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ByteDance´s path of breaking into the top tier of China Tech (1/2): A closer look at the core business

ByteDance successfully reached an astonishing 100 billion USD valuation in private markets by achieving a leading position in China´s advertising market. But for how long can the fast growth continue? And will it be enough to join Alibaba and Tencent?

· Internet

{{{Cedric Jaeger and Alexander Kremer}}}

In this two-part series, we first investigate how ByteDance was able to reach a leading position in the Chinese advertising market within just 8 years but how this likely also limits growth prospects in the core business at home. Part two then focuses on new potential growth avenues that ByteDance already embarked on and evaluates the prospect for success.

ByteDance continues dominating the headlines this year. It started with increased usage during Q1 with the world in lockdown, and continued in May with the announcement of hiring Kevin Mayer as the new global CEO of TikTok and Group COO. However, just shortly after, TikTok, among 59 other Chinese apps, got banned from Indian app stores. To make matters worse, since late summer there has been an US White House effort under way banning TikTok from US soil, which might have damaging impact on other developed markets as well. Moreover, Japan started considering a ban of TikTok in late July, according to reports. As a result, Microsoft and ByteDance have been negotiating to carve-out TikTok for English-speaking countries at a USD 30-50 bn price tag over the last few days.

A leak reported by Reuters in June now shines some light on the inner revenue planning of ByteDance. After stellar revenue growth from USD 7.4 to USD 20 bn in 2019 (+170%), the company aims for a modest 40% growth rate in 2020 to reach USD 28 bn. It is largely believed that 90%+ of those revenues came from the Chinese market.

Figure 1

To put things into perspective, Tencent, the company behind WeChat, achieved 21% revenue growth in 2019. Alibaba, the largest player in the ads industry, got to 35% growth in its last full business year. Both competitors though also have several revenue streams outside the advertising business (Tencent: 20% ads, Alibaba: 40% ads). Baidu in comparison, almost fully relying on advertising (circa 75%) and going through a corporate restructuring, only grew 2% in fiscal 2019.

The significantly reduced growth expectation, compared to 2019, made many wonder about what causes the massive slow-down for ByteDance and where future growth might come from for one of the world´s highest-valued pre-IPO companies. ByteDance so far maintained a rare feature among the new generation of Chinese tech companies: it did not receive any investment from either Alibaba and Tencent but rather emerged as a fierce competitor in the advertising space. This poses a question then: Will ByteDance be able to join the ranks of Alibaba and Tencent with USD 700 bn in market cap, or is it going to join the likes of Meituan, Pinduoduo and JD.com at USD 100 bn? Reflecting on past achievements and new growth expectations, the time seems right to take a step back and take a deep look into ByteDance´s core business.

The Rapid Rise of ByteDance

Today, ByteDance is worth more than USD 100 billion. This estimation is based on recent private trades and represents at least a 33% increase from its USD 75 billion valuation during a major funding round two years ago. ByteDance counts Sequoia, Softbank, Hillhouse, KKR and General Atlantic among its investors. In only 8 years, the company has risen to one of the highest valuations in private markets in the last decade - only topped by Alibaba and Ant Financial (valued between USD 150-200 bn and to IPO in Q3 this year). Looking at comparable public companies, ByteDance has already surpassed Twitter and Snapchat in terms of valuation.

Within its peer group, it becomes clear why ByteDance’s growth amazed investors so much. No other comparable company has reached such a high revenue number within just 8 years. To be fair, also (online) advertising markets were not that large around that time many of the competitors were established, yet this is truly the major achievement of ByteDance.

Figure 2

However, while many peers did not achieve the same scale of business within a matter of eight years, Tencent and Alibaba both eventually turned out being USD 50+ bn revenue companies. Baidu, almost entirely relying on ads, stands at USD 15 bn revenue though. American counterparts like Google stand at USD 160+ and Facebook at USD 70 bn. This clearly raises the question of potential future growth for ByteDance and whether it can join those ranks.

Besides the future growth prospect, the question arises whether the current valuation of ByteDance is justified given revenues of USD 20 bn and a net income of USD 3 bn.

