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TREND INVESTMENT OF JP MORGON AND FINANCE

TREND INVESTMENT OF JP MORGON AND FINANCE

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  • North America Equity Research02 January 2008Nothing But Net2008 Internet Investment Guide2007 saw Internet companies outperform the broader stock market, Internetas the HHH rose ~14%, vs. a ~5% rise in the S&P 500. We believe Imran Khan ACsome of the factors that drove F’07 outperformance will persist into (1-212) 622-6693F’08, and thus expect the sector to outperform the broader market. imran.t.khan@jpmorgan.com Bridget Weishaar• Expect 34% EPS Growth, vs. 8% for the S&P 500. We expect (1-212) 622-5032 revenue growth to decelerate to 21.2% in F’08, from 25.6% in bridget.a.weishaar@jpmchase.com F’07. We are projecting 34% earnings growth for our coverage Lev Polinsky, CFA universe, compared to 8% for the S&P 500. (1-212) 622-8343 lev.x.polinsky@jpmchase.com• Expect Blended CPM Pricing Growth Rate to Accelerate. We Joseph Boushelle, CFA think blended CPM pricing bottomed out in F’07. We expect (1-212) 622-8523 tighter offline inventory and better monetization techniques will joseph.d.boushelle@jpmchase.com lead to a re-acceleration of growth in F’08. China Internet• We Project Global Search Revenue to Hit $60B by 2011. We Dick WeiAC are raising our F’08 global search revenue estimate to $30.5B, (852) 2800 8535 from $26.2B, driven by strong volume trends, better-than-expected dick.wei@jpmorgan.com monetization, and continued robust growth in Continental Europe. We expect the global search market to reach $60B by 2011, growing at a 28% CAGR over the next four years.• Global Consumer Growth Should Benefit Internet Companies. Please see our notes changing World GDP growth has outpaced US growth in recent years, and a ratings for Priceline, and our note projected 3-year CAGR of 6.5% for emerging economies means changing estimates for the hundreds of millions of new consumers. We think large Internet remainder of our coverage companies’ global reach means they’ll benefit from this rising tide. released simultaneously.• M&A Market Likely to Remain Healthy. The five biggest companies in our universe generated $8.8B in FCF in F’07, a number we project will grow to $12.5B in F’08. While some of All data and valuation in this that cash should continue to fund share repurchases, we think a report priced as of 26 Dec 2007. significant portion of the incremental cash flow is likely to lead to continued M&A in the sector.• Top Picks. The above trends translate into our top Overweight ideas going into the new year: GOOG, YHOO, EXPE, OMTR, SFLY and MNST.www.morganmarkets.com J.P. Morgan Securities Inc.See page 309 for analyst certification and important disclosures, including investment banking relationships.JPMorgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firmmay have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor inmaking their investment decision. Customers of JPMorgan in the United States can receive independent, third-party research on the companyor companies covered in this report, at no cost to them, where such research is available. Customers can access this independent research atwww.morganmarkets.com or can call 1-800-477-0406 toll free to request a copy of this research.
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Table of Contents Key Investment Themes ..........................................................5 Dot.Khan’s Top Ten for 2008 .................................................13 U.S. Sector Outlooks..............................................................15 China Outlook .........................................................................99 Amazon.com, Neutral ($92.85) ............................................121 Blue Nile, Neutral ($74.16) ...................................................129 CNET Networks, Neutral ($8.90) ..........................................136 eBay, Overweight ($34.49) ...................................................144 Expedia, Overweight ($32.56)..............................................154 Google, Overweight ($710.84) .............................................161 HouseValues, Underweight ($2.94) .....................................169 InfoSpace, Neutral ($18.96)..................................................177 InnerWorkings, Neutral ($18.40)..........................................183 Liberty Interactive, Neutral ($19.79) ....................................190 Mercadolibre, Overweight ($72.85) .....................................199 Monster Worldwide, Overweight ($33.91)...........................208 Move, Inc., Neutral ($2.70) ...................................................215 Omniture, Overweight ($34.95)............................................222 Priceline, Overweight ($118.23)...........................................229 Shutterfly, Overweight ($27.38) ...........................................239 ValueClick, Overweight ($23.39)..........................................247 Yahoo!, Overweight ($23.96) ...............................................255 Baidu, Overweight ($399.67)................................................267 China Finance Online, Overweight ($23.75) .......................272 NetEase, Neutral ($19.33).....................................................276 Ninetowns, Underweight ($3.45) .........................................281 Shanda, Overweight ($34.39)...............................................285 Sina, Neutral ($45.50) ...........................................................290 Sohu, Overweight ($56.58)...................................................294 The9, Overweight ($23.50) ...................................................299 The authors acknowledge the contribution of Deval Delivala and Rachna Srivastava of J.P. Morgan Services India Private Ltd., Mumbai, and John Ventimiglia of J.P. Morgan Securities Inc. to this report.2
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comFigure 1: JPMorgan Internet Technology Universe$ in millions, except per share data JP Morgan Internet Technology Universe Ticker Rating Price Mkt Cap Ent .Val. EPS Cal PE LT EPS PEG EBITDA ($M) Ent. Val/EBITDA Rev ($M) 12/26 12/26 12/26 2007E 2008E 2009E 2007E 2008E 2009E Grth (%) 2007E 2008E 2009E 2007E 2008E 2009E 2007E 2008E 2009E 2007E 2008E 2009E Search/Advertising CNET CNET N 8.90 1,350 1,364 NM 0.14 0.22 NM NM 40.4 15 NM NM 2.7 82 100 118 16.7 13.7 11.6 411 451 494 Google GOOG OW 710.84 225,035 211,948 15.42 20.92 26.33 46.1 34.0 27.0 35 1.3 1.0 0.8 6,958 9,917 12,647 30.5 21.4 16.8 11,719 16,957 22,332 Infospace INSP N 18.96 629 54 (1.49) (0.88) 0.11 NM NM 167.0 5 NM NM 33.4 (9) 17 18 (5.8) 3.2 3.0 240 139 141 ValueClick VCLK OW 23.39 2,343 2,092 0.71 0.84 1.01 33.0 27.7 23.1 20 1.6 1.4 1.2 164 190 220 12.8 11.0 9.5 639 735 859 Yahoo* YHOO OW 23.96 33,426 25,615 0.43 0.49 0.58 55.9 49.4 41.0 25 2.2 2.0 1.6 1,906 2,248 2,533 13.4 11.4 10.1 5,095 5,895 6,433 Group Average 45.0 37.0 59.7 1.7 1.4 7.9 18.3 12.1 10.2 Leading e-Commerce brands Amazon AMZN N 92.85 39,461 39,294 1.10 1.51 1.87 84.5 61.6 49.7 20 4.2 3.1 2.5 1,093 1,474 2,178 35.9 26.7 18.0 14,488 17,938 21,269 Blue Nile NILE N 74.16 1,254 1,180 1.03 1.23 1.50 71.9 60.4 49.5 20 3.6 3.0 2.5 30 36 44 38.8 32.6 26.9 322 388 454 Dice DHX R 8.14 505 587 eBay EBAY OW 34.49 46,727 42,283 1.48 1.70 1.98 23.3 20.3 17.4 25 0.9 0.8 0.7 2,863 3,337 3,754 14.8 12.7 11.3 7,685 9,007 10,506 Expedia EXPE OW 32.56 10,183 10,326 1.23 1.39 1.58 26.5 23.4 20.6 10 2.6 2.3 2.1 725 808 887 14.3 12.8 11.6 2,643 3,006 3,318 InnerWorkings INWK N 18.34 921 852 0.32 0.52 0.73 57.3 35.1 25.1 20 2.9 1.8 1.3 27 46 65 31.8 18.6 13.1 288 472 641 InterActive Corp IACI N 27.56 8,410 7,421 1.55 1.81 NA 17.8 15.2 NA 10 1.8 1.5 NA 867 958 NA 8.6 7.7 NA 6,352 6,897 NA Liberty Interactive LINTA N 19.79 12,428 16,810 0.73 0.80 0.89 27.1 24.8 22.2 10 2.7 2.5 2.2 1,707 1,766 1,871 9.8 9.5 9.0 7,721 8,094 8,583 Mercadolibre MELI OW 72.85 3,227 3,164 0.21 0.58 0.86 354.1 126.2 84.6 30 11.8 4.2 2.8 24 43 68 132.2 73.7 46.3 84 134 195 Monster.com MNST OW 33.91 4,434 3,807 1.42 1.90 2.27 23.9 17.8 14.9 20 1.2 0.9 0.7 301 441 514 12.7 8.6 7.4 1,350 1,519 1,727 Orbitz Worldwide OWW R 9.43 784 1,320 Priceline.com PCLN OW 118.23 5,430 4,930 3.96 4.87 6.08 29.8 24.3 19.4 15 2.0 1.6 1.3 161 296 408 30.5 16.6 12.1 1,402 1,710 2,026 Shutterfly SFLY OW 27.38 671 576 0.38 0.53 0.75 71.6 51.3 36.3 20 3.6 2.6 1.8 32 45 61 18.1 12.9 9.4 183 251 328 Group Average 63.6 38.1 30.7 3.1 2.1 1.7 28.2 19.1 14.8 Online Services Move.com MOVE N 2.70 419 233 (0.05) 0.03 0.05 NM 88.6 56.1 25 NM 3.5 2.2 29 42 49 8.1 5.6 4.8 294 320 349 HouseValues SOLD UW 2.94 72 7 (0.09) 0.02 0.07 NM 191.8 40.3 10 NM NM NM 3 7 8 2.2 1.0 0.9 60 49 54 Group Average NM 140.2 48.2 NM 3.5 2.2 5.1 3.3 2.8 Enabling Platforms Akamai^ AKAM NR 36.80 6,590 5,859 1.29 1.66 2.01 28.6 22.2 18.3 25 1.1 0.9 0.7 275 368 469 21.3 15.9 12.5 628 805 994 Omniture OMTR OW 34.95 2,248 2,270 0.20 0.39 0.70 NA NM 49.8 35 NA NM 1.4 22 37 71 101.1 60.8 32.0 141 213 309 Salesforce.com^ CRM NR 63.87 7,682 7,176 0.13 0.32 0.65 NA 199.4 98.9 40 NM 5.0 2.5 38 77 NA 189.4 92.7 NA 741 1,030 1,372 Visual Sciences VSCN NR 19.31 369 394 0.59 0.75 0.74 32.9 25.6 26.1 20 1.6 1.3 1.3 15 21 NA 26.2 19.1 NA 82 90 NA Websense^ WBSN NR 17.16 777 496 0.90 1.13 1.35 19.1 15.1 12.8 15 1.3 1.0 0.9 53 47 85 9.4 10.5 NA 226 309 338 Group Average 26.9 65.6 41.2 1.4 2.0 1.4 69.5 39.8 22.2 Average 59.0 55.7 42.8 2.7 2.1 3.2 33.6 21.7 14.0Source: Company reports and JPMorgan estimates for JPMorgan rated companies. First Call consensus for non-covered companies. Note: Yahoo! EV assumes Yahoo! Japan is worth $26.9B. EBITDA – Operating Income + D&A +/- extraordinary chargesData in this table and this report is priced as of December 26, 2007 closeJPMorgan is currently subject to a research blackout period for Dice Holdings, Inc and Orbitz Worldwide, Inc. Company write-ups are omitted here in compliance with NYSE and NASD provisions relating to lock-up agreements. 3
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 1: JPMorgan Estimates vs. Consensus Estimates$ in millions, except per share data EPS RevenueCompany Ticker FC 08 JPM 08 FC 09 JPM 09 FC 08 JPM 08 FC 09 JPM 09Amazon.Com Inc AMZN 1.62 1.51 2.41 1.87 18,256 17,938 22,373 21,269CNET Networks Inc CNET 0.14 0.14 0.20 0.22 450 451 487 494eBay Inc EBAY 1.66 1.70 1.94 1.98 9,031 9,007 10,603 10,506Expedia Inc EXPE 1.46 1.39 1.74 1.58 3,008 3,006 3,371 3,318Google Inc GOOG 20.65 20.92 25.89 26.33 16,547 16,957 21,306 22,332IAC/Interactivecorp IACI 1.81 1.81 2.06 6,862 6,897 7,206Infospace Inc INSP -0.29 -0.88 -0.42 0.11 137 139 144 141Innerworkings Inc INWK 0.52 0.52 0.72 0.73 468 472 625 641Liberty Media Interactive LINTA 0.79 0.80 1.02 0.89 8,156 8,094 8,727 8,583Mercadolibre Inc MELI 0.53 0.58 0.83 0.86 131 134 186 195Monster Worldwide Inc MNST 1.83 1.90 2.22 2.27 1,561 1,519 1,815 1,727Move Inc MOVE 0.04 0.03 0.17 0.05 318 320 374 349Blue Nile Inc NILE 1.32 1.23 1.67 1.50 394 388 470 454Omniture Inc OMTR 0.41 0.39 0.69 0.70 220 213 327 309Priceline.Com Inc PCLN 4.78 4.87 5.79 6.08 1,690 1,710 1,870 2,026Shutterfly Inc SFLY 0.57 0.53 0.90 0.75 252 251 326 328HouseValues Inc SOLD -0.07 0.02 N/A 0.07 46 49 #N/A 54Valueclick Inc VCLK 0.82 0.84 1.06 1.01 741 735 869 859Yahoo Inc YHOO 0.55 0.49 0.72 0.58 5,954 5,895 6,833 6,433Source: Company filings, First Call, and JPMorgan estimates4
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Key Investment Themes We Expect CPMs to Rise in 2008 While we think CPM growth was relatively muted in 2007, we expect 2008 will see it accelerate, driven by several factors, including easier comps, better inventory sell- through, behavioral and geographic targeting, and ad exchanges. Tighter Offline Inventory Broadcast network total day ratings were ~8% lower in 2007, and we expect inventory is likely to continue shrinking further in 2008. Additionally, the reduced supply will face higher demand, as we believe as much as 6% of spot TV ads in 2008 may be taken up by political ads. We expect the inventory tightness will have a spillover effect online, as advertisers continue to shift a greater percentage of their spend away from traditional media. The Rise of Ad Networks More than 80% of online inventory currently sells for less than a $1 CPM. As such, we think ad networks present a significant opportunity for publishers to increase yield, and, given the low base, the CPM enhancement from using ad networks will not have to be very large, in absolute terms, to move the needle. Inventory Aggregation Many companies are aggregating traffic through partnerships and acquisitions. We think aggregation is likely to lead to a certain degree of pricing power for the aggregators. More importantly, we expect advertisers to be more willing to buy from aggregators that offer them sufficient scale. Easier Comps 2007 saw pressure on graphical ad CPMs, driven primarily by increases in non- premium inventory, from sites such as MySpace and Facebook. We think the 2007 softness in the market is likely to set a lower base for 2008. Free Cash Flow Likely to Drive M&A Activity Large Internet companies are generating a significant amount of cash flow: looking at the five largest Internet-only companies in our coverage universe, we estimate they generated nearly $8.8B in FCF in F’07, and are poised to produce $12.5B FCF in F’08. Table 2: Free Cash Flow Generation at 5 Large Internet Companies $ in millions 2007 2008 GOOG $ 3,490 $ 5,675 YHOO $ 1,307 $ 1,643 AMZN $ 1,351 $ 1,705 EBAY $ 2,067 $ 2,612 EXPE $ 566 $ 860 Top 5 Total $ 8,781 $ 12,494 Source: Company reports, JPMorgan estimates 5
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com While we believe some of these companies will use part of their income stream on share repurchases, we expect that a significant part will continue to spur increased M&A activity in the sector. Table 3: Uses of Free Cash Flow at 5 Large Internet Companies, TTM $ in million, 4Q’06 – 3Q’07 TTM FCF ($M) Cash Acquisitions/FCF Buyback/FCF GOOG 2,902 33.4% 0.0% YHOO 1,300 33.6% 104.9% AMZN 801 6.1% 31.0% EBAY 2,052 15.5% 105.8% EXPE 777 8.0% 179.8% Top 5 Total 7,831 23.4% 66.1% Source: Company reports, JPMorgan Estimates Note: Table does not include acquisitions made with stock, such as Google’s YouTube acquisition In particular, we believe large companies will continue to seek out investments in social media, where sites often grow virally and the large-caps appear satisfied, for the most part, to let the public pick the winners out of a crowded field before making acquisitions. In the ad network and ad exchange space, we expect the need for scale to lead to continued consolidation and M&A activity, although perhaps not at the scale we have witnessed in F’07, most sizably with the DoubleClick and aQuantive transactions. We expect continued M&A to be motivated by one or more of these key factors: • Traffic. Developing high-traffic sites is difficult, and larger companies are often willing to pay for sites that have proven an ability to generate traffic. • Technology. Companies that develop a technology that is difficult or uneconomical to replicate are often targets for acquisitions; such companies may also generate traffic, but the technology is a motivator for the buyer. • Transactional. Companies with a proven track record of revenue and sales generation make attractive targets, as well; a recent example of a transactional- focused acquisition is the 2007 purchase of Mezimedia by ValueClick. Additionally, we continue to believe that there are synergies to be captured by a strategic partnership among large-cap Internet companies, due to (1) increased scale, (2) strengthened global footprint, (3) broadened user insights and (4) improved operational efficiencies. We believe continuing share gains and product introductions by Google may compel other large-cap Internet companies to explore strategic alliances.6
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 4: Selected M&A Activity in the Internet Space, 2007 (Please see Appendix of this section for full list) Ticker Date Target Acquirer Seller Annc’d Tot Payment StatusAMZN 5/14/2007 www.Dpreview.Com Amazon.com Inc NA Undisclosed CompleteAMZN 5/23/2007 Brilliance Audio Inc Amazon.com Inc NA Cash CompleteCNET 10/25/2007 Webshots American Greetings Corp Cnet Networks Inc 45 Cash CompleteCNET 11/5/2007 Findarticles.Com CNET Neworks Looksmart 20.5 Cash PendingEBAY 1/10/2007 Stubhub eBay 310 Cash CompleteEBAY 2/27/2007 Beijing Union Mobile Pay Ltd eBay 105 Cash PendingEBAY 5/3/2007 Gittigidiyor.Com eBay NA Cash CompleteEBAY 5/30/2007 Stumbleupon Inc eBay 75 Cash CompleteEBAY 10/4/2007 Via-Online Gmbh eBay NA Cash CompleteEBAY 12/20/2007 Tom Online Inc eBay NA Undisclosed PendingEXPE 2/28/2007 Smarter Travel Media Llc Expedia Inc NA Undisclosed CompleteEXPE 5/23/2007 Independent Traveler Inc Expedia Inc NA Undisclosed CompleteGOOG 10/31/2006 Jotspot Inc Google NA Undisclosed CompleteGOOG 1/4/2007 Shenzen Xunlei Netwk Tech Google NA Undisclosed CompleteGOOG 3/16/2007 Adscape Media Inc Google NA Undisclosed CompleteGOOG 4/13/2007 Doubleclick Google Multiple Sellers 3100 Cash PendingGOOG 4/17/2007 Tonic Systems Google NA Undisclosed CompleteGOOG 4/20/2007 Video Conf. Software Google Marratech Ab NA Cash CompleteGOOG 5/29/2007 Greenborder Tech Ltd Google NA Undisclosed CompleteGOOG 5/31/2007 Panoramio.Com Google 7 Cash PendingGOOG 6/1/2007 Feedburner Inc Google NA Undisclosed CompleteGOOG 6/6/2007 Peakstream Inc Google NA Undisclosed CompleteGOOG 6/20/2007 Zenter Google NA Undisclosed CompleteGOOG 7/2/2007 Grandcentral Communicat. Google NA Undisclosed CompleteGOOG 7/9/2007 Postini Google 625 Cash PendingGOOG 7/19/2007 Beijing Feixiangren Informat Google NA Undisclosed CompleteGOOG 9/28/2007 Zingku Google NA Undisclosed CompleteGOOG 10/9/2007 Jaiku Ltd Google NA Undisclosed CompleteGOOG 12/18/2007 Endoxon Google NA Undisclosed CompleteIACI 12/20/2006 Ilike.Com IAC/ Interactive corp NA CompleteIACI 2/27/2007 Edodo.Com IAC/ Interactive corp NA CompleteIACI 2/27/2007 Netclub IAC/ Interactive corp NA CompleteIACI 3/1/2007 Insider Pages IAC/ Interactive corp NA PendingIACI 3/19/2007 Echomusic IAC/ Interactive corp NA CompleteIACI 4/19/2007 Rqi Holdings Ltd IAC/ Interactive corp Gaylord Entertainment Co 109.12 CompleteIACI 5/17/2007 Front Line Mgmt IAC/ Interactive corp NA CompleteIACI 5/24/2007 Emma Enterntainment Hold IAC/ Interactive corp NA CompleteIACI 7/2/2007 Paciolon IAC/ Interactive corp NA PendingINSP 9/17/2007 Switchboard.Com Idearc Inc Infospace Inc 225 Cash PendingLINTA 5/11/2007 Backcountry.Com Liberty Media Interactive NA Cash PendingMELI 10/1/2001 Ibazar Com Br Ltd MercadoLibre Inc Ebay Inc NA Stock CompleteMELI 11/13/2005 Deremate.Com MercadoLibre Inc NA Undisclosed CompleteMNST 1/17/2007 Arbeidskamerater As Monster Worldwide NA Undisclosed CompleteMSFT 5/18/2007 Aquantive Microsoft 5460.65 Cash CompleteMSFT 8/30/2007 Screentonic Microsoft NA Undisclosed CompleteMSFT 10/3/2007 Jellyfish.Com Microsoft NA Undisclosed CompleteMSFT 10/7/2007 Newsvine Inc MULTIPLE ACQUIRERS NA Undisclosed CompleteMSFT 10/24/2007 Facebook Inc Microsoft 240 Cash PendingOMTR 1/18/2007 Instadia Omniture Inc 14.41 Cash CompleteOMTR 2/14/2007 Touch Clarity Omniture Inc 48.5 Cash PendingOMTR 9/7/2007 Offermatica Omniture Inc 65 Cash & Stock PendingOMTR 10/25/2007 Visual Sciences Inc Omniture Inc 390.27 Cash & Stock PendingPCLN 11/8/2007 Agoda Co Priceline.com Inc NA Cash CompleteSFLY 6/27/2007 Make It About Me! Shutterfly NA Undisclosed CompleteTFSM 5/17/2007 24/7 Real Media Inc WPP Group PLC 580.67 Cash CompleteVCLK 12/4/2006 Shopping.Net ValueClick Inc 26.28 Cash CompleteVCLK 7/16/2007 Mezimedia Inc ValueClick Inc 100 Cash PendingYHOO 1/9/2007 Mybloglog Yahoo! Inc CompleteYHOO 4/30/2007 Right Media Inc Yahoo! Inc 340 Cash & Stock CompleteYHOO 6/21/2007 Rivals.Com Yahoo! Inc NA Undisclosed PendingYHOO 9/4/2007 Bluelithium Inc Yahoo! Inc 300 Cash CompleteYHOO 9/14/2007 Buzztracker.Com Yahoo! Inc Participate Media NA Cash CompleteYHOO 9/17/2007 Zimra Inc Yahoo! Inc 350 Undisclosed PendingSource: Bloomberg, company reports, news reports 7
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Worldwide Growth and Economic Prosperity Creating an Ever-Larger Consumer Base JPMorgan estimates that GDP growth has been stronger outside the US than domestically in all but one year since 2000. At the same time, worldwide Internet penetration has been growing rapidly, as well. As such, we believe that, for larger Internet companies, the importance of the US, while remaining high, will continue to fade in relative terms in coming years. Table 5: JPMorgan’s Global GDP growth projections 2001 2002 2003 2004 2005 2006 2007E 2008E 2009E World 1.6% 1.9% 2.5% 3.8% 3.2% 3.6% 3.4% 3.0% 3.4% Developed mkts 1.2% 1.3% 1.8% 2.9% 2.4% 2.8% 2.4% 2.1% 2.7% G-7 1.0% 1.2% 1.8% 2.8% 2.3% 2.7% 2.2% 2.1% 2.7% Emerging Econ. 3.0% 4.1% 5.0% 7.0% 6.3% 6.9% 6.9% 6.3% 6.2% Latin America 0.5% 0.1% 1.8% 6.2% 4.3% 5.3% 5.1% 4.5% 4.4% Emerging Asia 5.1% 6.6% 7.2% 7.9% 7.8% 8.4% 8.5% 7.7% 7.6% ex China 2.7% 4.8% 5.1% 6.3% 6.0% 6.5% 6.3% 5.8% 5.9% China 8.3% 9.1% 10.0% 10.1% 10.4% 11.1% 11.4% 10.5% 10.0% Emerging Eur. 1.6% 4.5% 5.7% 6.8% 5.8% 6.4% 6.3% 5.8% 5.7% ex Russia -0.6% 4.4% 4.7% 6.6% 5.5% 6.2% 5.5% 5.1% 5.2% Russia 5.1% 4.7% 7.3% 7.2% 6.4% 6.7% 7.5% 6.8% 6.3% Developed Eur. 1.9% 1.1% 1.1% 2.2% 1.8% 3.0% 2.8% 1.9% 2.4% World ex-US 1.9% 2.0% 2.5% 3.8% 3.2% 4.0% 3.9% 3.2% 3.5% United States 0.7% 1.6% 2.5% 3.6% 3.1% 2.9% 2.2% 2.5% 3.1% Source: JPMorgan Economic and Policy Research We believe the continued global GDP growth is creating an ever-expanding consumer class. Twinned with the trend of rising Internet penetration, we believe an ever-growing market opportunity exists outside the US for Internet companies, especially those with the scale to invest meaningfully in their international operations.Internet companies are more Table 6: Revenue Mix Is Shifting Away from US at Large Ad-driven, eCommerce and Travel Sitesinternationally diversified: we % of revenue derived from USestimate that ~64% of therevenue of S&P 500 companies 2006 2007E 2008E 2009Eis derived from US/North Amazon (see note) 54.8% 55.0% 54.7% 54.0%American sales, compared to eBay 52.1% 49.3% 47.5% 47.0% Expedia (see note) 74.2% 70.0% 67.1% 64.6%less than 60% for large Internet Google 57.0% 52.4% 50.6% 49.4%firms. Priceline 59.4% 44.9% 35.8% 29.8% Yahoo! 75.0% 74.9% 73.5% 68.9% Total (revenue wtd) 59.0% 55.8% 54.0% 52.4% Source: Company reports, JPMorgan estimates Note: For Amazon and Expedia, the percentage given is North America revenue share, rather than US. In this respect, we believe Internet companies are somewhat ahead of the broader market: based on FactSet data we estimate that ~64% of the revenue of S&P 500 companies is derived from US/North American sales. We see no reason for the shift away from the US to abate in the near future, and as such we believe that the large-cap companies in our coverage universe are likely to retain at least a somewhat firm footing even if the US economy and US consumer experience a slowdown. At the same time, given the significant exposure of these companies to the US, we believe it would be a mistake to think of them as “recession-proof”.8
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Rising Broadband Penetration Remains Growth Catalyst We believe faster Internet connections are necessary for a variety of online functions – obvious ones such as media and gaming, but even eCommerce – to achieve mainstream use. As such, we think rising broadband penetration across the world remains a key catalyst for the growth of the companies in our coverage universe. We note that, in the US, eCommerce spend as tracked by the Department of Commerce has increased at a similar pace as Broadband penetration. We believe this is not coincidental: speed is a key component of user experience, and a positive user experience is likely to drive greater use of eCommerce sites. Figure 2: US eCommerce has grown hand-in-hand with Broadband penetration $ in millions; eCommerce quarterly average spend 30% 30000 25% 20% 20000 15% 10% 10000 5% 0 0% 1H02 2H02 1H03 2H03 1H04 2H04 1H05 2H05 1H06 2H06 1H07 eCommerce, $M Broadband Penetration, % Source: Department of Commerce, OECD, JPMorgan estimates OECD data suggests many countries in Continental Europe remain 1-2 years behind the US and UK in terms of broadband penetration. As such, we think higher broadband usage is likely to be a growth catalyst in those countries as well as in the US in coming years. While eCommerce has grown in parallel with Broadband penetration, online ad spend, as measured by the IAB, has grown at a more rapid pace in recent years than Broadband adoption: Figure 3: US Online ad spend rising faster than Broadband penetration $ in millions; IAB quarterly average ad spend 30% 5000 25% 20% 15% 2500 10% 5% 0 0% 1H02 2H02 1H03 2H03 1H04 2H04 1H05 2H05 1H06 2H06 1H07 Ad spend, $M Broadband Penetration, % Source: OECD, IAB, JPMorgan estimates 9
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com We believe the faster rate of growth can be attributed in part to network effects: as more users have access to a faster, more complete Internet experience, a greater number of advertisers find it economical to direct part of their spend online. An additional factor is the ability of richer media ads – which take advantage of higher bandwidth – to command higher CPMs. Newspaper Ad Spend Declining Advertising spend at US newspapers is continuing to decline: 2007 saw an acceleration of newspaper ad spend declines, and we think this trend is likely to continue as time spent on newspapers declines in favor of time spent online. We expect a continuation of the shift away from newspapers to be a tailwind for Internet advertising in the coming year. Figure 4: Newspaper Ad Spend Continues to Decline $ in billions 3.9% 4.0% 1.9% 1.5% 2.0% 55.0 0.0% -1.7% -2.0% 45.0 -8.6% -4.0% 47.4 -6.0% 44.9 46.7 46.6 42.6 -8.0% 35.0 -10.0% 2003 2004 2005 2006 2007 Source: NAA.org, JPMorgan estimates Involvement of Regulatory Authorities Likely to Grow As the industry grows and becomes entwined in more and more aspects of people’s lives, we think regulators are going to take more and more notice of Internet companies. Going forward, regulatory risk will likely grow, although we believe it will remain relatively small, compared to other industries. M&A in question 2007 saw several large mergers take place within the Internet space, most notably Google’s purchase of DoubleClick and Microsoft’s acquisition of aQuantive. While the latter was able to achieve regulatory clearance, European authorities are still (as of mid-December) examining whether the Google – DoubleClick merger will create a player in the online ad industry that is too dominant. We think such regulatory flare-ups are likely to reoccur. Further, as online advertising continues to take share away from traditional avenues, we expect the incumbent players to pursue a variety of approaches, including lobbying for regulatory/legislative intervention, to attempt to defend their position. Privacy concerns abound As search companies become larger and ad networks begin to capture more and more data about users, privacy concerns have become more common.10
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com In response, several companies have made voluntary steps to lower the quantity of personalized data collection they do. For example, Google has said it will anonymize searcher data after 18 months, while Ask has given users the option of erasing their search history immediately. Social networking sites, which often collect more personal information than do search engines, have also faced attention in regards to their data practices. As we note in the Social Networks Primer, below, we think history indicates that users are willing to sacrifice incremental erosions of their privacy in exchange for features they find useful, especially if sites do not over-reach. Thus far, the desire of users to express themselves has been stronger than the desire to hide, and we think that is likely to continue. Internet Taxation: Likely Not on the Horizon in US Two key Internet tax issues exist in the US: an Internet access tax and a sales tax. A bill renewing the ban on an Internet access tax for seven years passed the US Congress in October 2007. As regards sales taxes on online retail sales, JPMorgan’s Senior Vice President for Government Relations, Tom Block, believes that a recently proposed bill, intended to allow states to implement an Internet sales tax under certain conditions, does not have a significant chance of passing in the foreseeable future. While offline retailers and state governors have lobbied for rules such as this, voting for this bill could be construed as a tax increase, and Tom Block thinks that makes passage of the bill a non-starter, especially in an election year. Internet IPO Market Remains Healthy 2007 saw solid IPO activity in the Internet and online space, with deals in the double digits (please see chart below). We believe the trend is likely to continue in F’08, as an ever-evolving marketplace gives rise to new opportunities.Table 7: Selected Internet IPOs, F’07$ in millions except per-share amountsPricing Date Issuer Name Symbol Amt ($mm) Mkt cap ($mm) % mcap Offering Price Price, 12/7 Performance06/26/07 Comscore Inc SCOR 101 457 22% 16.50 36.13 119%10/02/07 Constant Contact CTCT 123 433 28% 16.00 21.69 36%07/17/07 Dice Holdings Inc DHX 221 805 27% 13.00 10.01 -23%03/21/07 Glu Mobile Inc GLUU 86 327 26% 11.50 5.33 -54%11/16/07 Internet Brands Inc INET 48 334 14% 8.00 7.99 0%06/07/07 Limelight Networks Inc LLNW 276 1,192 23% 15.00 8.01 -47%08/09/07 MercadoLibre Inc MELI 333 752 44% 18.00 43.77 143%07/19/07 Orbitz Worldwide Inc OWW 510 1,244 41% 15.00 9.87 -34%07/25/07 Perfect World Co Ltd PWRD 217 894 24% 16.00 31.53 97%02/15/07 Salary.com Inc SLRY 69 158 44% 10.50 13.27 26%05/16/07 TechTarget Inc TTGT 115 508 23% 13.00 13.66 5%02/08/07 U.S. Auto Parts Network Inc PRTS 115 298 39% 10.00 8.59 -14%03/08/07 Xinhua Finance Media Ltd XFML 300 883 34% 13.00 6.80 -48%Source: Company reports, FactSet, JPMorgan estimates We see the Internet landscape continuing to undergo changes in F’08. We expect several types of companies to start achieving a level of scale and operational visibility where a public offering makes sense. Particularly, we think the growing maturity of sectors of the Internet previously thought to be not yet mature, such as social networks, will spur deal activity. 11
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com We Think 2008 Could Bring Greater Profitability In 2006, 12 of the Internet companies in our coverage universe saw EBITDA margins decline, and nine had increases. In F’07, the numbers were reversed, with 12 risers and nine decliners. We think, as some of the companies in our universe reach greater maturity, profitability becomes a higher priority than growth, and more achievable, and are forecasting rising EBITDA margins at 16 of these companies in F’08. At the same time, we do not believe that, given the scale of these firms, the leverage that can be achieved in the short term is significant: of the 16 companies whose margins we expect to improve, we are modeling greater than 100 bps EBITDA margin improvement at only eight. Finally, we would note that, should an economic downturn in F’08 be more severe than currently expected, it is possible that our projected margin levels could see pressure. Table 8: Change in EBITDA margins for the JPMorgan Internet Coverage Universe 2006 2007E 2008E EBITDA mgn Y/Y change EBITDA mgn Y/Y change EBITDA mgn Y/Y change AMZN 6.6% -1.0% 7.5% 1.0% 8.2% 0.7% CNET 20.8% 1.5% 19.9% -0.8% 22.1% 2.2% DHX 35.0% -0.4% 41.4% 6.4% 41.5% 0.2% EBAY 34.4% -6.3% 33.1% -1.3% 33.3% 0.1% EXPE 27.3% -3.2% 27.4% 0.2% 26.9% -0.6% GOOG 63.2% -2.0% 59.4% -3.8% 58.5% -0.9% IACI 15.2% 0.7% 13.6% -1.6% 13.9% 0.2% INSP -7.5% -28.3% -3.9% 3.6% -11.2% -7.3% INWK 9.0% 2.4% 9.3% 0.3% 9.7% 0.4% LINTA 36.3% 3.0% 35.2% -1.1% 34.8% -0.4% MELI 14.2% 5.8% 28.3% 14.1% 32.1% 3.8% MNST 25.1% 2.1% 22.3% -2.8% 29.0% 6.7% MOVE 8.4% 6.3% 9.8% 1.4% 13.0% 3.2% NILE 8.9% -0.8% 9.5% 0.5% 9.3% -0.1% OMTR 10.1% 24.1% 16.0% 5.9% 17.5% 1.6% OWW -8.3% -8.3% 11.6% 19.9% 16.8% 5.2% PCLN 9.5% 2.3% 11.5% 2.0% 17.3% 5.8% SFLY 16.8% -0.8% 17.4% 0.6% 17.8% 0.5% SOLD 8.3% -19.5% 5.7% -2.6% 15.1% 9.4% VCLK 26.6% -1.8% 25.6% -0.9% 25.8% 0.2% YHOO 41.8% -0.3% 37.4% -4.4% 38.1% 0.7% Source: Company reports, JPMorgan estimates12
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Dot.Khan’s Top Ten for 2008 1. CPM growth rate will accelerate 2. M&A market will remain robust 3. Audience Fragmentation: Will the Ad Network strategy work? 4. Domestic eCommerce growth will slow: Can Amazon continue to deliver above- market growth? 5. Can Jerry Yang turn Yahoo! around? 6. Mobile ads will be like video ads: A whole lot of talk, not a whole lot of $ 7. Booking fees are not going away: consider that USAirways just introduced fees 8. Economic slowdown may impact profitability somewhat, but we expect margins to stabilize 9. Internet will continue to cannibalize Newspaper ad spend, which declined ~8% in F’07 10. Battle of Facebook vs. MySpace: both will thrive, but we think Facebook will do better 13
