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Microsoft, Google duke it out for China

China is proving to be the next great Net marketplace, and the two tech giants are prepared to fight for it, starting in American courts.

China is quickly proving to be the next great Internet marketplace, and both Microsoft and Google are prepared to fight for it, starting in American courtrooms.

On Monday, the software giant sued Kai-Fu Lee, a former vice president of search technologies and Microsoft's chief architect of business strategy in China, for an alleged breach of a noncompete and confidentiality agreement. Microsoft also sued Google, claiming it was knowingly complicit in the alleged breach when it hired Lee to head up its new Chinese research center.

Certainly, that Lee was a top developer of speech recognition and search technologies and close to Microsoft Chairman Bill Gates was enough to draw the software giant's ire. But Lee's intimate knowledge of the Chinese Internet marketplace is something both companies likely covet.

News.context

What's new:
Microsoft lawsuit in response to Google's hiring of a Microsoft executive highlights the growing importance of China as an Internet marketplace.

Bottom line:
China's Internet audience is second only to that of the United States, and financial analysts believe it will surpass America's Internet population within five years.

More stories on this China

With an estimated 100 million people online, China's Internet audience is second only to that of the United States, and financial analysts believe it will surpass America's Internet population within five years. China also has 350 million mobile phone subscribers, 43 million broadband homes and 20 million online gamers--the largest gaming population in the world, according to Piper Jaffray.

China's Internet economy, which includes sales from e-commerce and advertising, also has plenty of room to grow. It's worth about only 5 percent of the U.S. Internet economy, according to analysts at Piper Jaffray. The analysts expect Chinese interactive sales, including online advertising, e-commerce, games and wireless, to be worth $1.38 billion in 2005. Next year, sales are expected to grow 37 percent to $1.9 billion.

"China is going to be the most significant opportunity for growth for Internet companies over the next five years," said Piper Jaffray analyst Safa Rashtchy.

No doubt, China matters a great deal to both companies. Most Google watchers can only remember one other occasion when the company publicized a new hire: When Silicon Valley veteran Eric Schmidt was hired as chief executive in 2001. But the Mountain View, Calif., company touted Lee's hiring as a "commitment to building a successful Chinese product research and development center and to expanding its international business operations" in a statement sent to press outlets Tuesday.

About the same time, clearly miffed Microsoft executives announced the lawsuit.

As former director of Microsoft's China laboratory with 380 researchers, Lee was privy to "Microsoft's overall China business strategy, target areas for expansion, Microsoft's plans for gaining market share with respect to Internet search in China, and Microsoft's key employees, partners and contacts in China," according to the 11-page complaint filed in a Washington state district court.

Microsoft did not immediately respond to requests for comment. Google declined to comment.

Google has long run a Chinese-language Web site, but in the last year, the company has invested more in operating there. According to a report by the Chinese Xinhua news agency, Schmidt made a trip in late June to Beijing and met with officials of the Chinese search company Baidu.com. Last year, Google acquired a 4 percent stake in Baidu.com, which is expected to go public on the Nasdaq stock exchange with a valuation as high as $1 billion.

Danny Sullivan, a search expert and editor of the industry site SearchEngineWatch.com, said he suspects Google might be interested in acquiring Baidu.com, arguably the top search engine in China, so it can comply with government requests for filtering through a separate brand.

"Part of the speculation is, does Google want Baidu so it doesn't censor listings on the flagship Google site," Sullivan said.

Google also opened a sales office in mainland China roughly six months ago, and has business partnerships with the Beijing-based gaming company Netease.com and the instant messaging company Tencent Holdings of Shenzhen.

Still, Google, Microsoft, Yahoo and others face many challenges operating in China without drawing the ire of the Chinese government. Google's site, for example, was blocked several times in 2002 by the Chinese government, which has asked it to censor search listings. Google has agreed to filter some news headlines in the country. Other challenges could include a relatively weak banking system, inflation and poor intellectual-property laws.

The American Internet companies also have local competition in the Middle Kingdom. Baidu.com for example is the largest search company in China, followed by Google, Yahoo and China-based Sohu.com. Sina is the largest portal site in China and has a deal with Yahoo for an online auction house. Yahoo China president Zhou Hongyi resigned last month for personal reasons, leaving the future of the portal's unit in question.

Sullivan also said Google may be losing ground in China to Baidu.com, citing research from one outlet overseas that claims Baidu.com commands roughly 30 percent of the marketplace and Google has 25 percent.

Of all the major American Internet companies, MSN has the smallest presence, Rashtchy said, but its IM client is second only to China's Tencent in the Chinese workplace.

Because China is such a fast-moving and populated marketplace, analysts say U.S. companies must establish a significant presence in the country if they want to thrive there. According to China's People Daily Online, Google was once the dominant search engine in China, but it lost market share to Baidu.com because it wasn't focused enough on the local market.

"For Google, the whole idea is that they can't do everything from Silicon Valley if they are a global outfit. To them, China is a big market, but they must develop features from China," said Rashtchy.

The search companies aren't the only tech-savvy Americans racing into China, of course. On Tuesday, Silicon Valley venture capitalist Accel Partners said it partnered with the media company International Data Group to form a $250 million fund to invest in Chinese tech companies. Others, including Intel, have established similar funds to take advantage of China's booming technology, gaming, broadband and cellular markets.

Meanwhile, a growing number of Chinese companies have gone public on U.S. exchanges in the past two years, some with strong results. Shanda Interactive, a gaming company, has seen its stock go from $11 per share at its initial public offering in May 2004 to more than $39, a return that's on par with Google's.

But clearly, Google is Microsoft's toughest competitor when it comes to hiring top engineers and perhaps the biggest threat in years to the Redmond, Wash., company's tech domination. And the toughest fights to come may take place on the other side of the world from the companies' headquarters.

"It's almost like the United States and the former Soviet Union launching missiles at each other," said Sullivan, "and Yahoo's like Canada."