Who wins when Google leaves China? Microsoft and Baidu might not like the answer

March 18, 2010: 3:06 PM ET

The big question in China isn't why Google is leaving but who will take its market share. Microsoft wants it, Baidu's a favorite, but local powers like Sohu and Tencent are more likely to be the big winners.

By Bill Powell, senior writer

The days are winding down for some of the best and brightest who went to work for Google (GOOG, FORTUNE 500) in China over the last couple of years. They can't say so publicly, of course—and some of the more than 700 employees who work at headquarters in Beijing will no doubt retain their jobs. But to say that others are fatalistic is to put it mildly.  "What can we do?'' says one computer scientist who has worked at Google China for more than two years. "If the search business in China is shut down, it's shut down. If I have to find another job when it happens, I'll do it. I don't want to—I like it here—but I will."

It's no longer a matter of if, but when Google is forced to exit the search business in China—and when could be in a matter of weeks.  The Mountain View giant's extraordinary insistence that it would no longer censor the search results on Google.cn—the second leading search engine in the country with the most Internet users in the world—will soon lead to the demise of its Chinese language search business. The Chinese government was never going to negotiate with Google on the issue of censorship—particularly not after the U.S. government hitched its wagon to Google's cause, in the form of Secretary of State Hillary Clinton's  January 21st speech on Internet freedom.  In fact, it's only within the last few days that anyone from the Chinese government has even conceded publicly that it was talking to Google at all.  And while Google's move may have sent a thrill up the leg of human rights activists the world over,  a lot of investors were—and remain—furious. Since posting the announcement on its website January 12 that it would no longer censor, Google's stock price has declined 5% to about $567 currently , while Baidu (BIDU), the leading search engine in China, has seen its stock price rise by 50%.

The reason for that is obvious.  January 12 was, in effect, the starting point for the next phase of competition in China's search market: the battle for Google's share, which is about one third in terms of search revenue.  The most obvious potential foreign beneficiary is Bing, Microsoft's (MSFT, Fortune 500) new search entry. And while it may not exactly have been handed the keys to a very rich kingdom, the executives there understand their good fortune—and have not been shy about subtly sticking the knife into Google.  On March 17, Craig Mundie, Microsoft's strategy chief, told the China Daily, a daily, English language house organ of the Communist Party, that  "we feel good enough now (about Microsoft's position in China)," and added: "But it's a 20 year (journey) and not just three years." While Bing has yet to make a dent in China—its market share is less than 1%— Mundie stated the obvious when he said that the company stood to gain share in Google's wake. And, he couldn't help but add: "Microsoft is here to stay."

That's no doubt true. But it's also true of several other domestic Internet companies who are moving swiftly to capitalize on Google's (choose one) self-inflicted wound/inspirational stand. Numerous sources says both Sohu.com (SOHU), a Yahoo-like website founded by MIT graduate Charles Zhang, and a hugely successful instant messaging company called Tencent Holdings,  are already aggressively trying to hire Google China staff. (Google China declined to comment.) Neither has much of a presence yet in search: both have less than 1% of the market.  But both were already investing significantly in search even before Google's ultimatum in January, and are now obviously even more determined to take on Baidu.

Analysts believe that of the two, Tencent has the better position to capitalize, given its dominant position in China's booming instant messaging business. According to estimates by Analysys International, nearly 70% of China's 400 million Internet users use instant messaging, and of those, 80% use Tencent's QQ program. That's the major reason why Tencent's current market capitalization is bigger than Baidu's, and an insider at the company acknowledges that search "is very much" a target of opportunity.

All of the potential usurpers do what the Chinese government requires: they censor their search results (as, still, does Google): random searches on all three platforms on March 17 for "Tiananmen Square, 1989," and "Falun Gong"—two hot buttons as far as Beijing is concerned—prompted the usual government approved pablum about both subjects. If Microsoft and the others intend to be "here to stay," as Mundie put it, there is no chance—none— that that will change for any of them going forward.

Since January 12, Google's primary mission when it comes to its China operations has been damage control. What, if any, of its businesses beside search will survive? So far, it appears that Chinese adopters of Google's new Android operating system—including China Mobile and China Unicom, the two dominant mobile phone companies—still have the government's permission to utilize the platform.  But the future of other businesses Google is involved in China—for example, TOP 100.cn. a music portal funded by  Google and several big music labels—is entirely unclear.

To date, in fact, the only thing crystal clear is the market's verdict on Google's stand. Markets don't do politics; they react to politics. And however noble Google's 'no censorship' stand may be, one of its large institutional investors (who did not want to be identified publicly) no doubt speaks for many when he says, "there are still a lot of us who can't believe they are going to be out of the Chinese search market;  that they've effectively made this choice."  But out is what the world's dominant search company will apparently be.  "And I guess," the investor says, "we just get to lump it."

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Dan Roth
Dan Roth

Daniel Roth is the editor of FORTUNE.com, overseeing its daily analysis of the biggest topics in business and the most important companies. Previously, Roth was a senior writer at Wired magazine. His 2008 cover story on Shai Agassi was a finalist at the Loeb business journalism awards and his story on Demand Media was included in Yale University Press' Best Technology Writing 2010. Before Wired, Roth was the first writer and founding member of Cond Nast Portfolio. Roth also served as a senior writer and senior editor at FORTUNE for eight years.

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