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com14
  • U.S. Sector Outlooks
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com 2008 Search Advertising Outlook Given a very strong 2007 performance, we are increasing our outlook for the global paid search market heading into 2008. We now believe global paid search revenues will reach $30.5B in 2008, up from our prior estimate of $26.2B. We believe that 2008 paid search growth will be driven by: • International growth due to continued adoption of paid search as a marketing vehicle • Keyword price inflation due to increased volume in advertisements • Volume growth driven by increases in web usage • CTR improvement driven by improvements in relevancy Within search, we continue to believe that Google will take volume market share from competitors as we have greater faith in the company’s ability to execute relevancy enhancements and technological improvements and in its superior brand. However, we believe that on a dollar market share basis, Yahoo! will grow its share over Google due to the improved monetization from the global rollout of Project Panama.Yahoo! will grow its share over We estimate that Google has a 73% dollar market share currently (including revenuesGoogle due to the improved from AOL, Ask, and other affiliates). We believe that this may decline to 71% bymonetization from the globalrollout of Project Panama. the end of 2008 as AOL and Ask have renegotiated their TAC rates and Yahoo! has improved its monetization. While Internet and broadband usage appears to be flattening out in developed countries, we believe that advertiser adoption of this well- targeted marketing vehicle is in its infancy and that there is still much room for monetization and click-through rate improvements. Lessons Learned from 2007 In our “Nothing but Net" preview and outlook for 2007, we stated that we preferred paid search to other Internet sub-sectors such as e-commerce, travel, and graphical advertising. Looking back on the year, paid search actually exceeded our expectations. Entering 2007, we expected the paid search market to grow 39% over 2006 (29% in the US and 52% internationally). However, due to better monetization by Google, Yahoo!, and MSN, as well as volume gains, we now expect global paid search revenues to grow 48% in 2007 (37% in the US and 64% internationally). We were surprised by how robust search volume growth was during F07. At the beginning of the year we thought that much of F’07’s US search market growth would come from increases in coverage and were modeling a 190 bp improvement in coverage vs. 18% Y/Y growth in search volume. We now think that F’07 US coverage will only improve 70 bps vs 25% growth in volume. We are encouraged by this trend as it demonstrates that the market is less mature than we thought and that search companies have not had to resort to increasing the number of ads on a page. Global Search Overview: Global Search Expected to Grow 39% in F’08 We believe 2008 will be another strong year for global paid search. On the back of 48.3% growth in 2007, we forecast that global paid search revenues will grow 38.7% 17
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com in 2008. From a metrics standpoint, we believe query volumes will grow 29.9% in F’08, while RPS will grow 6.8%. We believe substantial monetization opportunities exist and we anticipate a climb in search usage. In 2008, we expect local search, personalized search and vertical search to be hot topics. Beyond 2008, we expect the global paid search market to grow at a 28.4% CAGR through 2011.Table 9: JPMorgans Global Search Advertising Revenue ForecastUnits as indicated Global 2002 2003 2004 2005 2006E 2007E 2008E 2009E 2010E 2011E 07-11 CAGR Internet Population (M) 593 710 820 924 1,020 1,113 1,205 1,295 1,380 1,471 7.2% Queries / Month / User 12 17 22 29 36 44 53 61 68 74 14.2% Number of Queries (M) 83,030 142,017 220,128 323,827 441,796 585,395 760,474 943,475 1,123,558 1,313,311 22.4% RPS (per 1,000 searches) $14.57 $19.04 $23.42 $28.17 $33.58 $37.58 $40.12 $41.98 $44.75 $45.59 4.9% % Coverage 31.7% 35.3% 38.7% 41.7% 43.9% 44.5% 44.5% 45.2% 45.6% 47.1% 1.4% % Clickthrough Rate 15.1% 16.3% 17.3% 18.8% 20.6% 21.5% 22.2% 22.7% 23.5% 23.3% 2.0% $ Revenue / Click $0.30 $0.33 $0.35 $0.36 $0.37 $0.39 $0.41 $0.41 $0.42 $0.42 1.4%Global Search Forecast ($M) 1,210 2,704 5,156 9,121 14,835 21,999 30,511 39,606 50,275 59,868 28.4% Y/Y Growth 197.0% 123.4% 90.7% 76.9% 62.6% 48.3% 38.7% 29.8% 26.9% 19.1%Source: JPMorgan estimates, Company reports, comScore, Nielsen//NetRatings, IDC, IWS Increasing F’08 US Search Growth Estimate: Now We Expect to Grow 32% Based on out-performance in 2007, we are increasing our 2008 growth estimate for the domestic paid search market. We are now modeling 31.9% growth in 2008, up from our prior estimate of 19.9%. Broken down by metrics, we are modeling US query volume growth of 23.5% in 2008 (a very minor deceleration from the 25.4% we observed in 2007), driven by an increase in the number of searches conducted per user and a slight increase (3.0%) in the domestic Internet population.We expect the domestic RPS to On the monetization front, we expect the domestic RPS to reach $87.21 in 2008, upreach $87.21 in 2008, up from from $81.65 in 2007 (6.8% Y/Y growth). We expect increases in RPS to be driven$81.65 in 2007 (6.8% Y/Y growth) by advertiser demand for keywords as well as continued increases in sponsored-link relevancy. Table 10: JPMorgans US Search Advertising Revenue Forecast Units as indicated United States 2006 2007E 2008E 2009E 2010E 2011E 07-11 CAGR Internet Population (M) 203 211 217 222 227 231 2.4% Queries / Month / User 47 57 68 81 92 102 15.6% Number of Queries (M) 114,896 144,080 177,938 215,305 249,754 282,222 18.3% RPS (per 1,000 searches) $74.86 $81.65 $87.21 $88.73 $94.62 $94.91 3.8% % Coverage 62.8% 63.5% 64.2% 64.3% 64.3% 64.5% 0.4% % Clickthrough Rate 26.2% 27.3% 28.3% 28.6% 30.0% 30.0% 2.4% $ Revenue / Click $0.46 $0.47 $0.48 $0.48 $0.49 $0.49 1.0% US Search Forecast ($M) 8,602 11,764 15,518 19,104 23,631 26,786 22.8% Y/Y Growth 47.2% 36.8% 31.9% 23.1% 23.7% 13.4% Source: JPMorgan estimates, Company reports, comScore, Nielsen//NetRatings, IDC, IWS Our Proprietary Research Shows... Market Share Shifts Are Likely to Continue In November, the JPMorgan Internet Team surveyed over 1,200 US residents to determine Internet usage behavior. Our market research found that Google is the dominant search engine with 54.6% of participants listing it as their most frequently used search engine. Yahoo! ranked second among participants with 21.8% of18
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com participants using it most frequently. MSN and AOL trailed with 8.6% and 7.2% of participants using them most frequently, respectively. Figure 5: Most Frequently Used Search Engine % of participants Dont use/Dont Other know AOL 3% 2% 7% Ask Yahoo! 3% 22% MSN 9% Google 54% Source: JPMorgan research However, we note that while Google was the overwhelming favorite among participants, 38.5% of respondents use search engines other than their favorite at least 30% of the time. Thus, it appears that respondents are willing to try different search engines for better results.44% of participants older than 42 Surprisingly, older participants were more likely to try different brand search enginesused a search engine other than than younger participants. 44% of participants older than 42 used a search enginetheir favorite more than 30% ofthe time vs. only 32% of other than their favorite more than 30% of the time vs. only 32% of participants inparticipants in the 18-41 age the 18-41 age category. This difference was statistically significant (t=-4.37, p<.05).category. 62% of Respondents Would Be Willing to Consider Switching Search Engines When asked what improvements by other search engines would cause you to switch from your preferred brand, only 38% of respondents stated that nothing would cause them to switch as they were satisfied with their current search engine. The most frequently selected improvement was results that better matched the search term, with 43% of respondents stating that this would cause them to switch search engines. Other factors that would cause respondents to consider switching search engines were the user-friendliness of the site (28% of participants) and search engine speed (28% of participants). Table 11: Factors that Would Cause Search Engine Switching % of Respondents Results that better match search term 42.9% Results that include video, music, and other forms of information 14.2% A more uncluttered easy to navigate site 27.8% Ability to preview web content 22.5% Faster response speed to searches 27.5% Other 1.7% Nothing, happy with current search engine 37.6% Source: JPMorgan research 19
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com What would make participants try a different search engine? Friend and family recommendations held the most weight, with 33.8% of respondents stating this as a driver to try a new search engine. 21.7% of respondents stated that the recommendation of a tech expert would influence them to try a new engine. Trailing in the rankings of persuasiveness were TV ads (11.3% of respondents), billboards (4.1% of respondents), newspapers and magazines (7.7% of respondents), and radio (3.5% of respondents). Over Half of Respondents Use Their Toolbar for Less than 40% of Searches Approximately 75% of respondents to our survey use a search toolbar. Google was the predominant choice of toolbars, with 40.7% of respondents having downloaded it. Yahoo! came in second with 24.1% of respondents having downloaded it. MSN, Ask, and AOL all had under 10% usage by respondents. Surprisingly, while almost three-fourths of our respondents had toolbars, their usage of them was infrequent. 42.4% of respondents who had toolbars used them less than 20% of the time. Figure 6: Toolbar Usage Frequency % of respondents 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Less than 20% 21-40% 41-60% 61-80% 81-100% Source: JPMorgan research International Market to Top the US by F’09 We continue to believe the opportunities for paid search in the international marketplace are even more significant than in the US. In our estimate, while the U.K. is at par or ahead of the US market, the overall international paid search market is still 2+ years behind the US in terms of development.We expect the international However, we now believe that the international market will be larger than themarket to reach $20.5B in F’09 domestic market in F’09 with a market size of $20.5B vs. the US estimated marketvs. the US market size of $19.1B. size of $19.1B. As such, we believe that the international markets will be a key growth driver in the upcoming year. We believe a key driver in the international markets will be query growth. While we expect the US to experience query growth of 23.5% Y/Y, we believe international markets will see a 32% Y/Y lift in the number of queries.20
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Figure 7: US vs. International Query Volume millions 200,000 180,000 160,000 140,000 120,000 100,000 80,000 60,000 40,000 20,000 0 3Q06 4Q06 1Q07 2Q07 3Q07 U.S. International Source: comScore data and JPMorgan estimates We are modeling paid search revenues to grow 46.5% in F’08, up from our prior estimate of 34.9% driven primarily by higher growth in queries and, to a lesser extent, monetization gains. Broken down by metrics, we are modeling international query volume growth of 32.0% in 2008 (a very minor deceleration from the 35.0% we observed in 2007), driven by an increase in the number of searches conducted per user and an increase (9.5%) in the domestic Internet population. On the monetization front, we expect the international RPS to reach $25.74 in 2008, up from $23.19 in 2007 (11.0% Y/Y growth). We expect increases in RPS to be sustainable as the international market RPS is significantly below US levels ($81.65 in F’07). Gains will likely be driven by advertiser demand for keywords as well as continued increases in sponsored-link relevancy. Table 12: JPMorgans International Search Advertising Revenue Forecast Units as indicated International 2006E 2007E 2008E 2009E 2010E 2011E 07-11 CAGR Internet Population (M) 817 903 988 1,072 1,153 1,239 8.2% Queries / Month / User 33 41 49 57 63 69 14.2% Number of Queries (M) 326,900 441,315 582,536 728,170 873,804 1,031,0 23.6% 89 RPS (per 1,000 searches) $19.07 $23.19 $25.74 $28.16 $30.49 $32.08 8.5% % Coverage 37.2% 38.3% 38.5% 39.5% 40.2% 42.3% 2.5% % Clickthrough Rate 17.2% 18.4% 19.1% 19.8% 20.5% 20.5% 2.8% $ Revenue / Click 0.30 0.33 0.35 0.36 0.37 0.37 2.9% Intl Search Forecast ($M) 6,233 10,235 14,993 20,502 26,644 33,082 34.1% Y/Y Growth 90.1% 64.2% 46.5% 36.7% 30.0% 24.2% Source: JPMorgan estimates, Company reports, comScore, Nielsen//NetRatings, IDC, IWS 21
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com 2008 Graphical Advertising Outlook After a difficult 2007 where CPMs were pressured from a non-premium inventory glut, we believe that 2008 will see stronger graphical advertising growth. Specifically, we think that 2008 growth will be driven by: • Easier comps as growth will be computed off of this year’s depressed CPMs • Improving CPMs as companies employ targeting techniques and use ad exchanges • Improving RPMs due to higher sell-through and increased ads per page • Increased advertiser interest due to the increased TV ad demand due to political campaigns • Increased page views from rising broadband usage and social networking As a result, we are slightly increasing our F’08 graphical advertising global growth estimate to 22.1% from 20.6% to reflect better monetization (CPMs) through the use of targeting and exchanges and expected growth from social networking sites and blogs. We favor web publishers who are organically growing their page views at a rapid pace and who have targeting capabilities. Lessons Learned from 2007 In our “Nothing but Net” preview and outlook for 2007, we expressed our view that the US graphical advertising market was poised to grow 20% in 2007. Now that the year is almost complete, we have revised our F’07 US growth estimate to 23.4%. We believe that we correctly recognized the audience fragmentation trend due to the rise of social networking and blog usage. We also forecasted the resulting depressed CPMs from the glut of non-premium inventory. However, we did overestimate the impact of video advertising. We thought that the increase in video inventory, coupled with lower CPMs, would cause many graphical advertisers to shift their advertising budgets toward video and away from more traditional graphical advertising. We now recognize that reaching revenue sharing agreements and developing unobtrusive video ads accepted by viewers will be a longer process than we first thought. Global Graphical Advertising Overview: Expect to Grow 22.1% in F’08 We believe that 2008 will be a strong year for graphical advertising publishers, particularly those with targeting capabilities. On the back of expected 23.4% growth in 2007, we believe global graphical advertising revenues will grow 22.1% in F’08. From a metrics standpoint, we believe page views and RPMs will grow 11.1% and 9.9% in 2008, respectively. We expect the global Internet population to expand 8.3% to 1.2B in 2008 and web usage to expand by 2.7% per Internet user. We believe RPM growth will be driven by (1) improving CPMs as companies employ targeting techniques and use ad exchanges, (2) increased sell-through rates, and (3) increased ads per page. We expect the global graphical advertising market to grow at a 17.6% CAGR from 2007 through 2011.22
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 13: JPMorgans Global Graphical Advertising Revenue ForecastUnits as indicated Global 2002 2003 2004 2005 2006E 2007E 2008E 2009E 2010E 2011E 07-11 CAGR Internet Population (M) 593 710 820 924 1,020 1,113 1,205 1,295 1,380 1,471 7.2% Pages Viewed / User / Day 33 34 36 37 38 39 40 41 43 44 2.7% Total Pages Viewed (B) 7,209 8,897 10,724 12,607 14,275 15,986 17,768 19,563 21,469 23,487 10.1% RPM (per 1,000 pages) $1.02 $0.75 $0.81 $0.87 $0.97 $1.07 $1.17 $1.26 $1.33 $1.39 6.8% Global Graphical Forecast ($M) 7,354 6,674 8,642 10,984 13,829 17,068 20,846 24,561 28,573 32,685 17.6% Y/Y Growth -19.6% -9.2% 29.5% 27.1% 25.9% 23.4% 22.1% 17.8% 16.3% 14.4%Source: JPMorgan estimates, Company reports, comScore, Nielsen//NetRatings, IDC, IWS, IAB We Think that US CPMs Will Rise in 2008 We expect the US graphical advertising market to grow 19.9% in 2008, slightly below our estimate from a year ago. We believe that page view growth will slow to 6.5% in 2008 (down from 8.0% in 2007) as social networking sites and blogs begin to mature and reach saturated penetration levels. In our estimate, page view growth will be driven by an increase of 3.0% in Internet users and an increase of 3.4% in usage per Internet user. We are modeling RPMs to grow 12.6% in 2008, driven by an 8.3% increase in the number of ad impressions per page view and a 3.9% increase in CPMs. We expect the US graphical advertising market to grow at a 14.2% CAGR from 2007 through 2011. Table 14: JPMorgans US Graphical Advertising Revenue Forecast Units as indicated United States 2006 2007E 2008E 2009E 2010E 2011E 07-11 CAGR Internet Population (M) 203 211 217 222 227 231 2.4% Pages Viewed / User / Day 45 47 49 50 52 53 3.3% Total Pages Viewed (B) 3,341 3,608 3,843 4,093 4,297 4,512 5.7% Impressions / Page 0.50 0.60 0.65 0.68 0.70 0.70 3.9% Total Impressions (B) 1,671 2,165 2,498 2,783 2,987 3,158 9.9% CPM (per 1,000 impressions) $3.50 $3.31 $3.44 $3.60 $3.76 $3.86 3.9% RPM (per 1,000 pages) $1.75 $1.99 $2.24 $2.45 $2.61 $2.70 8.0% US Graphical Forecast ($M) 5,847 7,166 8,593 10,019 11,230 12,192 14.2% Y/Y Growth 23.0% 22.6% 19.9% 16.6% 12.1% 8.6% Source: JPMorgan estimates, Company reports, comScore, Nielsen//NetRatings, IDC, IWS, IAB Political Advertising Likely to Drive Up Scatter Inventory We estimate that political ad spend on TV will total approximately $2.2B in the 2008 political cycle, up about 38% from 2006 levels. We estimate that presidential TV ad spending alone should total over $600M in the 2008 election cycle. Since 1982, political advertising revenues have contributed about 34% of spot TV ad growth in even-numbered years.Political advertising revenues Given the fixed quantity of available TV inventory and our expectation that politicalhave contributed about 34% of ads may account for 6% of 2008 spot TV ads, we think that it is likely that somespot TV ad growth in even-numbered years. advertisers will shift their ad spend to online display advertising. 23
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 15: Political Ad Spending, 1992-2008E$ in millions 1992 1994 1996 1998 2000 2002 2004 2006 2008EPresidential $331.1 - $425.7 - $528.9 - $880.5 - $1,454.4+ Senate $397.1 $480.8 $435.8 $455.1 $547.5 $458.8 $573.1 $664.8 $758.8+ House $530.7 $573.6 $653.5 $677.9 $691.3 $761.8 $784.8 $1,012.2 $1,160.5+ Gubernatorial $60.3 $423.0 $68.6 $471.0 $97.8 $833.3 $112.6 $937.9 $136.9+ Other $263.7 $232.6 $310.2 $273.7 $364.9 $285.5 $406.3 $252.0 $447.0= Total Political Dollars Raised $1,582.8 $1,710.0 $1,893.8 $1,877.6 $2,230.4 $2,339.5 $2,757.3 $2,866.9 $3,957.5x % $$ Spend 95.0% 95.0% 95.0% 95.0% 95.0% 95.0% 95.0% 95.0% 95.0%= Total Political Dollars Spent $1,503.7 $1,624.5 $1,799.1 $1,783.7 $2,118.9 $2,222.5 $2,619.5 $2,723.6 $3,759.6x % Allocated to TV Advertising 35.6% 31.3% 34.6% 40.1% 41.0% 45.6% 53.4% 58.7% 58.7%= Political TV Advertising $534.8 $508.3 $621.9 $714.4 $868.9 $1,013.0 $1,400.0 $1,600.0 $2,208.6% Change from Prior Election Year --- (4.9)% 22.4% 14.9% 21.6% 16.6% 38.2% 14.3% 38.0%Source: Opensecrets.org and JPMorgan estimates. Note: Other $$ includes funds raised by political parties, interest groups, etc. Aggregators of Traffic Poised for Growth Audience Fragmentation Creates Difficulty for AdvertisersWhile portals were once While portals were once dominant, Yahoo!, AOL, and Microsoft only accounted fordominant, Yahoo!, AOL, and ~29% of minutes spent online in August 2007, down from 42% in August 2002.Microsoft only accounted for~29% of minutes spent online in Meanwhile, blogs, online gaming, and social networking websites have experiencedAugust 2007, down from 42% in double to triple digit Y/Y growth rates in page views. This fragmented audience notAugust 2002. only makes it more difficult for advertisers to reach their target audience through only a few publishers, but also makes it difficult for publishers to attract advertisers given their limited scale. We believe that companies that can aggregate traffic through the development of ad networks or partnerships will be more successful in driving growth in 2008. Please see the Ad Network section of this report for additional details. Targeting Capabilities Successful on Inventory with Overlapping User Base While increasing user reach is half the battle, we recognize that many page views are meaningless to advertisers unless user information can be gathered and ads are targeted. In order to most effectively target the ads, publishers need to have access to user behavior on multiple sites to collect data and to repeatedly show ads to the same user. We believe that companies with targeting capabilities will be able to command a premium CPM. Revenue Science estimates that there is a 15x CPM premium for behaviorally targeted ads.24
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Figure 8: Behavioral Targeting Effects on CPM 1600 80 Tier 1 Tier 2 Tier 3 1400 Revenue Science 70 $10+ $1-10 < $1 Targeting 1200 ~$10.00 - 12.00 12 Average CPM Dollars 1000 10 800 8 600 6 Traditional optimized 400 ad network Exchange model 4 $0.50 - 1.00 potential benefits 200 ~$0.75 - 1.50 2 0 0 1 2 20 3 4 40 5 6 60 7 8 80 9 Web impressions Percent Source: Revenue Science Presentation International Growth Is Still a Big Theme International markets continue to benefit from increased broadband penetration and increased ad spend moving online. Even in markets where broadband is approaching saturation, such as in the UK, display ad prices are likely to rise as more advertisers compete for a more limited quantity of inventory. We estimate that international display advertising will grow at 23.8% in 2008 and at a 19.9% 2007-2011 CAGR.We estimate that international Table 16: JPMorgans International Graphical Advertising Revenue Forecastdisplay advertising will grow at Units as indicated23.8% in 2008 and at a 19.9% International 2006E 2007E 2008E 2009E 2010E 2011E 07-112007-2011 CAGR. CAGR Internet Population (M) 817 903 988 1,072 1,153 1,239 8.2% Pages Viewed / User / Day 37 38 39 40 41 42 2.8% Total Pages Viewed (B) 10,934 12,378 13,925 15,470 17,172 18,975 11.3% RPM (per 1,000 pages) $0.73 $0.80 $0.88 $0.94 $1.01 $1.08 7.8% Intl Graphical Forecast ($M) 7,982 9,902 12,254 14,542 17,344 20,493 19.9% Y/Y Growth 28.1% 24.1% 23.8% 18.7% 19.3% 18.2% Source: JPMorgan estimates, Company reports, comScore, Nielsen//NetRatings, IDC, IWS, IAB 25
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Ad Networks on the Rise What Are Ad Networks? We see ad networks defined by the following: transacts, serves, tracks and reports the distribution of advertiser ads to publisher pages. enables marketers to advertise on multiple publisher sites through one central location publishers enjoy the benefit of advertising revenue without investing in a sales force or as a source to sell remnant inventory varies in the ability to target a specific audience and in methods of payment (CPM, CPC, and CPA) revenues are determined by revenue share agreementsLead generation is more vertical The definition of ad networks is fuzzy with lead generation sometimes included.specific and performance However, we are differentiating between the ad network and lead generation space.oriented than ad networks We are defining lead generation as much more targeted and deep into specific verticals. As a result, we believe that this commands much higher CPMs, in the $100-$150 range. While we believe that this is also an interesting ad model, we believe it deserves a more detailed consideration and will thus save it for a later note. A Significant Market Opportunity We estimate that the global graphical advertising market as a whole will grow over 22% through 2008. The sector should benefit from 1) increased online viewership as more people turn to the Internet as a source of content and 2) increased RPMs as audience targeting improves.Intl Ad Network penetration is Additionally, increasing keyword prices and the ability of networks to provideso small that it is not yet tracked response advertising in addition to branding campaigns will likely drive moreby ComScore. We expect that itis ~3-5 yrs developmentally marketers to ad networks. On the publisher side, as the long tail of information isbehind the US and will be a increasing, more publishers are looking to monetize their content. We estimate thatsignificant future growth driver. the top 20 ad networks will earn approximately $2B+ in revenue in 2007 (~14% of the display ad market) and are growing much faster than the general graphical advertising industry. We estimate ad networks to contribute ~17% of the total display ad market in 2010 (25% F’08-F’10 CAGR).26
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Figure 9: Global Ad Network Market Forecast $ in millions 6000 5000 4000 3000 2000 1000 0 2005 2006 2007E 2008E 2009E 2010E Source: ComScore data, Company reports, and JPMorgan estimates Table 17: Ad Networks by Page Views millions August Page Views (M) August Y/Y Growth Advertising.com 72,598.6 56% AdBrite 28,529.9 901% Traffic Marketplace 25,629.0 321% ValueClick 22,732.2 64% 24/7 Real Media 13,532.5 104% Tribal Fusion 10,829.5 -4% CPX Interactive 9,764.1 N/A Casale Media Network 9,575.9 -59% Blue Lithium 5,450.2 211% Specific Media 5,407.0 N/A Vibrant Media 5,096.6 168% ContextWeb 5,065.6 122% PrecisionClick 4,497.8 -52% Burst Media 3,746.3 26% DRIVEpm 2,993.1 140% Interclick 1,992.1 N/A Kontera 1,894.7 N/A adconion media group 943.6 N/A AdDynamix.com 918.3 264% Undertone Networks 441.2 734% Indieclick 175.8 N/A Rydium Network 27.3 -52% Total 231,841.3 77% Source: ComScore and JPMorgan estimates The Future of Ad Networks The ad network space is becoming increasingly competitive as new ventures are launched and as Google, Yahoo!, AOL, and Microsoft enter the space through acquisitions. We believe that differentiation will be key to success. Following are capabilities that we see important to market leadership. Behavioral TargetingBehavioral targeting will We believe that advertisers used to pay for audiences on websites but will now startincrease CPMs and drive to pay for specific users. Marketers appear to value targeted advertising as evidencedvolume. by Google’s well targeted search ads generating RPQs of more than double Yahoo!s. 27
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com We expect that this same principal will apply to graphical advertising and note that Revenue Science estimates a 15x CPM premium for behaviorally targeted ads. Figure 10: Behavioral Targeting Effects on CPM 1600 80 Tier 1 Tier 2 Tier 3 1400 Revenue Science 70 $10+ $1-10 < $1 Targeting 1200 ~$10.00 - 12.00 12 Average CPM Dollars 1000 10 800 8 600 6 Traditional optimized 400 ad network Exchange model 4 $0.50 - 1.00 potential benefits 200 ~$0.75 - 1.50 2 0 0 1 2 20 3 4 40 5 6 60 7 8 80 9 Web impressions Percent Source: Revenue Science Presentation Video CapabilitiesWe believe that the development Google’s $1.65B acquisition of video sharing site YouTube gives insight into theof a non-intrusive video ad value placed on video property. Traditional media companies have also moved ontodelivery system with contextualadvertising capabilities will be the Internet by offering TV episodes online and with Internet designed webisodes.valued by the ad network space. However, monetization of Internet videos has trailed its growth. Various companies have experimented with pre-roll, post-roll and in-video ads. Google has experimented with in video ads on select YouTube videos in which the ad is overlaid on the bottom 20% of the video soon after it is launched. If the user does not click on it, it simply disappears. Mobile AdsSuccess in mobile ads will be An even younger industry is mobile phone advertising. The development of thedependent on targeting, non- iPhone and speculation of Google phone devices or services have placed a growingintrusiveness, and ability to loadon slow-loading platforms. interest in the field. Performance-based AdvertisingWe see payment structures While many graphical ads were originally used for branding purposes with less of ashifting with objectives to focus on conversion, the developments in behavioral and contextual advertising haveinclude CPA models in additionto CPMs. put more pressure on ad networks to deliver conversions. Email MarketingWe believe marketers will turn to Ad networks have entered the realm of email marketing by placing advertisements intargeted email distribution given emails sent by other companies to their customers. As in the other categories, ROI isits high usage and push vs. pullad model. enhanced by careful pairing of the ad with a related company or email content. Email marketing is a preferred method of advertising with its easy trackability and ROI calculation. Furthermore, unlike other advertisements, email is pushed to targeted customers rather than assuming that specific websites will pull these customers to the ad.28
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Ultimately, we believe successful ad networks are going to need to be able to provide a diversity of advertising platforms to its marketers with clear targeting capabilities. Dominant Portals’ Role in the Growing Ad Network Market In our view, potential consolidation in the ad network space is strategically feasible. We believe that consolidation will occur throughout the industry as ad networks grow their user base and leverage user information through behavioral targeting across a larger audience base. We believe large portals are well positioned as it is easier for both advertisers and publishers to fulfill all of their needs on fewer platforms while a consolidated network yields greater leverage of technology and advertiser/publisher relationships. Creating Ad Networks Could be the Answer to an Ever-Fragmenting AudienceMinutes spent on portals has While portals were once the dominant source of news and information, Yahoo!, AOLdeclined over the last 5 years and Microsoft only accounted for ~27% of total minutes spent online in October vs.despite 37% growth in total 42% in 2002. A similar trend can be seen in page views as October page views on theminutes spent on the Internet. top 3 portals declined 22% from October 2004 vs. 22% total Internet growth in page views. We note that some of these losses can be attributed to losses in dial-up subs. We believe portals will become more significant players in ad networks as they turn to networks to grow their user reach, leverage user information through behavioral targeting, and leverage their existing capabilities to sell, place, and analyze display ads. Figure 11: Total Minutes Spent on Portal in October 2002 and 2007 millions 60,000 43% decline 50,000 34% growth 40,000 21% decline 30,000 20,000 10,000 0 Yahoo! Sites Time Warner Network Microsoft Sites Oct 02 Oct 07 Source: ComScore data and JPMorgan estimates 29
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Figure 12: Total Page Views for Leading Portals, October 2004 and 2007 millions 45,000 7% decline 40,000 54% decline 35,000 30,000 25,000 4% growth 20,000 15,000 10,000 5,000 0 Yahoo! Sites Time Warner Network Microsoft Sites Oct 04 Oct 07 Source: comScore data and JPMorgan estimates User Information Will Lead to DominanceIf a company had demographic, Accurate and rich user information is among an Internet company’s most valuablesearch query, and web assets. Additionally, the ability to leverage accurate user information to delivernavigation data on a user, webelieve it could provide relevant content to users is the key to increasing conversion rates. We think largeadvertising that is more user cap companies are particularly well suited to running ad networks as they can leverrelevant and could tailor the ads their user information with that of the publisher network to provide well targetedto the user as he/she navigates advertising. This should increase user conversion and monetization capabilities. Athe web. combination between any of the search players, a large publisher network, and a company with behavioral targeting capabilities would make sense, in our view. One Platform for Multiple Advertising Products=Higher Ad Dollar Allocation From the standpoint of an advertiser, advertising campaign management would be easier with a single ad firm offering multiple products (search, graphical, cost-per- lead, cost-per-action, in-game advertising, mobile advertising, video). Publishers would benefit from the scale of various advertisers across verticals and the higher CPMs accompanying better targeted ads.30
