Client Alert

Key Points for International Media and Content Companies to Understand the Largest and Fastest Growing Mobile Market in the World

10/1/2004

Almost any statistic regarding the mobile phone market in China is staggering -- more than 300 million users as of August 31, 2004, growth projected to continue increasing at double-digit rates for the foreseeable future, and billions of dollars in revenue for the principal mobile phone operators in China, just to name a few. This unprecedented explosion in mobile activity in China has spawned a vibrant "thumb culture" of mobile phone users. For these users, the mobile phone is not just a device for speaking to people, but rather is a complete mobile communication and entertainment center for playing games, downloading news, music, and cartoons, participating in fan clubs and engaging in a whole host of other activities. The thumb culture is visible everywhere in China with the sight of people busily typing messages or playing games on the dial-pads of their mobile phones as common as people speaking into their phones.

The key development in this market which should be of interest to international media and content companies is the convergence of several trends which has greatly heightened the potential appetite for premium branded content among mobile users:

  • increasing affluence in the eastern and southern provinces of China, combined with their growing familiarity with the major types of mobile services, which has greatly enhanced the willingness of mobile users' in these key areas to pay for sophisticated services,
  • rapid adoption of next generation mobile phone technologies which enable the delivery of richer, more interactive content than was previously available,
  • continued limited sources of cutting-edge entertainment in China, including as a result of low Internet penetration to date due to relatively low broadband PC usage, which makes the mobile phone the preferred distribution platform, and
  • increasing awareness among the mobile phone operators and service providers in China that premium branded content can differentiate the services offered and enhance profit margins, which has led to expanded promotion and product development activities.

Equally importantly, the market in China for mobile services, also commonly known as wireless value-added services, has one singularly unique characteristic which makes it very attractive to media and content companies: it is relatively free from piracy concerns which is a constant issue in other business sectors in China.

At the same time, the wireless value-added services market in China is both idiosyncratic and highly fluid, with constant technological and regulatory changes and the domineering presence of the two principal phone operators, China Mobile and China Unicom, which essentially still control the market at all levels. International media and content companies thus need to grasp clearly the practices and pitfalls of this market before entering it so they can understand how best to leverage their content, how and why they should select local partners and how to structure their fees and other aspects of cooperation with local partners. This article summarizes key features of the wireless value-added services market in China as we see it, and concludes with practical pointers on how best to navigate it.

The Wireless Value-Added Services Market in China

The Players
China Mobile and China Unicom currently control virtually all of the mobile phone market in China. As the wireless market in China continues to expand to less-developed and -wealthy provinces, an increasing portion of the mobile operators' users have relatively low per capita incomes. These subscribers generally yield lower levels of average revenue per user because they are primarily users of pre-paid services. In addition, China's wireless market is becoming increasingly competitive, with non-roaming, single-city limited mobility networks springing up across China. In fact, China Telecom and China Netcom, which are better known for their large fixed line telecommunication networks in China, claim to have added a total of two million new users per month on average in 2003 to their limited mobility networks located throughout the country. Due to these pressures on the traditional voice-related businesses of the mobile operators, wireless value-added services have become an increasingly important market development tool for China Mobile and China Unicom and the privately-owned service providers that support them.

In turn, the market for wireless value-added services in China has expanded significantly and is expected to continue to grow at a fast pace. Norson Telecom Consulting, an independent research firm, estimates that total wireless value-added services revenue in China rose from RMB1.0 billion ($120.8 million) in 2001 to RMB15.0 billion ($1.8 billion) in 2003 and is expected to grow to RMB26.0 billion ($3.1 billion) this year. The eastern and southern provinces of China have been key sources of this revenue growth because they are relatively wealthier than other parts of China. In addition, mobile users in those provinces have been exposed to wireless value-added services for a relatively longer period of time and have become discriminating consumers with high expectations as to the content of the services they purchase. Finally, growth in this market has also been driven by the fact that China has low personal computer, Internet and broadband penetration. In this entertainment vacuum, wireless value-added services have become an important form of entertainment for Chinese consumers.

Following the successful model established previously in Japan and South Korea, China Mobile and China Unicom outsource almost all content and applications for their wireless value-added services platforms, meaning that these operators rely almost entirely upon third party service providers to drive their network traffic, supply attractive services and increase revenue from their services. In turn, the mobile operators focus on the operation and technical enhancement of their networks, while monitoring service providers' offerings for prohibited content such as pornography and political and religious discourse. For their part, wireless value-added service providers in China rely on the two mobile operators for the network distribution of their content and services, billing and collection, and remittance of revenues.