Figure 3

Simple multiple analysis (Figure 3) indicates a fair valuation based on current revenue. ByteDance’s revenue multiple of 5.0 is in line with Alphabet’s as well as Weibo’s but undercuts Snap, Twitter, Facebook, and Tencent - all beyond 8. That indicates further room to increase, even just at the current revenue level. ByteDance´s 2020 40% growth target still looks ambitious, compared to its peers.

A look at the only available profitability multiple - based on net income - places ByteDance above its peers but still in the proximity of Facebook and Tencent, potentially indicating an expectation for further improvement.

Overall, let´s not forget though that valuations reflect in essence future expectation. Taking this into account, ByteDance’s valuation seems reasonable with open questions regarding profitability and cost control. Reaching the scale of a true Tech giant e.g. Facebook, Alphabet, Alibaba, or Tencent, however, requires further aggressive growth for many years – and beyond the 40% target for this year.

The interesting question then becomes, how much room for future growth there is in the original core products of ByteDance. Based on usage, only news aggregator Toutiao (115 mn DAU in August 2019), and the original, Chinese version of TikTok, Douyin (320 million DAU in July 2019), are considered core products. These two products account for the lion´s share of Chinese revenues. Xigua Video, a Netflix-like product with 55 mn DAU, and other smaller products are not considered core business at this point and will only be included in the second part of the series.

What ByteDance got right

Toutiao

Toutiao is ByteDance’s first product, launched only five months after the current CEO Yiming Zhang founded the company in 2012 that since became known as a super app factory. As a news aggregator, it serves targeted content and ads comparable to the Facebook news feed – except the content from friends. Although the app already peaked in mid-2018 at around 200 mn DAU’s, it remains highly relevant given that users spend on average 74 minutes in the app per day - nearly twice as long as Instagram and Snapchat and 50% longer than in Facebook. As monetization potential is directly linked to the duration users are spend in an app, this fact is highly relevant.

Figure 4

Its success can be attributed to a variety of factors including the favorable competitive environment during launch, an addictive product, advanced targeting functionality for advertisers, and an efficient go-to-market strategy.

At the time of Toutiao’s launch, China online news market mainly consisted of censored, state-controlled web portals like Sina and Sohu that offered lengthy articles, clearly optimized for desktop. Yiming Zhang exploited that situation by building a news product that is optimized for mobile by shortening existing pieces and changing titles as well as cover images. By targeting content based on individual user behavior, he achieved read rates of 80% per article without incurring the cost for traditional editors. Over the years, the superiority of the offered product was protected by attracting a large base of exclusive contributors through a revenue sharing model. Such variable compensation further decreased the risk and fixed cost incurred by the platform owner Toutiao. From the perspective of advertisers, the company’s capabilities in targeting and its wealthy user base in Tier 1 and 2 cities made it particularly attractive. Meituan (largest food delivery company), for instance, spends 50% of its ad budget on Toutiao as of July 2019 (followed by Douyin 30% and WeChat with only 3%). Beyond sheer product attractiveness, ByteDance got its first product of the ground exceptionally quick with 10 million users in only 3 months. This was possible by seeding the app through Weibo (Chinese version of Twitter) influencers and allowing an uncomplicated login with the users’ existing Weibo or Sina accounts.

Overall, Toutiao is considered one of the high-margin products in ByteDance’s portfolio. It already turned a profit in 2015 with USD 220 mn in revenue and has so far managed to

successfully compete against similar products launched by Baidu, Tencent and Alibaba.

Nevertheless, Toutiao has reached maturity in 2018 and ByteDance’s future growth will need to come from new products. As a result, it is also unlikely to have contributed to the recent increase in valuation.

Douyin

Douyin, ByteDance’s second core product, was first launched in late 2016 leveraging the distribution and AI capabilities the company had built up with Toutiao. The short-video app was originally called A.me and is widely known as TikTok outside of china (note that the international expansion of Douyin starting 2017 will be covered later in the analysis). In China, Douyin not only expanded ByteDance’s video ad inventory but allowed it to diversify its largely male user base and introduce further possibilities for monetization.