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Figure 13: Online Advertising Services by Company Service AOL GOOG MSN YHOO Search Ad Network Ad Serving*** Traffic Exchange*** Targeting Lead Generation Affiliate Marketing*** Rich Media Mobile Email ***Assumes DoubleClick/Performics acquisition Source: JPMorgan estimates, Company data Cost Synergies Entering the ad network space would allow large cap Internet companies to lever their existing sales force, technology, and publisher relationships in expanding their product offering. The sales team could expand its offering of graphical advertising to include properties on the ad network. Technology used to place graphical ads on owned and operated properties and for behavioral targeting could be extended for use on network sites. Finally, search network relationships could be leveraged in building the ad network. Scale Is Critical to Build a Market-Leading Product While we have established that the goal of ad networks should be to increase their exposure to an overlapping user base across a variety of properties for targeting, such an undertaking requires scale. Small Companies must choose between generalization across a variety of publishers or going deep into a few verticals. Both options carry risk, as generalization limits targeting capabilities while focusing on limited verticals exposes companies to industry risk (for example, the current mortgage industry weakness). Large Cap Companies, however, have the resources to be both broad and deep, offering targeting capabilities while maintaining diversification of risk. AOL Advertising.com revenue growth is not dependent on AOL usage trends Advertising.com has been a major contributor to advertising revenue growth in the past 12 months, driving 43% of ad revenue increase at AOL while accounting for 27% of total advertising revenue. Because its revenue is derived from placing third- party advertising on third-party sites, Advertising.com grew mainly through acquisition of new customers rather than through improved monetization of AOL traffic. 31
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Figure 14: Advertising.com has contributed the largest portion of Y/Y advertising revenue increases $ in millions 80.0 75.0 74.0 63.0 60.0 51.8 55.7 60.0 50.0 50.0 40.0 38.0 39.0 34.0 35.0 40.0 29.0 20.0 9.0 0.0 Q2-06A Q3-06A Q4-06A Q1-07A Q2-07A Search Graphical Ad.com Source: Company reports and JPMorgan estimates. We think that Advertising.com will continue to grow faster than AOL’s search and graphical revenue streams, helped by an industry-wide shift to more targeted adverting, increased CPM due to behavioral targeting added through acquisition of TACODA as well as overall Internet advertising market growth. Figure 15: We expect Advertising.com revenue to continue growing faster than search and graphical % 40.0% 36.9% 30.0% 20.1% 16.5% 18.0% 20.0% 13.4% 15.4% 10.0% 0.0% 07E 08E Search Graphical Adv ertising.com Source: Company reports and JPMorgan estimates. Acquisition of TACODA Adds Behavioral Targeting Capability We believe that the acquisition of TACODA, a behavioral targeting network, completed by AOL on September 6, ’07, makes sense strategically: • The deal’s logic is consistent with our view that improved monetization of non- premium inventory will continue to gain importance as premium inventory pricing growth is slowing industry-wide. • We expect TACODA technology to improve targeting at advertising.com thus driving CPM and helping maintain revenue growth rates.32
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com • Bringing behavioral targeting function in house is a prudent defensive move given recent consolidation, in our view. Recent M&A Activity Intensifies the Competitive Environment As discussed above, we see acquisition of TACODA as a positive strategic development that should help offset potential impact from the recent changes in the competitive landscape, two deals in particular: • Acquisition of Blue Lithium by Yahoo! We believe that Yahoo! used advertising.com as well as other networks to monetize its non-premium inventory, relationships that maybe scaled down following the acquisition of Blue Lithium. Furthermore, we expect Yahoo! to combine Blue Lithium with a recently acquired ad exchange, Right Media, and pursue third-party business, thus competing with Advertising.com. • Acquisition of Aptimus by The Apollo Group (University of Phoenix Online). The Apollo Group has been the single largest contributor to advertising.com growth. We estimate that it accounted for 73%, 60% and 62% of Y/Y revenue increase in Q3 ’06, Q4 ’06 and Q1 ’07, respectively. Although its possible that The Apollo Group will re-direct some of the inventory from ad.com to Aptimus, we expect the gains from the integration of TACODA to at least offset any potential impact. Google Becoming More than Just a Search Engine and Search Network A latecomer to the display advertising field, Google has made recent strides to enter it and, in our view, would be a likely candidate for building its AdSense network to include display advertising. As the leader in search market share, Google has much information about user preferences for hosting behaviorally targeted ads. Table 18: Search Market Share, October 2007 millions Core Search Searches Search Market Oct-07 Share Google Sites 6,151 59% Yahoo! Sites 2,405 23% Microsoft Sites 1,023 10% Ask Network 491 5% Time Warner Network 443 4% Source: ComScore Strategic Acquisitions Provide Fast-Paced Industry Entrance Recent acquisitions have positioned it well to quickly gain market share. With the pending acquisition of DoubleClick, Google gains ownership of two key technologies: the DART suite: a comprehensive set of technologies that enable advertisers to effectively manage their online advertising campaigns while providing publishers with the ability to dynamically place ads on their sites. the DoubleClick Advertising Exchange: a platform for buyers to gain immediate access to inventory with goal-based bid rules, defined budgets, 33
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com targeting, and frequency caps on inventory purchases, while sellers increase overall yield by reducing unsold and undervalued inventory DoubleClick has relationships with both publishers and advertisers that enable it to serve hundreds of billions of ad impressions per year. In 2004 (the most recent full- year data available), DoubleClick served over 800 billion online ad impressions (we expect it will serve ~2 trillion impressions in F’07). Beginning with display advertising tests within the AdSense for Content environment, Google has been exploring the serving of graphical advertisements for a couple of years. But we believe the acquisition of DoubleClick emphasizes the importance that Google places on entering the ad network market. Figure 16: Graphical Ad Market Will Represent 36% of Total in 2010 % of industry revenues Graphical Adv ertising 36% Search Adv ertising 64% Source: JPMorgan estimates, Company Reports, ComScore, Nielsen//NetRatings, IDC, IWS, IAB MSN Rich Targeting and Performance-based Advertising Capabilities With the acquisition of aQuantive, Microsoft obtained the DRIVE performance media platform, which provides premium advertising solutions to aQuantive advertisers and agencies. With a selective inventory from only the top 250 publishers, DRIVEpm offers brand protection to its advertisers. The collection of visitor data over several years and CPA payment options allows for behavioral targeting and performance-based capabilities. While the selectivity of the publisher network will likely limit its scale, this premium network will offer a point of differentiation from competitive networks. Figure 17: DRIVEpm Ad Network Behavioral Targeting Advertiser and Top 250 Remnant DRIVEpm Agency Clients Publishers Inventory Network CPA Solution Source: aQuantive reports and JPMorgan estimates34
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com AdECN Should Improve Monetization In July, Microsoft announced its intention to acquire AdECN in 1H08. AdECN serves as a hub for ad networks to buy and sell display advertising in a real-time auction marketplace. Advertisers will get more access to inventory to enable better matching to their requirements and increasing ROI. Publishers should be able to increase their yield through increased volume of available inventory. With both parties benefiting, AdECN should provide better monetization through higher CPMs for Microsoft remnant and non-premium inventory. We believe this will be instrumental in monetizing inventory from the Facebook and Digg partnerships. Partnerships Are Growing MSN’s Display Reach Outside Its O&O Properties Agreements to provide advertising on Facebook and Digg have expanded MSNs advertising network beyond its owned and operated properties and have allowed MSN to capitalize on the growing social networking trend. Facebook and Digg are two of the fastest growing social networks with Y/Y page view growth well in excess of 100%. The challenge that we believe Microsoft will face will be providing targeting capabilities sufficient to monetize such a diverse user and content base. Table 19: Partner Page View Growth, August 2007 millions Aug-2006 Aug-2007 Y/Y Growth Total Internet 501,260 474,003 -5% FACEBOOK.COM 6,463 15,260 136% DIGG.COM 4 24 496% Source: comScore data and JPMorgan estimates Yahoo! A Clear Fit in the Ad Network Space Yahoo! is particularly well positioned to provide targeted advertising to a network. As the top-ranked website by unique visitors (according to comScore), Yahoo! has a wealth of information about visitor habits and preferences. Figure 18: Top Sites by Unique Visitors and % Reach, October 2007 thousands 160,000 75% 72% 140,000 66% 66% 120,000 100,000 46% 80,000 60,000 40,000 20,000 0 Yahoo! Sites Google Sites Time Warner Microsoft Sites Fox Interactive Network Media Source: ComScore data Yahoo! has made strategic acquisitions to build off its existing assets and to gain dominance in this space. 35
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Its acquisition of Right Media, in addition to its owned and operated pages, has made it a destination for the buying and selling of inventory. The acquisition of Blue Lithium has provided Yahoo! with behavioral targeting technology, visitor information off its owned and operated sites, advanced analytic reporting, and a sales force more accustomed to direct response sales. These additions should have a smooth integration as Yahoo! already possesses a sales force accustomed to selling display and contextual advertising, has experience with behavioral targeting with SmartAds, and has entered the ad network arena with newspaper partnerships and agreements with eBay and Comcast. The acquisition of Blue Lithium builds on these earlier efforts and has now made it a significant player in the ad network space. Ad Network Growth Yields F’08 Revenue Upside Yahoo! has made significant progress in developing its own display advertising partnerships. Most recently Yahoo! announced an agreement to collaborate with Bebo on display and video advertising on the companys U.K. and Ireland sites. Using a $1.00 CPM, 80% TAC and 50% Y/Y page view growth rate, we estimate Yahoo!’s net take should be ~$16M. Given the high growth rate and the potential that this partnership could expand to other geographic regions, we think this agreement will yield additional long-term benefits. Table 20: F08E Partnership Revenue $ in millions Company Category Partnership Ave. Monthly PV (last 12 Estimated Date Unique Users Months Incremental (TTM) through YHOO Apr.) Revenue Comcast Cable 4/30/2007 17.8 31,690 25.4 The McClatchy Company Newspapers 4/16/2007 6.2 1,586 1.3 Calkins Media, Inc. Newspapers 4/16/2007 NA NA NA Media General, Inc. Newspapers 4/16/2007 1.9 288 0.2 Morris Communications Newspapers 4/16/2007 NA NA NA Paddock Publications, Inc. Newspapers 4/16/2007 NA NA NA Belo Corp Newspapers 11/20/2006 4.0 1,242 1.0 Cox Newspapers Newspapers 11/20/2006 3.4 1,089 0.9 The E.W. Scripps Co Newspapers 11/20/2006 16.1 4,778 3.8 Hearst Newspapers Newspapers 11/20/2006 7.2 119 0.1 Journal Register Company Newspapers 11/20/2006 NA NA NA Lee Enterprises Newspapers 11/20/2006 4.6 1,099 0.9 MediaNews Group, Inc. Newspapers 11/20/2006 2.4 442 0.4 eBay Online auctions 5/25/2006 79.8 129,421 59.6 Bebo Social Network 9/12/2007 11.9 84,012 16.4 Total 109.8 Source: ComScore, Company Reports, JPMorgan estimates36
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Ad Exchanges: A New Marketplace Ad Exchanges: A Response to Audience Fragmentation One of the largest deterrents to the graphical advertising market has been the increase in the difficult to monetize non-premium inventory. Social networking, blogs, photo sharing, and email have all increased inventory levels but are difficult to monetize given their non-targeted user base and lack of focus on ads. Ad Exchanges focus on better monetizing this portion of inventory through aggregation and an open market. While portals were once the dominant source of news and information, page views on the top three portals declined 18% from August 2004 to August 2007 while the total Internet market experienced page view growth of 21% during the same time period. Much of this decline can be attributed to audience fragmentation, a result of increases in non-premium inventory. Blogs, online gaming and social networking websites like Facebook, MySpace and YouTube have been experiencing strong growth in page views, with double- to triple-digit Y/Y growth rates. Figure 19: Non-Premium Inventory Growth Billions MySpace Facebook 45.24B Page views, Aug 15.26B Page views, Aug YouTube 38% Y/Y Growth 136% Y/Y Growth 4.46B Page views, Aug >100% Y/Y Growth Blogs Online Gaming 17.44B Page views, Aug 7.52B Page views, Aug >100% Y/Y Growth 30% Y/Y Growth Source: comScore and JPMorgan estimates We believe that this audience fragmentation hampered the development of the graphical advertising market as it resulted in the following challenges: • Audience fragmentation makes it difficult for advertisers to reach their target audience through only a few publishers • Small publishers have difficulty attracting advertisers due to limited scale • Monetization is limited due to the difficulty of attracting sufficient advertisers to cover available inventory (purchasing power) Ad Exchanges have emerged as an efficient solution to these new challenges and are gaining traction to alter the landscape for selling and purchasing display advertising inventory. 37
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com The Rise of the Ad Exchange The ad exchange is a real time marketplace with an auction-based system where the participants - advertisers and publishers – transact on a common platform to purchase and sell online graphical advertising. The publishers place remnant inventory on the exchange for the advertisers to purchase through bidding on a user-friendly interface. Network barriers are lowered and all participants interact on a common platform, while the outside relationships are not disturbed. Ad Exchanges do not compete with ad networks, targeting technologies, or publishers, but rather serve as a more efficient way for the exchange of inventory within these groups. Figure 20: Ad Exchange Linkages Bid Optimization Large Publishers Targeting Technologies Contextual Networks Ad Exchange Rich Media Vendors Agency Side Ad Servers Display Networks Other Ad Exchanges Source: www.clickz.com (Article: Ad exchanges are the future) Key features of ad exchanges: • Transparent and dynamic pricing landscape due to open bidding process • Reduced operational friction due to improved clarity of placement of ad serving on a website • Enhanced efficiency due to simplification and standardization of business processes • Improved liquidity of ad inventory • Interests of smaller niche players safeguarded as existing relationships and budget sizes exert no influence and each bidder has equal access to the media • Increased role of technology to automate and provide a common platform • Elimination of intermediaries and their margins The Value of an Ad Exchange For Advertisers: An advertising exchange establishes a transparent and automated clearinghouse, easing pricing concerns. The advertiser can place different bids for each ad impression after evaluation of the perceived value against the buy criteria. Thus, the advertisers gain from:38
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com • Smarter spending • Better ROI • Access for inventory for targeting purposes For Publishers: The ad exchange model will usher in more competition and enhanced technologies for targeting. This should drive the demand for inventory upwards, resulting in higher CPMs. The publisher can set a floor price for the impressions to be accepted by the exchange and will gain as yields optimize when highest bids win in a real-time auction. The benefits for the publishers are: • Better targeting • More valuable inventory • Higher prices • Better yield Key Takeaways • Exchanges should increase CPMs for publishers as they provide an open auction market to a large population of advertisers • Advertisers should gain easier access to a broad range of inventory, which can be used for targeted advertising • The major Internet players should become ad exchange operators as they strive to provide a one-stop solution to all of an advertiser’s needs 39
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com 2008 eCommerce Outlook 2007 saw the standard-bearer of eCommerce, Amazon.com, accelerate revenue growth for a second straight year as the company extended its presence in a variety of categories and geographies. At the same time, we believe the online presence of brick-and-mortar retailers such as Walmart and Target has taken a step forward, with their sites growing penetration. Looking forward to 2008, we expect competition to continue to heat up between online and brick-and-mortar retailers. The biggest unknown is to what extent the US economy sees a slowdown in ’08. Even in a slowdown, however, we think online retailers are likely to continue to gain market share from offline retail channels. 2008 eCommerce Forecast We think US growth in eCommerce (including eBay GMV) could experience weaker Y/Y growth rates if economic conditions worsen. At the same time, we expect a greater proportion of retail sales to continue to shift online, driven by (1) increases in product selection, (2) continued Y/Y improvements for brick-and-mortar retailers and (3) further improved efficiencies from site optimization.Table 21: US eCommerce Forecastunits as indicatedUS eCommerce Forecast 2004 2005 2006 2007E 2008E 2009E 2010E 07 - 10 CAGRInternet population (M) 186 195 203 211 217 222 227 2.5%Online Shoppers 104 117 130 143 152 162 173 6.3%Shopping sessions / shopper / month 1.92 1.99 2.08 2.10 2.23 2.40 2.59 7.3%Total shopping sessions / year (M) 2,394 2,788 3,241 3,614 4,074 4,658 5,363 14.1%Average price / session $39.50 $41.25 $43.00 $45.50 $47.50 $ 48.80 $49.75 3.0%Total eCommerce revenue (US $M)) 94,581 114,991 139,384 164,431 193,502 227,321 266,808 17.5%Product return rate 10.0% 9.0% 9.0% 8.0% 8.0% 8.0% 8.0% 0.0%Net Revenue 85,123 104,642 126,839 151,277 178,022 209,135 245,463 17.5%Y/Y Growth 22.9% 21.2% 19.3% 17.7% 17.5% 17.4%Source: Department of Commerce, Internet World Stats, company reports, JPMorgan estimatesNote: includes eBay US GMV Worldwide, we are projecting continued strong eCommerce growth. Note that, in 2007, the European growth rate had a ~10% impact from FX. Additionally, though we have assumed flat FX going forward, the projected ’08 dollar-denominated growth rate sees a boost as the $/Euro exchange rate at year-end was above the full- year average. For our international forecast, we expect the following drivers, some region-specific and some general: (1) continued rises in online shopping penetration in Western Europe, (2) continued investments by online retailers in broadening selection, (3) improvements in shipping infrastructure, (4) improved payment systems and (5) better fraud protection.40
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 22: Global eCommerce Forecast$ in millionsGlobal eCommerce Forecast 2004 2005 2006 2007E 2008E 2009E 2010E 07 - 10 CAGRUS 85,123 104,642 126,839 151,277 178,022 209,135 245,463 17.5%Europe 85,827 112,139 139,126 179,226 224,911 257,748 289,966 17.4%Asia 29,538 39,685 50,556 63,340 77,899 94,686 114,673 21.9%ROW 9,440 13,216 18,502 25,903 36,265 47,144 61,287 33.3%Total 209,927 269,681 335,024 419,745 517,096 608,714 711,390 19.2%Y/Y Growth 28.5% 24.2% 25.3% 23.2% 17.7% 16.9%Source: Department of Commerce, Internet WorldStats, UK eStats, Forrester Research, Iresearch, Korea National Statistics Office, eMarketer, company reports, JPMorgan estimates Large-Cap eCommerce Companies Growing Revenue Faster Both Amazon and eBay grew revenue at a faster pace than the US eCommerce market as a whole. For eBay, international growth, as well as growth in PayPal, have been key drivers. At Amazon, US revenues have grown faster in the US than internationally, paced by growth in third-party sales and 50% growth in Electronics categories in the first three quarters of F’07. Table 23: eCommerce Industry Comparable Table -- Small and Large Cap Revenue Growth Rates Market cap in $ millions Price Mkt Cap Y/Y Revenue Growth Ticker Rating 12/26 12/26 04/05 05/06 06/07E AUDIBLE INC ADBL NR $9.02 $220 84% 30% 32% AMAZON.COM INC AMZN N $92.85 $38,549 23% 26% 35% EDIETS.COM INC DIET NR $5.90 $147 18% -9% -40% DRUGSTORE.COM INC DSCM NR $3.37 $324 11% 4% 8% EBAY INC EBAY OW $34.49 $46,683 39% 31% 29% 1-800-FLOWERS.COM FLWS NR $8.83 $556 11% 17% 26% FTD GROUP INC FTD NR $13.30 $383 10% 6% 39% MERCADOLIBRE INC MELI OW $72.85 $3,222 84% 62% NAPSTER INC NAPS NR $1.95 $90 -53% 103% 40% NETFLIX INC NFLX NR $28.70 $1,888 35% 46% 21% BLUE NILE INC NILE N $74.16 $1,190 20% 24% 28% OVERSTOCK.COM INC OSTK NR $16.17 $385 63% -2% -1% SHUTTERFLY INC SFLY OW $27.38 $675 54% 47% 48% STAMPS.COM INC STMP NR $12.78 $253 62% 37% 3% Group Average 29% 32% 24% Large-cap Average 31% 29% 32% Small-cap Average 29% 32% 22% US E-commerce 22% 23% 20% Source: Department of Commerce, Company reports, Reuters, JPMorgan est. for rated companies, FactSet estimates for other companies. JPMorgan ratings: OW = Overweight; N = Neutral; UW = Underweight Takeaways from the 2007 JPMorgan Internet Team’s 2007 Consumer Survey In the second half of November, we conducted a proprietary survey of US consumers. The survey had 1,261 participants, residents of the United States aged 18+. In addition to asking consumers about their shopping plans for the 2007 holiday season, we asked the respondents a variety of questions about their online shopping habits in general, and the key broad takeaways are summarized below: Price is biggest factor in choosing a site 63% of shoppers said price was the biggest factor in choosing an online store, with selection also important. Of the options we offered, the least popular one, by a wide margin, was “recommendations from friends and relatives”. 41
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Table 24: Price is paramount: factors that influence buyers’ choices % among respondents who indicated they shop online Factor #1 factor #2 factor In top 5 Price 63.0% 13.7% 87.1% Selection 11.8% 36.5% 74.3% Customer service 3.9% 9.1% 48.0% Promotions/Advertisements 2.2% 7.3% 43.4% Payment options 2.3% 7.8% 42.0% Familiarity/experience with store 5.7% 6.2% 40.9% Name recognition 2.7% 6.3% 40.0% Ability to purchase multiple items 4.1% 5.0% 37.8% Access to customer reviews/product information 3.2% 4.6% 33.7% Recommendations from friends/relatives 1.3% 3.6% 23.1% Source: JPMorgan Internet Team 2007 Consumer Survey Looking at the data on a site-by-site basis does not change the conclusion: price remains the top consideration for shoppers regardless of site, with 60-63% of shoppers at each of Amazon, eBay, Walmart.com and Target.com listing price as their top factor in choosing a site. Higher-income shoppers look for slightly different things in a site. More than 50% of shoppers with incomes over $100K listed “familiarity/experience with store” as one of their top five factors, compared to below 40% for those earning less than $100K. Selection and the ability to purchase multiple items were more important to those with incomes over $100K, while payment options were less important. Even for the >$100K-income shoppers, price is the biggest factor: fewer respondents in this income category chose it as their #1 factor, but approximately 86% listed it in their top five, in line with the sample as a whole. Table 25: Familiarity and selection matter more to higher-income shoppers % of online shoppers who indicated factor was one of their top 5 factors in choosing a site Factor Income <$100K Income >$100K Difference Price 87.2% 86.2% -1.1% Selection 73.6% 79.7% 6.1% Customer service 48.0% 48.0% -0.1% Promotions/Advertisements 42.7% 48.0% 5.3% Payment options 43.7% 29.3% -14.5% Familiarity/experience with store 39.5% 50.4% 10.9% Name recognition 40.8% 34.1% -6.6% Ability to purchase multiple items 37.1% 43.1% 6.0% Access to customer reviews/product information 34.1% 30.9% -3.2% Recommendations from friends/relatives 22.9% 24.4% 1.5% Source: JPMorgan Internet Team 2007 Consumer Survey Walmart.com, Target.com catching up to large online sites Third-party metrics indicate eBay and Amazon are the two largest online-only stores in terms of unique users, whereas Walmart.com and Target.com are the two biggest sites belonging to brick-and-mortar retailers. In ’06, only Amazon and eBay drew business from at least 30% of our respondents, more than any other sites. For the ’07 holiday season, our survey shows no significant change in Amazon’s and eBay’s reach, but strong growth for the two largest brick-and-mortar retailers’ sites, with 20+% increases in respondents planning to use Walmart.com and Target.com. We also saw a significant increase in the number of users expecting to use Circuitcity.com.42
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Table 26: Respondents who used (’06) or plan to use (’07) specific sites for holiday shopping Site 2006 2007 Y/Y difference significant? Amazon 36.9% 36.2% No eBay 30.0% 28.4% No Walmart.com 22.9% 27.8% Yes, up 21% Y/Y Target.com 15.3% 19.9% Yes, up 30% Y/Y Bestbuy.com 17.9% 18.6% No Circuitcity.com 9.1% 12.0% Yes, up 31% Y/Y QVC.com 6.3% 5.9% No HSN.com 4.5% 4.7% No Source: JPMorgan Internet Team 2007 Consumer Survey. Statistical significance at a p<.01 level. Media, Apparel top categories Books, music and video were the top category, with nearly 66% of online shoppers reporting they had bought such items online within the past year. Apparel and accessories, at 57% penetration, was second, tilted predominantly toward female shoppers. Unsurprisingly, men were much more likely to shop in both the Computers and VideoGames category and the Electronics category. Table 27: Media items popular with both genders: Top five categories among men and women %, among respondents who indicated they shop online, that indicated they had made purchases in category Men Women Books, music, videos and other media 63.7% Books, music, videos and other media 67.0% Computer and videogames software and 51.4% Apparel and accessories (includes shoes, 64.2% hardware handbags and jewelry) Apparel and accessories (includes shoes, 46.5% Health and beauty 38.2% handbags and jewelry) Electronics (includes television and stereo 36.1% Computer and videogames software and 32.7% equipment) hardware Health and beauty 24.3% Toys 32.2% Source: JPMorgan Internet Team 2007 Consumer Survey Younger users shop online more, and gap is widening Among online shoppers, 29% of those aged 18-41 did more than 40% of their holiday shopping online in ’06, and 39% expected to do so this year. Among those aged 42+, the respective numbers were 17% and 20% for ’06 and ’07. Figure 21: Expectation of money spent shopping online, holiday season ’07 vs. ’06 % among respondents who indicated they shop online Ages 18-41 More, Ages 42+ 17% More, 43% About the About the same, same, 40% 51% Less, Less, 16% 31% Source: JPMorgan Internet Team 2007 Consumer Survey 43
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Internet Sales Tax: Likely Not on the Horizon in the US In May 2007, Senator Mike Enzi (R-WY) reintroduced a bill designed to allow states to collect sales tax from online sellers with revenues of $5M or more. The states must agree to certain terms to simplify their sales tax regulations in order to take advantage of the bill. JPMorgan’s Senior Vice President for Government Relations, Tom Block, believes that this bill does not have a significant chance of passing in the foreseeable future. While offline retailers and state governors have lobbied for rules such as this, voting for this bill could be construed as a tax increase, and Block thinks that makes passage of the bill a non-starter, especially in an election year. Catalysts for International Growth We believe the rising tide of increased Internet use across the world is likely to help lift eCommerce globally. However, we see three key challenges to overcome for eCommerce to fulfill its potential: • Improvement of shipping infrastructure. Postal and parcel service in many parts of the world can be unreliable, and a reliable distribution channel is an essential prerequisite for the growth of eCommerce. • Improved payment systems. This is not a world-wide challenge, but rather a slew of country-specific challenges related to the idiosyncrasies of different countries’ banking systems and conventions. Even in more developed countries, significant differences emerge: e.g., Germany and Austria have seen much lower rates of PayPal use than other eBay geographies due to the prevalence of bank transfers as a mode of payment there. We note the August 2007, announcement that Alibaba’s Alipay service will allow shoppers in China to buy products from non-China-based sellers in a variety of foreign currencies. We think such developments will eventually lead to a more fluid, interconnected global eCommerce market. Table 28: PayPal Penetration on select eBay country sites % of listings that include PayPal Country Penetration Canada 97.1% US 95.5% UK 95.4% Australia 72.1% Spain 70.3% Italy 67.8% France 66.3% Germany 33.5% Austria 23.3% Source: eBay.com (and country sites), JPMorgan estimates, data collected September - December, 2007 • Better fraud protection. The promise of eCommerce has been one of lower prices and/or better selection, with the trade-off that many purchases must be made sight-unseen. The threat of fraud remains present, and structures that insure buyers against fraud should help smooth operations in an eCommerce environment that is not yet fully mature. (An example is eBay’s PayPal, which provides up to $2K in fraud protection in the US to create44
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com buyer confidence, with transaction loss rates for the PayPal unit of 25-33 bps, as denominated by total payment volume). We note that the above is not intended to be an exhaustive list of catalysts for international growth – many specific markets can present unique challenges – such as governmental ones – for the operation of eCommerce companies. 45
