I somehow think that pressure created really strong companies."

Shocked and Confused

What's true for NetEase has been true for the others. Sohu.com was the first of the three living China portals to announce profitability, becoming GAAP-positive in the third quarter of 2002. Over each of the ten quarters since Sohu.com went public in July 2000, it has reported sequential double-digit revenue increases. In its latest quarter Sohu.com filed net income of US$4.6 million on revenues of US$14.4 million and its share price has come up 700 percent over the past year.

Sina, the biggest and richest of the three portals, trails the other two. Nevertheless, the company reported US$3.4 million net income on revenues of US$18.1 million in the latest quarter. Sina lost US$4 million in the same quarter a year ago. Its share price has risen 340 percent in 12 months.

The portals' success in 2002 is even more impressive when you consider their collectively dire 2001. NetEase CFO Denny Lee recalls that miserable year with an air of embarrassment. After all, the company did lose most of its management team, not to mention US$28.1 million on revenues of US$3.4 million. It was NetEase's revenue misstatement, however, that inflicted the most damage. For its 2000 annual results, the company improperly booked US$2 million in barter revenue, and erased from its records a further US$2.3 million of income based on dubious advertising contracts, which, vaguely, "lacked economic substance".

Problematically, NetEase included its 2000 Q1 results in its IPO prospectus and NetEase listed before its earnings restatement. This opened up the company to charges that these Q1 results were "materially overstated" and that the company had performed "accounting manipulations" to get itself listed. NetEase settled the lawsuit with a US$4.35 million payout.

Lee, a former KPMG auditor who was brought to NetEase to restore internal controls, says the scandal took the company to the edge of oblivion. "The new management team knows that the earnings misstatement was a very big problem. Another mistake like that could be catastrophic for the company," says Lee.

NetEase was not alone in its turmoil. Sohu.com was caught in a general shareholder revolt against dotcoms and its share price slumped in line with that loss of faith. Sohu.com spent a good part of 2001 bumping along the US$1 Nasdaq share limit, which put the company in danger of being delisted. Like the others, it was losing money: it booked a net loss of US$36.3 million in 2001 on revenues of US$26.6 million .

Risk Factors

Meanwhile, down the road, Sina was battling through its own wretched 2001. Sina lost US$43.5 million for the year on US$13 million in revenues as it found that its base of online advertisers - other dotcoms - was drying up. After floating at US$17, Sina found its share price dragging at the sensitive US$1 threshold for most of 2001 and it was also a delisting candidate.

Amid all this, the Sina board ousted its founder and CEO, Wang Zhidong, in June 2001, explaining only that he was no longer the right man for the business. Wang held an impromptu news conference declaring himself "shocked and confused" by the action and publicly fought the company for a settlement.

Sina CFO Charles Chao doesn't elaborate on why Wang was thrown out, saying only that, "his background was not suitable for the company." Wang is a former star software programmer. But former Sina CEO Jim Sha, who clashed with Wang before resigning in August 1999 (see "Coup City," below), offers some insight into the events leading to Wang's departure.

"People inside and underneath were very frustrated in terms of the recognition and compensation they were getting [relative to Wang]. It came to the point, for some of the very important management people, where it became either them or Wang," says Sha.

In his act of striking back, Wang threatened to take control of the company's internet content provider (ICP) license, with which Sina.com legally accesses all of its internet content.

At the time of their listing, the PRC government forbid foreign investment in China's internet companies. Sina, an amalgam of Hong Kong, BVI and California-registered companies, got around this rule by taking content from the locally owned Beijing Sina Internet Information Services Company, which holds an ICP license. Sohu.com and NetEase made similar arrangements when they floated.

At the time of his dismissal, Wang Zhidong owned 70 percent of Beijing Sina Internet Information Services, and his ability to take control of the ICP was outlined in the "risk factors" section of Sina's 2000 annual report. The report stated: "The ICP Company is controlled by Zhidong Wang, our president and chief executive officer. As a result, our contractual relationships with the ICP Company would be viewed as entrenching his management position or transferring certain value to him, especially if any conflict arose with him."