Looking at the drivers behind its phenomenal success of reaching more than 400 million monthly active users in two years, reveals similarities to the companies first big hit: Toutiao. Again, superior product design and an aggressive growth strategy appear to be the driving factors.

Figure 5

ByteDance’s product design decisions can be broken down into the following three categories.

First, Douyin utilizes the entire screen of mobile devices for video compared to only 16% for WeChat and 31% for Instagram. The intelligent overlay of menus and intuitive swiping motions in Douyin show, again, ByteDance’s capabilities in mobile first software design.

Figure 6 (Technode)

Second, the chosen format of short video clips - originally 15 seconds, now up to 120 seconds on Douyin - is not only very suitable for mobile consumption due to a fast dopamine release but makes it much easier to create content given that shooting and editing can easily be done on mobile. Furthermore, bite sized content translates to more content units per session (200+ units on Douyin/TikTok, 100+ on Instagram, 50-75 on Twitter, and only 3-5 on YouTube) which in turn generates more datapoints to train the recommendation algorithm on.

Third, Douyin appears to be a bit more of an entertainment platform than a social media app. It simply does not build as much on interaction with other users but instead presents users with hyper-personalized content without even requiring an account. Rather than users curating the content, Douyin automates this step by putting its AI recommendation engine at the product’s core. This has the advantage of avoiding context collapse and allows seamlessly mixing in ads (Douyin, unlike Facebook, Instagram, and Twitter, never had a chronological feed).

With respect to its growth strategy, Douyin implement a variety of tactics to attract both creators and consumers to its platform:

Besides regular paid partnerships in the seeding phase, creators were initially drawn in by superior video editing functionality. App policy, however, forced creators that used Douyin for this reason only to post content before being able to export with a watermark, later driving traffic back. Furthermore, influencers are given support beyond the industry standard with weekly content suggestions and personal product demos. For new content creators, Douyin is particularly interesting given the intelligent allocation of social capital of the app and algorithms that would give high-quality content the chance to go viral irrespective of a user’s current following.

On the consumer side, ByteDance made sure to establish a viral loop by heavily promoting the sharing functionality in-app and allowing receiving users to consume content without an account and even without the app as Douyin is optimized for mobile web. Based on the device ID, a preference profile is then created in case of a future download. The sharing loop was so successful that Tencent intervened by blocking access to Douyin videos shared by users on WeChat.

Today, Douyin has approximately 550 million MAU and 400 million DAU. Comparing these numbers with the historical growth in Figure 4 shows flattening growth. Especially the MAU metric developed as expected, following the s-curve shape typical for technological adoption. The relatively high number of DAU’s came as a surprise to some analyst given that Douyin outperformed expectations in terms of user stickiness (DAU/MAU).

Future room for growth in core products

With flattening growth in both core products, one might ask about the root cause of this development and whether substantial future growth can still be unlocked. To answer this question, there are three drivers to consider: 1. Users 2. Usage per user 3. Monetization.

1. More Users

In terms of users, the most recent company-wide figures are 1.5 bn MAU and 700 mn DAU in July 2019. This represents an increase in MAU of 500 mn in only 6 months. Moreover, Sensor Tower estimates 500 million new downloads in Q1 2020 alone putting ByteDance only after Google and Facebook. Despite the early international expansion, China remains the biggest market for ByteDance with 115 mn DAU on Toutiao (August 2019), and 320 million DAU on Douyin (July 2019). Ignoring the overlap in users between the two apps, they represented 62% of the total DAU .

In terms of mobile penetration, ByteDance still has room to grow as is shown in Figure 7.

Figure 7

However, with its focus on bigger cities, this gap could also be explained by differences in target groups. This, in turn, could make further growth with the existing product offerings difficult for ByteDance.