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com 2008 Online Travel Outlook In 2007, online travel agency companies continued to face slowing US growth due to a maturing market and increased competition from suppliers and have come to rely more heavily on growth from Europe. The companies in our coverage universe continue to pursue their international growth strategies and have begun to position themselves in the Asian market. Looking to 2008, we expect to see the following dynamics shape the online travel agency space: (1) acceleration of domestic growth as GDS air revenue declines are anniversaried, (2) increased dependence on international growth, (3) a focus on developing Asian markets as European markets mature, (4) higher sales and marketing costs due to keyword inflation, and (5) investment in customer service, technology and processes. Online Travel Market Should Continue to Grow US Online Travel Estimates We believe US online travel growth in 2008 will be driven by: (1) increased travel volume, (2) increased prices, particularly in hotel bookings where demand continues to exceed supply, and (3) to a lesser extent, increased online vs. offline travel booking. Our updated market forecast calls for F’08 online travel gross bookings of $90.4B, representing Y/Y growth of 9.5%. We are estimating domestic online travel gross bookings to grow at a CAGR of approximately 7.5% through 2010.Table 29: US Online Travel Market Projection$ in millions 2004 2005 2006 2007 2008E 2009E 2010E 2007-2010 CAGRAverage Price 272.6 287.1 302.2 317.3 331.6 343.2 350.1 3.3%Total Trips 1,953.3 1,992.4 2,032.2 2,072.9 2,114.4 2,146.1 2,178.3 1.6%Total Travel Spend 532,400.0 572,100.0 614,200.0 657,808.2 701,157.8 736,583.8 762,585.2 5.0%% online 9.8% 11.0% 12.0% 12.6% 12.9% 13.2% 13.5% 2.4%Online Travel Spend 52,400.0 62,800.0 73,400.0 82,600.0 90,449.4 97,229.1 102,949.0 7.5%Average Price Growth 5.3% 5.3% 5.0% 4.5% 3.5% 2.0%Total Trips Growth 2.0% 2.0% 2.0% 2.0% 1.5% 1.5%Total Travel Spend Growth 7.5% 7.4% 7.1% 6.6% 5.1% 3.5%Online Travel Spend Growth 19.8% 16.9% 12.5% 9.5% 7.5% 5.9%Source: JPMorgan estimates, PhoCusWright, eMarketer, Jupiter, and TIA International Online Travel Estimates Consistent with last year, many US companies are looking abroad to supplement slowing US growth. We believe international online travel growth in 2008 will be driven by (1) continued growth in online vs. offline bookings in Europe and Asia, (2) increased inventory placed online, (3) international acquisitions to facilitate market inroads, (4) continued investments in international operational infrastructure, (5) increased broadband penetration in Europe and Asia, and (6) increased prices and volumes.46
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Our updated forecast calls for F’08 European online travel gross bookings of $59.5B, representing Y/Y growth of 18%. We estimate that European online travel gross bookings will grow at a CAGR of approximately 16% through 2010.Table 30: Europe Online Travel Forecast$ in millions 2004 2005 2006 2007 2008E 2009E 2010E 2007-2010 CAGRAverage Price 621.3 627.3 642.0 652.9 662.0 668.6 675.3 1.1%Total Trips 1,423.1 1,480.0 1,552.0 1,629.6 1,694.8 1,762.6 1,833.1 4.0%Total Travel Spend 884,210.5 928,421.0 996,333.0 1,063,934.2 1,121,982.4 1,178,530.4 1,237,928.3 5.1%% online 2.8% 3.6% 4.2% 4.7% 5.3% 5.9% 6.3% 9.9%Online Travel Spend 25,100.0 33,500.0 41,900.0 50,300.0 59,465.1 69,533.3 77,989.5 15.6%Average Price Growth 1.0% 2.3% 1.7% 1.4% 1.0% 1.0%Total Trips Growth 4.0% 4.9% 5.0% 4.0% 4.0% 4.0%Total Travel Spend Growth 5.0% 7.3% 6.8% 5.5% 5.0% 5.0%Online Travel Spend Growth 33.5% 25.1% 20.0% 18.2% 16.9% 12.2%Source: JPMorgan estimates, PhoCusWright, eMarketer, Jupiter, and IPK International Our updated Asian F’08 forecast calls for online travel gross bookings of $43.6B, representing Y/Y growth of 35%. We estimate that Asian online travel gross bookings will grow at a CAGR of approximately 30% through 2010.Table 31: Asia Online Travel Forecast$ in millions 2004 2005 2006 2007 2008E 2009E 2010E 2007-2010 CAGRAsia Online 12,100.0 15,900.0 22,300.0 32,300.0 43,600.0 56,600.0 70,800.0 29.6%Travel SalesY/Y Growth 31.4% 40.3% 44.8% 35.0% 29.8% 25.1%RateSource: JPMorgan estimates, PhoCusWright, eMarketer, and Jupiter This adds up to an F’08 global online travel forecast of $193.5B, which is a 17% increase from 2007. Our forecasted CAGR through 2008 calls for 15% growth.Table 32: Global Online Travel Forecast$ in millions 2004 2005 2006 2007 2008E 2009E 2010E 2007-2010 CAGRUS Online 52,400.0 62,800.0 73,400.0 82,600.0 90,449.4 97,229.1 102,949.0 7.5%Travel SalesY/Y Growth 19.8% 16.9% 12.5% 9.5% 7.5% 5.9%RateEurope Online 25,100.0 33,500.0 41,900.0 50,300.0 59,465.1 69,533.3 77,989.5 15.6%Travel SalesY/Y Growth 33.5% 25.1% 20.0% 18.2% 16.9% 12.2%RateAsia Online 12,100.0 15,900.0 22,300.0 32,300.0 43,600.0 56,600.0 70,800.0 29.6%Travel SalesY/Y Growth 31.4% 40.3% 44.8% 35.0% 29.8% 25.1%RateWW Online 89,600.0 112,200.0 137,600.0 165,200.0 193,514.4 223,362.3 251,738.5 14.9%Travel MarketY/Y Growth 25.2% 22.6% 20.1% 17.1% 15.4% 12.7%RateSource: JPMorgan estimates, PhoCusWright, eMarketer, Jupiter, TIA.org, and IPK International 47
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Easing Domestic Comps but Keeping Market Share is Key Air Monetization Should Stabilize Throughout 2006 and 2007, online travel agency domestic growth suffered as GDS renegotiations resulted in significantly lower commissions on air tickets. Early reports of negotiated agreements directly with suppliers indicated the establishment of variable compensation tied to the value delivered to the supplier. 2008 should bring the first year of flattish comparisons on this new compensation structure, resulting in slightly easier domestic comps. However, we note that intense competition from suppliers may put further pressure on pricing. Priceline has decided to completely eliminate its domestic booking fees on air tickets. While Expedia and Orbitz do not currently plan to follow suit, the increased competition may further pressure their future volume or pricing strategies. Figure 22: Domestic Revenue as a Percent of Gross Bookings Trends at the Top 4 OTAs 14.5% 14.0% 13.5% 13.0% 12.5% 12.0% 11.5% 2004 2005 2006 2007E Source: Company reports and JPMorgan estimates. The effect of the air commission reduction can be seen by viewing trends in domestic revenue growth vs. gross bookings growth at the top 4 online travel agents. Note that in 2006 and 2007E, revenue as a percent of gross bookings declined 40 bps each year. For F’08E, we are modeling more flattish revenue as a percent of gross bookings. Preserving Market Share Will be Key The domestic online travel market is entering maturity with the percent of bookings online expected to increase only 30 bps in 2008. As a result, domestic online travel growth should only slightly exceed the total travel market (6.6% Y/Y growth expected for the travel market, vs. 9.5% estimated Y/Y online travel growth). With this expected declining growth rate, market share would become key in determining company sales increases.48
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Figure 23: Domestic Online Gross Bookings by Type 2006 2008E Total Total OTA OTA Gross Gross Bookings Non- Bookings 40% 42% Non- OTA OTA Gross Gross Bookings Bookings 58% 60% Source: PhoCusWright, Company Reports, and JPMorgan estimates We believe that online travel agents will continue to lose market share to hotel and airline suppliers. As a result we are modeling OTA gross bookings growth of 7.8% in F’08, slightly below the estimated 9.5% Y/Y growth for the online travel industry. We expect suppliers and other non-OTA sellers to grow 10.7% Y/Y in F’08. Our Proprietary Research Results Price is King in Booking Decisions The JPMorgan Internet Team completed a survey of over 1,200 U.S. residents in November to determine Internet usage behavior. We discovered that, of the participants who book travel online, 81.9% listed price as the most important factor in making booking decisions. 94% of participants who book travel online listed price as the top 3 most important factors for deciding where to book travel. The second most important criteria in booking decisions was the number of hotel and airline options available (57.7% of participants who book travel online listed this option as one of their top 3 factors in deciding with whom to book travel). Least important factors in online booking decisions were customer service and the availability of a rewards program, which only 20.0% and 31.2% of participants who book online selected as one of their top 3 factors in deciding where to book their travel. 49
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Figure 24: Most Important Factor in Determining Where to Book Online Travel % of participants who book travel online 7% 3% 2% 2% 4% 82% price # of hotel/airline options av ailability of a rew ards program customer serv ice ease of use customer rev iew s Source: JPMorgan research Online Travel Sites are Used Extensively for Research Purposes 61% of respondents visit two or more travel websites to research prices and offerings before booking a trip. Of participants who book travel online, Expedia appears to be the most popular vendor with 37.8% of respondents having booked a trip through the company in the last 12 months. Combined with participants who booked trips on Hotels.com and Hotwire, 70.9% of participants who book trips online did so through Expedia properties. Travelocity came in second with 26.5% of participants who book trips online using them in the last 12 months. 23.0% of respondents who book online used Orbitz in the last 12 months. Figure 25: Percent of Online Booking Respondents Who Have Made a Purchase on Site in Last 12 Months Other Yahoo! Trav el Trav elzoo Trav elocity Priceline Orbitz Kay ak Hotw ire Hotels.com Ex pedia Cheap Tickets 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0% Source: JPMorgan Research We Still See Much Room for Growth in Online Travel Surprisingly, over half of our respondents (55.1%) book less than 25% of their travel online. In fact, 34.6% of respondents do not book any of their travel online. Only 26.8% of respondents booked more than 75% of their travel online. We believe that this demonstrates additional room for growth for online travel companies from customers migrating online from offline sources in the U.S.50
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com However, our thesis that suppliers pose a threat to online travel agent market share seems to have been supported by our survey results. Of respondents who book trips online, 39.9% of respondents stated that they preferred to book flights directly from the airline while 45.3% of respondents stated that they preferred to book rooms directly from the hotel of their choice. 25% of respondents booking flights online and 23% of respondents booking hotels online stated that they had no preference in where they booked their trips. Given the stated priorities of our participants, we believe that pricing differences will be a key driver in their decision of where to book their trip. Package offerings do not appear to attract purchases with 38.1% of respondents who book online stating that they prefer to book hotel and air travel separately and 31.9% of respondents have no preference. International Expansion Integral to OTA Growth We expect this theme from 2007 to continue into 2008. As a result of GDS commission reductions and increased competitive pressure from suppliers on the domestic front, we believe that movement into international markets is critical to the success of OTAs in driving both top-line and bottom-line growth. We believe that international markets yield revenue as a percent of gross bookings margins almost double those of the US because the OTA services are more valued by suppliers abroad who find it difficult to market their inventory in multiple languages across Europe and Asia. Furthermore, we believe that international suppliers are less of a threat to OTAs as they tend to be smaller independent hotels that would have a difficult time achieving the scale necessary to move online booking in house. Europe is Starting to Mature; Companies Establish an Asia Presence While still a high-growth area, European online bookings growth is beginning to slow as the market enters maturity. For F’08 we are projecting online bookings growth of 18.2% (vs. 20.0% in F07) due to a 60 bp increase in online vs. offline bookings and a 5.5% increase in total European travel spend. Asia markets have become more attractive to OTAs. We are projecting F08 Asia online bookings growth of 35% to $43.6B. We expect that many OTAs will grow faster than the market rates as they increase inventory on their sites, expand into new markets, and make strategic international acquisitions. Figure 26: 2007 Estimated European Market Share Ex pedia 17% Others ebookers 40% 7% Lastminute (Trav elocity ) 17% Opodo Priceline 9% 10% Source: PhoCusWright, Company Reports, and JPMorgan estimates 51
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Rising Expenses Likely with Expansion and Market Share Retention Efforts Sales & Marketing Spend Necessary to Support Market Share Retention We expect that sales and marketing expenses will increase as a percent of revenue as (1) online travel agents invest more heavily in offline marketing mediums such as TV and (2) as increased competition for online marketing inflates keyword pricing. We expect this to be especially prevalent with companies focused on international expansion as we believe online advertising is the key means of marketing. Using Nielsen adRelevance data, we believe that ad spend on domestic graphical ads increased approximately 48% over the last four quarters at the top four online travel agencies. During the same period, we note that the average revenue increase at these same four OTAs was only 10%. Figure 27: Domestic Graphical Ad Spend vs. Revenue Growth at Top Four OTAs millions 30 1,500 25 20 1,000 15 10 500 5 0 0 4Q05 1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 Graphical Ad Spend Total Rev enue Source: Nielsen//NetRatings and JPMorgan estimates Expansion Efforts Likely to Be Supported by Technology Spend We think that global expansion efforts will likely result in companies investing more heavily in technology platforms to support growth. Additionally, companies may enhance their website and offer additional customer features or services in order to differentiate their product and grow market share. Orbitz Worldwide is in the process of rolling out Project Austin, which will provide a single, global, centrally managed platform. This should provide more scale for coding and consolidation of supply operations, accounting, customer service, and data center operations. Expedia has completed the first phase of a new platform that will allow the company to leverage the daily warehouse and make improvements in terms of merchandising, CRM, and segmentations. In 2008, the company plans to migrate different parts of sites onto the new platform and to enhance the data warehouse. We expect technology investment to be a theme in 2008.52
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Table 33: Top Worldwide Travel Sites by Unique Visitors thousands Aug-2007 Sep-2007 Oct-2007 Total Internet : Total Audience 791,338 797,836 804,546 Travel 301,118 290,081 293,713 1 Expedia Inc 62,427 56,938 56,228 2 Travelport 28,038 25,396 25,525 3 Yahoo! Travel 24,901 22,351 23,223 4 Priceline.com Incorporated 19,743 17,224 16,571 5 Travel Ad Network 11,561 14,881 15,344 6 TUI Group 14,384 14,379 14,214 7 Travelocity 13,313 13,433 13,263 8 Vueling Airlines 8,782 9,549 10,432 9 ViaMichelin 13,178 11,148 10,052 10 Lastminute.com Sites 14,770 11,009 9,972 11 Southwest Airlines Co. 9,104 8,705 9,419 12 SNCF 6,191 5,819 7,381 13 InterContinental Hotels Group 7,408 6,672 6,765 14 Hilton Hotels 6,991 6,605 6,670 15 Deutsche Bahn 5,563 5,713 6,649 16 About.com Travel 5,996 5,025 6,563 17 Air France-KLM Group 5,452 5,849 6,519 18 MSN Travel 4,589 5,452 6,422 19 Kayak.com Network 6,662 5,961 6,268 20 Marriott 7,094 6,251 6,264 Source: comScore and JPMorgan estimates 53
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Online Photo Market Outlook Digital Camera Penetration Continues to Grow Digital camera penetration continues to grow at a strong rate. We estimate that 73% of American households now own a digital camera. This is up from IDC’s estimate of 49% in 2005. We expect digital cameras to continue to increase penetration, although at a slower rate and we are currently forecasting 81% penetration by 2010. Figure 28: Increasing Digital Camera Penetration 100% 81% 73% 80% 60% 49% 40% 20% 0% 2005 2007 2010 Source: Shutterfly, IDC, InfoTrends, JPMorgan Internet Team 2007 Consumer Survey, JPMorgan estimates In addition to increasing digital camera penetration, we believe there are several key trends that will drive growth in the digital photo and online printing markets: (1) Digital camera owners take more photographs (2) Consumers purchase higher-quality digital cameras (3) Consumers upload more photographs on the web (4) Consumers seek more efficient and user-friendly photo printing technologies (5) Consumers will buy more personalized photo product, such as greeting cards, photo books and calendars. People are taking more photographs and spending money to develop themAs there is no cost associatedwith taking digital photographs, From 2003 to 2005, the average number of pictures taken per month by a digitalpeople are more apt to point and camera owner nearly doubled. As there is no cost associated with taking digitalclick with higher frequency. photographs (unwanted photographs can be deleted to free up storage space), people are more apt to point and click with higher frequency (vs. the replacement and processing cost associated with traditional film).. According to our 2007 Consumer Survey, approximately 29% of digital camera users take more than 50 photographs in a month. People are also spending to print their photos, with 35% having spent over $50 in the past year developing their digital photos.54
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comFigure 29: Number of Pictures Taken by Digital Camera Users, per Figure 30: Money Spent Developing Digital Prints, during the PastMonth Year% % 126 + 101-125 7% 50.0 3% 41.7 0-25 40.0 76-100 48% 8% 30.0 23.4 20.0 14.1 51-75 7.8 7.5 11% 10.0 2.0 3.6 0.0 26-50 $0-$24.99 $25-$49.99 $50-$74.99 $75-$99.99 $100- $125- $150+ 23% $124.99 $149.99Source: JPMorgan Internet Team 2007 Consumer Survey Source: JPMorgan Internet Team 2007 Consumer Survey People are buying higher-resolution cameras Whereas, in 2005, cameras with resolutions of six megapixels (MP) or more accounted for less than a quarter of manufacturers’ shipments, by 2008, estimates indicate that 95% of units will have 6MP or greater. As camera quality improves further, we believe home printing solutions will continue to become less attractive to consumers, and commercial processes capable of presenting the quality of the digital image captured by better cameras will continue to grow in popularity. Additionally, as digital camera penetration grows, the devices will likely be in the hands of people who are less technology savvy than the earlier adopters. We believe these users will be attracted to commercial printing solutions, such as online photo providers and local merchants, because of their ease of use. Table 34: Digital Camera Shipments – Breakdown by Quality Percent of shipments 2005 2006E 2007E 2008E 2009E 2010E 5MP or fewer 75.7% 40.5% 18.0% 14.0% 10.0% 5.0% 6MP or more 24.3% 59.5% 82.0% 86.0% 90.0% 95.0% Source: IDC, 2005, NPD, JPMorgan Estimates Digital camera owners use online photo services for sharing and storing photos As broadband penetration continues to increase and online photo sharing becomes more mainstream, we expect the percentage of consumers uploading their photos to the Internet to increase. Additionally, we believe consumers will find online photo storage an attractive backup option for their photographs as the quality of digital cameras (and therefore photo quality and size) continues to increase. According to our Consumer survey, 31% of users with a digital camera downloaded their photos to an online photo service. 55
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Figure 31: Percentage of Digital Camera Owners Who... % Order prints o nline - have 16.1% pho to s mailed Order prints o nline - pick 21.0% up at sto re Emails pho to s directly to 47.1% peo ple Do wnlo ad pho to s to an 31.0% o nline pho to service 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% Source: JPMorgan Internet Team 2007 Consumer Survey We expect more people to develop photos outside the home In addition to the old retail model of in-store drop-off and pickup, consumers also have the option of printing photos at home or uploading photos to online photo websites and ordering prints through the mail. As digital camera penetration increases, we believe online services, whether providing in-store pickup or mail order delivery, will prove to be the most convenient medium for people to store, enhance, print, and share their photographs.PMA Marketing Research Early on in the digital camera revolution, at-home printing was the printing format ofestimates indicate that by 2009more than 70% of digital prints choice. However, over the last few years, the introduction of self service retail kiosksproduced in the US will be and online photo websites has provided viable and less expensive alternatives. PMAprinted outside the home. Marketing Research estimates indicate that by 2009 more than 70% of digital prints produced in the US will be printed outside the home. Figure 32: Digital Photo Printing Trends Billions of prints 20 15 4.7 5.5 3.7 10 2.4 1.2 6.1 6.9 7.5 4.6 3.4 5 4.4 4.9 5.5 5.5 5.4 0 2005 2006 2007E 2008E 2009E Home Retail Online Source: PMA Marketing Research Between 2004 and 2006, the percentage of people printing the photos they wanted to save nearly doubled, from 19% to 36% (InfoTrends). In 2006, the online share of total digital prints purchased was approximately 20.2% (including in-store pickup orders placed online), up from 13.3% in 2005. We expect online market share to continue to grow as more users share photos online.56
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Figure 33: Number of Images Saved & Printed vs. Just Saved Billions 35 30 25 20 18.0 15.9 15 13.7 11.8 10 9.5 5 9.5 10.7 11.6 5.5 7.4 0 2005 2006 2007E 2008E 2009E Images Sav ed & Printed Images Sav ed, but Not Printed Source: PMA Marketing Research Photo products create growth opportunity for online photo printers We expect the personalized products category (personalized greeting cards, photo books, etc.) to be an area of growth for online photo providers during the next couple of years. Despite the strong trends we are seeing in digital camera penetration and the increase in photos printed using online sources, personalized photo product penetration remains low. According to our survey, only 11% of the respondents purchased photo greeting cards and only 8.2% purchased photo books. We expect penetration to improve during the next couple of years as users continue to shift to online photo services and new products become available to customers. According to PMA Marketing Research, spending on personalized photo products is expected to increase to $1,240M in 2008 from $694M in 2006.Figure 34: Low Penetration Leaves Room for Growth in Personalized Figure 35: Growth in Spending on Photo Products/GiftsPhoto Products% $ in millions 12.0% 11.0% 1,400 1,240 10.0% 1,200 8.2% 951 7.6% 7.5% 1,000 8.0% 800 694 6.0% 600 462 4.0% 270 400 2.0% 200 0.0% 0 Photo Greeting Cards Photo Calenders Photo Books Personalized T-shirts 2004 2005 2006 2007E 2008ESource: JPMorgan Internet Team 2007 Consumer Survey Source: PMA Marketing Research 57
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com 2008 Online Payment Outlook 2007 proved to be a strong year for online payment platforms. PayPal saw third- quarter growth accelerate as the Merchant processing business saw particularly strong growth, Amazon entered the payment foray with its Amazon Payment offering and Google Checkout is still viable. Revolution Money is trying to revolutionize money management with its new money transfer service and credit card offering. In Latin America, Mercadolibre has seen strong growth in its payment business and is rolling out direct payment features starting in Chile. We expect trends to remain strong in 2008 helped by: • Continued strength in global e-commerce growth, helped by increased global broadband penetration. • The growing acceptance of payment solutions on third-party platforms, including travel sites. • Increased P2P money transfers, driven by the growing remittance market and increased micro-lending. • Increased use of mobile money transfer platforms should help drive revenues for those with a presence in the market, such as PayPal and Amazon Payment (through its relationship with Textpayme). • Increased fee generation as platforms look at adding deferred payment plan options, which are particularly attractive in developing markets. Key Highlights from 2007 This past year was a successful one for online payment companies. Both PayPal, which benefited from strength in its Merchants business, and MercadoPago, Mercadolibre’s Latin America Payment platform, saw growth accelerate in the third quarter of 2007. Some key events in 2007: • PayPal launched a toolbar features that allows users to shop at any site that accepts MasterCard. The toolbar automatically populates the credit card information with a randomly generated credit card number. • Amazon launched its Amazon Payment service and now requires all third-party sellers on its Marketplace and Auction platforms to offer it as a payment option. • Steve Case entered the online payment business helping to fund Revolution Money, an online payment portal and credit card company. • MercadoPago launched a direct payment version and began offering services to third-party sellers, beginning with a roll-out in Chili. • Alipay began offering Chinese shoppers the ability to purchase merchandise from overseas web sites. Global e-commerce growth expected to remain strong We expect online payment portals to benefit from strong e-commerce growth in 2008 in both the U.S. and global markets. While we expect the overall retail environment58
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com in the U.S. to remain weak, we expect online retailers to benefit from the continued shift of retail dollars online, driven by (1) increases in product selection, (2) continued Y/Y online sales improvements for brick-and-mortar retailers and (3) further improved efficiencies from site optimization. Our international forecast is driven by (1) continued rises in online shopping penetration, especially Western Europe, (2) continued investments by online retailers in broadening selection, (3) improvements in shipping infrastructure, (4) improved payment systems and (5) better fraud protection.Table 35: JPMorgan Global E-commerce Projections$ in millionsGlobal eCommerce Forecast 2004 2005 2006 2007E 2008E 2009E 2010E 07 - 10 CAGRUS 94,581 114,991 139,384 164,431 193,502 227,321 266,808 17.5%Europe 85,827 112,139 139,126 179,226 224,911 257,748 289,966 17.4%Asia 29,538 39,685 50,556 63,340 77,899 94,686 114,673 21.9%ROW 9,440 13,216 18,502 25,903 36,265 47,144 61,287 33.3%Total 219,385 280,031 347,568 432,900 532,577 626,899 732,735 19.2%Source: JPMorgan estimates. Global remittance market is expected to grow 10.9% in 2008 Celent estimates that over $311B in 2007 was transferred in the global remittance market, and global remittance is expected to grow at a 10.2% CAGR between 2000 and 2008. The mobile global population and the desire to send money back to family have led to the strong growth in remittance. The United Nation estimates that about 3% of the worlds population, or roughly 175M people, is migrant, with the stock of immigrants to high-income countries growing at 3% per annum between 1980 and 2000. With about 31% of the population in developing countries under the age of 14, vs. 14% in developed countries, global migration is expected to remain robust. The World Bank highlights two drivers behind the expected strong migration trends through 2025. They include: 1. The labor force in high-income countries is expected to decline. The World Bank expects the labor force in high-income countries to peak near 500M in 2010, then fall to 475M by 2025. This would lead to 100 workers supporting 111 dependents, compared to less than 100 today. As a result, there would be greater demand for workers in the labor force. 2. Developing countries can supply the needed labor. With a large population under the age of 14, and higher birth rates, the developing world is expected to supply 1B workers by 2025, many of whom would migrate to higher-income countries to meet their labor demands. These workers likely would continue to send money back to their country of origin. According to the World Banks base-case scenario, new migrant workers could earn as much as $481B more in real (after-tax) income in high-income countries than they would have if they stayed in the developing countries. A large portion of this excess wealth would likely find its way back to the migrant workers country of origin through remittance channels. 59
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Figure 36: Global Remittance Receive Trends $ in billions 400 345 350 311 281 300 256 233 250 213 167 183 200 159 150 100 50 0 2000 2001 2002 2003 2004 2005E 2006E 2007E 2008E Source: Celent PayPal Remains the Dominant Player According to our proprietary survey, 55% of online shoppers use PayPal, compared to 6% who use Google Checkout and 7% who use Amazon Payment. While the sample is small, 57% of those who used all three payment services preferred PayPal. Credit cards remain the preferred method for online shoppers with 83% stating that they use credit cards to make online purchases. Table 36: Preferred Online Payment Providers for Users of PayPal, Google Checkout and Amazon Payments Preferred Service Number of GOOG AMZN Services Used Respondents PayPal Checkout Payments Other PayPal, Checkout & Payments 16 9 2 3 2 PayPal and Checkout 21 16 4 - 1 PayPal and Payments 39 30 - 8 1 Checkout & Payments 2 - - 2 - Source: JPMorgan Internet Team 2007 Consumer Survey Note: Survey of 1,261 Internet Users Figure 37: Payments Methods Used by Online Shoppers % of respondents who stated they shop online 100.0% 83.5% 80.0% 54.8% 60.0% 40.0% 20.0% 6.2% 7.0% 5.8% 0.0% Credit Card Pay Pal Google Checkout Amazon Pay ment Other Source: JPMorgan Internet Team 2007 Consumer Survey60
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Online Payment Providers Offer a Viable Alternative to Other Payment Options Users are still driven to online payment options despite strong satisfaction with credit cards PayPal, as well as Amazon Payment and Google Checkout, have been able to make inroads into the online retail business despite 89% of online shoppers who use credit cards rating their experience as either excellent or very good. Users of online payment services also seem to be content with credit cards with 92% of PayPal and Amazon Users rating their experience with credit cards as either excellent or very good and 91% of Google Checkout users experiencing the same level of contentment. Figure 38: Online Shoppers Satisfaction with Credit Cards for Users of Online Payment Services % of online shoppers who use the selected payment option 70.0% 65.9% 61.9% 60.0% 47.6% 50.1% 50.0% 41.0% 41.7% 40.0% 30.2% 30.0% 25.0% 20.0% 10.1% 9.1% 4.8% 7.5% 10.0% 1.3% 0.7% 0.0% 3.2% 0.0% Ov erall Pay Pal Google Checkout Amazon Pay ment Ex cellent Very Good Satisfactory Needs Improv ement Source: JPMorgan Internet Team 2007 Consumer Survey Given the high level of satisfaction with credit cards, we find it remarkable that penetration of online payment services is so high. We believe that the online payment services offer users security and ease of use advantages over credit cards, including eliminating the need to enter credit card numbers. Extending beyond e-commerce shoppers, online retailers can benefit from lower total transaction costs and P2P users benefit from lower costs and the added security benefit from not having to share personal financial information, such as bank account numbers. Figure 39: Online Payment Providers Simplify the Payment Process Traditional payment structure PayPal payment structure Merchant Consumer Merchant Consumer Payment Card issuer gateway processor provider Merchant Consumer Merchant Card-issuing bank bank bank bank Source: JPMorgan. 61
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com The young and wealthy are more likely to use online payment providers According to our proprietary survey, higher-income online shoppers, those earning more than $75K per year, are more likely to use both credit cards and online payment options. Almost 15% of those earning less than $25K/year selected “other” as the preferred choice, with most people in that group using money orders. Figure 40: Online Payment Option Use by Income % of respondents who stated they shop online 100.0% 81.8% 88.5% 80.0% 54.6% 55.2% 60.0% 40.0% 11.5% 10.0% 20.0% 4.3% 6.0% 7.4% 1.1% 0.0% Less than $75K More than $75K Credit Cards Pay Pal Google Amazon Other Source: JPMorgan Internet Team 2007 Consumer Survey Younger users, those between 18 and 33 years old, were the most likely to use online payment methods, with 64% stating they use online payment services. However, usage by 34 to 49 year olds was also strong, at 61%, and 60% said they used PayPal, more than any other age group. Only 47% of those over 50 years old used online payment services, with 88% stating they used credit cards, higher than any other age group. We expect usage of online payment services to increase as younger people age and move to higher-earning income brackets. Figure 41: Online Payment Option Use by Age Group % of respondents who stated they shop online 100.0% 80.0% 60.0% 40.0% 20.0% 0.0% Credit Cards Pay Pal Google Checkout Amazon Pay ment Other 18-33 34-49 50+ Source: JPMorgan Internet Team 2007 Consumer Survey Key Features of Current U.S. Online Payment Providers PayPal PayPal expanded its availability in 2007 to include airlines such as Southwest and Northwest, and is offered by thousands of merchants around the world. PayPal offers62
