China tech sector has taken its first step towards becoming more like Silicon Valley after the Youku-Tudou deal.
After Youku announced that it would take over Tudou in an all-share swap on Monday, in China’s highest profile internet deal, Citigroup thinks it’s the beginning of a wave of M&A activity in the sector. Aside from Youku, other high-profile corporate activity in the Chinese tech sector in recent months includes Alibaba Group’s privatization of its Hong Kong-listed unit, and Shanda Interactive Entertainment’s buyout by management. But it’s still a long way to Silicon Valley – Citi estimates that by comparison, some 85% of successful start-ups there get bought-out, which is a key driver of innovation, providing capital and support to young companies.
But these deals signal that China’s web industry has finally come of age, with a couple of catalysts for further M&A in the sector. First, says Citi, potential acquirers are facing less competition and have more opportunities as Chinese companies face greater difficulty going public domestically, and private equity investment in the sector is slowing. Valuations have also worked in the favor of acquirers. Youku chief executive Victor Koo noted that Tudou shares have underperformed relative to the company’s performance, and being bought could help unlock some of that value.
In the Youku Tudou age, video is an obvious area where more M&A is likely to happen, says Citi. The pressure is on for competitors to scale-up in a sector where costs are rising, but earnings have been slower to catch up.
“Everyone fears someone will do a deal with Baidu, which would direct all video searches through their search engine. Being marginalized leads to a vicious cycle, where you can’t raise capital, can’t spend on premium content,” said a banker close to the Youku deal.
Investor reaction would certainly seem to suggest that the space is ripe for more deal activity. Youku and Tudou shares both shot up in New York after the announcement of the deal on Monday.
Chinese tech companies are also responding to the powers of mobile, social and open platforms. Some of these platforms that have exploded on the scene include microblog service Sina Weibo as well as Qihoo’s cloud platform. But like tech companies everywhere, the challenge is how to monetize the technology. Citi thinks services like micropayment systems could be potential acquisition targets to help monetize these apps and further help drive innovation, particularly as most are too small to go public on their own.