The ICT landscape in the PRC market trends and investment opportunities

33188 The ICT Landscape in the PRC Market Trends and Investment Opportunities FINAL REPORT MARCH 2005  Preface Information and Communications Technologies (ICT) are increasingly an important tool for supporting sustainable development and economic growth in developing markets. By embracing communications at unprecedented rates, people around the world have demonstrated their appreciation for the contribution of ICT to the betterment of their lives. It took 113 years from its invention for the fixed telephone to reach ten percent global penetration. It took 15 years from its invention for the mobile telephone to reach the same penetration, and ten percent of the World's population are now Internet users less than twelve years after the birth of the World Wide Web. China's growth story, for ICT companies specifically, has been astonishing. China, often referred to as the "factory of the world" has traditionally had a strong manufacturing base, including a core focus on the electronics industry. In addition, in the past 10 years, we have seen an explosion of the mobile phone population to over 300 million subscribers, larger than any other country in the world. Further, the country's total number of Internet users has surpassed 90 million subscribers. Historically, sectors such as electronics manufacturing and mobile communications applications have enjoyed the benefit of growth, while we can already see new nascent sectors come up including media driven business, broadband applications and cutting-edge IC design houses. While much of the growth in the ICT sector has been funded by foreign investments, mainly through the private and public equity markets, it is anticipated that many sectors require substantial and ongoing funding. It is anticipated that such funding by international investors will continue to outpace domestic funding sources The International Finance Corporation (IFC) is committed to maintain and increase support to private sector businesses in China, in the ICT space. While in the past 15 years IFC has committed to over US$1.8 billion of investments in China, we envisage an increased participation in the domestic ICT sector, by providing a full array of financial products and services along with technical assistance regarding such matters as corporate governance. This study is sponsored and funded by the Swedish International Development Corporation Agency (SIDA). IFC would like to express its sincerest gratitude and appreciation to SIDA for its important contribution and support. The study represents an important tool and roadmap for private investors in supporting the ICT industry in China. Another key consideration is IFC's role in mobilizing funds by working with domestic and international financial and strategic partners. 2  Mohsen A. Khalil Javed Hamid Director Director Global Information and East Asia and Pacific Communications Technologies The International Finance Corporation 3  PRODUCED FOR IFC BY SPINTRACK AB AND BDA CHINA LTD: BJORN SODERBERG TED DEAN SPINTRACK AB BDA CHINA LTD bjorn.soderberg@spintrack.com ted.dean@bdachina.com JOHANNA BJORKSTROM XIA WEI SPINTRACK AB BDA CHINA LTD johanna.bjorkstrom@spintrack.com wei.xia@bdachina.com LIU BIN FANG MEIQIN BDA CHINA LTD BDA CHINA LTD bin.liu@bdachina.com meiqin.fang@bdachina.com S P I N T R A C K A B DROTTNINGGATAN 99, 7 TR., SE-113 60 STOCKHOLM, SWEDEN PHONE: +46-8-528 00 310 FAX: +46-8-528 00 315 WWW.SPINTRACK.COM INFO@SPINTRACK.COM BDA (China) Ltd. #2908 North Tower, Kerry Center, 1 Guanghua Road, Beijing, 100020, China PHONE: +86-10-8529-6164 FAX: +86-10-8529-6163 www.bdachina.com contactus@bdachina.com 4  Executive Summary The following report is the public deliverable of an IFC project which was funded by the Swedish International Development Cooperation Agency (Sida). The project was carried out, and the reports produced by Spintrack AB in close collaboration with and with significant contributions by BDA China Ltd. General Market Conditions in China Growing consumer demand coupled with continued growth in the export-led manufacturing sector has fuelled growth in China's gross domestic product (GDP). Continued growth in imports and exports tells a similar story of robust economic growth. Despite this growth, private companies (particularly smaller IT companies) in China have traditionally had limited choices when it comes to raising capital domestically. Instead, Chinese IT companies have turned to foreign investors to fill the void. Foreign investors have responded aggressively. In recent years, the initial public offerings of a growing number of Chinese companies and the sale of still more companies to foreign IT companies has proven to investors that they can exit from their investments in China. As a result, the pace of investment has accelerated. In 2004, venture capitalists invested USD 1.269 billion in 253 Mainland China or Mainland-related companies according to the research firm Zero2IPO. The number of deals was up 43% from 2003, and the funds invested increased 28% from the previous