When first setting-up, a third party service provider will obtain the requisite value-added telecommunications licenses from the Chinese government and seek permission from one or both of the mobile operators to offer its services through their networks to their ultimate end-users. The mobile operators, particularly China Mobile, have highly decentralized organizational structures. As a result, separate contracts are usually entered into by the service provider, on the one hand, and the national, provincial and local offices of the mobile operators, on the other hand. The relevant office of the mobile operators will then evaluate the proposed services to ensure, for example, that they do not contain inappropriate content and are not substantively identical to an existing service. If approved, the services can be offered to the mobile operator's users at a price approved by the mobile operator. Prices for the most basic services can be US$0.01 per use or less, while monthly subscriptions for more advanced services can be several dollars.

Approved services appear on the service menus of the mobile operators which can be accessed through mobile phones and on the websites operated by the mobile operators. When a mobile user selects a service, the third party service provider delivers it over the mobile operator's network and the charge for such service appears on the user's next mobile phone bill.

Given their dominant market positions, the mobile operators have significant negotiating leverage over third party service providers and largely dictate the terms of their cooperative agreements. However, recognizing that they are dependent on service providers to continuously create new, innovative services and drive revenue growth, the mobile operators have to date been willing to give service providers the majority of the revenue generated by their services, typically in the range of 80% to 90% of the gross revenue. In many cases, this percentage can change if the service provider fails to satisfy various performance criteria, such as revenue, number of users and number of customer complaints. Poor performance by a service provider can also lead to it being denied access to part or all of a mobile operator's network. In addition, service providers are usually charged network transmission fees for each message sent by them to the ultimate end-user according to a formula. (Recent rumored changes in the basic revenue sharing percentages have so far failed to materialize, but remain a distinct possibility as the mobile operators seek additional sources of revenue to fund their multi-billion dollar investments in the network infrastructure needed to support next generation, or 3G, mobile technologies and services.)

It is widely anticipated that other parties such as fixed-line operators China Telecom and China Netcom will also be granted licenses to operate mobile networks in China. While this should further heighten competition in the wireless value-added services market, it is difficult to predict what effect, if any, the entry of new operators will have on the revenue sharing model described above. Moreover, there has been speculation in the market that the current or new mobile operators could introduce their own portfolio of self-developed services, which, if true, could radically alter this market.

There are several hundred service providers operating in China at this time, and they generally fall into three categories:

  • Nationwide Internet Portal Operators, which have expanded into the wireless area. The main players in this category are Nasdaq-listed companies NetEase, SINA, Sohu and TOM Online, which is an affiliate of Internet portal operator Tom Group.
  • "Pure Play" Service Providers, which focus exclusively on offering a wide range of wireless value-added services. These providers include Nasdaq-listed companies Linktone and KongZhong, as well as privately-held companies such as MTone Wireless.
  • Niche Service Providers, which focus on a particular market segment or application. This category includes TENCENT, which is listed on the Hong Kong Stock Exchange and specializes in a type of wireless service known as instant messaging.

The Technologies
The predominant wireless value-added service in China is currently short messaging services, or SMS, that allow users to send and receive simple text messages over their mobile phones. Users can also play basic games and download ringtones and icons for the screens of their mobile phones through SMS. SMS is offered through China Mobile's and China Unicom's second generation, or 2G, mobile telecommunication networks.

In recent quarters, there has been dramatic growth in the use of services offered over the advanced second generation, or 2.5G, mobile telecommunication networks in China which are accessible with phones that are 2.5G-compatible. The advantage of the 2.5G technology standard is that it enables high capacity wireless data transmissions. As a result, services offered over 2.5G networks can be significantly more sophisticated and offer users higher quality graphics and richer content and interactivity, commanding a premium price over the more established SMS-based services. Thus, we are seeing increasing interest among service providers in China in obtaining premium branded content from international partners to fully utilize the capabilities of 2.5G services and thereby differentiate themselves from their competitors. The Chinese government has also announced its intention to grant licenses for 3G mobile telecommunication networks in the next several years, which will enable even more advanced, content-rich services to be offered.

The more common 2.5G services include games, information services (e.g. news stories sent directly to a user's mobile phone), community forums and dating services, animated cartoons and sophisticated ringtones and icons.

The third major category of wireless value-added services is interactive voice response services, or IVRS, which allow users to listen to songs, jokes, stories and other audio content. Users can also send such audio content, along with personal messages, to the mobile phones of their friends or others.

The Content
Service providers in China have shown great ingenuity in integrating all kinds of content into wireless value-added services. Thus far, the primary categories of branded content that have proved successful with Chinese mobile users include:

  • music, particularly Japanese and Korean pop music,
  • games, which encompasses both imported game technology, as well as branded content, such as famous Western cartoon characters, which is incorporated into a locally developed game,
  • news and entertainment-related information,
  • pictures, which includes everything from pastoral scenes to photos of hot pop stars, and
  • serial stories and cartoons.

