Ep. 53: Netease - Developing Pigs, Games, and People

Transcript

(Y: Ying-Ying Lu; R: Rui Ma )

[00:00] R: So October 1st marked the 70th anniversary of the founding of the People’s Republic of China, AKA mainland China, and also brings with it a weeklong holiday, usually referred to as Golden Week. For our listeners in China, we hope you’re enjoying your long vacation, and for those who are not, which would be  the majority of you, that would explain the slowdown in tech news coming out of the country.

Y: We were actually going to take this week off, but in light of our upcoming invite-only investor trip to China, we thought we’d squeeze in one last episode and take next week off instead. Oh, for those of you who are wondering, we’ll have a meetup in Beijing on Tuesday, October 8, at Taco Bar in Sanlitun, and in Shanghai on Thursday, October 10, at Hotel Indigo Rooftop.

R: We’ll be there on both days from 8:30-10:30PM, and so come and have a beer on us and with us! We would love to hear what you think and how we can improve to make TechBuzz even better.

Y: Well, while we decided to work instead of play, it looks like some other poor overworked investment bankers had clients who had the same idea, because on September 30, one day before the long holiday, the e-learning company Youdao filed for a $300mm IPO on the NYSE.

R: The IPO has been rumored for a while, so it’s not a surprise, and while we will go into it a little bit today, what we thought was far more interesting is the company behind Youdao, its controlling shareholder Netease. One of the earliest Chinese internet companies to public, it’s held up fairly well. At $33Bn in  market capitalization, it’s neck and neck with Baidu and only a little bit behind JD.

[1:44] Y: Its founder 丁磊 William Ding is also pretty interesting, and not nearly as well known in the West as say a Jack Ma or Robin Li, even though as recently as 2016, supposedly, the Financial Times called the tech giants of China BANT, meaning Baidu, Alibaba, yup, Netease, and Tencent.

R: So we thought we’d talk a little today about Netease, William Ding, and how he built a business empire from offering email to publishing and developing games, to now breeding pigs and educating people. 即养猪又育人 is what people are saying about him, and you know what? That is kind of his style. He’s said more than once that a company doesn’t need a direction, or specifically, he doesn’t want it to be associated with a specific label, like Alibaba and e-commerce, or Baidu and search, so Netease, he wants it to be very free forming because in his opinion, it is less limiting.

Y: And so yeah, Netease is many things. It’s actually quite strong in multiple niches, and in addition to developing games, pigs and people, it’s not bad at e-commerce or music either. And these things aren’t as closely related as say, e-commerce and payments, or search and AI. So in that sense, Netease is somewhat atypical.

R: Yet it’s worked, for the most part, anyway. William Ding is worth $16Bn today, and Forbes puts him as #81 richest in the world and Hurun puts him as 16th richest in China. No small feat. How did he do it? Let’s find out!

[3:50] R: Hi everyone! We are TechBuzz China by Pandaily, powered by the Sinica Podcast Network!

Y: We are a biweekly podcast focused on giving you a peek into what’s buzzing within the tech community in China.    

R: We uncover and contextualize unique insights, perspectives and takeaways on headline tech news that don’t always make it into English language coverage. So you can be smarter about the world of China tech. TechBuzz China is a part of Pandaily.com, an English language site that tells you “everything about China’s innovation.” I’m one of your two co-hosts, Rui Ma.

Y: And I’m your other co-host, Ying-Ying Lu. We’d like to acknowledge our partners DealStreetAsia and SupChina, creator of the Sinica Podcast Network! In addition to TechBuzz, you can also find Sinica which covers current affairs, NuVoices and Ta for Ta on women, the business-oriented ChinaEconTalk, and the Caixin-Sinica Business Brief from China’s leading business magazine.

R: Oh, before we forget, we want to share with you The Information’s expertly curated event on The Tech & Transport Revolution in Asia, taking place in Hong Kong on the afternoon of November 6th. Go to theinformation.com for more information and let them know we sent you!