year. As the pace of investment has increased, valuations in some sectors have shot up, and there has been speculation that some sectors are becoming overcapitalized. But with the domestic venture capital industry still in its infancy and most foreign investors being new to China, investment flows have tended to be concentrated in a few "hot" sectors. Other sectors, where the regulatory risks are greater or the development cycle is slower are still starved for capital. The State of the IT and Telecom Sectors Uncertainty over how the government will address issues such as 3G licenses, potential restructuring of the state-owned telecom operators, development of Chinese technology standards, opening of the market to foreign telecom operators, development of a system for a Universal Service Obligation, and the control and censorship of content and applications offered over fixed-line and mobile telecom networks, remains a consistent concern of industry players, complicating their business planning and ability to raise capital. Ongoing reform is however gradually leading to a more transparent regulatory environment. As part of these changes, China's regulatory agencies are shifting away from an economic planning function to act as more independent regulators. 5  The mobile subscriber base has now surpassed the fixed subscriber base, with fixed-line penetration of 25% (including PHS) and mobile penetration of 26% mobile (GSM and CDMA). The number of Internet users reached 94 million at year-end 2004. China's Internet access market is in the midst of a migration from narrowband to broadband access. Total broadband users in China reached 26 million in 2004, compared with the 1.9 million in 2001. The timing of 3G license issuance, which operators will receive licenses, and the selection of technology standards remains uncertain. China Mobile is certain to receive a license for W-CDMA, and Unicom is expected to upgrade its CDMA network to EVDO, but whether both fixed-line operators will receive licenses and what technology they might deploy is still undecided with China's TD-SCDMA standard representing the biggest wild card. The possible break-up of China Unicom is another complicating factor. It is widely believed that the government will delay the issuance of 3G licenses until the second half of 2005 at the earliest. IT Sub-Sectors Covered in the Report The report cover the following sub-sectors: - Infrastructure and Software Telecom Equipment The Chinese IC Industry and Fabless Chip Design The Chinese Software Industry Security Services - Applications Mobile Data Online Gaming E-commerce Digital Media Applications - Outsourcing Software outsourcing and IT Services Handset Design in China Telecom Equipment Foreign IT and telecom equipment vendors are well established in China. In fact, foreign firms in these sectors are among the largest foreign investors in China and the largest exporters from China. Domestic IT and telecom equipment vendors have emerged from the shadow of foreign market leaders and won significant market share in important market segments. In mobile handsets, domestic vendors have won close to 50% share in a market that was once completely dominated by foreign vendors. In ADSL, Huawei alone holds 44% of the 6  market, while two other domestic vendors, ZTE and Harbour Networks, hold an additional 16% and 9% share respectively. Thanks to improved R&D, domestic vendors are also expected to take a larger share of China's 3G market, once licenses are issued. Huawei and ZTE in particular have mature 3G products and are likely to win a significant slice of operators' capital investment in 3G networks. Increasingly, leading domestic vendors have global ambitions for their business. Lenovo's recent purchase of IBM's PC business for USD 1.25 billion in cash and stock is the most significant example of a Chinese company expanding overseas, but Lenovo is not alone. In fact, the Lenovo-IBM deal is part of a continuing trend of Chinese firms striking deals to expand their business overseas. The Chinese IC Industry and Fabless Chip Design Due to the growing domestic demand of electronic products and the development of foundries, the growth of the Chinese IC design market is set to continue. Nevertheless, despite the growth in demand and manufacturing capacity, China still trails other markets in terms of domestic design capability. In order to succeed, the Chinese IC industry will need to identify or create new applications (i.e. DTV) or market opportunities. Human resources continues to be a bottleneck with experienced IC designers and professionals with experience in managing the design process in short supply. Highly educated overseas Chinese are returning to mainland China, but not in sufficient numbers to fill the industry shortfall. The Chinese Software Industry The Chinese Software Industry has grown rapidly in the last few years, reaching RMB 163.3 billion (USD 19.67) in 2003. The annual growth for 2004 was expected to reach 29%. Private and foreign software companies dominate the market while many Chinese companies are attempting to