I’m Feeling Lucky

Google’s Growth Prospects in China

INTRODUCTION

This paper will examine Google’s attempts to expand into China, one of the company’s
most challenging growth areas. It will focus on Google’s battle with local search engine
Baidu and why Google has struggled so much in China despite dominating elsewhere.
There are three variables that are out of Google’s control but influential in determining its
success: politics, culture, and Baidu, as well as one variable that Google can control:
technology. This paper will break down these variables by looking the past, analyzing the
current state, and projecting how developments on the horizon will affect Google’s
position in China.

GOOGLE’S INTERNATIONAL PRESENCE

Today Google lists local domains in 170 countries and controls over 80% of the search
market in most of Europe and South America. International revenues have increased as a
percentage of total revenue and in 2008 accounted for 51% of total revenue, up from 48%
a year agoi. There are however still several regions where Google has struggled to
penetrate the market, namely Russia and East Asia. As of January 2008, Google
commanded a measly 32% in Russia, 19% in China, and 5% in Koreaii. In each of these
countries, it has been unable to unseat incumbent local search engines. This failure is
troubling for Google because these countries are rapidly developing economies with
growing Internet user populations. On the other hand, if Google can gain an 80%
majority like it does in most of the world, the effect on revenue growth would be
tremendous. In China alone, there are more Internet users than in all of the U.S. In 2008,
Chinese Internet usage grew 42% to 298 million, but only 1 in 4 have Internet access.
The Chinese government hopes to provide phone and broadband access to every village
by 2010iii.

GOOGLE IN CHINA

Google first translated its search engine to accept Chinese and other Asian languages in
2000. In 2006, Google opened offices in China and launched a modified version of its
search engine with a Chinese domain name, google.cn. Google put former Microsoft
executive Kai-Fu Lee in charge of its China operations and installed content filters in
accordance to Chinese censorship laws. In 2008, Google increased its share from 23% to
28% while Baidu also grew from 59% to 62%iv. Despite difficulty in growth, Google
realizes the importance of the Chinese market. At the 2009 Morgan Stanley Technology
Conference, Google CEO Eric Schmidt called China “the obvious prize” in international
expansion.v

POLITICAL FACTORS

The biggest challenge for Google’s future in China may be political forces. China’s
central government lacks the transparency of its U.S. and European counterparts and a
sudden policy change from Beijing can dramatically affect Google’s fortunes.

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Censorship
The central political issue surrounding the search engine business is censorship. It was
censorship that first stunted Google’s growth in China: In 2002 Google.com controlled 25
percent of the Chinese market while underdog Baidu was struggling with less than 3
percent.vi Then starting September 3rd, 2002, Google was blocked by the “Great Firewall
of China” for two weeks and afterwards suffered continuous outages to the point where it
was inaccessible 15 percent of the time. Baidu however had no such problems because
their servers were located in China. Faced with a severe competitive disadvantage,
Google decided to open offices and data centers in China and subject itself to Chinese
censorship laws. In January of 2006, google.cn was officially launched. By then, Baidu
had already taken command of over half the Chinese market while Google essentially
remained unchanged at 27 percent. Worst of all, Google was getting almost no exposure
to the all important college demographic because it had been blocked at Chinese
universities.

Since then, the Chinese government has shown no indication that it is relaxing its
censorship rules and a brief March 2009 blockage of YouTube served as a reminder to
Google that it is on a short leash. Google must remain vigilant and keep its site in
compliance with Chinese laws. If government censors find objectionable content, they
can block access to Google’s search engine without warning. Any long term outages
would severely damage Google’s reputation in China and undermine its growth efforts.
In fact, many American executives in the industry believe the Chinese government was
urged on by Baidu to shut down Google in 2002vii. Beijing tech insiders say it is common
for domestic firms to use censorship laws to keep out foreign competitors.

Nationalism
If government favoritism were not enough of a problem, Google also faces the threat of
consumer nationalism. Nationalist sentiments are high in China as a result of the Beijing
Olympics and the global recession, which many Chinese view as the U.S.’s fault. The
mood is especially strong among younger Chinese who are the target of Unhappy China,
a nationalistic book which has become a bestseller in China.viii The book prescribes a
greater reliance on domestic technology, which plays right into Baidu’s hands. If there is
no significant differentiation in technology, nationalistic Chinese may choose
homegrown Baidu over the American Google.

In addition, any strains in Sino-American relations could lead to a boycott of American

companies, including Google. In 2008, 20 million Chinese signed an online petition to
boycott French products in response to French protestors at the Olympic torch relayix.
Although the French boycott fizzled because many of the targeted products were basic
necessities, Google is easily substitutable by Baidu because there are minimal
differentiation and switching costs. Unfortunately, Google has no control over Sino-
American diplomacy. Its best hedge would have been to partner or operate through a
Chinese subsidiary, but it has established too much of a name for itself to go that route
now. Google can only hope that disputes between the U.S. and China over Tibet or naval
surveillance ships do not create harsh anti-U.S. backlash in China.

