The Profitability Predicament

According to the current business mantra, any company that wants to be global has to do business with China. And international internet companies were not slow to try to exploit the Chinese market for its huge user base. They were initially confident about conquering the market, given that they had always performed well in non-domestic markets and rapidly became market leaders with a strong presence. However, no matter how great their achievements outside China, their initial success in China faded in the end. It seems that they did not know exactly what Chinese customers want and, for one reason or another, they failed to find a formula that would allow them to hold onto or win over Chinese customers.

Examples such as this leave many multinational companies with haunting questions: What makes the Chinese market so different? And specifically, what did Chinese internet companies understand that foreign entrants failed to grasp?

Many point to unfair competition from obstacles like the infamous China firewall, and while it may be true that the objectives of foreign market entrants such as Google and Amazon are complicated by their US-based operations, this explanation fails to grasp the more fundamental challenges of succeeding in China—challenges faced by indigenous and foreign players alike.

Indeed, the success of Chinese internet companies is due to their ability to develop business models that account for inherent Chinese qualities, namely the issue of piracy, consumer concerns over online security and consumer unwillingness to pay for services. Chinese companies may not yet be well-rounded competitors in terms of technology, innovation, marketing, and the like, but they know how to interpret local customer behaviour and translate it into revenues in an innovation way.

Issue of piracy
Piracy on the internet is often associated with customers’ unwillingness to pay. The perception that everything online is free is ingrained in people’s minds. However, demand in this market does obviously exist. Otherwise, piracy would not be rampant. The question is how enterprises can fulfill—and even create—people’s needs and monetize them simultaneously.

Originally, Chinese company Baidu provided an MP3 music download service. However, as a result of the illegal downloads, Baidu became entangled in lawsuits over copyright with seven music companies. Instead of dispensing with the music service, it sided with its users and kept the service, but solved the problem in an innovation way. Baidu actively sought partnerships with leading music companies and launched an advertising-supported streaming service. While consumers listened to the music gratis, they would be targeted by internet advertising according to their interests. Baidu split the advertising revenue with the music companies, and at the end of the first quarter of 2011, Baidu’s net profit, most of it generated from advertising revenues, had more than doubled compared with the same period the previous year.

The online games industry has also come up with innovative ways of combating piracy. Shanda, a leading interactive entertainment media company in China, is famous for the most popular massively multiplayer online role-playing games (MMORPGs). The technology used to link hundreds of thousands of people simultaneously playing games over the internet (not on personal computers) removes the possibility of piracy.

Overcoming online payment problems
Credit card penetration is relatively low in China, and concerns over the security of online payments make those consumers who do have credit cards wary of using them to pay for internet services. In order to remove payment barriers, game companies distribute prepaid cards to local merchants, where players can buy them with cash.

By December 2010, around 300 million people in China used mobile phones to surf, to shop and to read novels online. Mobile media users are becoming accustomed to paying for various applications and, indeed, are increasingly using their mobile phones to pay for other products and services. Mobile payment does not require any extra effort—Chinese users just enter their cellphone number and at the end of the month receive a single bill, itemizing all the goods and services they have used, alongside the mobile phone contract fee. It is as convenient as a credit card, with one bill per month regardless of how many times user pay for various goods and services. Thus, by overcoming payment problems, the willingness to pay is greatly increased through mobile phones.

Overcoming unwillingness to pay
Increasingly, internet companies the world over are realizing that they need to make people want something so much that they do not mind paying for it and, indeed, understand the value of what they are getting.  To this end, free trial of an online game routinely precedes the official launch so that players can sample a few levels without charge. Once they are seduced and eager to experience more, the game-maker achieves payback.

Another good example is internet company Tencent’s QQ show, launched in 2003. This virtual avatar game has become something of a mania with teenagers and students.  All players need is a free QQ account and a virtual image representing them. Each image is granted 100 sets of basic virtual clothing, hairstyles, faces and accessories, but if players want to try out the Adidas t-shirt recently endorsed by a movie star, they either have to buy Q coins (virtual credits) or become a member of the “Red Diamond” club, where they have a choice of 50,000 outfits, hairstyles and accessories.

Likewise, Shanda’s most famous MMORPG—The Legend of MIR—allows players to purchase virtual weapons and equipment, including more than 40 different swords featured in typical Chinese Kung Fun novels. Consumers do not have to pay, but with such enticing options available, they want to.

In both examples above, consumers are only required to pay small amounts in order to have full access to the virtual options that allow them to individualize their virtual personalities. However, small amounts multiplied across China’s vast population can mean big profits for internet companies.

Shanda capitalizes well on this principle with its Shanda Literature, a web literature business and part of Shanda Group. On its market-leading website dedicated to original fiction, readers can download 100,000 words at a cost of just RMB 2-3 ($0.30-0.50). People who sign up as writers on the site can publish their stories in serial form. If their work attracts a large number of readers, the website editors call the writers and ask if they would like to sell the copyright. Once the contract is signed, their works are displayed in the site’s VIP section, where readers can read a certain number of chapters for free and then pay for the rest of the novel. The website then splits the profit equally with the writers.

Free access to material on the internet is the lowest-cost way to reach the largest number of people. As long as readers wish to read the remaining chapters, they will pay for them. Moreover, the literature website adopts a low price strategy, but the more readers it attracts the more profit it reaps.

While Chinese internet companies may face the same challenges as foreign competitors, they have very flexible business models. Unlike multi-national rivals who indiscriminately apply to China the models implemented elsewhere, they constantly adjust to customer needs and accept the reality of consumer demands. Rather than operating as though piracy will be regulated or that customers will accept to pay for basic services, they approach the market with creativity and innovate in such a way that profitability is made possible, even in China’s rigorous business context.

Winter Nie is a Professor of Operations and Service Management at IMD. She teaches on the Managing the Global Supply Chain program.

[This article has been reproduced with permission from IMD, a leading business school based in Switzerland. http://www.imd.org]