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The Impact of Censorship On China’s Fastest Growing Web Companies

The Great Firewall of China is something most American’s are alert to; whether it's Google’s (GOOG) exit from the country in 2009 or the U.S.-parallel companies like Baidu (BIDU) that seek to

The Great Firewall of China is something most American’s are alert to; whether it’s Google’s (GOOG) exit from the country in 2009 or the U.S.-parallel companies like Baidu (BIDU) that seek to replicate American sites on the limited Chinese internet. The most recent development that 39 Chinese internet companies were called together in a meeting with the China’s government, for a discussion on further heightening censorship, has once again called attention to the perils of being a web company operating in China.

The businesses involved in the meeting are said to have agreed to the more intense monitoring against “harmful “ information, which is disconcerting both from the American perspective on censorship and  the potential impact of the measures on growth at top Chinese web companies. Whether Chinese internet leaders will continue to operate is not in question. In many cases, Chinese citizens are limited to these sites and will continue to visit, if not as frequently as those who enjoy the Internet playground without a fence. The monitoring, though, can be expected to hinder profits, with the larger corporations required to employ a monitoring staff of hundreds, simply to comply with the government’s stringent censorship demands.

The direct fiscal cost of monitoring is only one negative corollary to the measures. The lethargic loading rate of many sites and the threat of surveillance reduce level of enthusiasm and amount of time Chinese citizens spend on the web.

Michael Schulman, a Chinese journalist for Time discussed this issue in a recent blog, “Major international sites, including Twitter, Facebook and YouTube, are completely blocked here. Certain searches are impossible, emails are monitored, many web pages simply won’t open, and others open so slowly (like this blog) that only the most patient or determined will endure the wait.”

Schulman adds that during periods of political sensitivity, the Internet can slow to a point where it fails to function because of the surveillance and blockages. The severity of censorship is an obvious impediment to internet companies, as users are discouraged from bouncing site to site or sharing information during critical times. Youtube and Twitter are both sensations because of the manner in which it encourages users to share groundbreaking, of-the-moment content in the blink of an eye. The government is cracking down on their Chinese equivalents Youku (YOKU), Sina (SINA) and Tencent (TCTZF), which have become platforms for extrapolation and real-time discussion that regulators have struggled to cage.

Schulman’s statements represent the double-edged sword of Chinese internet investment. Major popular sites are blocked, leaving a massive population to access exclusively Chinese-run search engines and social networking platforms. The sites may be worse, but they are all that is available. Interaction will not be as easy or as enjoyable, but it will be all most Chinese citizens know.

Free-form discussion is not the only thing Chinese internet users will be missing out on. The government also intends to censor what it considers “harmful” content, such as certain political pieces or pornography. The absence of compelling topics can be expected to negatively impact both the Chinese people, who will not have as much intellectual information at their disposal, and the internet leaders would otherwise profit from housing such content.

Even with clunky service, riddled with blind spots, the Chinese will not abandon the internet. The web leaders there have the unique advantage of a captive audience with no other options. There are roughly 500 million registered internet users according to Chinese government reports. That’s only one-third of the total population, but still well beyond internet usage in any other nation. The censorship can be expected to blunt interest and cap global competitiveness on a long enough timeline, but for the moment, Baidu, Youku and RenRen (RENN) possess the advantage of novelty. They will not be unencumbered, but they will be profitable.

The Internet will never have the exact same role in China that it does in the United States, Europe, India, or any other nation that allows free discussion. Maintenance costs, as a consequence of the added man power, will never be as low as they are elsewhere. Monitoring fees will cut the profits on every page view. That’s among the reasons why popular sites like Sina (SINA), that should be booming, are still reporting quarterly losses. Sina is the largest internet portal in China, but higher costs excise a massive portion of its growing revenue. Even with a 20-percent increase in revenue during the latest period, Sina reported a loss of $336.3 million. The latest set of measures can be expected to intensify those overheads, but eventually higher expenses can be projected to be negated by a massive, captive audience.

The next earnings season will be especially interesting for social networking companies, like Renren, that will have the most work to do in terms of monitoring as a result of the more capricious content creation. The initial impact of government regulation has the potential to be highly detrimental, and it may take them longer than other companies to develop an effective censorship strategy. This could cut into profits, but with more users joining every day, growth, even if it’s slower and interaction is weaker, can be anticipated.

Meanwhile, the success of Baidu, which has added over 40 percent to its share price YTD is essentially built in to the growing population. Censorship overhead and its China-centric appeal will likely keep it from Google-level global dominance. The topical limitations on Baidu results will surely keep the company from performing to the levels it otherwise could, but Baidu has considerable revenue potential regardless simply by the sheer number of people who will use it for at least basic searches. What Baidu loses as a result of the shorter duration of visits that can be predicted will likely go to other Chinese companies unimpeded by censorship, specifically game makers and e-commerce sites.

In the absence of sexual, historical and political content, Chinese internet users could will perhaps  spend more time gaming and shopping on e-commerce sites. In August, the Economist predicted that these areas will quadruple in profitability by 2015 to $305 billion. Alibaba, whose Taobao websites are essentially the kingpin of Chinese web commerce, reported earnings growth beyond that of Baidu. The strength of the company, which Yahoo! (YHOO) has a 39 percent stake in, would seem to indicate the disadvantage of heavy censorship on profits. Perhaps the Chinese will ultimately use the Internet differently than we do. Videos and social networking will still be popular from a numbers standpoint, but the absence of compelling materials may drive the Chinese down less cerebral avenues.

The increased censorship will not appear to be reflected in the revenues of the major sites that we hear about like Baidu and Tencent; those companies will grow. Internet usage is increasing, the economy is growing and by extension, their profits are expected to flourish, but they are unlikely to reach the potential of the American sites they were modeled after. The censorship will have an effect on internet dynamics and the way Chinese people interact on the web. This, in turn, will cap potential even if the zeroes on the earnings sheets don’t look it at first.

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