Practical Pointers

A number of major international media and content companies have already entered the Chinese wireless value-added services market, including Sony, MTV and Time Warner. However, a consistent approach to entering this market has yet to emerge, and many entrants have entered into arrangements that do not properly reflect the nature of the market or do not fully maximize the opportunities available. The following are practical pointers we believe are key to avoiding such problems:

  • Partner With a Local Service Provider. China Mobile and China Unicom have preferred to work only with domestically incorporated and owned service providers. Even Nasdaq-listed service providers such as Linktone have had to establish elaborate corporate structures whereby affiliated domestic companies, which are owned by Chinese individuals and controlled by the listed company through a series of contracts, actually contract with China Mobile and China Unicom and provide the services to their users.

    Thus, international media and content companies must, in essence, funnel their content through one or more local service providers. Although this involves sharing revenue with the service providers and the loss of a certain degree of control over the content, many local service providers can add significant value by, for example, customizing and localizing content to maximize its appeal to the Chinese market (see discussion in next bullet point).

    Additionally, given the rapid speed at which the wireless value-added services market is evolving in China, careful thought should be given to whether multiple local partners, licensed on a non-exclusive basis, should be used. In particular, the mobile operators have recently begun enforcing their customer service policies more rigorously than in the past and have initiated steps to improve customer service. This rigorous enforcement has resulted in severe penalties being imposed on numerous participants in the market. Penalties have included prohibiting these service providers from offering certain services over a mobile operator's network, or from offering new services, for a fixed period (to date, publicly announced suspension periods have typically ranged from six months to one year). Naturally, no international media or content company wants to be in the position of signing an exclusive content license with a service provider and then discover that its new partner has been banned from a mobile operator's network for violating customer service policies.

  • Consider More Than Just Market Share When Evaluating Local Partners. With several hundred service providers in China, identifying and choosing the right partners can be an overwhelming task. While the market share of a service provider is clearly an important factor, it may not be the only factor worth considering. Other relevant considerations include:
    • Does the service provider have a presence in both 2G and 2.5G services and offer a full portfolio of services that can utilize your content? The nature of wireless value-added services enables service providers to offer the same content through a variety of services and technology platforms. For example, the music or images of a famous pop star could be used for SMS ringtones and icons, sophisticated 2.5G animated cartoons, games and fan clubs and customized IVRS audio downloads, in order to reach the widest possible audience. Thus, a service provider that has a presence in both the 2G and 2.5G markets and has experience offering multiple kinds of services could be in a better position to leverage a company's content than a more narrowly focused service provider.

      It is also important to note that while 2G SMS services represent the dominant service category now in China, 2.5G services are rapidly gaining ground. Furthermore, many of the strong 2G service providers have had very mixed success thus far in 2.5G services. As a result, prior performance in the 2G market is not necessarily indicative of future performance in the 2.5G market.

    • Does the service provider have market share with the user bases of both China Mobile and China Unicom? Some service providers sell most or all of their services to China Mobile's or China Unicom's user base, but not to both. This dependence on a single operator means that not only will such provider's services be excluded from a significant portion of the market, but also that the provider is especially vulnerable to penalties such as service suspensions that could be imposed by the operator with which it does have a relationship.
    • Does the service provider have the technical ability to localize and customize your content? In the wireless value-added services market, localization and customization means more than just translating content into Chinese. Rather, it is a complex task of incorporating the content into a service that is specifically designed for the small screens and dial-pads of mobile phones, such as games that can be easily played on the tightly packed buttons of most mobile phones. In addition, Chinese mobile users tend to be young and highly fashion conscious, so localization and customization must be done with an eye to creating something that young Chinese will consider "hip and trendy."
    • Does the service provider have a solid management team that will be committed to observing contracts and maintaining accurate records? The quality of the management of service providers in China varies enormously. Some firms boast highly experienced, international management teams, while other companies are simple start-ups operated by local managers who are only familiar with the province in which their companies operate. The interests of international media and content companies will obviously be better served in the long-run if their local partners in China understand their contractual obligations, are committed to observing them and maintain accurate records so that the relationship does not degenerate into squabbles over each party's share of the revenue.
  • Define the Appropriate Scope of Cooperation with Local Partners. We have seen a number of Western content providers enter into a cooperation or license agreement with a local partner for the provision of a single type of wireless value-added service using a single type of content offered over a single technology platform. For example, the content provider may license the image of a pop star for inclusion in a particular 2.5G picture download service.

