Virtual reality exploded across China last year, attracting attention as well as investment from people who see the wave of the future. But the real-world business of virtual reality is less solid than it could be

On Singles Day in November, Alibaba’s ever record-breaking shopping holiday, Chinese consumers travelled across the world to shop at Macy’s in New York City… sort of. The carrier for the journey was Alibaba itself, which sold 150,000 pair of RMB 1 cardboard virtual-reality (VR) ‘goggles’ to shoppers. Similar to Google Cardboard, the shopper could slip a smartphone into the headset and make a virtual promenade through Macy’s flagship department store on 34th Street in Manhattan.

J. Michael Evans, Alibaba’s president, told online magazine Quartz in November that virtual reality can help redefine how brands and consumers interact. VR allows “consumers a chance to more deeply engage with the product, to understand it better,” he said.

Alibaba is moving to tap the fledgling but ascendant market of virtual reality. According to IT industry research firm IDC, VR device shipments in China reached nearly 300,000 units in the first three quarters of 2016, partly due to a 367% spike in Q3 from the previous quarter.

According to Niko Partners, an Asian games market research firm, the 2016 market size for hardware hit $300 million. And according to Bloomberg, China’s VR market will be worth $8.5 billion by 2020. A huge portion of this is the market for video games and other forms of entertainment, such as VR movies. But there is promise for many other applications, including the retail shopping experience offered by Alibaba.

China’s VR market is surging on the back of heavy investment in hardware and widespread infrastructure deployment. In contrast to the US and Europe, thousands of VR internet cafes and dedicated experience centers have sprung up across China in the past two years.

“Having VR equipment readily available for public use makes people a bit more comfortable with the options,” says Tom Lewis, director of production and operations at London-based CreateVR, a consultancy specializing in the use of virtual reality in marketing.

Chinese consumers also show fewer reservations about VR than their counterparts in the US and Europe.

“The Chinese are very eager to try new technology,” says Brian Blau, a research vice president and expert on mobile and wireless consumer technologies at the California office of IT industry research firm Gartner.

All of this augurs further growth in China’s VR market in the near term, analysts say. “It will be a year of big opportunities and challenges for China’s VR industry,” says Beijing-based IDC analyst Neo Zhang. He notes that as competition intensifies, some cash-strapped startups will fold. But that doesn’t mean the market is cooling off. IDC expects China’s VR market to expand more than 441% in 2017, at least in terms of units shipped.

However, the VR industry is surrounded by a certain level of hype, and the business model is not yet solidly defined. Although some expect VR to revolutionize multiple sectors, it may yet be a while before the market firms up.

Fun and Games

China’s entertainment segment—which includes the world’s largest digital games market—offers the most opportunities for VR in the near term. Interest among Chinese gamers is high: A survey conducted last year by Niko Partners found more than half of Chinese gamers are interested in VR and roughly 30% are willing to spend up to $200, about RMB 1,400, on a device.

While that puts ownership of high-end PC VR headsets, such as the RMB 6,000 HTC Vive headset, out of the reach of most consumers, they can instead pay to play at the more than 3,000 VR cafes and gameplay centers, called “experience zones,” throughout China. A half hour of gameplay costs RMB 50-80.

“China’s good at pushing VR to the mass market,” says Jenny Guo, co-founder of LumiereVR, a Las Vegas-based virtual reality entertainment firm, noting the speed at which VR cafes and experience zones are springing up nationwide. (Perhaps too fast: An industry white paper published in February found that most small-scale operations were struggling, with less than 30% turning a profit.)

But bigger Chinese investors are looking at VR’s long-term potential. Tencent, China’s largest internet company and the world’s top digital games maker, is investing in VR content production. Tencent-backed Original Force, which specializes in computer-generated content, is working on VR movies for Tencent Pictures and creating content for Facebook’s Occulus Rift headset. Zanadu, a popular travel site in China, received $12 million from Tencent last year to develop a virtual-reality studio that will provide content for its app and third-party travel partners.

Search giant Baidu also has sizable VR ambitions. In May 2016, its video-streaming subsidiary iQiyi announced it would develop the world’s largest Chinese-language VR content platform. iQiyi executives said the company would target sales, through its manufacturing partners, of 10 million VR headsets and mobile VR devices on the mainland, and would offer at least 10 VR films and 100 games to its subscribers for free.

China is a promising market for VR video content, says Steven Hsu, an industry analyst at Taiwan’s Market Intelligence & Consulting Institute (MIC), a technology industry consultancy. “The Chinese video content service market is mature enough to support VR services,” he says. “The explosion in popularity of live-streaming is going to help VR live-broadcasting become the next thing in China.”

With a first-mover’s advantage, “iQiyi has a high chance of becoming a big player in China’s VR content industry,” he adds.

Beyond Entertainment

Entertainment represents just the tip of the iceberg for VR in China, analysts say. E-commerce, driven by “Alibaba’s aggressive investment,” is one industry with growing potential for VR applications, says MIC’s Hsu.

In March 2016, Alibaba set up the Gnome Magic Lab (GM Lab) for VR and augmented reality (AR) development—AR overlays material onto the real world, and some including Apple’s CEO Tim Cook believe that it will be more significant than VR in the end. The Lab helps sellers on Alibaba platforms to build their own 3D product inventories, with a long-term goal of helping businesses set up VR stores.

In September, Alibaba’s finance arm, Ant Financial, launched a VR payment service called VR Pay that allows users to complete online transactions without removing their headsets—users can interact with the system with head gestures and a controller.

Alibaba’s archrival JD.com launched a VR/AR alliance last September. The alliance contains 30+ companies, among them hardware developers, content developers and coding developers.