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com a money market account for deposits, financing options and P2P money transfers. While a majority of PayPals volume still takes place on eBays site, its Merchant business is growing at a faster rate. We expect 2008 to be another strong year for PayPal as it grows its international and Merchants business and are forecasting transaction volume to increase 24.2% Y/Y to $61.36B. Table 37: PayPal Fee Structure Description Personal Account Premier/Business Account Fee for a buyer to make a purchase Free Fees for specific actions Open an Account Free Free Send Money Free Free Withdraw Funds Free for bank accounts in the US Free for bank accounts in the US Add Funds Free Free Receive payments funded by PayPal Free 1.9% to 2.9% + $0.30 USD Balance, PayPal Instant Transfer or PayPal eCheck Receive payments funded by Credit Card, 4.9% + $0.30 USD (limit of 5 1.9% to 2.9% + $0.30 USD Debit Card or Buyer Credit transactions per 12 month period) for domestic or U.S. transactions 2% + applicable Fees for cross border payments 4.9% plus $0.30 USD for card payments received using PayPal on Skype Multiple Currency Transactions Exchange rate includes a 2.5% fee Exchange rate includes a 2.5% fee Source: www.paypal.com Amazon Payments Amazon rolled out its Amazon Payments Service in 2007 and now requires all third- party sellers on its Marketplace and Auctions platform to offer it as a payment option. Amazon Payments offers P2P money transfer options and has teamed up with Textpayme to offer mobile services. Amazon Payments is also integrated with Amazon Web Services to help developers create e-commerce sites. Table 38: Amazon Payments Fees Fees to send payments Fees Sending Payments No fees Fees to receive payments (by less than $0.05 $0.05 to $9.99 $10.00 and more payment method) Bank Account 2% of T V + $0.05 2% of T V + $0.05 2% of T V + $0.05 Credit Card 5% of T V + $0.05 5% of T V + $0.05 2.9% of T V + $0.30 International Credit Card 6% of T V + $0.05 6% of T V + $0.05 3.9% of T V + $0.30 Amazon Payments stored 20% of T V, minimum fee of 1.5% of T V + 1.5% of T V + $0.01 funds $0.0025 $0.01 Source: payments.amazon.com Google Checkout Google Checkout is now available on hundreds of Internet retail sites. Google Adwords advertisers are offered discounted processing rates. Google Checkout does not currently offer P2P money transfer services. 63
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Table 39: Google Checkout Fees Description Fee Fees to use Google Checkout to process sales 2% + $0.20 per transaction. AdWords advertisers, will also be eligible for free transaction For every $1 spend on AdWords each month, processing for some or all of the Google Checkout sales advertiser can process $10 in sales the following each month. month for free through Google Checkout. Source: www.google.com Revolution Money Revolution Money was started in 2007 and offers a low fee credit card, Revolution Card, and a P2P money transfer platform, RevolutionMoney Exchange. Table 40: Revolution Money Fees Transaction Description FEE RevolutionCard Integrates credit, stored value, prepaid and loyalty card NO interchange fees functionality. Cardholders can activate RevolutionMoneyExchange functionality to their card account, which allows users to transfer money to other customers for free*. Cost to Accept RevolutionCard RevolutionCard only charges 0.50% (50 bps) of the transaction value per transaction for processing. Where is it accepted Currently being rolled out in the US, not available internationally RevolutionMoney Account registration Free Exchange Register for an Account Free Add Money electronically from Bank Account Free Send Money Free Receive Money Free Request Money Free Withdraw Money electronically to Bank Account Free Withdraw Money by Check $2.50 per check Paper Statement $5.00 per statement Returned ACH Fee $35.00 per returned ACH Overdraft Fee $35.00 per overdraft Stop Payment on a Check $20.00 per check Source: www.revolutionmoney.com64
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com 2008 Social Networks Primer Key Takeaways • Runaway growth continued in 2007. Of the major sites, Facebook posted the most impressive growth, with user minutes worldwide multiplying more than six-fold, according to comScore data. • Not a fad – a technology that solves users’ problems. 2007 showed even the strongest doubters that there is very strong demand by users for the kind of interaction offered by social networks. We believe the sites’ gains in usage share, partly at the expense of email sites, demonstrate user needs are being better met. • One question for ’08: Will older users sign up? Our proprietary survey indicates 70% of users aged 18-41 use social network sites, and only 22% among those aged 42 or older. • Privacy concerns overstated. Internet users have consistently demonstrated a willingness to trade information for features they find useful. So long as sites do not overreach, we expect this trend to continue, with yesterday’s outrage becoming tomorrow’s hot feature (please see p. 68 for a more nuanced discussion). Growth still very strong in 2007 The growth of social networks in 2007 was very strong, with Facebook in particular really coming into its own. For the three months ended October, US unique users to Facebook’s site were up 125% Y/Y, while time spent on the site rose 157%. By October, 18% of all US Internet users visited Facebook, compared to less than 9% a year prior. Facebook’s 18% penetration remained a far cry from MySpace, which saw almost 40% of US Internet users visit its site that month. Globally, the growth picture is even more drastic. In terms of growth in users worldwide, Facebook paced the competition with a 397% Y/Y growth rate. MySpace, Orkut, Bebo, Friendster and Hi5 all grew their unique users at least 35% Y/Y. Table 41: Social Networks users are growing fast, and user time is growing even faster Y/Y growth in August-October ’07 vs ’06; six largest sites worldwide in terms of minutes spent Worldwide US Users, Y/Y Minutes, Y/Y Users, Y/Y Minutes, Y/Y Myspace 36% 33% 25% 17% Facebook 397% 558% 125% 157% Orkut 57% 65% 66% 95% Friendster 75% 160% 56% 359% Bebo 135% 276% 85% 198% Hi5 43% 187% 4% 76% Source: comScore Networks, JPMorgan estimates 65
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Meet the big six Based on minutes spent in the second half of the year (as measured by comScore), the following six sites are the largest social networking sites in the world: • MySpace. Launched August 2003, the site was acquired by News Corporation in July 2005. MySpace’s user base tends to tilt somewhat toward teens, and is more US-based than the audience for any of the other big six. Also popular with musicians and bands. • Facebook. Launched February 2004, the site remains independent but in October 2007, drew a $240M investment from Microsoft, which acquired a 1.6% equity stake. Microsoft also sells ads on Facebook. The site became open to non-academic users in September 2006. • Orkut. Launched by Google in January 2004. The site has not taken off significantly in the US, but is quite popular in Brazil as well as India and Pakistan. • Friendster. Launched March 2003. In the US, the site has faded somewhat after being an early leader in the space, but it remains quite popular in Southeast Asia. • Bebo. Launched January 2005. The site is popular in the UK and other English-speaking countries, including Ireland, as well as in Poland. In 4Q’07, announced a partnership with AOL for integration of instant- messenger software. • Hi5. Launched 2003. The site, though based out of the San Francisco Bay Area, maintains a base of popularity in Latin America, as well as some Asian countries. Technology that fits a customer need We think much of the success of social networks is attributable, at heart, to the fact that they provide a superior technology for filling users’ social needs more efficiently. In our 2007 Consumer survey, over 80% of social network users indicated that they use the sites to keep in touch with friends. Table 42: Users overwhelmingly lean on social networks to keep in touch % among users of social network sites; respondents could choose multiple answers Function % choosing Keep in touch with friends 80.1% Reconnect with old friends 47.7% Share photographs 36.8% Meet new people with similar interests 34.7% Share Music/Find new music 17.8% To plan social events 17.5% Play games 11.6% Career networking 9.0% Source: JPMorgan Internet Team 2007 Consumer Survey When it comes to filling this user need, we believe social networks have two key competitive advantages over alternative methods of keeping in touch:66
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com • News feeds. A news feed is a feature that enables users to see updates on their friends’ lives, and vice versa, without needing to specifically contact each other. As any social network user updates his/her profile, those updates become visible to that user’s circle of friends. • Built-in spam filter. The promise of email is that anyone can contact you, and that has also become its curse. Many proposed spam solutions have focused on attempting to verify that the person contacting you is a friend, but social networks have a built-in verification system that allows one to ensure that the bulk of communication is from confirmed friends. We think it is not coincidental that, at the same time that social networks have shown significant Y/Y usage growth, the number of minutes users devote to email has declined: Table 43: comScore data indicates user time spent on email sites is declining Y/Y Minutes of usage in millions Worldwide US Aug-Oct 06 Aug-Oct 07 Y/Y Aug-Oct 06 Aug-Oct 07 Y/Y Yahoo! Mail 47,132 44,230 -6% 23,651 20,828 -12% Windows Live Hotmail 32,862 28,739 -13% 10,290 8,786 -15% AOL Email 13,150 12,488 -5% 12,208 11,796 -3% Google Gmail 4,179 7,494 79% 1,084 2,136 97% All email sites 113,241 106,144 -6% 50,082 46,481 -7% Source: comScore Networks, JPMorgan estimates High User Engagement Social network sites excel in their ability to keep users on the site: comScore data indicates that, on the six biggest social networking sites in the world, users spend an average of 7 minutes per day, a number that has grown Y/Y. Figure 42: Average time per user is growing on social networking sites even as it shrinks for email Average minutes spent on site, per user per day 10.0 7.7 7.2 8.0 6.5 6.1 6.0 4.0 2.0 0.0 Aug-Oct 06 Aug-Oct 07 All email sites Top six social netw orks Source: comScore Networks, JPMorgan estimates Survey results: older users remain on the sidelines Our November 2007 proprietary survey of consumers’ Internet usage patterns reinforced the idea that social networking sites remain primarily the province of younger users. 89% of users aged 18-25 reported that they visited a social 67
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com networking site at least once a month, while less than a quarter of users 42 or older went to such sites. Figure 43: Younger users more likely to visit social network sites % of users, in each age group, that reported visiting a social networking site at least once per month 100% 89% 74% 80% 53% 60% 40% 25% 20% 20% 0% 18-25 26-33 34-41 42-49 50+ Age Source: JPMorgan Internet Team 2007 Consumer Survey Further, we would note that our survey did not include users younger than 18, an age group that, on the whole, tends to be a very heavy user of social networking sites. Privacy concerns overblown Many social networking sites, especially Facebook, have faced public criticism for their use of user information. Whether or not these criticisms have merit, from an operational standpoint we believe concerns about privacy are unlikely to hamper the growth of sites. We think history suggests that users are willing to give up incremental information in exchange for features they find useful. Additionally, we think the history of the rollout of news feeds on Facebook is extremely instructive: In September 2006, when the feature was first introduced, it was met with an uproar from users who cited concerns about privacy. In response, Facebook emphasized that users have the ability to opt out of the feature. A year later, the news feed is one of the central aspects of the Facebook interface, and other sites, including MySpace and LinkedIn, have added similar features. We believe such flare-ups are likely to re-occur. Nevertheless, we believe the track record of social sites’ development suggests users have a strong desire for expression and for an avenue to share what is going on in their lives – and the desire to share is stronger than the desire to hide. Features that meet users’ need for expression are likely to catch on, in our opinion, even if they carry with them an incremental erosion of users’ privacy. Eventually, the CPMs will move up Social networking sites, as a general rule, have not been able to command very high advertising rates for their page view inventory. Indeed, we believe the arrival of a significant quantity of bulk page-view inventory from social networks contributed to stagnant graphical ad CPMs for much of the last years. As time goes on, however, we believe social networks will develop better targeting and monetization of their page view inventory. Given the wealth of personalized68
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com information available to the sites, there are powerful avenues for improved monetization, although the technology remains fairly nascent. Large Internet and media companies have not been shy about making their presence felt in the social space, both through acquisitions and through advertising deals, such as Google’s $900M partnership with MySpace and Microsoft’s relationship and small ownership stake in Facebook.Table 44: Large Internet Companies’ Investments in and Partnerships with Social SitesDate Acquirer Target DescriptionJanuary, 2004 Google Launch of Orkut Social Network site3/12/2005 Yahoo! Inc Ludicorp Research, the owner of Flickr ($40M) Photo-sharing site5/18/2005 Google Dodgeball A social networking software provider for mobile devices.6/20/2005 Yahoo! Inc Yahoo! acquires Blo.gs. RSS aggregator7/19/2005 News Corp Intermix (including MySpace) ($580M) Social Network site8/7/2006 Google Fox Interactive Media Enters Into Agreement with Google Inc. Advertising deal8/23/2006 Microsoft Microsoft Signs Agreement to Show Ads on Facebook Advertising deal11/17/2006 Yahoo! Inc Bix.com Interactive contests12/20/2006 IAC/ Interactive corp Ilike.com Music sharing for SN sites12/30/2006 Yahoo! Inc del.icio.us Website sharing1/9/2007 Yahoo! Inc Mybloglog blog communities service2/27/2007 IAC/ Interactive corp Edodo.Com Dating site in China2/27/2007 IAC/ Interactive corp Netclub Dating site in France5/30/2007 eBay Stumbleupon Inc ($75M) Website sharing6/1/2007 Google Feedburner Inc RSS feed distribution.8/1/2007 Disney ClubPenguin ($350M) Virtual world9/14/2007 Yahoo! Inc Buzztracker.Com Popularity-based news9/28/2007 Google Zingku Photo sharing for mobile phones10/4/2007 Time Waner AOL’s AIM and Bebo to offer seamless integration A global partnership to deliver AIM to Bebo users10/7/2007 GE and Microsoft Newsvine Inc (acquired by MSNBC Interactive News) Popularity-based news10/9/2007 Google Jaiku Ltd Social Networking software for mobile phones10/24/2007 Microsoft Facebook (Microsoft acquired a 1.6% stake for $240M)Source: Company reports, news reports 69
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com 2008 Virtual Online Worlds Primer Key Takeaways • The market is in its infancy, so ’08 should bring continued rapid growth. Due to increased awareness, continued product innovation, and faster Internet connections, we think the short-term portends significant usage growth for virtual worlds. • We are bullish on sites for children. Virtual worlds present parents an opportunity to let their kids play online and interact in a closed environment that is perceived as safe, especially when sites are operated by companies with trusted brands. • We think sites aimed at adults have yet to prove mainstream appeal. Adults have much more freedom than children to choose other avenues of social interaction. As such, while short-term growth should remain robust, we think that, in their current form, virtual worlds aimed at adults are unproven in their ability to achieve meaningful mainstream penetration over the long term. Two Audiences, Two Differing Growth Curves With investments by major media companies, virtual worlds have been making news for several years. Most recently, Disney purchased Club Penguin in July ’07 for as much as $700M, and throughout the year there has been a steady flow of news stories, both positive and negative, regarding virtual world sites, primarily Second Life. We believe that virtual worlds are still in the very early stage of their growth, and as such have the capacity to grow very rapidly in the near future. However, we think the market is ultimately one that should be seen as consisting of two parts – virtual worlds for children, and ones for adults– with diverging longer-term growth prospects. We think virtual worlds for kids are a product with strong promise, and one that could achieve mainstream status in coming years. To the contrary, we think that virtual worlds aimed at adults face greater challenges. We think it is telling that virtual worlds have proven successful among kids, who have limited social options, and in places such as Finland, where external factors such as climate may limit users’ offline social options. As such, we think the ability of virtual worlds (as distinct from video games, which target a different, more male demographic) to achieve mainstream penetration has not yet been proven.70
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Figure 44: In the US, virtual worlds for kids have a much bigger audience Average monthly US unique users in millions, Aug-Oct 07 7.0 Virtual Worlds for kids Virtual Worlds for Adults 6.1 6.0 5.0 5.0 4.3 4.0 3.0 2.0 2.0 0.5 1.0 0.0 WebKinz ClubPenguin Neopets IMVU SecondLife Source: comScore Networks, JPMorgan estimates Some Terms, Defined What is a Virtual World? Two other definitions are important: • Social Network: a site that allows users to form connections with others. Sites that are considered social networks will generally consist of profiles intended to represent the user more or less faithfully. Examples: MySpace, Facebook. • MMORPG: (stands for Massively Multiplayer Online Role Playing Game) a game that creates an opportunity for users to interact with each other and with an immersive game environment. Prominent examples: World of Warcraft, EverQuest. • Virtual world: these sites straddle a middle ground between social networks and MMORPGs, offering social functions in an immersive world. Some examples of virtual worlds include Second Life, Gaia Online, ClubPenguin and Neopets. A virtual world creates an immersive environment for users to interact with each other, but the emphasis is not chiefly on gameplay, as in a MMORPG. Rather, the focus is on interaction with other users in a social way, and often on personalizing a user’s VW presence, called an avatar, or personalizing the avatar’s surroundings and possessions. How Do They Make Money? Most virtual worlds operate on one, or a combination, of three models: advertising, subscription revenue and the sale of virtual goods – whether virtual currency to be used inside the world, or improvements to a user’s avatar. As the worlds mature, especially in those aimed at adults, advertising may play a larger role, although we think the exact look and feel of VW ads will likely change before we see a significant influx of revenue from external advertisers. 71
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Challenges to an advertising-supported virtual world model: • Kids and pre-teens a key market. Although some children’s sites have used sponsorships and ads as a revenue stream, we believe parents who oversee their kids’ browsing may be leery of strongly commercial sites, especially for younger kids. • Hard to control environment. The free nature of many virtual worlds means many sites have adult content that mainstream advertisers may not be comfortable appearing next to. • Issues of scale. Some companies have set up a presence on Virtual Worlds, esp. Second Life, that must be continuously overseen by an employee whose avatar interacts with visitors. The investment of time may not pay off if traffic is too low, and such a presence does not scale well. • High site engagement. If users are highly immersed in an online environment, their lower response to call-to-action advertisements is unlikely to generate attractive CPMs. Virtual Worlds for Kids and Teens Audience Is Growing eMarketer estimates that nearly 4 out of 5 US teens will be online in 2008, and projects a 25% 2007-2011 CAGR in the number of kids aged 3-17 visiting virtual world sites. Figure 45: More than half of kids expected to visit Virtual Worlds in 2011 Users in millions 25 60% 20 50% 40% 15 30% 10 20% 5 10% 0 0% 2006 2007 2008 2009 2010 2011 Kids 3-17 Visiting VW sites % of Kids 3-17 Visiting VW sites Source: eMarketer, September 2007 We believe there is considerable cause for optimism in terms of kids’ adoption of these sites, for several reasons. Captive Audience One key reason, and a differentiating factor between kids’ worlds and ones for adults, is that kids’ entertainment options are severely constrained, compared to those of adults. The successful kids’ sites are those that can give children a degree of freedom and interactivity, while assuring parents that their kids are in a safe environment.72
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Major Media Brands Are Investing Two major media companies, Walt Disney and Viacom, have made significant investments in the Virtual World space, exemplified most recently by Disney’s purchase of Club Penguin. Table 45: Major Media Companies Forays into VW space Company Date Event The Walt Disney Co. June 03 Launched Toontown Online July 07 Acquired ClubPenguin for $700M ($350M + $350M earnout) Viacom June 05 Acquired NeoPets for $160M Jan. 07 Launched Nicktropolis Source: Company releases In the area of trust, we think the big media companies have an advantage, with established brands that parents are already familiar with. At the same time, any site aimed at kids is going to be subject to the whims of a fickle audience. As such, we think media companies are likely to remain open to acquiring sites that generate significant viral traffic. Table 46: Summary of Virtual Worlds Aimed at Kids and Teens Site Owner Target Business Geographic Aug-Oct ’07 avg. Y/Y User Audience Model Base monthly UU Growth BarbieGirls Mattel Young Girls Toy Sales, US, WW 3.4M N/A Subscriptions ClubPenguin Disney Kids Subscriptions US, WW 10.3M 152% CyWorld SK Teens, 20s Virtual Goods Chiefly: Korea 14.8M N/A Telecom Gaia Online Private Pre-teens Virtual Goods, US, WW 2.0M 195% and teens ads Habbo Hotel Sulake Teens Ads and Europe, WW 6.3M 23% (Finland) Virtual Currency Millsberry General Kids Product US 2.4M 11% Mills Promotion NeoPets Viacom Kids Premium WW 7.5M 20% Memb., Ads, Virtual Items Webkinz GANZ Kids Toy Sales US 5.9M 545% Whyville Private Kids Ads US 0.1M 22% Source: Company sites, comScore Networks, JPMorgan Estimates User statistics are based on worldwide usage as tracked by comScore. Virtual Worlds for Adults Whereas virtual world sites aimed at children are starting to gain significant traction, the marketplace of sites aimed at adults remains in a much earlier phase of development. E.g., Second Life, often touted as representative of the mainstreaming of virtual worlds, had 0.2% penetration of US Internet users in 10/07, according to comScore data. As such, the site could grow traffic five-fold or even ten-fold and still retain a somewhat limited reach. 73
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Table 47: Summary of Virtual Worlds Aimed at Adults Site Business Model Geographic Base Aug-Oct ’07 avg. Y/Y User Growth monthly UU ActiveWorlds Subscriptions, Hosting US, WW 0.1M 181% IMVU Premium Accounts, Ads US, WW 4.9M 71% Kaneva Ads, Virtual Currency 70+% US 0.7M 365% SecondLife Subscriptions, Virtual 75% Outside US 2.3M N/A Goods and Virtual Currency, Ads There.com Premium Accounts US, WW 0.2M 0% Source: Company sites, comScore Networks, JPMorgan Estimates User statistics are based on worldwide usage as tracked by comScore. Not Just a Toy for Men Virtual worlds’ interactivity and social aspect differentiates them from MMORPGs such as World of Warcraft, both in terms of usage and in terms of the demographics they attract. And while Second Life seems to attract more male users, a site like IMVU, with its focus on the social aspect, actually has a higher percentage of users who are female, according to comScore metrics. Figure 46: While Warcraft attracts men, a site like IMVU tilts female. 100% 26% 80% 38% 54% 50% 60% 40% 74% 62% 46% 50% 20% 0% World of Warcraft Second Life IMVU My Space Male Female Source: comScore Networks, JPMorgan estimates comScore data for October 2007, Worldwide user base. Warcraft and Second Life based on application users. Challenges Second Life, in particular, has generated a significant amount of publicity over the past year, both positive and negative. The site has been very aggressive in signing up corporate sponsors, with companies such as IBM, Cisco, Toyota, Mazda and dozens of others setting up a presence in the world. The site has also generated negative attention due to gambling (banned after an FBI investigation) and adult content. While we do not believe these issues present an existential threat, we think they are unlikely to go away, as world designers must navigate a narrow path between a total free-for-all and a site where usage regulations become too restrictive, significantly affecting the site experience and user growth.74
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com The Mobile Ad Market One-third of the World’s Population Are Mobile Subscribers The mobile market is a large and quickly growing industry with an estimated 2.2B mobile subscribers worldwide growing at an estimated pace of 23% Y/Y. Given this level of reach, we think this medium would be attractive to advertisers. A quick comparison to broadband penetration demonstrates this point. We estimate that 67% of Americans are mobile phone subscribers while only 57% have broadband subscriptions.On a worldwide basis, 33% of We believe that this disparity is even greater in developing countries. Inthe population has mobile China, for example, our estimates indicate there are approximately 30%subscriptions vs. 4% withbroadband subscriptions mobile subscribers per 100 persons but only 4% broadband subscribers per 100 people. On a worldwide basis, 33% of the population has mobile subscriptions vs. 4% with broadband subscriptions. In short, this medium offers advertising brands very large reach in marketing their products. Please see Table 1 on the following page for a breakdown of subscription rates by country. Mobile Ads Offer Targeting and Relationship Capabilities Traditional advertising forms offered limited targeting capabilities. Advertisers would select specific television programs, newspaper sections, or magazines that attracted a certain demographic and then hope that some of those viewers were searching for their product. Targeting capabilities were much better with the Internet. Search marketing offered the opportunity to pair an advertisement with a person searching for information on that specific product. Display advertising is improving so that ads can now be targeted to consumers based on previous sites they have visited. In all cases, the ads were typically pushed onto the consumer. Figure 47: Traditional Advertising Methods Consumer Behavior: Watch The Consumer Behavior: Search for wine Food Network Advertiser Response: Show ad for Advertiser Response: Show ad for for general food products popular red wine brand Source: JPMorgan 75
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Table 48: Mobile and Broadband Penetration by Country millions Broadband Subs BB Subs per 100 Mobile Subs per Country Population (M) (M) Persons Mobile Subs (M) 100 Persons Egypt 71.4 0.1 0.1 13.6 19.1 Morocco 30.7 0.3 1.0 16.0 52.1 South Africa 47.6 0.2 0.5 39.7 83.3 Africa 914.3 2.9 0.3 193.8 21.2 China 1,323.7 47.0 3.6 461.1 34.8 Hong Kong 7.1 1.5 21.6 9.4 131.5 India 1,119.7 2.0 0.2 166.1 14.8 Indonesia 225.5 0.5 0.2 63.8 28.3 Japan 128.2 24.2 19.0 101.7 79.3 Malaysia 25.8 0.7 2.7 19.5 75.5 Pakistan 157.0 0.1 0.1 34.5 22.0 Philippines 84.5 0.1 0.2 42.9 50.8 South Korea 48.0 12.8 26.1 40.2 83.8 Taiwan 22.8 4.4 19.2 23.2 102.0 Thailand 64.8 0.3 0.5 40.8 63.0 Vietnam 85.3 0.3 0.4 15.5 18.2 Asia Pacific 3,693.0 99.6 2.7 1,073.3 29.1 Austria 8.2 1.5 17.8 9.3 112.8 Belgium 10.4 2.0 19.5 9.7 92.6 Czech Republic 10.2 1.0 9.4 12.1 119.0 Denmark 5.4 1.6 29.1 5.8 107.3 Finland 5.3 1.3 25.0 5.7 107.8 France 60.7 11.1 17.7 51.7 85.1 Germany 82.7 12.4 15.1 84.3 101.9 Greece 11.1 0.3 2.8 11.1 99.6 Hungary 10.1 0.8 7.9 10.0 99.0 Italy 58.1 8.0 13.8 71.5 123.1 Netherlands 16.3 4.7 28.5 15.8 97.2 Norway 4.6 1.1 24.7 5.0 108.6 Poland 38.5 2.0 5.3 36.7 95.5 Portugal 10.5 1.4 12.8 12.2 116.0 Romania 21.6 0.4 1.8 17.4 80.5 Russia 142.5 2.1 1.5 150.0 105.2 Spain 43.4 5.9 14.6 46.2 106.4 Sweden 9.1 2.1 22.7 9.6 105.9 Switzerland 7.3 2.0 25.9 7.4 102.1 Turkey 74.2 2.1 3.0 52.7 71.0 Ukraine 46.0 0.1 0.2 49.1 106.7 United Kingdom 59.8 11.6 19.1 69.7 116.4 Europe 813.1 72.4 9.0 797.6 98.1 Iran 69.1 NA NA 13.7 19.4 Israel 6.4 1.5 23.5 8.4 122.7 Middle East 190.0 3.8 2.0 63.6 33.5 Canada 32.4 7.2 21.5 17.0 52.5 Mexico 108.3 3.0 2.7 57.0 52.6 United States 299.7 56.5 18.8 201.7 67.3 North America 439.0 66.6 15.2 275.7 62.8 Australia 20.4 3.5 17.3 19.8 97.0 New Zealand 4.0 0.5 11.7 3.5 87.6 Oceania 33.2 4.0 11.8 24.1 72.6 Argentina 39.1 1.1 2.7 31.5 80.5 Brazil 188.9 4.9 2.6 99.9 52.9 Chile 16.5 1.1 6.8 12.5 75.6 Colombia 46.3 0.5 1.1 29.8 64.3 Peru 28.4 0.4 1.5 8.5 30.0 Venezuela 27.2 0.4 1.6 18.8 69.0 South America 461.8 9.7 2.6 282.3 61.1 World Wide 6,544.4 259.1 3.9 2,710.4 41.4 Source: CIA Government Stats (http://www.cia.gov/cia/publications/factbook/index.html), International Telecommunications Union (http://www.itu.int/ITU-D/ict/statistics), JPMorgan estimates.76
  • Imran Khan North America Equity Research (1-212) 622-6693 02 January 2008 imran.t.khan@jpmorgan.com Mobile advertising has the potential to offer even more specific capabilities. Local search advertising overlaid on map applications could become key as users want information on the nearest restaurants, hotels, and entertainment. Application providers will likely amass much user information as cell phone owners download ringtones, games, and wallpaper, sign up for stock quotes and news headlines, andMultimedia and interactivity participate in social networking activities.create a relationship with thecustomer. Additionally, the ad format could move from a one-way message directed at the user to an interactive multimedia means of communicating with potential customers. Mobile advertising could eventually make use of the following tools: SMS Applications MMS Video Web Cell TV Search Broadcast TV Game For example, a wine brand could create an interest group with a WAP site for viewing recipes and wine pairings, wine tasting dates, making purchases, and communicating with others connoisseurs. Figure 48: Potential Mobile Ads for Customer Interested in Wine Brands offer dinner music ringtone downloads and recipes with links to appropriate wine pairings Invite friends to join club Email questions about wine and food pairings Wine store sends texts about local wine tastings Source: JPMorgan 77