Y: And, as always, if you enjoyed listening to our podcast, please leave us a review on iTunes or whatever other platform you use.  And to incentivize you to do so, we’re going to enter everyone who writes us a review on iTunes into a drawing and the winner shall receive a copy of Matt Sheehan’s The Transpacific Experiment. We’ll do the drawing when we hit 100 ratings! So help us get there!

[5:33] Y: Oh, and one more thing before we start, we want to tell you about a brand new Master’s program nearby, at the University of San Francisco. USF’s Master’s in Applied Economics combines econ training with the practical skills in data analytics that you really need to understand today’s new digital economy. Their curriculum covers skills like R and Python, machine learning, and experimental design. To learn more and to get a fee waiver for the Fall 2020 class, please go to usfa.edu/techbuzz.

[6:13] R: So today’s topic is Netease, which is an old, old Chinese internet company, positively ancient by internet time, and what’s interesting about it, actually, is how it’s gone into all these different business lines and started to spin them off, something we haven’t really seen a ton of American companies do, but actually happens a lot more in China and Asia more generally.

Y: To talk about Netease though, is really to talk about its CEO and founder William Ding 丁磊. Like many of the entrepreneurs you’ve heard us talk about on TechBuzz, William came from a relatively privileged family. Now, he was born in 1971, meaning he’s almost 50 years old, which puts him on the older side of tech entrepreneurs in China.  It also means that he came of age in the late 70s and early 80s, when China was still very, very poor.

R: Everyone was poor though, so it wasn’t that he was growing up wealthier than everyone else, but his advantage lay in that his parents were very well-educated, which was a comparative rarity at the time. So, instead of playing with mud and sticks like many other kids at the time, he was able to pursue his fascination with electronics at a young age.

Y: Yeah, as a child he was building wireless radios and other toys for himself, which the Chinese media like to say was an early sign of his genius, but which I really think just showcased how educated his parents were, to even be able to procure the parts that he needed.

[7:45] R: After attending the University of Electronic Science and Technology of China, he went to a state-owned enterprise, hated it and quit, much to the displeasure of his parents. He then went to work at Sybase China, for those of you who remember that old software company, before eventually working at an internet company, where he programmed some message boards.  When the company failed, he was on his own, and decided to start his own thing.

Y: He founded Netease with his own money, beginning with a mission statement of: “让上网变得容易一些。“ which translates directly to “let going online become easier.” Hence, net ease.  At the time, together with the founders of Sohu and Sina, they were called the Chinese Internet 3 Musketeers. 

R: His first project was a search engine called “Yeah.” However, this wasn’t such a great idea. Technology aside, there were only something like 200 Chinese websites in the world, which meant, well, there wasn’t much to search, was there? Instead, with the popularity of Hotmail surging in the US at the time, he decided to build an email system, and that got him his first half a million RMB in revenue in six months, which was very significant.

Y: I’d say that even today that would at least land you a proper seed investment, much less twenty years ago. Anyway, as portals like Yahoo grew in popularity in the US, William also sought to convert the Netease homepage into a portal where people can click through to whatever interested them. And in a stroke of genius, he bought the domain 163.com, because obviously the letters spelling out Netease is very unintuitive to Chinese users.

[9:32] R: Around that time all the popular Chinese websites were based on numbers. Netease also discovered fairly early on the value of content, and thus to this day, its news is the top performing news app based on  user activity and time spent, ahead of Tencent. So I guess we can add news to one of the things Netease excels at too.

Y: When Netease went public on the NASDAQ in mid-2000, it was one of the casualties of the dot com bust and lost 97% of its value in a few months. William has since revealed that all he wanted to do was sell the company, but there were no buyers. At all. So he was stuck with it. He had to figure out how to grow the business.

R: So Netease started doing what everyone else did at the time, which was work with telecom operators and provided wireless value-added services, things like basic SMS and mobile email, in order to make money. But the much more significant move they made was they got into online gaming, and specifically, MMORPGs, or massive multi player online role playing games.