It seemed entirely prescient, but Sina CFO Chao takes pains to explain that the company was never at risk, and that Wang never had the right to walk away with the ICP. "Eventually he [Wang] realized he did not [have that option]," says Chao, laughing. "At the time he was a little bit emotional...All I can tell you is that it's not true that he had control [of the ICP] and there was obviously a misunderstanding." Chao says Sina's ICP is contractually bound to provide content to the portal, and that Wang never had the right to end that arrangement. "Legally we feel comfortable in terms of our control [of the ICP]. That has been proven by many, many lawyers," he adds. Nevertheless, the company has since acquired Wang's share in the ICP company, and Wang found the settlement he fought for. At the time of his departure, Sina bestowed on Wang the title "Honorary Chief Sina" and gave him a one-year consultant's salary worth US$275,000. Wang was also granted free options on 107,310 Sina shares that were immediately exercised and then repurchased by the company (for about US$186,719). Sina also forgave two company loans to Wang worth US$370,178 and Rmb50,000 (US$6,047). Wang's total take: US$837,944. Following that agreement, 60 percent ownership of the ICP was passed to the Sina CEO, Daniel Mao, and president, Wang Yan (Mao has since resigned but remains on the board and Wang Yan has taken over as CEO). Four unnamed Sina employees hold the remaining 40 percent.

Dotcom, Meet Profit

SMS, or short messaging services, have pulled Sina, Sohu.com and NetEase to profitability. SMS applies to anything that can be downloaded or billed via mobile phones, and includes elaborate handset icons or ring tones that mimic that latest pop tune. It is a growing market. Pyramid Research, a telecoms research group in Hong Kong, estimates that SMS generated US$750 million in revenues in 2002, and that this income will grow to US$16 billion by 2007.

None of the portals booked SMS income at year-end 2001, their worst loss-making year. But in 2002, when they did roll out these services, they all started making money. Sina CFO Charles Chao says SMS contributes about 30 percent of company revenues. It is a similar story at Sohu.com, which derives 48 percent of revenue through sales of mobile content, and NetEase, where SMS income makes up 40 percent of revenue. All are experiencing strong growth and fat margins in that segment.

Sina, Sohu.com and NetEase have developed hundreds of SMS applications from the basic, such as graphics and ring-tone downloads, to the more sophisticated, such as news bulletins, dating services and mobile games. For example, for Rmb30 per month Sina will beam daily news bulletins to subscribers' handsets.

SMS has lifted the portals to the internet holy grail: the so-called monetization of the user base. They are extracting from their users small fees for tiny services, and they can do this thanks to their access to the payment systems of the mainland's cellular operators. China Mobile and China Unicom monopolize the PRC mobile industry and they have billing relationships with 200 million subscribers. The mobile operators tack the portals' services charges onto their monthly bills, and then collect about a 15 percent payment fee.

See-same Street

The arrangement has problems. Some say the portals have not always received the money they were owed from the carriers, or that the carriers have been slow to pay up. Subscribers might change numbers creating confusion over whom should be billed, and users have found ways to eke out extra time on prepaid debit cards, which leads to disagreements on billing amounts.

None of the three portals say they have SMS billing problems. But that may say more about the portals' dependency on China Mobile and Unicom as payment gateways than it does about the relative harmony of their working arrangements.

Cyrille Even, vice president Asia for Mobileway Asia Pacific, an SMS company with operations in China, says billing spats are indeed common, and these disputes are not so much settled as waved away by Mobile and Unicom. "When you are a carrier, you have only so many resources to deal with the content providers...they [China Mobile and China Unicom] are usually not flexible [regarding payment disputes]," says Even.

China Mobile and China Unicom also directly compete with the portals: they have launched their own websites that sell other companies' "white labeled" SMS graphics and ring tones. Even says most of the SMS content posted on the portals and the carriers' websites comes from third parties, such as Japanese and Korean SMS content makers.

This points to the other weakness of the portals' SMS model: the easy replication of the applications. There is little more that can be done with ring tones that has not already been done and one site's SMS logo offerings look similar to the others.

Sina and Sohu.com have launched legal suits with both sides accusing the other of pirating their SMS intellectual property. In December 2002, Sina won a first round: a Chinese court ruled that Sohu.com had plagiarized 383 of Sina's mobile phone icons, and ordered Sohu.com to pay damages of about US$18,000. Sohu.com is counter-suing Sina - it is also claiming that Sina has copied its online SMS property.

Sohu.com is appealing against the court's ruling, but it doesn't deny that Sohu.com staff may have copied Sina's materials. When Sohu.com chief operating officer (and former CFO) Victor Koo and spokesperson Caroline Straathof are asked if Sohu.com's alleged pirating acts did take place, they shift around in their seats, glancing uncomfortably at each other. "It could have happened, sure," Straathof finally confesses. She believes, however, that Sina's rights to the graphics are dubious. Adds Koo: "We don't agree with the agreement [the court finding]. And we can probably say that Sina did the same thing."

