Will China Be Netflix Inc.'s Toughest Expansion Market?

By Markets Fool.com


Image source: Netflix.

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It's no secret that Netflix plans to launch video streaming in China. It kind of goes with the territory when your CEO says the entire world should have access to Netflix services no later than 2016. The company is already looking for experts in simplified Chineseto help out with captions and other local language needs.

And, of course, the Chinese market is bracing itself for the coming Netflix winter.

Youku Tudou already boasts about 500 million users for its YouTube-style video service, which also includes access to professionally produced TV series. WhileWalt Disney has a domestic Netflix distribution deal in place, it didn't want to wait for its partner to launch in the Middle Kingdom, so Disney and its Marvel division recently struck a Chinese marketing deal with Youku.

Shenzen-based social media giant Tencent Holdings tapped Hollywood's largest studios to create a high-quality online movie service. Focused on aging catalog titles but with a sprinkling of more recent movies, the so-called Hollywood VIP service looks much like Netflix streaming offering did five years ago.

Most recently, Alibaba said it would launch an online streaming service by the end of the summer. Known as TBO, or Tmall Box Office, it is aimed directly at Netflix and archrival Time WarnerHBO . "Our mission, the mission of all of Alibaba, is to redefine home entertainment," said Patrick Liu, Alibaba's head of digital entertainment. "Our goal is to become like HBO in the United States, to become like Netflix in the United States."

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And that's just a sample of the thriving digital video market in China. Name a Chinese online giant, and chances are that it either runs a streaming video service today or has a quick launch right up its sleeve.

Maybe it's unfair to say the Chinese online giants are preparing specifically for the imminent Netflix launch.But comments like Liu's certainly show the local media industry looks to Netflix for inspiration.

Can Netflix find its way through the streets of Shanghai?

Is China worth it?
Netflix has a tough row to hoe in China. The burgeoning digital video market makes it difficult for newcomers to waltz in and start stealing eyeballs, and China's notoriously difficult regulatory systems add to the challenges any foreign company faces.

With so many roadblocks to overcome, you might wonder if it's even worth Netflix's effort to enter this market. But think about the massive size of the Chinese opportunity.

The Chinese middle class is exploding. In 2000, McKinsey found that only 4% of Chinese households wielded purchasing power on the same level as their Italian or Brazilian middle-class counterparts. By 2012, that segment had grown to cover 68% of China's 1.4 billion citizens. That's nearly a full billion people with money to spend.

If you're worried about China's networking infrastructure, it's true that less than half of the country's 256 million households have Internet access at all today. Moreover, many connected households rely on technologies far too slow to enjoy a high-definition movie stream.

On the other hand, Chinese Premier Li Keqiang is investing $182 billion of government money to erase the broadband problem. Over the next three years, the nation will be crisscrossed by brand new fiber-optic and wireless networks, aiming to reduce consumer costs and raise broadband speeds significantly.

So, yes, Netflix most certainly wants a slice of the Chinese pie. This market will soon dwarf our domestic broadband-connected middle class. Might as well get started before the broadband rollout is finished, since the newly connected Chinese consumers are about to pick their favorite services for years to come.

What's the plan, then?
The obvious question, then, is how does Netflix plan to overcome the difficult competitive landscape and China's draconian bureaucracy?

The obvious solution might be to partner with one of the many existing local services. If Netflix could strike some kind of co-branding deal with Alibaba or Youku Tudou, that simple step would instantly remove plenty of governmental red tape. Bundling the Netflix brand with a well-known Chinese name could also kick-start the marketing effort.

In such a partnership, the China-based participant would provide infrastructure, procedural know-how, and marketing muscle. Netflix would add a healthy content portfolio with the promise to add more Chinese titles -- and the brand is actually not totally anonymous behind the Great Wall.

Yo, ho ho and a bottle of rum!

Netflix original series House of Cards sees plenty of piracy worldwide, according to piracy tracking firm Excipio, but China accounted for a full 9% of the latest season's illegal downloads.

Netflix CEO Reed Hastings likes to view piracy as a measure of market readiness, by the way. The company is about to open shop in Spain, which is known for heaps of piracy downloads, but Hastings shrugged off that concern in media interviews.

"You can call piracy a problem, but the truth is that it has also created a public that is now used to viewing content on the Internet," Hastings told Spanish newspaper El Mundo at the announcement event. "I think Spain will be one of our most successful countries. There is a high rate of Internet connectivity and a population that is accustomed to the use of electronic commerce and that has shown signs of being interested in our product. We are very optimistic."

On that note, Netflix might hit the ground running in China. Local consumers already want to see Netflix originals, and perhaps even more so when the content comes from a legit and easy-to-use streaming service.

Plan B
Of course, Netflix could also choose to go it alone. Chinese business partners might ask for too much control, too much ownership, too many Netflix concessions for Hastings' tastes.

I wouldn't be shocked to see this happen. But as a Netflix investor, I would be disappointed.

This would be a far more difficult idea. Getting local help with government processes is a big deal, and a joint venture would offer a one-two punch of branding power. Driving solo on the streets of Beijing would cost Netflix far more money and slow the growth process. On the upside, the company would then hold on to 100% of its Chinese income, as opposed to sharing it with the likes of Tencent or Youku.

In the very, very long run, that makes sense. But a hybrid solution looks even better.

Netflix wouldn't be the first company to start a new market as a joint venture and then buy out its original partner a few years down the road. That's the ideal solution in my eyes. I'd be thrilled if Netflix goes down that specific path.

We'll just have to wait and see what Netflix does. For now, China is girding its collective loins for a digital media war, and Netflix intends to join that battle. That's all we really know today.

The article Will China Be Netflix Inc.'s Toughest Expansion Market? originally appeared on Fool.com.

Anders Bylund owns shares of Alibaba, Netflix, and Walt Disney. The Motley Fool recommends Netflix and Walt Disney. The Motley Fool also owns shares of Netflix and Walt Disney. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.