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CULTURAL FACTORS
Piracy
A second challenge for Google is the difference in China’s online culture. One difference
that Baidu readily exploited was piracy. In China, legal music stores like iTunes are less
popular than in the U.S. and downloading pirated software, movies, and especially music
is much more socially acceptable. 70% of Chinese web users download music and the
International Federation of the Phonographic Industry (IFPI) claims that 99% of those
downloads are illegal.x Baidu’s homepage has a tab that generates links specifically for
mp3 files. In 2006, illegal mp3 searches accounted for one-fifth of Baidu’s trafficxi. As a
law abiding American company, there was no way Google could offer an analogous
service, even just in China.

Google’s solution was a free, ad supported legal alternative launched officially on March
30, 2009xii. Google partnered with Chinese web site Top100.cn to make over one million
songs from more than 140 record labels available for free. Lee called it “the key missing
piece” to Google’s service in China and hopes to earn $14.6 million from the service in
annual revenue in a few years. At the end of the test period, users were downloading or
streaming 1.5 million times a day from the site. While this is a good start for Google, it
does not give Google a competitive advantage over Baidu, especially if there are tracks
available on Baidu that have not been licensed to Google. If anything, it merely evens the
playing field. The real game changer will be a societal shift in attitudes toward piracy, a
successful lawsuit by the IFPI, or a combination of the two. The IFPI currently has a
pending lawsuit against Baidu alleging the company facilitates illegal downloads. There
is no question who Google is rooting for.

Small Businesses
Another cultural difference Google has been slow to pick up on is the Chinese business
culture. Chinese businesspeople prefer in person communication to e-mail, which helps
explain why neither Baidu e-mail nor Gmail are offered in China. Instead, Baidu captured
users by allowing instant discussion group for search queries, which are wildly popular in
China. Baidu has also aggressively gone after small businesses by educating them in
search and search advertising while Google has stuck to its Silicon Valley culturexiii.
Google has been unable to replicate its fun and collaborative atmosphere in its Chinese
offices, thus making it awkward for visitors. Baidu’s offices, while less colorful, are
much more welcoming for Chinese businesses because they provide more personal
attention. Baidu provides incentives to advertising companies to make ads cheaper for
businesses.

Overall, Baidu’s greater mastery of Chinese business culture has allowed it to build up a
strong network of small business users. Google has committed several missteps by trying
to import its American success formula without adapting it to local cultural nuances. As
the duration of Google’s Chinese presence continues though, the company will learn
from its mistakes and close the culture gap as it begins to understand Chinese businesses
and Internet usage.

THE BAIDU FACTOR

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Some of Google’s success in China will be determined by the actions and strategies of its
main competitor Baidu. Up until now, Baidu has exploited its knowledge of Chinese
customs and outmaneuvered Google in the search engine market. Recently however,
Baidu has made several missteps that could cost it market share and investors have
responded. Over the past year, Baidu’s stock has been down over 33 percent versus
Google’s 18 percent.

Search Accuracy
The single greatest source of controversy surrounding Baidu has been its practice of
giving preference to paid advertisements over organic search result. This practice came to
haunt Baidu when China’s state run CCTV network reported in November that some
patients sought care from unlicensed pharmaceutical companies because they appeared
higher on Baidu’s search results. Baidu’s stock took a 25 percent hit in one dayxiv and the
company cut its fourth quarter revenue forecast by 15 percent. Baidu quickly removed the
unlicensed companies from its results and on March 29th, 2009, it announced it would
drop paid search rankings completelyxv.

Baidu’s search problems do not stop there. Some former Baidu clients claim the search
engine dropped their web sites after they stopped buying search ads from Baiduxvi. Baidu
has denied these accusations, but a group of more than 50 companies are planning to
launch a lawsuit against Baidu for anti-trust, fraud, and infringement violationsxvii. Baidu
is also allegedly complicit in another Chinese corporate scandal: a leaked document
shows Sanlu, the dairy company responsible for the melamine milk crisis, offered to pay
Baidu to bury negative publicityxviii. Baidu denied it took any action.

In the short term, the damage has been done. Baidu saw its first sequential decline in
quarterly sales since the company became publicxix. Google was able to make gains in the
online advertising market, increasing its share by 4.4 percent to Baidu’s 2.9 percentxx. In
the long run though, Baidu will get over its recent publicity problems and maintain its
position on top. Despite an initial backlash against Baidu, Google has been unable to
make a sustained gain in the search engine market. Google may temporarily have the
better image, but Baidu still has nationalism on its side. Said one Chinese marketing
executive, “I got a pretty bad impression of Baidu at first, but it’s also important to
support domestic companies.xxi”

Baidu’s Expansion
Baidu has made some questionable decisions to expand recently. In 2007, Baidu
announced it would spend $15 million on its first overseas expansion, Baidu Japanxxii.
Baidu was confident that its search engine was well adapted for the Japanese market
because the two languages share many of the same characters. However, the Japanese
market is dominated by Yahoo! Japan and Google, who control 51 and 39 percent
respectivelyxxiii. So far Baidu’s presence has been insignificant. Its main advantages,
nationalism and culture, are gone in Japan. At the same time, it is drawing resources and
attention away from its domestic operations. If anything, the decision to expand indicates
that Baidu is getting desperate to find new sources of growth. If Google can contain