    This approach may make sense if the content provider is still evaluating the local partner or if the local partner is particularly strong in that one type of service. On the other hand, the one constant in China's wireless value-added services market is rapid change in technologies and mobile users' tastes, resulting in relatively short life spans for many individual services. Consequently, the value of the cooperation or license agreement between the parties can be severely affected if the agreement is not flexible enough to allow the services offered under it to evolve in a timely manner as the market changes. Moreover, to maximize the potential user base, the parties should consider how the content could be used across multiple 2G and 2.5G services.

  • Prepare Agreements That are Consistent With the way the Market Works in China. It is not uncommon for international media and content companies to use their standard, off-the-shelf cooperation or license agreements when partnering with local service providers. Due to the peculiarities of the Chinese wireless value-added services market, these agreements usually do not work, which can lead to confusion and disagreement among the parties and longer "time-to-contract." For example:
    • Revenue Sharing Arrangements. Standard cooperation or license agreements often provide that the content provider will receive a percentage of the service provider's net revenue generated by the content, as reflected in the records of the service provider. While all service providers in China maintain their own records of the services they provide to China Mobile's and China Unicom's users, these records will usually not match the revenue actually received from the mobile operators. This inconsistency arises from the fact that neither the mobile operator nor, by extension, the service provider is paid for those services which are sent, but not ultimately delivered successfully, to the end user due to technical or other problems. Service providers cannot identify which of their services resulted in such delivery failures, and are dependent on the mobile operators to report to them their actual revenue. As a result, to better reflect the economic realities of this market, the content provider's revenue share should be calculated based on net revenue, as reflected in the monthly revenue confirmation statements provided by the mobile operator to the service provider, and include an appropriate mechanism (such as reasonable reporting and audit provisions) enabling the content provider to verify the same. Furthermore, it would advisable if the parties agreed in advance on the methodology for estimating which of the services using the content resulted in delivery failures and for which no revenue was received.
    • Multi-layered Organizational Structure of the Mobile Operators. The cooperation or license agreement must be prepared with the multi-layered organizational structure of the mobile operators in mind. Thus, provisions which impose uniform, nationwide requirements on the service provider may not be appropriate since each provincial and local office of the mobile operators has its own policies and procedures. For example, a requirement that the service provider must charge the same price for a service to all users in China is not practical since the provincial and local offices of the mobile operators often make their own pricing decisions.

      In addition, termination clauses can be problematic. If a service provider is denied access to the networks of one or both of the mobile operators, that would seem a fair basis to allow the content provider to terminate the relationship. But what if the service provider receives a temporary or permanent service suspension in only one or two provinces? Or alternately, what if the service provider only obtains approval to offer services utilizing the content in a handful of provinces after a significant roll-out period has lapsed? There is no bright line industry standard in these cases, and the parties, along with their legal advisors, will have to carefully consider what events should justify termination.

    • Compliance with Mobile Operator Policies. China Mobile and China Unicom have a wide range of policies and procedures regarding customer service, quality control and other aspects of the wireless value-added services industry. As the industry has evolved over the last several years, the mobile operators have refined these policies to improve overall service quality.

      These policies need to be considered when preparing the cooperation or license agreement so that, for example, services and their pricing are updated flexibly in the manner and timeframe allowed by the mobile operators. It is also advisable that the agreement recognize that the mobile operators' policies change over time. Thus, the parties may authorize each other to use personal information of the service provider's users but only to the extent allowed under the mobile operators' then current privacy policies.

  • Protect Intellectual Property. Protection of intellectual property is a perennial concern in China. Fortunately, unlike CDs and DVDs which can be reproduced in huge volumes for very little marginal cost once the copy-protection codes are overcome and the printing equipment is purchased, content appearing on a mobile phone is confined to the phone itself, unless the mobile operator allows the user to forward it to other mobile phones. In turn, China Mobile and China Unicom have taken it upon themselves to closely monitor their service providers and users to ensure that no unauthorized usage of third party intellectual property occurs. Cases of service providers being punished by the mobile operators for offering services which include stolen content have been reported in the Chinese media. Indeed, the contracts between the mobile operators and service providers usually provide that the mobile operators can terminate the relationship without warning if the service provider is caught infringing other parties' intellectual property rights.

    To further augment the protection of intellectual property, it is helpful to partner with a local service provider which also diligently monitors the wireless value-added services market so that it can quickly notify the mobile operators of any suspected infringement.

Conclusion

The wireless value-added services market in China is dynamic and rapidly-evolving which can present risks for the unwary. However, international media and content companies which are well-prepared and enter with a comprehensive understanding of the market and its players can also find that wireless value-added services are an effective and profitable way to distribute content in China.



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