Fung Business Intelligence, a Hong Kong-based research firm, noted in a March report that some fashion brands have partnered with e-commerce players to provide a virtual fitting room service. After providing their body measurements, consumers can try on clothes with a customized virtual model. US-based fashion brand Gap is offering that service on Alibaba’s Tmall marketplace.

Meanwhile, China’s education industry sees considerable potential in the application of VR in the classroom. In a November report, China’s state-owned Xinhua News noted that online game developer NetDragon has created a VR fire-safety lesson. In the lesson, students find themselves in a simulated fire emergency. To escape to safety, they must bypass obstacles like desks and chairs as they crawl across the floor. NetDragon also has developed immersive VR classrooms, and its headsets can even use motion sensors to determine if children are focused on their work.

Education could be an ideal industry for VR in China given the value Chinese people place on their children’s schooling, says LumiereVR’s Guo. Further, “young people in China are passionate about VR. The next generation will be the adopters,” she says.

Yet another application for VR is in the healthcare sector. According to a November report in the English-language version of the The People’s Daily, the official Communist Party newspaper, Sichuan University’s West China Foundation Medicine and Forensics School has developed an award-winning anatomy course. Medical students can examine virtual bodies and can even remove an organ to view it up close. Sichuan University’s medical school is now developing a virtual scalpel that promises to allow students to hone their surgical skills “without the need for a real human body.”

However, all of these new potential game changers are just that. To some extent companies are crowding around every single idea, with perhaps little thought as to how they will eventually profit.

Hype and Reality

Given the excitement surrounding VR in general, it can be difficult to accurately assess market conditions.

“There is an undue amount of hype,” says Gartner’s Blau, who has been involved with VR technology since 1988. “It is good in that it translates into an interest in buying, but people put on a headset and the experience is not always what they expect.”

He adds: “I have yet to see a great user interface for shopping—something that significantly improves the buying experience. All you can do is play with the product in 3D.”

CreativeVR’s Lewis attributes some of the hype to the large amounts of capital investors have already sunk into VR hardware. “There is a lot of energy behind the hardware. Investors are betting big on it,” he says.

The first indication of volatility in the China VR market came in the second half of 2016, when a number of local hardware startups folded. The startups were squeezed by the arrival of a slew of heavyweight tech manufacturers: foreign firms like HTC, Samsung, Sony and Microsoft, and Chinese brands Xiaomi, Huawei, Lenovo and LeEco. Some startups collapsed before shipping a single unit, notes IDC’s Zhang. Investors got spooked.

“You could say the investment climate turned cold for VR hardware makers,” he says. “But the capital markets remain optimistic about investing in startups for VR content.”

For now, high-quality content is in short supply, hamstrung by high costs and a lengthy post-production process. In a December post on the company website, Verizon Ventures (the venture-capital arm of the US’s Verizon Communications) manager Suresh Madhavan wrote: “Production of full-capture VR-related content is particularly expensive, typically running at two to three times the cost of normal video content.”

Some observers are questioning VR’s revenue-earning capacity. “There’s no model for monetization right now besides selling games,” says CreateVR’s Lewis.

Tech-news site Venture Beat notes that Vrideo, a US startup founded in 2014 aiming to become the YouTube of virtual reality, collapsed in November after two years, its founders unable to squeeze any more out of the $2 million they raised in early 2015. With a dearth of high-quality content, Vrideo was unable to grow a strong user base and attract the additional funding it needed to continue.

One of the reasons for weak VR content is that the technology is in a nascent stage and developers have yet to determine its best applications. For instance, in China, some real-estate firms see VR as a useful tool to promote property listings, as the technology could eliminate the need for a brick-and-mortar showroom and reduce their expenses. Consumers would benefit from being able to view the property from the convenience of a VR headset.

There’s just one problem: VR’s simulation of spatial relationships is extremely accurate. “That means a small property is going to look small in VR,” says Gartner’s Blau. “It’s not like a photograph where you can use a wide-angle lens to make spaces seem much larger than they are in reality.”

Doubling Down

Although the wider significance of VR in the future leaves much room for doubt, platform developers seem willing to pay for premium content to generate user interest in VR products.

Analysts are sanguine about the emergence of content. “We expect the quality of VR content to improve while development speeds up,” says MIC’s Hsu, noting Oculus and HTC Vive “have invested a massive amount of funds to streamline VR content and the ecosystem.” IDC’s Zhang reckons “impressive VR content” (some focused on entertainment) will be launched in the first half of the year.

Hardware prices will also begin to fall as vendors ramp up production capacity. Microsoft has already launched a headset priced at $299, notes Hsu, nearer to the price that Niko Partners says Chinese consumers are willing to pay. But hardware manufacturers will need to do more than slash prices to attract customers, Hsu says. “Instead of initiating a price competition, VR headset vendors should focus more on developing game-changing VR applications to help the industry flourish.” That can be accomplished with partnerships between VR hardware makers and content and peripheral providers, he adds.

Vendors will need to improve the performance of VR headsets as well. Verizon Ventures’ Madhavan observes that users find VR headsets relatively uncomfortable—such that usage time peaks at only six minutes. As a result, the headsets will need to be upgraded before more substantive, and lucrative, content is introduced. “Immersive sporting experiences or premium cinema-quality content are difficult to deliver if a user has to adjust their hardware every few minutes. What’s needed is better hardware, not a greater number of models,” he wrote in a December post on the Verizon Ventures website.

Gartner’s Blau returns to the example of real estate to illustrate VR’s limitations: “If you plan to live in a house, you are going to want to see it with your own eyes and walk around in it before you commit to making the purchase,” he says.

“VR is not going to replace the buying experience we have today. It will be an augmentation,” he adds.