By Perry Wu
Netease is one of the leading Chinese Internet companies, distributing content both through the web and through its wireless subscription services. Its position comes not least from being early to market, as it was one of the first Chinese language sites to offer a free Hotmail-like email service, beginning in 1997. These days it is involved in a wide variety of Internet businesses including short-messaging services (SMS), online games, and a Web portal combining news, entertainment, and a search engine.

This year Netease has been in the news for all the wrong reasons, having received a Wells notice from the U.S. SEC. A Wells notice is used by the SEC to inform a company of a recommendation that civil action will be taken for wrongdoing. The wrongdoing, according to the SEC, was not recent but occurred around the time of Netease's IPO in 2000. Netease does, therefore, have a point when saying this was in the past, under different management, at a different time, and that investors should focus on the future. So, dear readers, let's instead ignore this SEC warning and see what has happened just recently to send shivers down the spines of Netease's investors.

On July 7, Netease surprised investors by issuing a press release warning that it is having problems in its short-messaging services (SMS) business. As a result, Netease's second quarter revenue from wireless value-added products will be between US$4 million and US$4.3 million, a decline of about 40% from its first quarter revenue from wireless services. According to Netease, this revenue decrease in SMS services will make total second-quarter revenue about US$23.4 million to US$23.8 million, falling about $1.5 million short of market expectations.

Netease's stock promptly fell 12% on the day of its press release.

So how is the company explaining this revenue shortfall?

First of all, the company is blaming that old bugaboo: competition. Netease says that the competition continues to be "intense". Don't you just love it when companies blame competition? As if it's a new thing that competition could exist in a market economy. It's like an airplane pilot blaming gravity for crashing a plane. Any sane investor in Netease knows (or should know) that Netease faces competition from dozens of other Internet players in China, including Sina.com, Sohu.com, Tom.com, 263.net, Linktone, Shanda, Tencent, and chinadotcom. The question is how Netease deals with these competitors.

Next, Netease points to a structural change in how consumers buy SMS services. With the help of a Ms. Christina Splinder at Ogilvy, one of the world's most prestigious advertising and public relations firms, Netease has managed to write what is surely one of the longest run-on sentences (108 words) ever to be seen in the annals of press releases:

"Second, under the direction of the Chinese governmental authorities, the mobile phone operators, China Mobile and China Unicom, together with all third party service providers such as our company have adopted certain new policies and procedures, which on the one hand can facilitate mobile phone users to cancel the wireless value-added monthly subscription services which are no longer needed, and on the other hand, make it more complicated for mobile phone users to order and receive new wireless value-added services by requesting the mobile phone users to send a re-confirmation SMS message using their mobile phones to the service providers confirming the services they ordered through the Internet."

English translation: It's easy for customers to cancel their old SMS service, but it's hard for them to sign up for a new SMS service.

Netease tries to strike an upbeat note by claiming that its online games and advertising business are still prospering. But it is really with SMS that Netease has its strongest position. For the full year 2003, revenue from wireless services of US$33.7 million accounted for more than half of Netease's total net revenues of US$65.5 million. As noted in previous columns, the SMS business involves a complicated tango with the Chinese telecoms, with the telecoms holding most of the power. Netease's problems in its SMS business might just be an ominous symptom of more trouble to come for Netease and other companies in this sector.

With other Chinese Internet stocks dropping along with Netease this week, this might mark the beginning of a reality check that investors make about Chinese Internet stock valuations. Then again, probably not. History shows that nonsensical valuations can be sustained much longer than people might think. So don't call your broker with short-selling orders just yet.

About the author:
Perry Wu is a writer and correspondent for ChinaTechNews.com and can be reached here at the site. Perry Wu does not hold any positions, long or short, on any of the Chinese or American company securities mentioned in this article.