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Can Mobile Ads Achieve the Internet Ad Growth Curve? While Internet ad spend growth rates remain very strong, they have begun to stabilize as the industry has become more established. Many Internet companies are now looking for the next medium to sustain their top-line growth.We are estimating an ~80% 4- Strategy Analytics is forecasting that advertisers will spend $1.4B globally on mobileyear CAGR with mobile media this year. If mobile advertising follows a similar trajectory to Internetmarketing spend reaching $13Bby 2011, putting it in what we advertising, the medium could mean the next wave of growth to online adview as the very beginning companies. We estimate that Internet advertising has grown at a 25% CAGR overstages of the Internet ad growth the past 5 years globally. Currently, we are estimating an ~80% 4-year CAGR withcurve. mobile marketing spend reaching $13B by 2011, putting it in what we view as the very beginning stages of the Internet ad growth curve. Figure 49: Comparison of Global Search, Graphical, and Mobile Growth Curves $ in millions 40000 35000 30000 25000 20000 15000 10000 5000 0 2001 2002 2003 2004 2005 2006 2007E 2008E 2009E 2010E Search Graphical Mobile Source: Company reports, JPMorgan estimates, Strategy Analytics, eMarketer, ComScore, Nielsen NetRatings, IDC, IWS, and IAB. Table 49: A Comparison of Online and Mobile Advertising Online Advertising Mobile Advertising Targeting high targeting through search; less in very targeted especially on a geographical graphical and video ads basis User Information user information primarily obtained through great deal of user information direct from cookies customer Format high text, video, and imaging capabilities low formatting abilities given phone quality Bandwidth high bandwidth available low; dependent on carrier Standardization very standardized dependent on phone and carrier Source: JPMorgan research and company reports Domestic Market Overview While we believe the market is clearly attractive for its size, reach, targeting and multimedia capabilities, monetization of the space will likely be more difficult than the Internet. Following is a discussion of the key issues that we believe online advertising companies will face as they try to gain share in the space. Mobile Carrier Control Having learned a lesson from watching Internet service providers miss benefiting from online ads, we believe mobile operators will be careful to make sure that they78
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com get a good slice of the mobile advertising pie. As a result of this, they have created a somewhat “walled garden” in their mobile portals where operators have better control over the flow of mobile ads and the revenue they generate.Mobile carriers control what Recently, we have seen Internet companies partner with operators in revenue sharingsoftware, services, and agreements. For example, Yahoo! and Rogers Communications just announced aapplications will be available onmobile phones. partnership for Yahoo! to deliver their Go 2.0 and oneSearch products across wireless customers in Canada. Another notable partnership was the iPhone arrangement between Apple and AT&T. While AT&T allowed Apple to develop an ongoing relationship with customers through its iTunes platform, AT&T was named the exclusive domestic mobile provider of iPhones. We believe that more partnerships will be developed but that mobile carrier control has somewhat hindered mobile innovation due to the lack of scale developers can achieve. Google has approached the control issue differently with its entry into the 700 MHz spectrum auction. Partly as a result of Googles lobbying efforts, the FCC ruled that the C Block of spectrum would be limited open access (open devices and open applications) if a minimum bid of $4.6B was met. In December, Google officially announced its intention to participate in the FCC auction scheduled to start January 24th. If Google is successful, it is in the position to operate a wireless network itself or to help it build one and potentially resell wireless services. Device and Network Capabilities Until the advent of the iPhone, cellular devices were not well designed for web browsing and messaging use. Small screen size prevented easy viewing. Small keyboards demanding multiple taps to get the letter desired made messaging difficult.Complex user-interfaces, small Navigation to various features required multiple clicks and complexity for manyscreens, and slow loading people. Slow-loading browsers and networks make mobile web navigationbrowsers have limited mobilefeature use. reminiscent of PC capabilities over a decade ago. As a result of this, US uptake of various features has been limited. In a survey by NPD Group, only 13% of Americans had mobile access to their email, 12% had mobile Internet access, and 39% used text messaging features. Figure 50: U.S. Mobile Feature Usage 100% 80% 60% 40% 20% 0% Mobile email Internet access from Tex t Messaging Instant Messaging handset Source: NPD Group and JPMorgan estimates 79
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com User Reaction Consumers consider cell phones a highly personal device and it is not clear how they would react to having advertisements delivered through it. Some advertisers may fear reactions similar to those to email spam and telemarketer calls.Consumers may have a negative We believe that in order for advertisers to successfully use this medium, they mustreaction to mobile advertising. deliver clear value to consumers. This could take many forms, including: Free or reduced-priced mobile service Additional services or applications provided by the advertiser Ads targeted to a specific and immediate need Opt-in/out features Whatever the method, we believe advertisers must be sure not to alienate the customer and his/her privacy in marketing endeavors. International Markets Are More Attractive The U.S. Trails International Markets in Mobile Services AdoptionWhile U.S. adoption of mobile While U.S. adoption of mobile services outside of phone use has been low,services outside of phone use international users have embraced the technology. In Japan, 85% of cellphonehas been low, internationalusers have embraced the owners have mobile email and 78% access the Internet from their handset. Overtechnology. 66% of Japanese mobile phone owners use PDA functions on the device.80
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Figure 51: Mobile Feature Use in Japan and the U.S. Watch TV on Mobile Phone Video Messaging Instant Messaging Digital Music Play er Tex t messaging Picture messaging Play mobile games Dow nload graphics/screensav ers PDA functions Dow nloading ringtones Internet access from handset Mobile email 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Japan US Source: NPD Group and JPMorgan estimates Although mobile feature usage in Europe is not as high as in Japan, Europeans, on average, still outpace Americans in mobile feature usage. The two countries are similar on SMS usage with 41% of Europeans using the technology vs. 39% of Americans. However, there are vast differences in multimedia messaging and mobile Internet access. In both cases, approximately 26% of Europeans use the technologies while only 12% of their American counterparts do. Table 50: Mobile Feature Usage in Europe US Europe SMS 39% 41% MMS 12% 26% Mobile Internet 12% 26% Source: NPD, Gartner G2, M: Metrics, Forrester, comScore, and JPMorgan estimates So why are American consumers trailing in mobile adoption? It doesn’t appear to be due to lack of interest. In a Pew Research Center survey, the company found that 47% of Americans would like to have mobile maps, 38% were interested in IM services for their phone, and 24% wanted email access and search capabilities to find movie listings, weather reports, and stock quotes. Media-Screen surveys found that the reasons most cited for not using mobile Internet services were cost and connectivity issues. 81
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Figure 52: U.S. Survey Respondents Interested in Using the Following Mobile Services 50% 40% 30% 20% 10% 0% Maps IM Search for Email Cameras serv ices (mov ies, etc) Source: Pew Research Centers and JPMorgan estimates International Advertisers Have Begun to Enter the Market Due to these higher mobile services adoption levels, marketers have begun to experiment with mobile advertising in the international market.Surveys of 50 brand name Surveys by Airwide Solutions of 50 brand name European companies revealed thatEuropean companies revealed 89% of brands plan to use text and multimedia messaging to reach their audience bythat 89% of brands plan to usetext and multimedia messaging 2008. Of these, one-third plan to spend over 10% of their marketing budget on theto reach their audience by 2008. medium. In five years, 52% of the brands expect to spend between 5%-25% of their total marketing budget on mobile marketing. Currently, 40% of the brands have already initiated text messaging campaigns and 18% have launched MMS campaigns. Figure 53: Global Mobile Ad Spend Forecast for 2011 1% 10% 2% 2% 3% 1% 1% 32% 48% SMS MMS Web Search Game Application Video Cell TV Bcast TV Source: Strategy Analytics, eMarketer, and JPMorgan estimates Challenges in the International Market While the launch of mobile ad campaigns seems to have progressed further overseas than domestically, it is not without its weaknesses. For mobile advertising to maximize revenue streams, business models need to be established by carriers, advertisers, and marketing companies. Issues such as opting in or opting out of text advertisements and controlling the number of text ads received still need to be determined. Finally, each country’s privacy laws must be taken into consideration to determine how much information possessed by operators about their clients’ habits can be shared with advertisers and marketers to target ads.82
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Conclusions Attractive market size and reach The mobile market is a large and quickly growing industry with an estimated 2.2B mobile subscribers worldwide growing at an estimated pace of 23% Y/Y. On a worldwide basis, 33% of the population has mobile subscriptions vs. 4% with broadband subscriptions. In short, this medium offers advertising brands a very large reach in marketing their products. Strong targeting and relationship building capabilities Application providers will likely amass much user information as cell phone owners download ringtones, games, and wallpaper, sign up for stock quotes and news headlines, and participate in social networking activities. Additionally, the ad format could move from a one-way message directed at the user to an interactive multimedia means of communicating with potential customers including email, text messaging, web pages, applications, search, and MMS. Mobile ad growth could approximate that of the Internet We estimate that Internet advertising has grown at a 25% CAGR over the past 5 years globally. Currently, Strategy Analytics and eMarketer are estimating an ~80% 4-year CAGR with mobile marketing spend reaching $13B by 2011, putting it in what we view as the very beginning stages of the Internet ad growth curve. Barriers to entry could slow domestic adoption We believe that development of mobile ads has been inhibited primarily by three factors. First, mobile carrier control seems to have limited Internet entrants who need to make partnerships to have their services available on the phone. Second, devices have poor user interfaces, high costs, and slow connectivity times. Finally, users view their mobile phones as personal devices and reception to mobile marketing may be cool. International markets are in the early stages of development Use of mobile services and features is greater in Europe and Japan than in the U.S. As a result marketers have begun to test mobile advertising in these markets. Surveys by Airwide Solutions of 50 brand name European companies revealed that 89% of brands plan to use text and multimedia messaging to reach their audience by 2008. Of these, one-third plan to spend over 10% of their marketing budget on the medium. Company Initiatives Google Introduces Android Google decided to address distribution difficulties head-on with the creation of the Open Handset Alliance, composed of leading technology and wireless companies committed to the development of an open platform for mobile devices. The Android platform is a fully integrated mobile "software stack” consisting of an operating system, middleware, user-friendly interface, and applications. The first phones based on Android are expected to debut in the second half of 2008. By bringing the Internet developer model to the mobile market, it is hoped that increased innovation will make the phone features more attractive, affordable, and user-friendly for the consumer. 83
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Despite speculation about the development of a Google Phone or GPhone, we believe that it is unlikely that Google will choose to enter the hardware business. First, none of Google’s core competencies lie in this business and it would take much investment in technology, marketing, and people to ramp it up. Secondly, the handset business is a much lower-margin business than online advertising. We estimate that operating margins for handset makers range from 10%-20% and are skewed toward the lower end of the range. In contrast to this, we believe that Google will achieve an operating margin north of 50%. Instead, we believe that it is more likely that Google will pursue methods to increase the distribution of its products and services, so that they may later be monetized. If the Android open platform is widely rolled out, more consumers would have access to Google features. Google has introduced many mobile products, including search, Gmail, YouTube, Picassa, maps, and GOOG-411. We believe that Google is well positioned to capitalize on the mobile space with its search dominance. Currently, advertisers can elect to place mobile search or content ads through AdWords. Yahoo! Enters Carrier Partnerships Similar to Google, Yahoo! is focused on increasing the distribution of its mobile products. Yahoo! recently announced nine new partnerships with mobile operators across Asia Pacific, as well as the availability of Yahoo! Go 2.0 in Chinese language for Taiwan. These new partnerships bring the total distribution partnership count to 20, and include Rogers Communications, Telefonica, BPL Mobile, and 3 Group. We believe that these agreements, in addition to the company’s leading email platform and content portal, will firmly establish Yahoo! in the mobile market. The Yahoo! Go 2.0 application allows consumers to personalize their mobile Internet experience with content across the Internet and access to oneSearch. Users are offered access to Yahoo! Go widgets, personal channels for email, local information, satellite and hybrid maps, news sports, finance, entertainment, weather, Flickr, search, and some GPS integration capabilities. On the advertising front, Yahoo! offers mobile display advertising in 19 countries with search marketing live in the U.S., the U.K., and Japan. Yahoo! is also the exclusive advertising partner for Vodafone in the U.K. Publishers can use Yahoo!s Mobile Publisher Services to increase the discovery, distribution, and monetization of their content on mobile phones and to access the Yahoo! Mobile Ad Network, Mobile Content Engine, Mobile Media Directory, and Mobile Site Submit. MSN Updates Its Mobile Portal and Acquires Ad Firm Earlier this summer, Microsoft launched MSN Mobile, a redesigned portal providing customers with access to email, news, sports, entertainment, local movie listings, maps and directions, Windows Live Messenger, and Live Search. Like Yahoo!, Microsoft is pursuing alliances with operators to integrate MSN Mobile on WAP home pages. Microsoft now has a firm footing in the mobile advertising world with its May announcement of the acquisition of Screen Tonic, a Paris based company that specializes in delivering location-based ads to mobile devices. ScreenTonics platform, called Stamp, enables delivery of text or banner links on portals, ads in SMS (Short Message Service) messages and ads in mobile Web pages that vary depending on where the reader is located.84
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Mobile Payment Business Outlook Mobile networks cover over 80% of the world’s population and over 2.7B people have access to mobile phones. Meanwhile the global remittance market is expected to grow at a 10.2% CAGR between 2000 and 2008 as the world’s population has become more mobile. In this section we analyze the impact of the growth in the global remittance market and mobile phone technology on the emerging payment portals designed to take advantage of this growth. • Global remittance is expected to grow 10.9% in 2008. According to Celent, the global remittance market is expected to grow at a 10.2% CAGR between 2000 and 2008 as the global population becomes more mobile. Inexpensive methods for P2P money transfers do not exist, except in the most developed remittance corridors. Mobile money transfer solutions could provide an inexpensive solution for the 200M people who are involved in the global remittance trade. • Increased utilization of mobile phones and broadband mobile networks provides opportunity for growth in mobile payments business. According to the CDMA Association, there are over 402B 3G subscribers around the world and according to JPMorgan’s estimates, global mobile phone penetration is expected to reach 68% by 2010. With lower infrastructure costs, we expect mobile Internet penetration growth to exceed land-based broadband penetration growth during the next five years. We believe increased mobile broadband penetration provides a robust platform for growth in both the mobile remittance and m-commerce business. • M-commerce is expected to grow as mobile Internet usage increases. According to Jupiter Research, m-commerce was a $30B industry in 2006. While most m-commerce money was spent on phone features, the amount of money spent on physical purchases still remains relatively small. However, we expect this number to grow as broadband Internet connectivity increases and the difference between accessing the Internet from a mobile phone compared to a broadband connected PC is minimized. While we expect POS transactions to increase, we believe users will be slow to warm to NFC devices and bar-code displays will be limited to ticket purchases (both transportation and entertainment) and coupons. • While a number of players are currently looking to enter the mobile payment business, we expect only a few to survive. In the U.S., PayPal Mobile and Textpayme both benefit from their relationships with the large online retailers, eBay and Amazon, respectively. We believe smaller players who enter the field will eventually need to team up with bigger operators, such as Obopay’s relationship with Citibank, in order to compete against the likes of Western Union, MasterCard, and major banks. Background Global Remittance Is a $311B Market Celent estimates that over $311B in 2007 was transferred in the global remittance market, and global remittance is expected to grow at a 10.2% CAGR between 2000 and 2008. The mobile global population and the desire to send money back to family have led to the strong growth in remittance. The United Nation estimates that about 3% of the worlds population, or roughly 175M people, is migrant, with the stock of 85
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com immigrants to high-income countries growing at 3% per annum between 1980 and 2000. With about 31% of the population in developing countries under the age of 14, vs. 14% in developed countries, global migration is expected to remain robust. The World Bank highlights two drivers behind the strong migration trends through 2025. They include: The labor force in high-income countries is expected to decline. The World Bank expects the labor force in high-income countries to peak near 500M in 2010, then fall to 475M by 2025. This would lead to 100 workers supporting 111 dependents, compared to less than 100 today. As a result, there could be greater demand for workers in the labor force. Developing countries can supply the needed labor. With a large population under the age of 14, and higher birth rates, the developing world is expected to supply 1B workers by 2025, many of whom will migrate to higher income countries to meet their labor demands. These workers likely would continue to send money back to their country of origin. According to the World Banks base case scenario, new migrant workers could earn as much as $481B more in real (after-tax) income in high-income countries than they would have if they stayed in the developing countries. A large portion of this excess wealth would likely find its way back to the migrant workers country of origin through remittance channels. Figure 54: Global Remittance Receive Trends $ in billions 400 345 350 311 281 300 256 233 250 213 167 183 200 159 150 100 50 0 2000 2001 2002 2003 2004 2005E 2006E 2007E 2008E Source: Celent Inefficiencies and high costs still impact a large part of the remittance market Despite the robustness of the global remittance market, the cost of remitting remains high, except in the most developed and competitive markets. According to the World Regulations and competition can Bank, the cost to transfer $200 (the average remittance size), excluding foreign have a major impact on exchange fees, ranges as high as 17% between the United States and Columbia to as remittance fees. little as 0.4% between the U.S. and the Philippines. Fees are often impacted by regulation (see U.S. to Columbia example) and competition. We believe that there are 4 main reasons for high remittance fees:86
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com 1. Lack of competition 2. Lack of innovation 3. Burdensome regulatory and compliance requirements 4. Low remittance volume in certain markets. Table 51: Approximate Cost of Remitting $200 % of principal amount Major MTOs Banks Other MTOs Hawala Belgium to Nigeria* 12.0 6.0 9.8 - Belgium to Senegal* 10.0 - 6.4 - Hong Kong, China to the 4.5 - - - Philippines New Zealand to Tonga ($300) 12.0 3.0 8.8 - Russia to Ukraine 4.0 3.0 2.5 1-2 South Africa to Mozambique - 1.0 - - Saudi Arabia to Pakistan 3.6 0.4 - - United Arab Emirates to India 5.5 5.2 2.3 1-2 United Kingdom to India 11.0 6.0 - - United Kingdom to the - 0.4-5.0 - - Philippines United States to Columbia - 17.0 10.0 - United States to Mexico 5.0 3.0 4.7 - United States to Philippines 1.2-2.0 0.4-1.8 - - Source: World Bank There are solutions to help drive down remittance costs The low cost of remittance in the Philippines is the result of utilizing new technologies and competitive pressures. Smart Communications, the largest mobile phone provider in the Philippines, has set up an SMS-based text messaging service to transfer money (see the SMS section below). Users can withdraw money using a debit card (see Obopay below) or through a number of stores that Smart has formed partnerships with, including McDonalds, gas stations and 7-11s. Smart has also formed partnerships with a number of remittance companies. The simple SMS technology helps keep costs down, and as a result, the Philippines have one of the lowest international remittance costs (see Table 1 above). Figure 55: Barriers to Entry Cited by Remittance Providers % of responding firms Accessing U.S. financial 7 Establishing commercial contacts 7 Technology 11 Acquiring know -how 14 Building customer trust 16 Getting licenses abroad 18.2 Funding w orking capital 23 Getting U.S. bond 23 Getting bank account 27 Building compliance sy stems 27 Creating agent netw ork 32 Getting U.S. Licenses 40 0 5 10 15 20 25 30 35 40 45 Source: World Bank 87
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com While there are a number of barriers to entry in the global remittance market, we believe there is ample room for new entrants to come into the market and provideIncreased competition and use lower cost solutions for most of the worlds population. The growth of new moneyof new technologies can help transfer options, from PayPal in the US, to Smart Communications in the Philippines,lower remittance costs. demonstrates that it is possible for new entrants to not only come into the market but also to thrive and make a meaningful impact; although many smaller operations may eventually be forced to team up with larger money transfer firms or banks. Figure 56: Money Transfer Operating Margins % 35.0% 31.0% 32.0% 29.1% 30.0% 25.0% 19.3% 18.7% 17.0% 18.6% 20.0% 15.7% 15.0% 10.9% 10.0% 5.0% 0.0% 2004 2005 2006 Global Pay ments (Money Transfer) Money Gram (Global Fund Transfer) Western Union (C2C) Source: Company reports. We believe the growing mobile phone market provides a platform to grow lower cost remittance solutions The mobile market is a large and quickly growing industry with an estimated 2.7B mobile subscribers worldwide growing at an estimated pace of 23% Y/Y. Given this level of reach, we believe mobile solutions provide an attractive method to send money around the world. We believe there are three key reasons that make the mobile market a viable solution to lower remittance costs. 1. We estimate that 67% of Americans are mobile phone subscribers while only 57% have broadband subscriptions.On a worldwide basis, 41% of 2. We believe that this disparity is even greater in developing countries. Inthe population has mobile China, for example, our estimates indicate there are approximately 35subscriptions vs. 4% with mobile subscribers per 100 persons but only 4 broadband subscribers perbroadband subscriptions 100 people. 3. On a worldwide basis, 41% of the population has mobile subscriptions vs. 4% with broadband subscriptions. JPMorgans Wireless team expects mobile penetration to reach 68% by 2010.88
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Table 52: Mobile and Broadband Penetration by Country millions Country Population (M) Broadband BB Subs per Mobile Subs Mobile Subs Subs (M) 100 Persons (M) per 100 Persons Egypt 71.4 0.1 0.1 13.6 19.1 Morocco 30.7 0.3 1.0 16.0 52.1 South Africa 47.6 0.2 0.5 39.7 83.3 Africa 914.3 2.9 0.3 193.8 21.2 China 1,323.7 47.0 3.6 461.1 34.8 Hong Kong 7.1 1.5 21.6 9.4 131.5 India 1,119.7 2.0 0.2 166.1 14.8 Indonesia 225.5 0.5 0.2 63.8 28.3 Japan 128.2 24.2 19.0 101.7 79.3 Malaysia 25.8 0.7 2.7 19.5 75.5 Pakistan 157.0 0.1 0.1 34.5 22.0 Philippines 84.5 0.1 0.2 42.9 50.8 South Korea 48.0 12.8 26.1 40.2 83.8 Taiwan 22.8 4.4 19.2 23.2 102.0 Thailand 64.8 0.3 0.5 40.8 63.0 Vietnam 85.3 0.3 0.4 15.5 18.2 Asia Pacific 3,693.0 99.6 2.7 1,073.3 29.1 Austria 8.2 1.5 17.8 9.3 112.8 Belgium 10.4 2.0 19.5 9.7 92.6 Czech Republic 10.2 1.0 9.4 12.1 119.0 Denmark 5.4 1.6 29.1 5.8 107.3 Finland 5.3 1.3 25.0 5.7 107.8 France 60.7 11.1 17.7 51.7 85.1 Germany 82.7 12.4 15.1 84.3 101.9 Greece 11.1 0.3 2.8 11.1 99.6 Hungary 10.1 0.8 7.9 10.0 99.0 Italy 58.1 8.0 13.8 71.5 123.1 Netherlands 16.3 4.7 28.5 15.8 97.2 Norway 4.6 1.1 24.7 5.0 108.6 Poland 38.5 2.0 5.3 36.7 95.5 Portugal 10.5 1.4 12.8 12.2 116.0 Romania 21.6 0.4 1.8 17.4 80.5 Russia 142.5 2.1 1.5 150.0 105.2 Spain 43.4 5.9 14.6 46.2 106.4 Sweden 9.1 2.1 22.7 9.6 105.9 Switzerland 7.3 2.0 25.9 7.4 102.1 Turkey 74.2 2.1 3.0 52.7 71.0 Ukraine 46.0 0.1 0.2 49.1 106.7 United Kingdom 59.8 11.6 19.1 69.7 116.4 Europe 813.1 72.4 9.0 797.6 98.1 Iran 69.1 NA NA 13.7 19.4 Israel 6.4 1.5 23.5 8.4 122.7 Middle East 190.0 3.8 2.0 63.6 33.5 Canada 32.4 7.2 21.5 17.0 52.5 Mexico 108.3 3.0 2.7 57.0 52.6 United States 299.7 56.5 18.8 201.7 67.3 North America 439.0 66.6 15.2 275.7 62.8 Australia 20.4 3.5 17.3 19.8 97.0 New Zealand 4.0 0.5 11.7 3.5 87.6 Oceania 33.2 4.0 11.8 24.1 72.6 Argentina 39.1 1.1 2.7 31.5 80.5 Brazil 188.9 4.9 2.6 99.9 52.9 Chile 16.5 1.1 6.8 12.5 75.6 Colombia 46.3 0.5 1.1 29.8 64.3 Peru 28.4 0.4 1.5 8.5 30.0 Venezuela 27.2 0.4 1.6 18.8 69.0 Latin America 461.8 9.7 2.6 282.3 61.1 World Wide 6,544.4 259.1 3.9 2,710.4 41.4 Source: CIA Government Stats (http://www.cia.gov/cia/publications/factbook/index.html), International Telecommunications Union (http://www.itu.int/ITU-D/ict/statistics), JPMorgan estimates. 89
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Developing payment processing solutions geared around mobile devices would greatly improve the reach of current remittance options, in our view. With the growing prevalence of mobile devices, someone in Ghana may some day be able to transfer money to someone in Northern Alaska without needing to visit a bank or Western Union. As the example of the Philippines demonstrates, this may even be at a lower cost than the options that are currently available. Increased Mobile Internet Penetration Gives Users the Freedom to Access and Send Information from Almost Anywhere U.S. mobile Internet usage has been slow to take off; the number of users with Internet capable phones and high-speed mobile data connections has remained small. However, that is changing as more users buy data-enabled phones, such as the iPhone, and access high-speed mobile data networks such as Sprint’s EVDO networkAccording to the FCC, and AT&T’s HSDPA network. According the Pew Internet & American Life Projectindividuals in the U.S. with high- report on mobile usage, only 14% of mobile subscribers use their phones to accessspeed mobile access increased the Internet, but 16% stated that they would like to have mobile Internet access.to 2.4M in Dec. 2006, from 2,574in June 2005. Despite a low penetration, mobile broadband access (defined as speeds of 200kps or more in at least one direction) continues to grow, increasing from 2,574 individual users in June 2005 to 2.4M individual users (21.9M if business devices are included) in Dec. 2006, according to the FCC. We expect mobile broadband growth to remain robust and to play a key role in the adaptation of m-commerce and mobile payment solutions. Figure 57: U.S. Mobile Device Usage % Trade instant messages Perform Internet searches Send/receiv e email Access the Internet Play games Take still pictures Send/receiv e tex t messages 0% 10% 20% 30% 40% 50% 60% Currently use Would like to hav e Source: Pew Internet & American Life Project Mobile Users Are Adopting SMS as a Primary Way to Communicate While mobile Internet growth has been slow, text messaging, or SMS, use has thrived, unencumbered by slow connections or text-heavy displays. According to the Pew Internet & American Life Project, over 35% of all cell phone users use text-In the U.S., 65% of 18-29 year based messaging, while 65% of those 18-29 use text messaging. SMS growth in theolds use text messaging. US has been robust during the past 2 years, growing 300%, according to the CTIA. SMS usage outside the US has also been strong, with 41% of Europeans using text messaging services. SMS, which doesn’t require the latest mobile technology or high-priced cell phones, provides a low-cost method to grow the mobile remittance90
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com market in developing countries and to attract the greatest user base in more developed markets like the U.S. and Europe. Figure 58: US SMS Usage by Age Group % 70% 65% 60% 50% 35% 37% 40% 30% 20% 13% 8% 10% 0% Total 18-29 30-49 50-64 65+ Source: Pew Internet & American Life Project Figure 59: June Monthly SMS Usage in the US and UK Billions of SMS Messages 35.0 28.8 30.0 25.0 20.0 12.5 15.0 7.2 10.0 3.4 4.4 2.6 5.0 - 2005 2006 2007 US UK Source: CTIA, Test.it, JPMorgan Estimates We Expect Mobile Commerce to be a Catalyst for Growth in Mobile Payment Platforms According to Jupiter Research, mobile commerce was a $30B market in 2006. Most m-commerce has been, and continues to be, limited to the purchase of customizable ringers, downloadable games and screensavers, all features that are used on the phone. The use of a mobile phone to purchase physical merchandise has remained small. However, we expect m-commerce transactions to grow as more mobile users gain access broadband mobile networks and phones with improved display and Internet features. Jupiter Research expects m-commerce to reach $63B by 2010. As growth an e-commerce helped online payment providers, such as PayPal, grow its transaction volume, we expect strong growth in m-commerce to help grow mobile payment transaction volume and create an incentive for companies looking to enter the space. 91