2. More Usage per User

Both in terms of average daily usage duration and user stickiness, ByteDance is already performing extremely well. As mentioned earlier, users spend on average 74 minutes per day on Toutiao and consume 200+ content units in an average Douyin session. Furthermore, the DAU to MAU ratio of Douyin is far exceeding the industry standard of around 50% with a strong 70%.

3. Better Monetization

Monetization is closely linked to advertising budgets and therefore overall demand for ads. As Figure 8 shows, ByteDance’s domestic market share has skyrocketed from 5% to 22% in two years due to competitive offerings in both news (Toutiao) and social media (Douyin).

Figure 8 (Totem Media)

Despite this initial success and having reached a significant market share, ByteDance now faces increasing levels of competitive pressure in an almost stagnant market with an estimated growth rate of only 3.6% in 2020. Baidu is eager to fight back and Tencent continues trying to win back market share as well. Also, gaining more market share from offline advertising will be hard, given the already high advertising online penetration in China (way above 60%).

On the supply side, ByteDance has both the option to increase ad load and to add new ad types. Currently, its core products have an ad load of approximately 2.5% (ratio of ads to other content), which is at the lower end of the competitive spectrum. In the future, an increase of up to 4.0% can be expected. Naturally, such a decision comes with a negative effect on user experience which might lead to users switching to other platforms. So far, the management’s priority is on user growth.

In terms of ad types, Douyin offers stationary and dynamic ads during initial app opening, single page or native in-feed ads as well as full campaigns. More recent formats include an e-commerce integration, AR ads, and donation stickers. Embedded e-commerce allows creators to post shoppable videos linked through Alibaba’s Taobao store while taking a 1% cut in fees for ByteDance. Said stickers are being used for tipping creators while training users to transact in the app. Influencer marketing is further facilitated by the so-called Creator Marketplace, a platform that connects companies and popular creators. Expanding into e-commerce will allow ByteDance to obtain access to a new use case directly linked to (e-commerce) purchase conversion, and might eat a bit into the market share of Alibaba, JD.com and the likes.

Tweaks to the already-advanced real-time-bidding mechanism (“programmatic”) might further increase the monetization by a few percent points as well but potentially hamper conversion rates.

At the crossroads: join AT or MPJ?

The stories behind Toutiao and Douyin clearly show ByteDance’s super app factory´s capability of creating disruptive, mobile-first products and successfully launching them in networked markets with strong competition. Recent news report on leaks from internal revenue targets suggest that ByteDance lacks revenue streams to keep the massive growth from previous years up.

Despite the sky-high valuation, the current revenue multiple applied to ByteDance seems reasonable compared to peers, according to our analysis. At the current numbers, a further increase in valuation would still be possible. The amazement and questioning comes from the speed at which ByteDance reached these revenue numbers. However, growth prospects in the core product portfolio seem limited. In terms of users, there is still some room to grow penetration among users in China but recent numbers suggest a platooning. In terms of usage intensity, ByteDance products already show an intense usage paired with high stickiness. Considering the Chinese ads market will only grow a mere 3.6% this year, major growth must come from increasing ads loads and opening up new ad use cases such as e-commerce direct conversion. That highlights the need for ByteDance to pursue new growth avenues outside the core business. However, if not for growth in the core business, ByteDance still has plenty of room to improve profitability further.

Keeping that in mind, ByteDance now stands at the crossroads. It has the potential to emerge into the league of Tencent and Alibaba (tier 1) both at almost USD 700 bn market cap, or it remains in the league of Meituan, Pinduoduo and JD.com (tier 2) which each reached beyond USD 100 bn in market cap. Given the lack of future growth potential in its core business, a major challenge arises. The company has to show that it can replicate past successes - even in verticals outside of news and social media, or in markets outside of China, to open up new revenue streams with high growth rates.

As it turns out, after years of success, 2020/2021 will be extremely challenging years for one of the hottest pre-IPO companies right now. It might be the year determining whether or not ByteDance is able to break into the China Big Tech duopoly Alibaba/Tencent. The next part of this series decomposes ByteDance’s complex growth portfolio and evaluates its likelihood of helping to achieve this target.

All opinions expressed in this essay represent our personal views only.

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