Industry Note September 13, 2004 Safa Rashtchy, Senior Research Analyst Technology 650 838-1347, [email protected] The China Analyst: Online And Mobile Games Aaron M. Kessler, Sr Research Analyst 650 838-1434, [email protected] Gaining Popularity Reason for Report: KEY POINTS: Industry Overview The China Analyst is our weekly report on the Chinese Internet and technology market. Our commentaries are based on data we collect daily in China using our Related Companies: staff and consultants as well as industry contacts in Mainland China and Hong CTRP 31.52 Kong. Our goal is not to summarize news, but to analyze the most important CHINA 6.73 developments in Internet, online games, wireless services, economy, technology, NTES 35.51 SINA 22.23 consumer behavior, corporate activities, and government regulations, and to SOHU 15.13 discuss how these trends impact both our existing coverage companies in China as SNDA 24.19 well as the broader, long-term development of the Chinese Internet market. Summary of Internet Activity in China (MM) Jun-04 Jan-04 Jun-03 Y/Y % Total active users 87 80 68 28% Dial-up subscribers 52 49 47 11% ISDN subscribers 6 6 5 20% ADSL subscribers 31 17 10 210% Source: China Internet Network Information Center, Piper Jaffray China Research Summary of Telecom Activity in China (MM) Jul-04 Jun-04 Jul-03 M/M % Y/Y % Fixed line subscribers 299 295 241 1.4% 24% Penetration rate 24% 24% 19% - - Mobile users 310 305 239 1.6% 30% Penetration rate 24% 24% 18% - - Source: Ministry of Information Industry of China, Piper Jaffray China Research Industry Commentary – Online and Mobile Games Gaining Popularity as more companies are focusing on this fast growing, and relatively safe, segment. Industry News - Olympics benefits Sina, eBay to integrate Eachnet, etc. China Stocks This Week - Update on company performance. Company Updates - Our latest thoughts on Sina, Sohu, NetEase, Ctrip, and Shanda. Piper Jaffray China Internet Index (PJCII) Index Last Week YTD LTM Piper Jaffray China Internet Index 5.1% -36.2% -40.7% NASDAQ 2.7% -5.4% 2.6% Risks - Include the volatility of wireless revenues, investor sentiment toward a young and new sector, the potential of government intervention, and the potential of decline or volatility of economic growth. The unique corporate structure of the Chinese Internet companies also poses additional risk factors for investors. Piper Jaffray & Co. does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decisions.This report should be read in conjunction with important disclosure information, including an attestation under Regulation Analyst Certification, found on pages 6 - 8 of this report or at the following site: http://www.piperjaffray.com/researchdisclosures. Customers of Piper Jaffray in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost to them, where such research is available. Customers can access this independent research by visiting piperjaffray.com or can call 800 747-5128 to request a copy of this research. Page 1 of 8 Industry Note September 13, 2004 Industry Commentary Online And Mobile Games Gaining Popularity . The online game sector in China is gaining more respect and popularity from an increasing number of Internet and wireless companies, as well as from U.S. based game companies. In addition to the expansion of the existing titles and game genre, many companies are now focused on developing new mobile games, which we believe will eventually constitute a large opportunity. Several factors are contributing to this trend, in our opinion. First, the continued growth and success of companies like Shanda and NetEase's online game operations have been in sharp contrast with the difficulties faced by the wireless entertainment and services sector. Second, while there has been some crackdown by the government to control the content of the games and ensure that violent and adult material is excluded, the most successful games in China have traditionally avoided these sensitive areas and thus, only minor, gray-market type games were impacted (unlike wireless services, all legal online games must be pre-approved by the government agencies before they are offered even as beta products). Finally, the popularity of the online games has expanded to a wider user base and now includes older users as well as more women, especially as more "casual games" (less intense than the Role Playing games) are developed and marketed. These trends all bode well for a clear expansion path from online games to mobile games (we note that is not a migration path since the functionality and interface offered by high bandwidth, large screen PCs cannot be duplicated by handheld mobile devices). Many of these games can also be ported to wireless platforms in new formats and titles, and we fully expect that in the next three years, the games segment will constitute a large part of the wireless services revenues. Revenues from wireless games are now negligible, but the operators (China Mobile, China Unicom) as well as service providers and the games developers are highly focused on this segment. Industry reports suggest that the U.S.-based Electronic Arts is actively looking for investment and/or partnership opportunities in China. Several Japanese and Korean game companies have also stepped up their involvement in China and are now looking to expand into the mobile game sector. Shanda, the leading online games company in China recently announced the acquisition of a small wireless games developer, Digital Red. Separately, KongZhong recently signed a deal with mobile game maker Superscape for distribution of its games through KongZhong's China Mobile platform. We believe most of the wireless service providers will now heavily focus on developing mobile games, both because of the increasing popularity of the games and the availability of the new handsets, as well as the relative stability and safety of these games compared with other types of wireless entertainment content. Unlike IVR, chats, or online dating and friend-finding applications, mobile games don't involve much user generated content. As such, once approved, they are a reasonably safe and stable source of revenue. At the same time, mobile users are getting accustomed to these new forms of entertainment and we believe will be increasingly likely to pay for these games. Industry News Olympics Benefits Sina . Industry sources report that China's Neilson Netratings has declared Sina the big winner of the online traffic generated by the Athens Olympics. While all portals saw a significant rise in traffic, Sina apparently saw the heaviest the traffic, getting 28 million visitors during the events, from the 13 th to 29 th of August. eBay To Integrate Eachnet . Media reports in China suggest that eBay will finally integrate its Chinese auction site Eachnet into the eBay platform, giving it the eBay look and feel and also requiring eBay registration. The new platform is expected to take effect on Sep. 17th. The registration process may cause some short term drop in listings or closed auctions if all sellers and buyers are required to register as new eBay users. We note that Alibab's auction site Taobao has created fierce competition in China for Eachnet and various industry sources have suggested that Eachnet, in response, has stepped up its advertising spending heavily. Within this context, changes to the platform are particularly important and potentially risky. Alibaba Expands Its Ad Campaign . Alibaba, the largest B2B network connecting Chinese manufacturers with international exporters, has renewed its ad commitment with CNBC, signing a new contract for nearly $5 million with CNBC, according to industry reports. Alibaba's ads on CNBC show successful U.S. and European business managers who have been able to very efficiently locate Chinese exporters for their products, using Alibaba's network and website. The website allows Chinese business to be listed in a directory that is then searched by businesses worldwide looking for cost-effective producers of a given product. Alibaba also operates the C2C auction site Taobao, referenced above, which competes with eBay's Eachnet in China, and recently announced its intention to invest an additional $42 million in Taobao. China Stocks This Week. China stocks were mostly higher this week in the absence of any new suspensions and investors getting more comfortable that the major suspensions are behind us. Our China Internet index increased 5.1% last week versus the NASDAQ's 2.7% increase. Year-to-date, the China Index is down 36.2%, while the NASDAQ is down 5.4%. On average, we expect the Chinese stocks to appreciate from current levels as investors become more comfortable with the wireless revenue pattern as well as the heavy sell-off Piper Jaffray & Co. does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decisions.This report should be read in conjunction with important disclosure information, including an attestation under Regulation Analyst Certification, found on pages 6 - 8 of this report or at the following site: http://www.piperjaffray.com/researchdisclosures. Customers of Piper Jaffray in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost to them, where such research is available.