Y: Without going into too much detail, William, against the advice of many, acquired a Guangzhou-based game developer and bet big on online gaming. The IP he chose was Journey to the West, you know, that age-old Chinese tale about the Monkey King and all the fantastical things that happen as he accompanies his master, a monk, to the land of Buddha to retrieve holy scriptures.

[11:06] R: It’s one of the most popular and most cherished Chinese tales, ever, and that certainly helped, but it really was the quality of the game itself that pushed Netease to great profitability. But being a developer is very risky, as we all know. Either way, these combined efforts made Netease so successful that William, who owns about half of the company, became China’s richest person at the tender age of 32.  Of course, he’s been displaced many places since then, but he’s basically been a billionaire for a very, very long time.

Y: But back to Netease, by 2008, after seeing the immense potential with its self-developed MMORPGs, Netease also expanded into publishing. The most notable partnership it had was with Blizzard Entertainment, maker of Starcraft, World of Warcraft, Overwatch, Hearthstone, and other top-tier IP.

R: The running commentary about Netease is that it takes its time with its products, and that everything it puts out is of high quality. 网易出品，必属精品.  It’s a good reputation to have. But I’m not sure that it’s completely deserved. However, compared to the reputations of a Pinduoduo, for example, which is almost still equivalent with “shoddy quality,” Netease is aging relatively well, though we’ll see later that it has run-ins with IP theft as well.

Y: Yeah, it’s got this aura of patience where it’s just going to take its time with its products, be more like an artisanal or boutique brand. It probably has something to do with the fact that William has such power over the company, and he’s no longer that young, and has been rich for a very long time. He’s probably just got less to prove.  Or that’s the perception, anyway, there’s no way for us to know if it’s really true.

[13:03] R: So now we come to the interesting companies it’s spinning off, or will be spinning off, or could be spinning off.  So, in chronological order … first there was youdao 有道.

Y: We had briefly thought about doing an entire episode on Youdao, but frankly, just didn’t find it that interesting.  As we’ve mentioned, it’s an e-learning business that was founded in 2006 as part of Netease, and its first hit was the most unsexy product ever, a dictionary,which by the way I still use. I mean, if you go to youdao.com on your laptop today, what you’ll see is still an input bar that defaults to translating Chinese into English.

R: It also offers tools for you to learn English, such as vocabulary flashcards, and also premium courses on a wide variety of subjects.  And then there is a note-taking app, like an Evernote. And don’t forget smart devices, like pocket translators and smart pens and stuff like that.

Y: If you go to its recently filed prospectus, you’ll see that it’s growing pretty quickly, almost 70% year-on-year for the first half of 2019, but it’s got a pretty low gross margin at 29%. While the bulk, or almost 60% of its revenues comes from its education business, there’s still a lot of advertising, which makes sense since it does have over 100mm MAU after all.

[14:28] R: Of the over half a million paying customers of Youdao’s premium courses last year, over a fifth were K12 students. As we’ve explained previously in TechBuzz Episode 47 on learning for children, English is a huge category. But tutoring for all subjects is very much in demand and Youdao has modified the traditional MOOC (massive open online course) to be what they call “dual-teacher.”

Y: It sounds a lot more complicated than it is,  because it’s basically just livestreaming a “primary teacher” on a screen while there is another teacher, or even multiple teachers, offline in the classroom alongside the students to provide additional assistance. Pretty basic, but this “method” has taken Chinese edtech by storm and has become a super popular pedagogical method in the last few years.  

R: OK, so that’s the “developing people” business that’s going public, and hoping to raise $300mm. It’s two-thirds owned by Netease by the way, which means William basically owns 30%, and the CEO he brought in to run the business owns 20%.  And then, well, now we get to talk about the pork business. 

Y: In case you didn’t know, pork accounts for 70% of all meat consumed in China, with chicken at 15%, and beef and mutton so far behind at 10%. In fact, on many Chinese menus, the word “meat” is basically used as a substitute for pork, since it’s only specified as something else when it’s, well, not pork.