5
Baidu within China, it can limit Baidu’s growth opportunities and force Baidu into a war
of attrition.

In 2007, Baidu also decided to enter the consumer-to-consumer (C2C) e-commerce

market. Strategically, it makes little sense for Baidu because it moves away from its core
search business. The move pits Baidu against another Chinese online heavyweight,
Alibaba, which controls 83% of the C2C market through its subsidiary Taobao. Since
then, relations between the two companies have soured. On October 10, 2008, Alibaba
sent a letter to Baidu saying it would terminate its advertising on Baidu because of “lack
of effectiveness.”xxiv Taobao, which had already pulled its ads from Baidu and blocked
Baidu’s bots, saw traffic increase 180% over the past year anyway. In addition to the
direct blow to revenues, Baidu puts itself in the unenviable position of fighting a war on
two fronts against Google and Alibaba.

This is Google’s best shot at exploiting Baidu’s mistakes. Alibaba is currently seeking a
partnership with several large American companies for international expansion, including
Googlexxv. If Google can extend that partnership into China as well, the two companies
can really put the squeeze on Baidu—Alibaba from the e-commerce side, and Google
from the search side. Google should not expect Baidu to self-implode from its mistakes,
but it can take advantage of every window of opportunity that Baidu leaves open and chip
away at its dominance.

IT’S THE TECHNOLOGY, STUPID

If there is one bright spot for Google, it is that it controls the one factor which is also its
greatest strength: innovation. Baidu can ride nationalism and cultural sensitivity all it
wants, but all of that is moot if Google can come up with a dramatically better search
product than Baidu. The two most promising sources of innovation for Google China are
semantic search and mobile search. Fortunately, these two areas are also part of Google’s
overall long term strategy.

Semantic Search
Semantic search is widely believed to be the future of Internet search. Unlike traditional
keyword search, which Google had been using, semantic search aims to understand the
query by associating it with certain words and concepts. This will help improve search
results and cut down attempts to game the system. In March, Google announced that it
added semantic search to its algorithmxxvi. The current algorithm uses a combination of
keywords and semantic search. Baidu has not shown any public signs that it is working
on semantic search. If Google can effectively adapt its semantic search to the Chinese
language, it can exploit Baidu’s recent troubles with search accuracy and tout its
technological superiority. Google can then gain and hold onto a significant portion of
Baidu’s market share while Baidu plays catch-up.

Mobile Search
An even more promising source of growth is mobile search. In August 2008, there were
616 million mobile users in China and it is growing at 19.46% a yearxxvii. Google

6
positioned itself to profit off a large piece of the pie by partnering with China Mobile,
China’s largest mobile carrier, for exclusive rights to process its customers’ search
queries. China Mobile controls about 70% of the Chinese mobile marketxxviii. Google
already leads Baidu in mobile searchesxxix and it will look to extend its lead with the help
of China Mobile.

Google has the additional advantage of its Android open source platform. China Mobile
recently acquired 3G licenses from the government and is set to release China’s first
Android phone, the Lenovo OPhone in 2009xxx. While Android has been slow to catch on
in the U.S., it may have an easier path to adoption in China because it does not have to
battle the iPhone. Google can make itself the default search engine and mobile operating
system for many new Chinese smartphone users. This is a capability Baidu currently does
not have and Google can use it to shut Baidu out of mobile search. This could prove to be
the real prize as Google China expects to process more mobile queries than Internet
queries by 2011xxxi. However, Google needs to avoid the same legal trouble Microsoft did
when it packaged Internet Explorer with Windows. Baidu will not hesitate to bring an
anti-trust lawsuit against Google if the Android-Google search combination proves to be
too effective.

CONCLUSION

Baidu has won the early rounds of the search game in China thanks to its home court
advantage. It has received favorable treatment from the Chinese government and people
and has taken advantage of its cultural knowledge. Google is in it for the long haul
though and many of Baidu’s early advantages will fade while Google’s greatest asset, its
technology, will shine through. Google China is now based in China so censorship for the
two companies is the same. As time goes on, Google will undoubtedly understand the
local culture as well.

Google needs to turn future rounds of the battle into a war of attrition. It needs to open up
new fronts against Baidu in mobile search and e-commerce with the help of Alibaba to
contain Baidu’s growth opportunities and limit it to online search in China. There Google
can use its superior financial resources and market diversity to poke and prod at Baidu’s
every weakness. Although it may not win every fight, Google just needs to chip away.
Coupled with superior technology, Google can overtake Baidu in time. Despite
nationalist sentiments, American brands like Coca-cola, KFC, and Buick have all found
success in China. With a superior product offering, Google can join them as well.

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Exhibit 1. Google Share of Search in Selected Markets

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Exhibit 2. One Year Stock Prices, Google v. Baidu

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10
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