qualify for international standards with an eye on the international markets. Currently, Japan is the biggest market for Chinese software exports, followed by the US. Government investment in software represents a major market for software companies, and an increasing demand from small and medium-sized enterprises is helping to drive the enterprise software market. Security Services The security market is signified by a split between corporate and government markets with the domestic (and government backed) companies focusing on government projects, and private and foreign companies focusing on the fast growing corporate market. Government projects are gradually opening to private domestic firms, but foreign firms are unlikely to be able to win government projects. The corporate market makes up the majority of the Chinese security market. This sector is growing rapidly as security threats escalate and dependency on IT systems grows for both multinational and domestic enterprises. 7  The Chinese government tightly controls the security products market requiring vendors to obtain official approval to sell security-related products. Some security technology and products are restricted to only state-owned companies that are appointed by the government. Mobile Data The Chinese mobile market is the largest subscriber market in the world. With a number of mobile data companies already listed, there is a proven pathway to an exit in the sector, either through an IPO or a sale to one of the already listed companies. New opportunities are likely to only exist in new applications where technology transitions open up new markets. The dependency on mobile operators constitutes a significant risk for all companies in the sector. While the pathway to an exit in the sector is clear, the market may be over invested and reaching the end of the current investment cycle as the sector consolidates around already listed players. 2.5G services have become the new driver of the mobile data sector as the 2G market, primarily SMS-based services, is saturated, and the growth is stagnant. China Mobile and China Unicom will strategically support the 2.5G wireless data market to maintain overall growth. The uptake of WAP and MMS accelerated in 2004 because of increased penetration of 2.5G handsets and aggressive promotional activities by the operators. However, Java and BREW-based services are unlikely to realize growth similar to the explosion in SMS traffic because the penetration of Java-enabled or BREW-enabled handsets is still much lower. In 2.5G services, technology market entry barriers have increased, and operators have limited the number of service providers for these new services. Content acquisition and partner management has become a key success factor for 2.5G service providers. Online Gaming Like the movie industry, the Chinese online gaming industry revolves around blockbusters. As a result, it is a risky business forcing investors to bet on whether companies will be able to continue to churn out blockbuster titles. The intense competition, between both foreign and domestic companies, is likely to lead to a wave of consolidation during 2005, and to put greater pressure on margins especially as game licensing fees and marketing costs increase. Despite these challenges, the market is expected to continue to grow strongly as PC and broadband penetration increases and more gamers come online. Investing in established leaders with proven R&D abilities, or a large user and established channels may help to minimize risks. e-Commerce The China B2C market will maintain rapid development in the future. However, the increasing trade quantity may not ensure the profitability of leading B2C websites. 8  Margins are limited due to the high cost of operation and intense price competition. Furthermore, logistics, distribution and payment system are still issues. The reach of logistics and payment system limits the market to higher end cities. Since leading players have already raised capital, with one company purchased by eBay and another invested by Amazon, the market is likely to consolidate around these top players. Some smaller players may survive in particular market niches. Digital Media Applications The digital TV (DTV) market is at a very early stage, with less than 1% of the total 120 million cable subscribers accessing DTV programs. The limited market demand can be attributed to a lack of compelling new DTV content, the availability of pirated content, and the high-cost of set-top boxes (STBs). STB costs are not expected to come down dramatically in the short term because so many cable operators still demand customized units, especially for conditional access (CA), which makes large scale production impossible. Given slow growth in service revenues, the lack of a business model to support STB subsidies will likely trump a political push by the State Administration of Radio, Film and Television (SARFT) to force subsidies on the industry. Cable networks are highly fragmented, which is likely to delay the industry's growth. SARFT has made an effort to integrate city