[16:09] R: Which means this fact shouldn’t be a surprise: China produced and consumed about half of the world’s pork in 2018. But it was still a surprise in 2008 when Netease announced that they were going to experiment with raising pigs. This wasn’t going to be some hobby farm that William was going to have on the side, but an actual corporate initiative, with its own branding, Weiyang 味央, and its unique selling point, which was this special breed of black pigs that they were gonna raise organic free-range.

Y: The narrative is that William was disturbed by all the food safety issues that were sweeping through China, and wanted to use his funds to research and develop a scalable way of raising pigs that would deliver the healthiest meats with the best taste, and of course in a humane and sustainable manner.  All the buzzwords.

R: After seven years of development, he unveiled the first batch of pork, which were hailed to be as delicious as he promised. I mean, these are some special creatures that were bred and yield. Netease pigs supposedly know how to use the toilet and only eat natural food, I think that means organic. And they live in such a high tech environment that the entire farm is overseen by just a few people. In 2017, William raised over $20mm from Meituan and Sinovation Ventures to continue funding the project.

Y: Aside from grabbing headlines, it’s generally agreed that he’s trying to curry favor with the government, because food safety is such a sensitive and important issue in China. But I’d like to ask — who cares? It is not a big cost, and it’s bought him plenty of goodwill. And his pork is affordable too — before the recent outbreak that decimated pork production, it was selling for less than $15 a pound, which is comparable to other black pork brands.

[18:36] R: But although the pig-raising business has received external funding, it’s probably not next on the list of spinoffs ready for IPO. There are two contenders for that spot — Netease music and e-commerce.

Y: You see, in 2013, well after BAT have been working on their respective internet music businesses, William decided to jump in with his own product. The story being that he was disappointed by all the choices out there and figured that he could make something better that others would appreciate as well.  Non-trivial, given how competitive the space was, which by the way, we outlined in TechBuzz Episode 33: Tencent Music, Totally not China’s Spotify.

R: The TL;DR on that is it’s now worth at least $3.5Bn, after raising $600mm from Baidu and General Atlantic last year and more recently another $700mm from Alibaba and other investors. It’s probably an IPO candidate, especially after the recent antitrust case against Tencent Music, that company, by the way, is worth $21Bn. It is true that it’s considered a distant second, but I guess the bet is that the market will become a duopoly, since there are no real other viable alternatives.

Y: And that brings us to the last business line we want to talk about today, which is Netease e-commerce.  It may have popped up on your radar recently because Netease sold off a portion of it to Alibaba recently — a line called Kaola 考拉 specializing in cross-border e-commerce, ie selling imported goods to Chinese people, for $2Bn.

[20:05] R: Originally, it was supposedly being considered by Amazon, which has a 6% market share in imported goods e-commerce in China.  Together with Kaola’s 23% market share, they would have been even with Tmall’s 29%, but now Alibaba will have the overwhelming lead when it comes to selling imported goods to Chinese people online.

Y: Kaola, as far as we could tell, was growing fairly quickly despite the general economic slowdown.  But it for sure had a much lower profit margin than Netease’s core business of gaming, and so there were probably some tradeoffs to be made, especially if Netease wanted Alibaba’s unwavering support for its music business.

R: Or something like that. E-commerce in China is basically a duopoly between Alibaba and JD, and some will say we might even be a little generous to JD to include them, but the point is, it’s super competitive unless you have a unique edge. And with Kaola, it was also hard to tell how well it was doing exactly compared to Netease’s other e-commerce business, since the two were lumped together into the same unit financial report will be reported. 

Y: The other e-commerce business is Yanxuan 严选, Netease’s consumer goods e-commerce platform. It launched in April 2016, so it’s relatively young.  In terms of look and feel, think of Muji, the near $4Bn revenue a year Japanese brand that has made minimalistic design and packaging its trademark.  By the way, the word Muji, which is 无印良品 in Chinese, literally means “no-brand, high quality.”