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Figure 60: PayPal Transaction Volume Growth and eCommerce Penetration 2000-2007E $ in millions 500,000 12.0% 400,000 10.0% 8.0% 300,000 6.0% 200,000 4.0% 100,000 2.0% - 0.0% 2000 2001 2002 2003 2004 2005 2006 2007E eCommerce Sales Pay Pal TPV TPV as % eCommerce Source: US Department of Commerce, JPMorgan estimates, Company data. We expect point of sale transactions to have a limited impact on mobile commerce growth Companies such as Nokia and Samsung have looked at adding microchips to cell phones to drive mobile commerce growth at the retail store level. Using a chip embedded in their cell phone, a user can scan their phone near a reader and pay for merchandise at the store (point of sale) using funds from their credit card, bank account or other account, possibly set up through the cell phone provider. While companies focus on near field communication solution (NFC) to drive point of sale (POS) transactions, the marketplace for NFC solutions and the new technologies being tested are beyond the scope of this report. However, we are skeptical of the long-term viability of NFC solutions principally for four reasons – 1. We believe most people are fairly happy with their current POS solutions – NFC using credit cards, regular credit and debit cards and cash, and have little incentive to try something new. 2. Security is an issue for many users who are concerned about not only extra phone charges when they lose their phone, but also someone purchasing items with it. Also, many people are concerned about accidental charges, since their phone only needs to pass in the vicinity of a reader. 3. Having a chip embedded in the cell phone limits a customer’s choices and the ability to change phones, mobile providers or credit card companies easily. 4. Transactions can require the cooperation of as many as seven separate parties: (1) consumer, (2) merchant, (3) the consumers bank, (4) the merchants bank, (5) the payment network, (6) mobile operator, and (7) merchant processor. All of these parties create additional transaction costs and make implementation more difficult. Bar codes are another payment option for POS transactions. Under this method, a mobile user purchases an item online, usually a ticket, and then receives a bar code verifying that the payment was made. When the user goes to use the ticket, or pick up the merchandise, the bar code on the phone is scanned. Mobilrelay (mbo.com) is one92
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com company that sells movie tickets online and sends users a bar code to confirm their purchase. In Belgian, users who purchase tickets for the De Lijn train line between Antwerp and Ghent can use SMS to receive rail tickets. Bar codes and SMS payment confirmations are essentially a replacement for the printed ticket. As a result, we expect usage will be primarily limited to entertainment and travel ticket purchases. Current Mobile Payment Systems SMS-Based Solutions With the popularity of SMS services on mobile networks, and helped by the fact that SMS-based services can operate independently of the users mobile service provider, SMS-based solutions are the most common option for mobile P2P money transfers. A typical P2P money transfer takes place in the following steps: 1. Send a text message to the Payment providers number. Include the amount and phone number or email address (some providers, such as PayPal, allow transfers to PayPal members using an email address). 2. Since the transaction occurs over an unsecured SMS channel, the payment processor will typically send a text message or make a phone call to confirm the payment. 3. Once the payment is confirmed, the recipient receives a text or email notifying them that they have funds available in their account. If the recipient is not a current user of the payment service, they are invited to join, and typically cannot access their funds until they do so. Money that is not claimed is usually returned to the sender after a set period of time. Users of SMS-based solutions can often use SMS messaging for other account- management services. Some common features include: 1. The ability to check your balance by sending a predetermined text message (ex. bal) to the service provider’s number. 2. The ability to request money from other users. This can be done by sending a text message to the provider’s number with the user’s information and the amount requested. Funds are not deposited until the transfer is confirmed by the user sending the money. 3. Users can also text to buy items using SMS payment solutions. Adding and withdrawing money is usually done online, through a web-based interface, or sometimes through the use of a specially branded credit/debit card. Web Interface and Software-Based Solutions Slow speeds and difficult to read text displays have kept many away from web interface solutions. However, as newer mobile broadband technologies (3G, etc) and better graphical interfaces (i.e. Apple iPhone) are rolled out, we expect cell phone Internet usage to grow. Web-based interface has the benefit of operability on most service provider networks (at least those that offer advanced Internet capabilities) and eliminates the need to download software on the user’s phone. It also creates a more secure transmission environment; the sender usually must log in with a user 93
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com name and password prior to sending money, and can enter a PIN number through the web interface, eliminating the need to receive a callback and/or text message verifying the sender’s information. Figure 61: How KushCash Works Source: www.kushcash.com Software-based applications, offered by firms such as KushCash and retail banks (such as Bank of America, Citibank and Wachovia), offer another secure solution. The drawback to using software-based applications is that their usage is limited to certain carrier networks, which often depend more on relationships than the size of the network, and model of cell phones, although this limitation also exists for both SMS-based and web-based services. The advantage of software solutions is usually a more secure environment, as transfer requests are encrypted, and increased functionality over SMS-based solutions. Conclusions Global migration has created a large market opportunity in remittance The increase in global migration has created a global remittance market that is expected to reach $345B by 2008, according to Celent. According to the World Bank remittance options for many people still remain high, with some people paying fees of 10% or more, before foreign currency exchange costs. We believe there is room for new competitors, other than the existing money transfer companies, to provide lower cost solutions, such as Smart Communications does in the Philippines. The growth in mobile penetration creates an attractive vehicle to transfer funds. With over 68% of the world expected to have a mobile phone by 2010, we believe that mobile technology offers a viable and low-cost solution in the global remittance market. The attractiveness of this market has not been lost on the big players in the space as Western Union and MasterCard have teamed up with the GSM Association and Citibank has teamed with Obopay to offer mobile money transfer solutions.94
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com M-commerce is still in its early stages but should grow with high-speed connections We believe that m-commerce is still in its early stages, as users mostly limit their purchases to cell phone features, such as ring tones, games and screensavers. We expect this to change as more mobile users gain access to high-speed mobile connections on 3G and later mobile devices and viewing screens continue to improve, as on Apples iPhone. POS m-commerce solutions are not expected to take off We believe that mobile phone subscribers will be slow to adopt near field communication solutions (NFC) as they already have a number of viable payment options. Since a significant amount of capital needs to be spent developing an NFC infrastructure, including readers, we believe usage will be limited to wealthier countries and usage will be more prominent among those who do not have other viable payment alternatives, such as teenagers. We expect bar code POS solutions to be an attractive alternative to paper ticket sales, for entertainment events and travel, however, usage should be limited to more developed markets. SMS and web-based solutions are expected to remain the main portals for mobile money transfers We expect SMS and web-based solutions to be the most successful mobile payment solutions. SMS service is widely available and used by a large portion of young mobile subscribers. The service does not require advanced broadband technology or expensive hardware and is relatively inexpensive to implement, which should help drive its usage. However, security is a concern, as most SMS messages are unencrypted, and a user most give a PIN number or password in response to a text message or voice call. Web-based solutions offer a more secure alternative for those with a broadband mobile Internet connection and Internet-capable phone. Current Providers KushCash KushCash is a software-based money transfer solution based in Southern California. Its user base is currently small and the company is focused on growing in its core California market. The application is available on select phones that operate on the Boost, Cingular and Sprint networks and through a web-based interface. A user can access its KushCash account through 1) the mobile application or 2) an Internet or mobile Internet browser. In addition users can send, receive and borrow money from KushCash members using the KushCash application. Table 53: KushCash Fees to: Open an Account FREE Add Money 2.80% + $0.30 Send Money FREE Withdraw to Bank 0.5 Receive Money 0.5 How it works Install KushCash directly to your supported phone. 1. Register an account online. 2. Follow the download instructions. 3. Instantly install KushCash. Source: www.kushcash.com. 95
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Obopay Obopay was launched in 2005 and some of its investors include ONSET Ventures, Qualcomm, Redpoint Ventures and Richmond Management. The service operates on any SMS or web-enabled phone device. Obopay works primarily as a P2P service, however, it was teamed up with Verizon to offer the Verizon Get It Now Catalog, that allows the purchase of digital downloads and physical goods. Users can use credit cards, bank accounts and even an Obopay-branded ATM card to deposit and withdraw funds. Obopay founded BillMonk, which allows users to lend and borrow money from friends and to keep track of and settle expenses. BillMonk users can use Obopay to settle and collect their debts. Other Obopay partners include Citibank and AIM, which offers an Obopay plug-in. Table 54: Obopay Fees to: FEE Sign up for Obopay Free Receive money Free Receive money as a merchant (get paid) Free Withdraw money to your bank account Free Send money (or accept a request for money) $0.10 Add money from your credit or debit card (standard) 1.50% Add money from your bank account (economy) Fee is waived Mobile Operators Verizon Wireless HELIO Cellular South Merchants RIPmobile Online Partners AIM Source: www.obopay.com. PayPal Mobile PayPal Mobile is the mobile version of PayPal’s payment processing platform. The platform can work either via SMS, with users receiving a callback or text message to verify their PIN, or through a web based interface. There are no extra fees for sending money via PayPal Mobile as opposed to using the regular PayPal service. In order to purchase items on eBay, users must first download an application to their cell phone. Users can also buy merchandise from other vendors on web-enabled phones or by sending a text message to a number on a Text to Buy ad. Users can even use SMS messaging to change currencies.96
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Table 55: PayPal Mobile Fees to Personal Account Premier/Business Account Open an Account Free Free Send Money Free Free Withdraw Funds Free for banks in the U.S. Free for banks in the U.S. Fees for other banks Fees for other banks Add Funds Free Free Receive payments funded by PayPal Balance, Free 1.9-%-2.9% + 0.30 USD (in PayPal Instant Transfer or PayPal eCheck U.S.) Receive payments funded by Credit Card, Debit 4.9% + $0.30 (in U.S.)** 1.9-%-2.9% + 0.30 USD (in Card or Buyer Credit U.S.) Additional fees for cross Additional fees for cross border border payments payments Multiple Currency Transactions Exchange rate includes a Exchange rate includes a 2.5% 2.5% fee** fee Additional fees for cross Additional fees for cross border border payments payments Supported Carriers Alltel AT&T Cincinnati Bell Midwest Wireless Sprint T-Mobile T-Mobile (prepaid) Verizon Virgin Mobile Source: www.paypal.com/mobile. Note: Personal accounts may not receive payments funded by credit card, debit card or buyer credit for sales on eBay. Users who would like to receive these payments must upgrade to a premier or business account. Textpayme Textpayme is an SMS-based money transfer solution that recently moved out of its beta testing phase and is linked to Amazons Payment Services. In order to create a Textpayme account, users must first create, or already have, an Amazon account. In addition to being able to transfer money, users can also use Textpayme to purchase items on Amazon.com. In order to encourage users to try its service, the company is currently offering $5 to new members and since it is SMS-based, the service is accessible to subscribers on any mobile network that offers text messaging. Fees are only charged when money is added via credit card. Bank deposits and withdrawals are free, and users can choose to receive their money in the form of Amazon gift certificates. 97
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Table 56: Textpayme Fees to: Signup for a TextPayMe Account Free Send Money Free Receive Money Free Deposit Funds through Bank Account Free Withdraw Funds to Bank Account Free Auto Debit from Credit Card Free for first $200 ($0.15 + 1.35% after) Supported Carriers AT&T Alltel Boost Midwest Wireless Nextel Communications Sprint PCS T-Mobile Verizon Wireless Source: www.Textpayme.com.98
  • China Sector Outlook
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Strong Internet User Growth Continues China’s Internet users continue to swell, and have crossed 162 million as of Jun-07, compared to 137 million as of Dec-06 and 123 million as of Jun-06 (or up ~32% Y/Y), as per CNNIC (China Internet Network Information Center). This makes China’s Internet population second only to the US (~212M). However, China’s population penetration is still only 12%, versus 65%+ in more developed Internet markets like Japan, Korea and the US. We expect the Internet population in China to continue to grow robustly and reach ~239 million by 2010 (‘06-‘10E CAGR of 15%). Figure 62: China Internet Users and Penetration Forecast 250 230 239 20% 221 212 18% 200 189 200 175 16% 162 14% 150 137 12% 123 111 10% 103 100 87 94 8% 80 68 59 6% 46 50 34 4% 23 27 2% 0 0% Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07E Dec-08E Dec-09E Dec-10E Jun-08E Jun-09E Jun-10E Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Number of China Internet Users (Left, millions) Penetration Rate as % of Total Population (Right) Source: CNNIC, JPMorgan estimates. Besides the typical benefits of Internet access (information, communication, etc.), we believe a few China-specific reasons still continue to drive Internet usage: 1) relatively low-cost entertainment source (Internet cafe access fee of ~US$0.30 per hour to enjoy online games, online music, movie downloads), 2) community tools for the large floating population in China (eg. workers moving from rural to urban areas), 3) alternative news source (due to few media with nationwide coverage). Table 57: Common Applications of Internet in China % of Users % of Users Information Life Assistance News 77.3% Look for jobs 15.2% Search engine 74.8% Online education 24.0% Communication Online shopping 25.5% IM 69.8% Online banking 20.9% E-mail 55.4% Stock 14.1% Entertainment Online music 68.5% Online video 61.1% Internet games 47.0% Source: CNNIC Survey (Jun-07). 101
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comFigure 63: Broadband Internet Users in China Figure 64: Broadband Internet Users as % of Total Internet Users 140 100% 122 90% 120 75% 80% 100 91 66% 70% 63% 77 58% 80 60% 51% 64 46% 50% 53 36% 60 40% 43 40 31 30% 22% 17 20% 14% 11% 20 7 10 4% 2 10% 0 0% Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- 02 02 03 03 04 04 05 05 06 06 07 02 02 03 03 04 04 05 05 06 06 07 Broadband Internet Users (millions) Broadband users as % of total Internet usersFigure 65: China Internet Users by Age Group Figure 66: Main Locations of Internet Access in China 40.0% 34% 80% 74% 70% 30.0% 60% 18% 19% 50% 20.0% 37% 40% 31% 10% 8% 7% 30% 10.0% 3% 1% 12% 20% 0.0% 10% Under 18 - 25 - 31 - 36 - 41 - 51 - Abov e 0% 18 24 30 35 40 50 60 60 Home Internet Café Workplace School102
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Online Advertising Remain positive on the secular high growth online advertising sector Online advertising (display and search advertising) in China continued to see strong growth in 2007, with ~50% YoY growth, as per our estimates. Online advertising thus accounted for ~6.7% of the total advertising market in China in 2007 (as per our estimates), up from ~5.2% in 2006. We remain positive on the online advertising sector in China and forecast 50% growth in 2008. We expect the 2008 Beijing Olympics to act as a significant growth driver in the near to medium term, as advertisers try to take advantage of this key event (a source of great national pride) to build and strengthen their brand awareness among consumers.Table 58: China Online Advertising Forecast 2004 2005 2006 2007E 2008E 2009E 2010E 2011E 2012E 2013E 2014E 2015EBranded Advertising Market (US$M) 205 287 425 586 809 970 1,213 1,431 1,689 1,993 2,352 2,775Email Advertising Market (US$M) 8 11 14 16 17 19 21 23 25 28 31 34PPC Search Market (US$M) 37 67 140 309 562 911 1,384 2,046 2,748 3,507 4,310 5,196Fixed Price Ranking (US$M) 37 42 48 50 53 55 58 61 64 68 71 75Total Online Ad Market (US$M) 287 407 626 961 1,441 1,956 2,677 3,561 4,527 5,596 6,764 8,080Growth (%) 97% 42% 54% 53% 50% 36% 37% 33% 27% 24% 21% 19%China overall ad market (US$M) 8,449 10,184 12,051 14,236 17,479 19,588 22,918 26,356 30,309 34,855 40,084 46,096Online as % of total China ad market 3.4% 4.0% 5.2% 6.7% 8.2% 10.0% 11.7% 13.5% 14.9% 16.1% 16.9% 17.5%Source: CNNIC, JPMorgan estimates. The key drivers for the continued momentum in online advertising remain: (1) strong economic growth across sectors, (2) continued increase in disposable income and consumer spending, (3) competitive business environment and increasing brand investments across sectors and (4) secular growth in advertising dollars moving online (from more traditional media, as users spend more time online).Figure 67: Nominal GDP Growth in China Figure 68: Ad Spending as % of GDPUnits: RMB Bn (Y-axis) 25,000 0.5% 0.47% 0.45% 0.46% 1992-2006 CAGR of 16% 0.38% 0.39% 20,000 0.4% 0.34% 15,000 0.27% 0.3% 0.25% 10,000 0.2% 5,000 0.1% 0 0.0% 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006Source: CEIC/SAIC. Source: CEIC/SAIC. 103
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comFigure 69: Growth in Urban Disposal Income per Capita Figure 70: Growth in Retail Sales of Consumer GoodsUnits: RMB Units: RMB Bn 1992-2006 CAGR of 13% 1992-2006 CAGR of 15% 14,000 8,000 12,000 7,000 10,000 6,000 8,000 5,000 4,000 6,000 3,000 4,000 2,000 2,000 1,000 0 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006Source: CEIC. Source: CEIC.Figure 71: Average Weekly Online Time Figure 72: China Online Ad Market as % of Total Ad Market 20 Average Access Time Per Week (Left, hours) 18.6 4,000 16% 18 15.9 16.5 16.9 13.5% 16 14.0 3,500 14% 13.0 13.4 13.2 11.7% 14 12.3 3,000 10.0% 12% 12 9.8 8.7 8.5 10 8.3 2,500 8.2% 10% 8 6.7% 6 2,000 8% 4 5.2% 1,500 4.0% 6% 2 3.4% 0 1,000 4% Jun-01 Dec- Jun-02 Dec- Jun-03 Dec- Jun-04 Dec- Jun-05 Dec- Jun-06 Dec- Jun-07 500 2% 01 02 03 04 05 06 Average Access Time Per Week (Left, hours) - 0%Source: CNNIC. 2004 2005 2006 2007E 2008E 2009E 2010E 2011E Online ad market size (US$m,left) As % of total ad market (% , Right) Source: JPMorgan estimates.104
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Branded Advertising Segment Branded advertising strength should continue; Olympics should give a boost in 2008 The branded advertising segment grew ~38% in 2007 to reach US$586 million, as per our estimates. In terms of the advertiser sectors, automobiles, real estate and IT remained the largest, (together accounting for 40%-50% of branded ad spend on top portals), while financial services, FMCG and online games were among the fastest growing (with 100%+ YoY growth in branded ad spend on top portals). For 2008, we forecast the branded advertising segment to witness ~38% YoY growth to reach US$809 million, with the Olympics being a key driver for the segment. We expect listed portals such as Sina, Sohu, Tencent and NetEase to remain the market leaders and be the key beneficiaries of the segment growth due to their strong brand names, superior content offering and proven execution ability. Figure 73: China Branded Advertising Forecast 1,600 72% 1,431 75% 1,213 48% 60% 1,200 40% 38% 38% 970 809 45% 800 20% 425 586 25% 18% 30% 205 287 400 15% 0 0% 2004 2005 2006 2007E 2008E 2009E 2010E 2011E Branded Advertising Market (US$M,left) YoY growth (% , Right) Source: JPMorgan estimates. Internet users’ online time continuing its up-trend The duration of time spent online by users continues to increase in China. The average weekly online time has increased to 18.6 hours for Chinese Internet users as of June 2007 (as per CNNIC survey), up from 16.9 hours as of December 2006; the average weekly online time has thus more than doubled over the last 5 years in China (from 8.3 hours in June 2002). The factors that have contributed to the up-trend include: (a) major portals have been increasing their content investments over the past few years to make more information and differentiated content (such as the NBA, European soccer leagues, Asian Games, Olympics lead-up, etc.) available to users, and (b) the Internet is viewed in China as an alternative information source that is more friendly and entertaining to use (as most traditional media remains tightly controlled by the government). 105
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Figure 74: Internet User Online Time Trend 20 18.6 Average Access Time Per Week (Left, hours) 18 16.5 16.9 15.9 16 14.0 13.0 13.4 13.2 14 12.3 12 9.8 8.5 10 8.7 8.3 8 6 4 2 0 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Av erage Access Time Per Week (Left, hours) Source: CNNIC. Olympics should be a key driver in 2008 The 2008 Beijing Olympics should be a key driver for the overall advertising industry in China, as well as for the online advertising sector. As a historical event for China, and a matter of great national pride, advertisers will try to take advantage of the Olympics to build and strengthen their brand awareness among consumers. In terms of impact on leading players, we forecast both Sina and Sohu to experience nearly 50% YoY growth in their branded advertising segments in 2008, up from ~40% YoY growth in 2007.Figure 75: Sina Branded Ad Revenue Growth Figure 76: Sohu Branded Ad Revenue Growth 350 49.9% 310 60.0% 200 48.4% 188 60.0% 300 41.3% 40.4% 253 164 50.0% 40.0% 50.0% 250 150 35.1% 40.0% 40.0% 200 169 111 120 30.0% 100 79 30.0% 150 22.9% 20.0% 14.7% 20.0% 100 50 50 10.0% 10.0% 0 0.0% 0 0.0% 2006 2007E 2008E 2009E 2006 2007E 2008E 2009E Sina Branded Ad Rev enue (US$M, left) YoY grth (%, right) Sohu Branded Ad Rev enue (US$M, left) YoY grth (%, right)Source: Company, JPMorgan estimates. Source: Company, JPMorgan estimates. Sohu, being the official Beijing Olympics Internet content sponsor, has already begun to see some benefits of ad spending by Olympics partners and sponsors - Olympics sponsors as a group increased ad spending on Sohu by 60% YoY in 3Q07 and by 80% YoY in 2Q07 (These sponsors/partners include Coca Cola, Lenovo, Adidas, Yili, Bank of China, Volkswagen, et al). Sohu believes that the larger Olympics ad spending is yet to come, and the spending is likely to be in three phases:106
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com (1) 4Q07 until early May: Advertisers likely will still be relatively slow in Olympics- related spending. (2) From May until early August: The Olympics torch relay will begin in May, and advertisers likely will increase their ad spending. (3) During the month of August: The largest ad spending likely will take place during the actual Olympics event. Growth after the Olympics We expect online ad spending to continue to grow after 2008, on the back of: (1) strong domestic consumer growth and high industry competition should continue even after Olympics, (2) while a portion of Olympics-related ad spend may come from international companies targeting international visitors (buying ads in China during Olympics to show their presence there) and will not come back post- Olympics, we believe these international companies likely weill not use Chinese Internet portals to advertise in the first place, (3) accelerated Internet usage likely in China after Olympics – as Olympics are held during daytime, office workers likely turn to Internet for updates, (4) various industries, such as FMCG, will likely increase their percentage of online spending after the Olympics - as they are likely to see good ROI during Olympics advertising, and (5) the 2010 World Expo in Shanghai is another highly anticipated international event, and would provide advertisers another opportunity to associate their products / brands with a high- profile international event that demonstrates the success of China. Regulatory risk remains lower than other online sectors We believe the regulatory risk remains lower for the portal online ad business, compared to other segments in China, such as WVAS, online music or online games. Online advertising is the most established online business in China (since the late 90s), and regulations and boundaries are well-understood by industry players. We believe the leading portals have strict internal compliance departments and automated content scans to ensure content is in compliance with government standards. While Web 2.0 content such as music, video, and blogs has come to the government’s attention, we believe if there is further regulatory tightening for Web 2.0 content, leading portals should be less impacted than pure Web 2.0 companies. Leading portals are the most trusted by the government among Internet companies and have the best compliance procedures; further, the financial impact would be less significant because only a small portion of their revenues is likely to be from Web 2.0 content. 107
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Online Search Online search advertising still in early high-growth stage The online search segment in China was up ~120% YoY in 2007 to reach US$309 million, as per our estimates. We believe online search advertising is still in an early high-growth stage in China, and forecast search revenues to experience 56% CAGR over ‘07-11, driven by: (1) rising Internet penetration in China, (2) significant growth in websites and pages, (3) higher search usage (due to greater mass of web content), and (4) large number of SMEs (with small ad budgets) turning to search advertising (due to higher ROI). For 2008, we expect the search advertising segment in China to witness ~82% YoY growth to reach US$562 million. We expect Baidu to remain the dominant player in China in the near to medium term and be the key beneficiary of the industry growth. (Baidu’s market share is around 65%-70%, with nearest rivals Google and Yahoo! together having around 25%-30% market share). Table 59: China Paid Search Forecast 2004 2005 2006 2007E 2008E 2009E 2010E 2011E Avg Internet users (millions) 94 111 130 168 195 217 234 253 Number of search (billions) 51 67 86 119 145 169 190 214 Coverage 12% 14% 17% 21% 25% 29% 33% 38% Click through rate 20% 21% 22% 24% 26% 27% 28% 28% Price per click (RMB) 0.25 0.29 0.34 0.40 0.47 0.55 0.62 0.69 Market size (US$M) 37 67 140 309 562 911 1,384 2,046 YoY Growth (%) 83% 82% 109% 120% 82% 62% 52% 48% Source: CNNIC, JPMorgan estimates. Note: Excluding distributor discount. Search market outlook: Usage As Internet users become more experienced, they look for information on the Internet beyond the major portals. Entertainment-related content, such as pictures and music, have always been popular in China. Going forward, we believe the non- entertainment-related searches, such as eCommerce, e-Government will continue to gain popularity. Growing usage in China Latest statistics from CNNIC show that the number of users in China has reached 162 million (Jun-07). We expect usage to continue to grow driven by such factors as:Table 60: Entertainmentcomparison • Entertainment tool. Digital entertainment (MP3, movies, etc.), can be Entertainment Fee downloaded from the web virtually free of cost or at a very low cost. Online option games—LAN-based, MMORPG, or casual board and chess games—are also Webcafes with Rmb2-4 per hour low-cost alternatives to offline entertainment. Internet is a low cost form of online games entertainment—Internet café access is about Rmb2-4 / hr vs. Rmb40 for a movie. Movie Rmb30 - 60 Big Mac meal Rmb20 • Communication tool. Migrant workers (~10% of total population, or 140M Karaoke Starting Rmb30 per hour people in China are floating population) as well as relocated white-collar workers Beijing subway Rmb2-5 visit Internet cafés after work to use instant messenger and email, or to play fee (one way) games or watch movies. Despite the government constantly monitoring theseSource: JPMorgan estimates. services, blogs and bulletin board services have also increased in popularity in China (as channels to express personal views and communicate with others).108
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com • Information source. Most traditional media is still tightly controlled by the government. Internet offers an alternative information source that is more friendly and entertaining to use. Major portals have also been increasing their content over the past few years to make more information available to users. Other government initiatives, such as electronic tax filing, customer clearing, and government agency websites, also help in improving Internet usage. Surge in websites and webpages in China China is no exception to the information boom. As of December 2006, there were around 4.4 billion webpages, up from 650 million in December 2004 (CNNIC, excludes 217 million overlapped pages). The number of websites (located in China) is also rapidly growing. According to CNNIC, the number reached 1.3 million by July 2007, up from 669k by end-2004. Despite the recent stricter registration requirements, we believe the government strongly supports healthy websites. The amount of information per page (in terms of number of bytes) is also on the rise. Figure 77: Number of websites in China Figure 78: Number of webpages in China Number of w ebsites in China Webpages (millions) 1,400,000 5,000 1,200,000 CAGR (02-06): 26% 4,000 1,000,000 CAGR (02-06): 131% 800,000 3,000 600,000 2,000 400,000 200,000 1,000 - 0 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 2002 2003 2004 2005 2006 Source: CNNIC. Source: CNNIC. Note: Includes static and dynamic pages, excludes overlapped pages. Users turning to searches in China With information on the Internet ever expanding, it is natural that users turn to search engines to get organized information on the Internet. As a result, the number of searches in China is expected to increase by more than 4-fold from 2003 to 2008. According to the 2006 CNNIC report, more than 80% of Internet users perform a search every time they get on line. 109
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Figure 79: Number of searches per day in China Figure 80: Number of searches per user daily 400 357 2.5 350 2.0 1.9 295 2.0 1.8 300 1.7 236 1.5 250 1.3 1.5 200 177 136 150 96 1.0 100 0.5 24 0.5 50 0 0.0 2002 2003 2004 2005 2006 2007E 2008E 2002 2003 2004 2005E 2006E 2007E 2008E Number of search per day (million, Left) Search per Internet user per day (Left) Source: I Research, JPMorgan estimates. Source: I Research, JPMorgan estimates. Note: Includes traffic form toolbar and address bar. Note: Includes traffic form toolbar and address bar. Search market outlook: Advertisers’ readiness Online advertising accounts for only ~7% of the total ad spending in China in 2007. The search revenue is even smaller, at approximately 37% of the online ad market. As in the US, we believe the paid search ad is particularly well-suited for small and medium enterprises (SME) in generating sales leads. Yet, as with the low Internet adoption rate in China, paid search is still a new advertising concept for these advertisers. Continuous education/marketing are required to drive market growth. Large available SME market for search advertising but low Internet usage According to the National Development and Reform Commission, Department of Small and Medium-Sized Enterprises figures, as of end 2005, there were 43 million SMEs in China. These SMEs are mainly 39 million individual businesses (these are small businesses registered with some government departments). Statistics from SAIC (State Administration for Industry & Commerce) suggest that the number of SMEs in China is roughly 24 million. Despite the discrepancies, we believe the overall number of SMEs is large. According to SAIC, as of end of 2005, there were 4.3 million larger-size SMEs (that are registered directly with SAIC). The total number of websites in China is 843,000 (as of December 2006). We estimate 60% of the websites are corporate (excluding personal sites, bulletin boards, and inactive sites). Therefore, the number of corporate websites in China is roughly 506,000. The Internet penetration rate among larger SMEs is 12%, roughly in line with personal Internet penetration rate of 12.2% (or 162 million). We do not think the market is saturated Based on Baidu’s 2Q07 active marketing customers of 128,000, the company’s penetration among larger SMEs is 2.9%. Hence, we believe the market is far from reaching saturation point.110