The Magnificent Three

In their darkest 2001 days, morale at the portals withered. NetEase CFO Denny Lee says workers feared for their company's survival amid its delisting struggles. Sohu.com was laying off staff following its US$30.8 million acquisition of rival portal ChinaRen.com, when it consolidated operations between the two. Sina was sacking staff simply as a matter of addressing its losses and lousy business prospects.

But from crisis grew strength. In BDA China's Duncan Clark's view, the portals have survived so many immolations in their short history, it's as if they have been through a refiner's fire which has hardened them into tough, profit-minded enterprises. They have, for example, been creative in figuring out new business lines. NetEase has focused on its online gaming, from which it gets most of its earnings growth. With a jealous eye on NetEase's success here, Sina and Sohu.com have followed NetEase into the games business. All the portals have taken to licensing software from the Koreans, who are the center of the industry in terms of subscribers and product development. NetEase licenses Prison Tale from the Koreans. Sina has signed a deal with the Korean developer NCsoft to launch Lineage - Asia's most popular internet game - in China.

Sohu.com recently announced a similar agreement with another Korean software company, Wizgate, to release the internet game Knight Online.

Sina, Sohu.com and NetEase are also among the few internet sites worldwide that make money out of online advertising. Sohu.com says its online advertising income rose by 72 percent in 2002. Sina booked US$7.4 million in online advertising dollars in its most recent quarter (57 percent of revenue) and reported 44 percent growth in that segment. NetEase trails in this market but it still reported a 27 percent increase in ad revenue in fourth quarter 2002.

The portals have also been lucky. Lucky because competition has been scant since the dotcom bust. Lucky that China's mobile industry is concentrated in the hands of two operators that have offered them their billing relationships.

Bless These Companies

For all their progress, the portals attract minimal research coverage, suggesting scant institutional holding. Sina and Sohu.com have also been busy in that activity that sends investors to the exit doors: management selldowns of company stock. Sohu.com founder and CEO Charles Zhang filed to sell 240,000 of his company's shares in January-February 2003 (for about US$2.1 million). "He is an over 25 percent shareholder, and he has never sold shares since founding the company. That's all I need to say about it," says Sohu.com spokesperson Straathof.

Sina has been much more active on that front. SEC filings reveal that former president and now CEO Wang Yan, Charles Chao (CFO) and Hurst Lin (vice president) sold Sina shares in late January and February, worth a combined US$1.4 million. Stone Group, a joint venture that holds Sina shares for founding shareholders and Lan Yang, a mainland TV personality, have also filed recently to sell 775,000 shares in the portal.

"The general perception is that everyone has been filing [to sell Sina shares]. It's reflected in Sina's share price," says Duncan Clark of BDA. Sina's share price has fallen by about a third since news of these selldowns hit the market.

Sina also suffers from that other affliction affecting so many Nasdaq dotcoms: rich executive compensation schemes. Sina granted 2 million stock options to former CEO Daniel Mao, which were on top of an annual base salary of US$277,083. The options are exercisable at US$1.68 (compared to Sina's current trading range of US$6-7). In rumblings not dissimilar to those made prior to Wang Zhidong's ouster, insiders say that some Sina staff are unhappy with the size of Mao's options grant.

Sina CFO Charles Chao says he has not heard of any internal complaints regarding Mao's compensation, adding simply: "The board believed that was the right compensation for the CEO." But one insider in the Beijing portal scene says this: "Within our circle [Mao's option scheme] is considered a lot. It's probably the most generous options grant out there."

But the negatives don't justify outright skepticism. Consider a Merrill Lynch report of October 2000 (Three Kingdoms) which outlined the investment case for Sohu.com, Sina and NetEase. Co-written by ex-analyst Matei Mihalca, a dotcom supporter, it weaves through the portals' stories in the vague terms current at that time. It speaks hopefully of ADPV (average daily page views) figures and CPM (cost per thousand ad impressions), and somehow gleans from these figures forecasts of the portals' revenues and profits.

The amazing thing is that the report underestimated the companies' potential. It predicts the portals would not be profitable until 2004, and then only just. The portals beat those estimates by a full two years, as they are beating the report's estimates on gross profit margins. They have plenty of cash, little debt and are impressing investors with their growth and profitability. Few portals in the world are finding themselves in such a blessed place, and in China there are three of them.