[21:46] R: Which is exactly what Yanxuan is also going for. It works directly with high quality ODMs, or original design manufacturers, who usually work with famous consumer brands that do all the design and manufacturing for those brands.But ODMs have no retail distribution or brand name of their own to speak of.  That’s different from OEMs, who don’t do the design.  So yes, ODMs do all the work, sometimes own the IP even, and the brands take all the credit and get most of the profits.

Y: That makes it sound like vaguely unethical, but of course, there’s a reason why things work this way. The ODM business operates very differently and has a completely different kind of risk profile, so you really can’t compare it to a brand.  What is true is that if you’re an ODM, margins are generally thin, and you thrive on scale.  And this is where Netease saw an opportunity.

R: Yanxuan literally means “carefully selected,” so Netease is basically saying to you, hey, we are going to find all these amazing manufacturers, but instead of paying the markup for a Levi’s, we’re going to find the folks that make their jeans, strip off the brand, and make you something similar but sell it to you at a significant discount.

Y: So it’s as if Netease is running its own private label. Except that they’ve chosen to minimize the branding and instead kind of pretend they are a master curator, so as to give you the illusion that the ODM is selling directly to you. Or at least that’s the impression I get when I visit Yanxuan. The brand is “no brand.”

[23:32] R: Yup, they try to pass off the product as selected versus branded by them, which is implicit in the name. They reinforce this by advertising the credentials of the manufacturer.  For example, today, you can find socks and belts made by the same supplier to Calvin Klein that available for a huge discount. It literally says “CK manufacturer” on the image. Kind of like you know when you shop somewhere and the store brand says “compare to XYZ premium brand!” on its label. Sometimes, though, there is no specific brand associated and it does just say “overseas manufacturer or something generic like that.”

Y: Anyway, it makes sense that ODMs love this right? These goods are not meant to be trend-setting.  They’re meant to be practical and appeal to the value sensitive shopper. They’re basic items derivative of other products that’s already been made for other brands.  Except now connect this with Netease’s huge base of traffic, the trust it’s built up with its users, and voila! You have scale, and you have a business.

R: Which is why it makes sense that higher quality, larger manufacturers with larger minimum order quantities are probably happy to work with Netease.  And why they say that their margins are actually better with Netease than with their traditional clients at up to 20% with Netease, which is a significant bump from the 10-15% they’re used to getting.

Y: Of course, just because you’re using the same manufacturer as Calvin Klein doesn’t mean that manufacturer will use the same raw materials as it does for CK. Some Yanxuan goods are ten times cheaper than their luxury counterparts.  Some of the savings come from lack of branding, but some of it doubtlessly comes from lowered quality, which has definitely been a complaint.

[25:53] R: Overall though, the business has grown like a weed and initial concerns that Chinese consumers would care about designs ripped off of other brands never really amounted to anything. I mean, I am not sure why people were even afraid of that, haven’t companies like Zara demonstrated that most of the world don’t care about originality as long as it looks good and is priced reasonably?

Y: Netease also was smart to stay out of apparel in the beginning and start in home textiles. Sheets and towels are some of the best products to sell. People care about the quality, but are relatively brand agnostic, and the products themselves are extremely standard, so return rates and thus restocking fees were low. It’s just a low frequency business and tough that way.

R: Netease isn’t the only one to think to combine Muji’s style with e-commerce.  Remember that Lei Jun of Xiaomi also said he aspires to Muji’s look and feel. And there are so many other players trying to do something along the same lines. In the US, there’s Softbank-funded Brandless, and of course Amazon itself with the AmazonBasics line.

Y: And do you think Alibaba and JD were going to be left behind? Of course not. Alibaba’s version even sounds similar … it’s called 心选 Xinxuan. Although it doesn’t highlight the ODM at all, so there’s no mention of similar, branded products.

