What Valley Companies Should Know about Tencent

Quick quiz: Who are the three largest Internet companies in the world by market capitalization?

If you guessed Google and Amazon you got two right, but I’m betting few of our American readers guessed the third. I certainly wouldn’t have a year ago. It’s not eBay or Yahoo; it’s Tencent. If you are in the Web space and haven’t heard of them, read this post, because Tencent’s cutesy penguin mascot is only going to cast a larger shadow in the global Web world in coming years.

Low-key Tencent is the largest, most profitable Internet company in China and it has just under 400 million active users–comfortably bigger than the population of the United States. Tencent recently bought 10% of Digital Sky Technology, which in turn owns huge chunks of Zynga and Facebook.

In the past, Tencent has held joint venture talks with Google and Facebook and made acquisition offers to a few smaller Valley companies that haven’t resulted in deals. But if investor pressure on the Hong Kong Stock Exchange is anything like investor pressure on Wall Street, some deal will happen soon.

Tencent’s stock has more than doubled in the last year, and it has a P/E ratio more than six times Google’s, according to Yahoo Finance. You think Apple’s stock has appreciated in recent years? Check this out. Tencent has had more than double the stock appreciation of Apple over the last five years, according to Yahoo Finance. Investors itch for a company like that to go do something with that rich of a stock currency.

Even if you don’t know the name Tencent, you’ve probably heard of its core IM product QQ. Tencent started in instant messaging in 1999 and unlike nearly everyone else, figured out a way to make money from it by selling virtual goods and services to enhance your avatar. Today, the bulk of its revenue comes from online games, with meaningful amounts also coming from virtual goods sold over its social network QZone and ads over its QQ.com portal and search property.

Tencent has also made forays in online payments and ecommerce, but it has had the least success in that category. The company isn’t giving up. I met with Tencent’s CTO Jeff Xiong in Hong Kong last week and when I asked him what the company’s core strength was, he answered “patience.”

Tencent has benefited from some luck and market timing, like most Web giants. In 2005, there was a big debate within the company over whether they should develop its own search technology or partner with someone. It did both—partnering with Google but developing its own at the same time. Last September the company replaced Google’s search with its own product, in November it replaced Google’s search ad platform with its own and in February it replaced its mobile search with its own. Google started its feud with the Chinese government in March. “We were lucky,” Xiong says. “If three years ago we hadn’t made that decision, we would have been trapped.” Tencent is a small player in search now, but in a market feeling the pain of that Baidu monopoly, many people welcome Tencent getting stronger.

Then again, many others don’t want the company getting any stronger in anything. Tencent uses its near-ubiquitous QQ messaging platform to push users to its other properties, skirting the existing problem in China of sky high prices for keywords and directory listings. Having almost zero user acquisition cost is a formidable advantage. (When it’s used wisely that is. Tencent pushed users to its ecommerce marketplace prematurely, and it just convinced a lot of users to stick with Alibaba’s Taobao.)

Indeed, nearly every startup I spoke with in China was more scared of Tencent getting into their markets than anyone else—the way people in the Valley used to fear Microsoft.

“We’re not doing everything,” protests Xiong, a former Microsoft employee during the anti-trust trial years, who is visibly uncomfortable with the Microsoft analogy. For instance, after big in-house debates Tencent has decided to stay away from business software or a Chinese equivalent of Google Docs, he says. It is making small or no bets on categories like online video, a traditional ecommerce store like Amazon, a reservation engine like OpenTable or Digg-style news aggregation. (Despite Xiong’s protestations, that’s a pretty small slice of the consumer Web the company is not going after.)

I asked Xiong where he expected Tencent to be in ten years. He responded first by saying China only has about 20% Internet penetration. Just growing in China in one of the company’s verticals would grow Tencent dramatically– that’s no doubt driving the stock up. I asked him if he thought Tencent would buy a big Silicon Valley company in the future. He said yes, without blinking. (The company has an office on University Avenue, and Xiong travels here several times a year.)

Tencent is an impressive company, but it’s fair to say the stock is over-heated. It should do something with that currency while it can, the way Google used its enviable stock currency to outbid rivals for acquisitions like YouTube back in 2006. Every Internet company can tell you, that advantage doesn’t last forever.

Indeed, it’s hard to think of an Internet company Tencent’s size that hasn’t done a big, even company changing deal. EBay changed its fortunes with PayPal (and several bad acquisitions unfortunately), Yahoo got into search with Overture, and Google expanded its business with YouTube and DoubleClick. Even Amazon added to its ecommerce arsenal with its recent acquisition of Zappos.

Still, odds are any near-term deals will be modest ones. Pony Ma, Tencent’s founder and CEO, has walked away from large acquisitions in the past because of concerns that the culture’s wouldn’t mix, Xiong says. Indeed, Tencent’s staff has an average age of 26 and has that somewhat cocky but fun feel of working for the coolest company on the planet at just the right time. (I snapped the pictures in this post during a visit to the company’s Shenzhen headquarters.)

Patience is one thing, but Tencent has been cautious long enough– pretty soon it’ll need to start acting like the global Internet company it is becoming.