networks within one province into single provincial network but progress has been still slow. Despite these challenges, a focus on moving the DTV market forward ahead of the Beijing Olympic Games in 2008 may give the industry the extra push it needs to take off. The Internet video-on-demand (VOD) market is still small, but growth is expected to be strong, more than doubling from 2004 to 2005. One problem is that users are unwilling to spend on VOD services, resulting in low revenue. Research shows that one VOD user spends only RMB 4 (USD 0.48) per year on average. Domestic TV stations and movie producers are struggling to create attractive programs under government controls. Imported foreign content is strictly censored. Pirated DVD/VCDs are widely available in China for less than USD 1, posing a serious challenge to any VOD business case. The only opportunity for Internet VOD may exist in new business models that cut through piracy issues, such as interactive applications like healthcare, education, and gaming. Software Outsourcing & IT Services There is every reason to believe that the growth of China's software outsourcing market will continue thanks to continued government support, investment from foreign companies, and strong demand from Japan. Moreover, the entry of more western and now Indian companies should serve to accelerate the industry's growth. Given the small size of China's pure-play outsourcers today, it may take years for a company comparable to leading Indian outsourcing firms to develop. However, in the meantime, China's software exports are likely to continue their explosive growth and China will play an increasingly large role in software development globally. 9  China's software outsourcing market will probably develop along different lines than its Indian counterparts as domestic demand will play a larger role. Some Chinese outsourcing firms are already seeing opportunities in this area. Handset Design in China The global handset value chain has become increasingly fragmented over the past few years. The disintegration of the handset value chain has opened up opportunities for Chinese domestic handset manufacturers to compete more effectively with foreign vendors and challenge the primacy of Motorola and Nokia in China. Consolidation in the crowded design house sector is inevitable as manufacturers push upstream and chipmakers move downstream in the handset value chain. Low costs, strong R&D and stable customer relationships will be key factors for company survival. Operators play an increasingly important role in handset distribution, a trend that is likely to have a positive effect on design houses. Although the 3G market will initially account for a small share of the overall handset market in China, it is likely to offer the highest margins. However, demand for 3G handsets will take time to develop. The outsourcing trend is likely to continue among domestic vendors, driven in part by shortened product life cycles. 10  Table of Contents 1 INTRODUCTION....................................................................................................................................16 2 GENERAL MARKET CONDITIONS...................................................................................................17 2.1 MAIN DEMOGRAPHIC INDICATORS AND MARKET CHARACTERISTICS .................................................17 2.1.1 Economic, Telecom, and IT Market by the Numbers: The Size and Shape of the Market...........17 3 THE STATE OF THE IT SECTOR.......................................................................................................20 3.1 IT POLICY AND REGULATORY ENVIRONMENT - OVERVIEW ................................................................20 3.2 COMMUNICATION INFRASTRUCTURE AND USAGE ...............................................................................23 3.3 URBAN VS. RURAL CONNECTIVITY......................................................................................................24 3.4 ACTORS AND SOLUTIONS IN CHINESE TELECOM SERVICES MARKET ..................................................27 3.4.1 Actors in the Fixed Network........................................................................................................27 3.4.2 Solutions and Competition in the Fixed Network........................................................................28 3.4.2.1 Internet Access.................................................................................................................................... 28 3.4.2.2 WiFi .................................................................................................................................................... 28 3.4.2.3 Backbone and International Gateway Operators ................................................................................. 29 3.4.3 Actors in Mobile Networks..........................................................................................................30 3.4.4 Mobile Networks Competition and Solutions..............................................................................31 3.4.4.1 3G