[27:21] R: The lack of marketing around ODMs might be due to legal reasons though, since actually most ODMs are prohibited from using the brands they service to promote their own products at least not directly to consumers. That makes sense. Total e-commerce revenues for Netease in 2018 was $2.8Bn, and analysts think that at least half of that was from Yanxuan.  Not bad for a three year old business, especially when global juggernaut Amazon’s private label business is estimated to be still under $1Bn. And that’s Amazon we’re talking about.

Y: Alright, I think that’s a pretty thorough summary of Netease for Techbuzzers who are new to the company and the status they occupy in Chinese internet.  How about we do a summary of what we’ve learned today?

R: OK, so we decided to do this episode on Netease because of the fact that one of the companies it controls as a major shareholder, Youdao 有道, just filed to go IPO on the NYSE. But rather than just talking about Youdao, we thought Netease was more interesting. It was founded way back in 1997 by a guy named William Ding 丁磊, and it’s gone through a few phases, but now has a $10Bn a year revenue business that’s almost two-thirds from online games.

[28:43] Y: And even though Netease actually started as a portal and was first famous for offering email addresses through its 163.com domain, the dot com bust, when it lost 97% of its value, basically forced it to find other sources of revenues.  It probably also gave it its current culture where William, who owns almost half of the company, is constantly still experimenting with new directions.

R: One of the first things they tried is the e-learning company Youdao that has just filed for IPO. And even that business has changed a lot since it first began in 2006. Originally an online dictionary and translator that relied on advertising revenues, it’s now a proper online education company offering paid classes, especially going “all in on K12.” It’s not yet profitable though, but Chinese tech is looking at it with intense interest because it would be the first separately publicly listed company from the Netease family, whereas all the other internet giants in China each have one of their own already, at least one.

Y: But of course, Netease doesn’t just have one business it’s been patiently incubating and growing. In addition to educating people, it’s been breeding pigs for their meat, which happens to be a very good business in China, or at least was before the epidemic this year. Its selling point is that its meat is healthy and safe, organic and free-range, and delicious.  So far the messaging seems to be working although it’s a pretty small business at current.

[30:22] R: In addition to games, people, and pigs, Netease also started a music business 6 years ago and has raised well over $1Bn of outside capital for it, from both Baidu and Alibaba, which makes sense, since the first-place player is Tencent Music, which went public last year. Concurrent with raising money for its music business from Alibaba this year, it also sold off its cross-border e-commerce business, Kaola.

Y: Netease holds on, however, to its private label business 严选 Yanxuan, which sells minimalistically designed consumer goods straight from high quality manufacturers at a fraction of the price of their designer counterparts. That’s a business that’s estimated to have done $1.5Bn last year, and is still growing well above double digits.  Critics call the items rip-offs of famous brands, while fans say that the value proposition is quite appealing.  This is one of Netease’s fastest growing segments but also much lower margin than gaming.

R: Confused? I mean, Netease’s William Ding certainly has his hands in a lot of pies.  But that’s kind of the way Chinese internet companies roll. For him, especially, with gaming such a hits driven business and growth slowing, finding other avenues of growth such as through e-commerce is definitely a worthwhile experiment. We’ll see if Youdao makes a decent public debut — my guess is that it’s going to have a tough time — but Netease, the parent company, has a few other tricks up its sleeve, so I’m sure we’ll be seeing it again in the news shortly!

 [32:08] Y: Alright, that’s all for this week folks! Thanks for listening. As a reminder, our next episode will be out in two Fridays. We really enjoyed putting this together, and we are always open to any comments or suggestions. You can find us on twitter at thepandaily, at techbuzzchina, and my personal Twitter account is GINYGINY.

R: And my Twitter is spelled RUIMA. TechBuzz China by Pandaily is powered by the Sinica Podcast Network on SupChina. Pandaily.com is an English language site that tells you “everything about China’s innovation.” Our producers are Shaw Wan and Kaiser Kuo. Our intern is Wang Menglu. Thank you so much for listening!