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com 50% of corporate websites get fewer than 50 page views per day According to the CNNIC survey, about 50% of all corporate websites in China have fewer than 50 page views per day. With a low hit rate, we believe corporates would use the search engine market (both search engine optimization and paid search) to increase traffic to their sites and as a result generate new business leads. Figure 81: China—Number of SMEs by different segments SME with websites 500 k Larger-size 4.3 million SME Individual 20 - 42 million businesses Source: SAIC, JPMorgan estimates. Ecommerce should be another growth driver We expect C-C eCommerce to see better adoption in the next few years driven by factors such as: (1) better acceptance for “mail order” (China’s catalogue sales are non-existent, and most transactions are done faceto-face) through increased marketing, more variety, and increased adoption of home TV shopping networks, (2) improved trust and safety features by eCommerce sites, and (3) more regulated online payment infrastructure. In the US, eCommerce companies are leading users of paid search advertising. We believe a similar trend will emerge in China, too, as paid search is an effective method to target prospective buyers who already have items in mind. Currently, leading online search advertisers in China include Alibaba, Taobao, Dangdang, Joyo, Ctrip, and eLong. Given the expected higher growth in eCommerce, we expect paid search to benefit from this growth. Local search: Another promising area Similar to the US, we believe there is a large commercial potential for local search in China. Particularly, there are a large number of households/individual businesses eager to promote their local businesses. In addition, IP address assignment is quite well organized in China. We expect IP-based marketing to be more popular going forward as online advertisers are more sophisticated. 111
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com IT outsourcing companies are the main educators for search usage The two types of companies that help drive paid search usage of SMEs are ad agencies and IT outsourcing companies. While ad agencies mainly focus on companies that already have websites, IT outsourcing companies target SMEs that are less sophisticated in IT infrastructure. IT outsourcing companies such as Sino-I (250.HK), and Hichina (net.cn), provide one-stop services for SMEs—domain name registration, web hosting, website design, promotions (mainly through search engine optimization (SEO), paid search, directory listing). We believe the IT outsourcing companies will be key players in the future to drive Internet adoption growth and search usage for SMEs. China Enterprise (ce.net) (fully owned by Sino-I) is one of the first official agents for Google in China. It has approximately 220,000 customers. The company is a dedicated educator for IT services in China with each of its 77 offices conducting regular meetings for entrepreneurs and SMEs. We believe this kind of education will help expand the number of advertisers for online search services. Ad agencies would have to drive search market growth Paid search marketing campaigns are usually more involved than display ads. Advertisers need to decide on what keywords to use, the number of keywords, bidding strategy and bidding period. In addition, more sophisticated advertisers also pay attention to competitors’ strategy, lead quality and ROI. A well-run search campaign is arguably more difficult than banner ads where advertisers simply design the banners and place them on as many relevant websites as possible. Furthermore, budgets for search campaigns are more difficult to manage as spending is based on the number of clicks, which non-experienced advertisers do not have control over. The ad spending amount essentially has no limit. Hence, advertisers are generally quite cautious about the initial spending and only allocate a small daily budget for trial, or even worse, just give up on paid search campaigns. We believe education by agents and distributors can eventually help advertisers overcome these barriers, and advertisers will thus increase their budgets on search campaigns. Search market outlook: Monetization We expect monetization of the paid search market to grow quickly driven by both higher search usage by users and better adoption by advertisers. The coverage ratio is low compared with the US, and we expect it to increase and drive monetization of the market. Self-fueling cycle to expand monetization We view the market as a self-fueling cycle driven by user and advertiser growth. Higher search usage typically leads to a higher number of sales leads for advertisers. With more high-quality leads coming from paid search, advertisers would place more keywords in more search engines. As users find more relevant product information by advertisers, they likely will conduct more searches, thus leading to higher usage. This cycle should continue and lead to market-size expansion.112
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Selling channel comparison Baidu: Mixed distribution strategy In top cities, such as Beijing, Shanghai, and in the Dongguan/Guandong province area, Baidu builds up its in-house sales force to distribute its own products. In most other cities, it uses distributors to sell products. The company has a mixed strategy in Shenzhen, where it has its own sales office and distributor. Typically, Baidu only grants exclusive rights to one distributor in each geographic area. Distributor discount We believe Baidu gives distributors discounts of around 30%-40%, lower than other search engines (such as Sogou and Zhongsou), which give discounts of 40%-50%. We believe agents accept this lower discount because Baidu generates a higher number of clicks, and as such higher absolute revenue. Google: Distribution strategy still uncertain From mid-2005 to late-2006, Google has signed roughly 20 authorized resellers in China. However, we believe that some of these distributors have ended their partnerships with Google. The main reason is the low distributor discount. We believe Google only offers less than 10% of profits to distributors vs. roughly 30% by Baidu. Google, in our opinion, faces a dilemma. If the company offers larger discounts in China, advertisers in other countries may place their ads through distributors in China, and potentially obtain a discount, therefore, impacting Google’s revenue. We also believe that Google’s distribution is still significantly behind Baidu in terms of penetration. Yahoo! While the Alibaba group has an internal sales force of over 3,500 across the country, Yahoo! search mainly relies on third-party distributors. Sohu Sohu also uses distributors for its search products. Distributors are typically exclusive for each region. Search market outlook: Key Issues with segment growth Fraudulent clicks and trust issue to weigh on industry growth Although not addressed in detail by industry players, we believe fraudulent clicks are a significant problem. Parties that could benefit from fraudulent clicks are value chain players—search engine companies, search partner sites, distributors, and agencies -- as more clicks could translate into more commissions or advertising fees. Table 61: Search ad buyers’ attitude to invalid clicks (click-fraud + accidental clicks) issue Issues % of Respondents Invalid click issue is not a significant concern 3% Invalid click rate is within acceptable limit 28% Its OK if ROI is OK 23% Invalid click rate is too high and discouraging 39% I am not aware of invalid clicks 6% Sum 100% Source: China IntelliConsulting (CIC). 113
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Unethical practices by ad agencies remain a risk As most search advertisers turn to agents to manage their ad campaigns, agents have full access to advertisers’ accounts. It is not uncommon for some ad agencies to deceive advertiser clients (as per search ad buyer surveys) by, for example, increasing the bid price for keywords or adding some unrelated high-price keywords (and receiving monetary benefits from search partner sites or search engines), or even colluding in fraudulent clicks (as previously mentioned). Despite this industry- wide issue, advertisers continue to place ads on search sites, which we believe demonstrates that search advertising provides a reasonable ROI (return on investment) despite fraudulent click issues. Nonetheless, we believe unethical practices by ad agencies remain a risk to healthy long-term growth of the search advertising market in China. Regulatory Risks Search companies are in an interesting position. On one hand, search engines try to index as much information as possible, on the other hand, some of these materials may be deemed to be politically sensitive. We believe Chinese Internet companies in general are cautious about the issue, and avoid keywords/results content that could be sensitive. We believe this political risk has existed since the beginning of the Internet in China 10 years ago, and none of the major websites were closed because of it (the only widely mentioned incident was the Google site being blocked in China in 2002). Hence, we do not believe the political risk is high. We also do not expect search companies’ revenue growth to be affected by politically sensitive content, as they are difficult to commercialize, and we believe search companies have no interest in including them in search results.114
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Online Gaming Robust growth outlook for online gaming The online gaming sector witnessed revenue acceleration in 2007, with 55% YoY growth, and reached ~US$1.33 billion, as per our estimates. The MMORPG segment (~85% of total gaming market) grew 54% YoY to reach ~US$1.12 billion in 2007, as per our estimates, with the success of the free-to-play (item-based sales) model being among the key factors. The casual game segment, meanwhile, grew 56% YoY to reach ~US$206 million in 2007. For 2008, we forecast ~37% YoY growth in the MMORPG segment and ~43% YoY growth in casual games. With more game companies having listed in 2H07, we expect leaders and laggards to emerge. We maintain Shanda (leading free-to-play game operator, strong operating and marketing capabilities and healthy game pipeline) as our top pick in the gaming sector. Table 62: China MMORPG Market Forecast 2005 2006 2007E 2008E 2009E 2010E 2011E MMORPG gamers (million) 18.9 24.6 34.4 44.7 55.9 66.0 75.9 Internet users (million) 111.0 137.0 175.0 200.3 220.8 238.8 258.3 Game users penetration 17.0% 17.9% 19.7% 22.3% 25.3% 27.6% 29.4% Average ARPU per month (RMB) 21.7 20.5 20.7 21.7 22.4 22.8 23.3 Market size (RMB million) 4,918 6,043 8,544 11,663 15,016 18,073 21,200 MMORPG Market size (US$M) 592 728 1,124 1,535 1,976 2,378 2,789 Growth Rate: 35% 23% 54% 37% 29% 20% 17% Source: iResearch, JPMorgan estimates. Table 63: China Casual Game Market Forecast 2005 2006 2007E 2008E 2009E 2010E 2011E Casual game players (million) 24.4 32.6 42.4 50.9 59.0 66.1 71.4 Internet Users (million) 111.0 137.0 175.0 200.3 220.8 238.8 258.3 Casual players penetration 22.0% 23.8% 24.2% 25.4% 26.7% 27.7% 27.6% Assumed Ratio of paying users 22% 23% 25% 27% 29% 30% 31% APRU per month (Rmb) 11.0 11.6 12.2 13.5 14.5 15.6 16.7 Market size (RMB million) 708 1,044 1,563 2,227 2,996 3,714 4,435 Casual Market size (US$M) 85 132 206 293 394 489 584 Growth Rate: 82% 54% 56% 43% 35% 24% 19% Source: iResearch, JPMorgan estimates. Key industry drivers We expect continued robust growth of online gaming in China to be driven by: (1) Continued strong Internet user growth in China (‘06-‘10E CAGR of 15%). (2) Upside in gamer penetration, which is still <25% (as % of Internet users); less than half of Korea’s (also below HK and Taiwan); additional gamers particularly from lower-tier cities. (3) Increasing broadband penetration, with 122 million broadband Internet users as of Jun-07, or 75% of total Internet users; CAGR of ~100% over last 5 years. (4) Efforts of game companies - better quality, innovative games and more effective promotions to continue to attract players; also, success of the free-to-play (item- 115
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com based sales) model (contributing ~63% of industry revenues in 2007, up from ~52% in 2006, as per IDC estimates). (5) Limited leisure alternatives - teenagers in first-tier China cities spending more on entertainment like Internet/games, with the trend being replicated in smaller cities. Good understanding of gamers’ needs will be a key success factor for companies Competition within the online gaming industry increased in 2007, with more free games, more competitors, and further public listings (significant capital raised via IPOs in 2H07). With the continuing popularity of the free-to-play model, we believe game companies can continue to generate revenue growth as long as gamers believe it is really “worth it.” Thus, we expect game companies that continue to maintain a good understanding of what gamers will pay for (or strong marketing capabilities), and respond accordingly, to see greater success going forward. Hence, in our view, companies like Shanda (leading free-to-play game operator with strong operating and marketing capabilities) are more likely to capitalize on the robust industry growth. Comparison of leading games and game companies Table 64: Leading MMORPG Companies by Revenue Market Share 2006 9M07 Shanda 22% 24% NetEase 31% 23% Giant Interactive 7% 18% The9 17% 14% Perfect World 2% 6% CDC Games 4% 4% Kingsoft 3% 4% Others 14% 8% Source: Company reports, JPMorgan estimates. Table 65: Leading MMORPGs by PCU (Peak Concurrent Users) (PCU in ‘000s) 1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 Fantasy WWJ (NetEase) 1,236 1,313 1,223 1,335 1,503 1,472 1,443 Sequential growth 18.5% 6.2% -6.9% 9.2% 12.5% -2.1% -1.9% ZT Online (Giant) 120 320 558 755 874 1,073 888 Sequential growth 166.7% 74.4% 35.3% 15.8% 22.7% -17.2% WoW (The9) 610 630 595 680 680 665 809 Sequential growth 15.1% 3.3% -5.6% 14.3% 0.0% -2.2% 21.7% WWJ2 (NetEase) 581 562 593 603 480 505 305 Sequential growth 4.8% -3.3% 5.5% 1.7% -20.4% 5.3% -39.7% Eudemons Online (NetDragon) 26 50 128 325 438 496 527 Sequential growth 92.3% 156.0% 153.9% 34.8% 13.2% 6.3% Yulgang (CDC Games) 330 348 331 333 343 na na Sequential growth 26.9% 5.5% -4.9% 0.5% 3.2% Source: Company reports.116
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Table 66: Leaders in MMOG Active Paying Accounts (Free-to-play Model) (In ‘000s) 1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 Shanda 2,470 2,230 2,140 2,290 2,340 2,720 3,080 Sequential growth -9.7% -4.0% 7.0% 2.2% 16.2% 13.2% Giant Interactive 143 602 698 787 986 1,248 1,318 Sequential growth 321.0% 15.9% 12.8% 25.3% 26.6% 5.6% Perfect World 26 602 695 1,040 1,390 Sequential growth 2215% 15.4% 49.6% 33.7% Sohu 209 690 Sequential growth 230.1% The9 4 194 183 Sequential growth 4995% -5.3% Source: Company reports, JPMorgan estimates. Note: Perfect World: based on item-based games; Sohu: based on TLBB; The9: based on SUN and JJW. Table 67: Leaders in MMOG Quarterly ARPU per Active Paying Account (Free-to-play Model) (In Rmb) 1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 Giant Interactive 84 117 220 220 320 295 305 Sequential growth 39.3% 88.0% 0.0% 45.5% -7.8% 3.5% Shanda 91 137 155 165 177 174 179 Sequential growth 49.7% 13.4% 6.8% 7.1% -1.9% 3.1% Perfect World 12 76 95 98 136 Sequential growth 544.9% 25.2% 2.8% 38.8% Sohu 171 118 Sequential growth -30.8% The9 88 85 175 Sequential growth -3.4% 105.4% Source: Company reports, JPMorgan estimates. Note: Perfect World: based on item-based games; Sohu: based on TLBB; The9: based on SUN and JJW. 117
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com118
  • U.S. Company Previews
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Amazon.com, Neutral ($92.85) We are maintaining our Neutral rating on Amazon. Although we have been impressed with the company’s ability to generate above-market revenue growth despite its size, we believe the stock’s valuation leaves limited room for upside. • Third-party sales growth to offset margin pressure from pricing. As a percentage of units, the company saw third-party sales increase more than 200 bps Y/Y in the first three quarters of ’07. We believe third-party as a % of sales is likely to continue growing in F’08. Further, we believe the platform helps Amazon expand selection, which ranked as the #2 factor influencing shoppers’ site choices in our proprietary survey. We think the more profitable 3P business should help offset margin pressure resulting from the site’s continued competitiveness in the #1 factor, price. As such, we are modeling flat gross margins in F’08, at 22.9%. • Slight improvement in operating margins. We are modeling F’08 operating margin improvement of ~30 bps and F’09 improvement of ~20 bps, partly due to our expectation of increased leverage in expense lines such as tech & content as the company grows. We do not expect any leverage on gross margins, as we expect Amazon will continue to offer discounts to spur continued US sales growth. Additionally, we do not expect material leverage from fulfillment, as the company invests to support sales growth. • 2008 drivers. In our view, the following factors will drive the stock in 2008: (1) Amazon’s continued ability to outperform the eCommerce market’s growth rate; (2) the competitiveness of online offerings from brick-and-mortar retailers; (3) third-party sales mix; (4) potential for tech & content leverage. Additionally, the broader state of consumer spending is likely to have a continued impact on Amazon. • Maintaining 4Q and 2007 estimates. We remain comfortable with our 4Q revenue, GAAP operating income and EPS estimates of $5.3B, $273M and $0.46. For the full year, we expect revenue, GAAP operating income and EPS of $14.5B, $657M, and $1.10. Table 68: Amazon Estimates Snapshot $ in millions, except per share data AMZN Y/Y 4Q07E F07E F08E F09E F07E F08E F09E JPM Revenue 5,325 14,488 17,938 21,269 35.3% 23.8% 18.6% EBITDA 392 1,093 1,474 2,178 84.0% 34.8% 47.8% EPS 0.46 $1.10 $1.51 $1.87 144.2% 37.2% 23.8% Consensus Revenue 5,360 14,504 18,256 22,373 35.4% 25.9% 22.5% EBITDA 393 1,080 1,446 1,884 81.8% 33.9% 30.3% EPS 0.48 1.12 1.61 2.41 148.6% 44.2% 49.2% Source: Company reports, FactSet, JPMorgan estimates 121
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com We See Slight Margin Expansion in F’08 and F09 We think Amazon is poised to continue to benefit from improved leverage across its operating expense lines in the coming years. We think increased scale is likely to help the company boost its operating margins, up 30 bps in F’08 and up ~20 bps in F’09, to 6.3%. Table 69: Key Expense metrics for Amazon.com 2006 2007E 2008E 2009E Fulfillment 8.5% 8.4% 8.3% 8.2% Marketing 2.4% 2.2% 2.2% 2.2% Technology and content 5.7% 5.0% 4.8% 4.7% General and administrative 1.6% 1.4% 1.4% 1.3% Y/Y Change in: Revenue growth 26% 35% 24% 19% Fulfillment 5 bps 8 bps 11 bps 11 bps Marketing -14 bps 19 bps 1 bps 3 bps Technology and content -88 bps 69 bps 16 bps 8 bps General and administrative 8 bps 27 bps 2 bps 2 bps Operating Margin (pro forma) -204 bps 123 bps 30 bps 18 bps Source: Company reports, JPMorgan estimates Our Estimates and Outlook for 2008 We believe Amazon’s F’08 North America sales are likely to slow their pace of growth from the rapid growth exhibited in F’07, with a slightly softer economic outlook likely to cut into retail sales, as well as tougher comps due to the absence of Harry Potter. We are modeling 23% NA sales growth in F’08. Internationally, we expect the company to grow slightly faster, at 25%. International sales should continue to benefit from favorable Y/Y FX rates (even assuming no further weakening of the dollar). We now expect Amazon F’08 revenue of $17.9B, up from $17.4B previously, and we continue to project a 22.9% gross margin. We expect gross margins to see roughly offsetting impact from higher third-party sales on the one hand and more aggressive product pricing, on the other. We are projecting GAAP operating income of $881M, from $844M previously, and EPS of $1.51, up from $1.45, with the upside driven by our higher revenue projections, as we continue to expect the company to post a 6.1% pro forma operating margin. Our Estimates and Outlook for 2009 For F’09, we expect revenue growth to continue to moderate somewhat, as the company drives benefits from better scale and slight improvements in profitability. We are forecasting 19% overall revenue growth, to $21.3B, and slight Y/Y erosion in gross margin, to 22.8%. We are modeling F’09 GAAP operating income of $1.1B, and EPS of $1.87. Valuation and Rating Analysis AMZN trades at a premium to its peers. Our F’07 assumptions yield a 2007 EV/EBITDA multiple of 35.9x our F’07 EBITDA estimate of $1,093M, versus the ecommerce group at 28.2x. AMZN trades at 26.7x our F’08 EBITDA estimate of $1,437M, versus the ecommerce group at 19.1x. Despite strong EBITDA growth in both F07 and F08, we believe that AMZN shares are fully valued.122
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Risks to Our Rating AMZN could outperform if the company is able to successfully expand its third-party relationships faster than we are forecasting, in which case our margin assumptions could be too conservative. Additionally, an ever-growing portion of Amazon’s revenue is from its international business, exposing the company to foreign currency fluctuations. AMZN could underperform if it encounters difficulties in its international expansion, including regulatory hurdles that make the business climate less hospitable and potentially less profitable than the markets where it currently operates. Amazon may have difficulty growing revenues while maintaining its current operating margins. 123
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 70: AMZN Annual Income Statement$ in millions, except per share data FY FY FY FY 2006 2007E 2008E 2009ENet sales 10,711 14,488 17,938 21,269Cost of sales 8,256 11,172 13,826 16,410Gross profit 2,455 3,316 4,111 4,859Gross Margins 22.9% 22.9% 22.9% 22.8% Fulfillment 912 1,223 1,473 1,747 Marketing 259 323 399 466 Technology and content 607 721 873 1,007 General and administrative 176 198 254 284 Other operating expense (income) 10 9 16 16 Stock-based compensation (1) 101 185 216 240 Amortization of other intangibles - - - - Restructuring-related and other - - - -Total operating expenses 2,065 2,659 3,231 3,760Total recurring operating expenses 1,964 2,474 3,015 3,520 - -Operating Profit (Reported) 390 657 881 1,099Operating Profit (Pro Forma) 491 842 1,097 1,339Operating Margin (Reported) 3.6% 4.5% 4.9% 5.2%Operating Margin (Pro Forma) 4.6% 5.8% 6.1% 6.3%EBITDA 702 1,093 1,474 2,178Income (loss) from continuing operations 491 842 1,097 1,339 Interest Income 60 81 89 89 Interest Expense (80) (75) (64) (64) Other Income, net (3) (2) - -Total non-operating expenses, net (23) 4 25 25Income (loss) before equity in losses of equity-method investees 468 846 1,122 1,364Income (loss) before change in accounting principle (reported) 468 846 1,122 1,364 - -Cumulative effect of change in accounting principle - - - -GAAP Income before taxes 377 652 906 1,124Tax Rate 49.6% 29.0% 29.0% 29.0%Provision (benefit) for taxes 187 189 263 326Net income (loss) 281 657 859 1,038 Remeasurement of 6.875% PEACS and other 10 (9) - - Other gains (losses), net - - - -Total Extraordinary Items 10 (9) - -Net income (loss) Reported 190 463 643 798GAAP EPS $0.45 $1.10 $1.51 $1.87Shares Outstanding 425 423 426 428% Of Revenue Fulfillment 8.5% 8.4% 8.2% 8.2% Marketing 2.4% 2.2% 2.2% 2.2% Technology and content 5.7% 5.0% 4.9% 4.7% General and administrative 1.6% 1.4% 1.4% 1.3%Y/Y ChangeRevenue 26% 35% 24% 19% Fulfillment 25% 34% 20% 19% Marketing 34% 25% 23% 17% Technology and content 50% 19% 21% 15% General and administrative 21% 13% 28% 12% PF Operating Income -13% 72% 30% 22%Source: Company reports and JPMorgan estimates.124
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 71: AMZN Quarterly Income Statement$ in millions, except per share data FY 2006 FY 2007E FY 2008E Q1-06 Q2-06 Q3-06 Q4-06 Q1-07 Q2-07 Q3-07 Q4-07E Q1-08E Q2-08E Q3-08E Q4-08ENet sales 2,279 2,139 2,307 3,986 3,015 2,886 3,262 5,325 3,864 3,601 3,910 6,563Cost of sales 1,732 1,630 1,758 3,136 2,296 2,185 2,500 4,191 2,944 2,726 2,971 5,185Gross profit 547 509 549 850 719 701 762 1,134 920 875 938 1,378Gross Margins 24.0% 23.8% 23.8% 21.3% 23.8% 24.3% 23.4% 21.3% 23.8% 24.3% 24.0% 21.0% Fulfillment 190 182 209 331 253 248 285 437 313 299 336 525 Marketing 54 52 63 90 71 63 72 117 89 82 90 138 Technology and content 138 151 156 162 167 176 181 197 205 216 223 230 General and administrative 45 44 49 38 49 49 47 53 62 58 59 75 Other operating expense (income) 3 3 2 2 - 3 3 3 4 4 4 4 Stock-based compensation (1) 11 30 30 30 34 46 51 54 54 54 54 54 Amortization of other intangibles - - - - - - - - - - - - Restructuring-related and otherTotal operating expenses 441 462 509 653 574 585 639 861 726 712 766 1,026Total recurring operating expenses 430 432 479 623 540 539 588 807 672 658 712 972Operating Profit (Reported) 106 47 40 197 145 116 123 273 193 163 173 352Operating Profit (Pro Forma) 117 77 70 227 179 162 174 327 247 217 227 406Operating Margin (Reported) 4.7% 2.2% 1.7% 4.9% 4.8% 4.0% 3.8% 5.1% 5.0% 4.5% 4.4% 5.4%Operating Margin (Pro Forma) 5.1% 3.6% 3.0% 5.7% 5.9% 5.6% 5.3% 6.1% 6.4% 6.0% 5.8% 6.2%EBITDA 160 123 133 286 241 225 235 392 193 433 329 518Income (loss) from continuing operations 117 77 70 227 179 162 174 327 247 217 227 406 Interest Income 15 13 14 18 20 20 23 18 20 20 29 20 Interest Expense (21) (19) (21) (19) (19) (19) (19) (18) (16) (16) (16) (16) Other Income, net (1) 1 4 (7) - (1) (1)Total non-operating expenses, net (7) (5) (3) (8) 1 - 3 - 4 4 13 4Income (loss) before equity in losses of equity-method investees 110 72 67 219 180 162 177 327 251 221 240 410Income (loss) before change in accounting principle (reported) 110 72 67 219 180 162 177 327 251 221 240 410Cumulative effect of change in accounting principle - - - - - - - - - - - -GAAP Income before taxes 96 54 38 189 144 111 124 273 197 167 186 356Tax Rate 46.9% 59.3% 49.6% 48.1% 22.9% 29.7% 35.5% 29.0% 29.0% 29.0% 29.0% 29.0%Provision (benefit) for taxes 45 32 19 91 33 33 44 79 57 48 54 103Net income (loss) 65 40 48 128 147 129 133 248 194 172 186 307 Remeasurement of 6.875% PEACS and other (3) 12 1 - (2) (5) (2) - - - - - Other gains (losses), net - - - - - - - - - - - -Total Extraordinary Items (3) 12 1 - (2) (5) (2) - - - - -Net income (loss) Reported 51 22 19 98 111 78 80 194 140 118 132 253GAAP EPS $0.12 $0.05 0.05 $0.23 $0.26 $0.19 $0.19 $0.46 $0.33 $0.28 $0.31 $0.59 125
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com FY 2006 FY 2007E FY 2008E Q1-06 Q2-06 Q3-06 Q4-06 Q1-07 Q2-07 Q3-07 Q4-07E Q1-08E Q2-08E Q3-08E Q4-08EShares Outstanding 426 426 424 422 420 423 425 425 426 426 426 427% Of Revenue Fulfillment 8.3% 8.5% 9.1% 8.3% 8.4% 8.6% 8.7% 8.2% 8.1% 8.3% 8.6% 8.0% Marketing 2.4% 2.4% 2.7% 2.3% 2.4% 2.2% 2.2% 2.2% 2.3% 2.3% 2.3% 2.1% Technology and content 6.1% 7.1% 6.8% 4.1% 5.5% 6.1% 5.5% 3.7% 5.3% 6.0% 5.7% 3.5% General and administrative 2.0% 2.1% 2.1% 1.0% 1.6% 1.7% 1.4% 1.0% 1.6% 1.6% 1.5% 1.2%Q/Q ChangeRevenue -23% -6% 8% 73% -24% -4% 13% 63% -27% -7% 9% 68% Fulfillment -23% -4% 15% 58% -24% -2% 15% 53% -28% -5% 13% 56% Marketing -19% -4% 21% 43% -21% -11% 14% 63% -24% -8% 10% 53% Technology and content 12% 9% 3% 4% 3% 5% 3% 9% 4% 5% 3% 3% General and administrative -2% -2% 11% -22% 29% 0% -4% 13% 16% -7% 2% 29% PF Operating Income -35% -34% -9% 224% -21% -9% 7% 88% -24% -12% 5% 79% PF Net Income -69% -38% 21% 165% 15% -12% 3% 86% -22% -11% 8% 65%Y/Y ChangeRevenue 20% 22% 24% 34% 32% 35% 41% 34% 28% 25% 20% 23% Fulfillment 17% 19% 26% 35% 33% 36% 36% 32% 24% 21% 18% 20% Marketing 23% 30% 50% 34% 31% 21% 14% 30% 25% 30% 25% 18% Technology and content 68% 62% 44% 32% 21% 17% 16% 22% 23% 23% 23% 17% General and administrative 7% 38% 88% -17% 9% 11% -4% 40% 26% 18% 25% 42% PF Operating Income -9% -42% -42% 25% 53% 110% 149% 44% 38% 34% 30% 24%Additional Revenue 377 386 449 1,009 736 747 955 1,339 849 715 648 1,238Operating profit (11) (55) (51) 46 62 85 104 100 68 55 53 79Contribution Margins -3% -14% -11% 5% 8% 11% 11% 7% 8% 8% 8% 6%Source: Company reports and JPMorgan estimates.126
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 72: AMZN Annual Balance Sheet$ in millions FY-06 FY-07E FY-08E FY-09EASSETS: Cash/Equivalents 1022.0 2610.3 4315.2 6396.9 ST Investments 997.0 543.0 543.0 543.0 Inventories 877.0 1224.8 1575.2 1861.6 A/R, net and other current 477.0 639.0 787.6 930.8Total Current Assets 3373.0 5017.1 7221.0 9732.3 Equipment, Net 457.0 510.0 584.0 682.0 Other LT Assets 139.0 254.0 254.0 254.0 L.T. Investments 199.0 218.0 218.0 218.0 Goodwill/Intang. 0.0 0.0 0.0 0.0 Goodwill 195.0 231.0 231.0 231.0Total Other Assets 990.0 1213.0 1287.0 1385.0Total Assets 4363.0 6230.1 8508.0 11117.3LIABILITIES: Accounts Payable 1816.0 2396.4 2953.5 3490.6 Accrued Expense 716.0 798.8 984.5 1163.5 Unearned Revenue 0.0 0.0 0.0 0.0 Oth. Curr. Liab. 0.0 0.0 0.0 0.0 Curr.Port.LT Debt 0.0 0.0 0.0 0.0 Advertising 0.0 0.0Total Current Liabs 2532.0 3195.2 3938.0 4654.1 Long Term Debt 1400.0 1538.0 1538.0 1538.0 Capital Leases 0.0 0.0Total Long Term Debt 1400.0 1538.0 1538.0 1538.0Total Liabilities 3932.0 4733.2 5476.0 6192.1SHAREHOLDER EQUITY:Total Equity 431.0 1497.0 3032.0 4925.3Liabilities + Equity 4363.0 6230.1 8508.0 11117.3Source: Company reports and JPMorgan estimates. 127
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 73: AMZN Annual Cash Flow Statement$ in millions FY-06 FY-07E FY-08E FY-09EOPERATING CASH FLOWS Net Income 190.3 462.9 643.0 798.2 Depreciation and amortization 205.0 248.0 300.0 338.0 Stock-Based Amort. 101.0 185.0 216.0 232.0 Other operating expense - - Excess tax benefit on stock awards Equity in Loss 2.0 - - - Amort. Intangibles 6.0 3.0 - - Merger/Acquisition - - - - Mrktbl.Secs. (4.0) - - - Remeasurement and other - - Investment Inc/Loss 3.0 - - - Interest Expense 3.0 - - - Accounting Change - - - - Deferred Taxes 23.0 (2.0) - -Changes current assets 245.0 755.9 835.9 1,043.6 Inventories -282.0 (213.0) (347.8) (350.4) Prepaid Exp./Other -103.0 62.9 153.9 182.6 Accounts Payable 402.0 582.8 769.5 904.0 Accrued Expense 203.0 297.3 260.4 307.3 Other Operating 158.0 121.0 - - Non-Cash Items (133.0) (95.0) - - Interest Payable - - - -Cash From Operations 701.3 1573.9 1994.9 2411.7FCF 485.3 1350.9 1704.9 2081.7Y/Y Growth -8.5% 178.4% 26.2% 22.1%INVESTING CASH FLOWS Mat./ST Investments 1,844.0 1,155.0 - - Purch./ST Investment (1,929.0) (777.0) - - Capital Expenditures (216.00) (223.0) (290.0) (330.0) Sale of Subsidiary - - - - Invst. in Affiliates - - - - Acquisitions (32.0) (47.0) - -Cash From Investing (333.0) 108.0 (290.0) (330.0)FINANCING CASH FLOWS Options Exercised 36.0 79.0 - - Tax benefit of stock awards - - Issuance of Common - - - - Options/Common Issue - - - - Proceeds/LT Debt 99.0 33.0 - - Repay. LTD (70.0) (58.0) - - Repayment of Debt (313.0) (17.0) - - Financing Costs - - - - Purch./Sale of Stock (252.0) (248.0) - - Long Term Debt - - - -Cash From Financing (399.0) (118.0) - -Foreign Exch Effects 40.0 24.0 - -Net Change In Cash 9.3 1,587.9 1,704.9 2,081.7Beginning Cash 1,013.1 1,022.4 2,610.3 4,315.2Ending Cash 1,022.4 2,610.3 4,315.2 6,396.9Source: Company reports and JPMorgan estimates.128
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Blue Nile, Neutral ($74.16) We think that NILE will continue to experience both strong revenue growth and margin expansion in F’08. We believe that engagement products are less discretionary than other jewelry purchases and that the company’s value-driven model will be attractive to customers in a weak economy. However, we think that, at the stock’s current valuation, NILE will likely trade in line with its peer group. Hence, we reiterate our Neutral rating. • Gains in traffic and number of purchases likely to continue. Traffic growth accelerated to 20% Y/Y in 3Q’07, the highest third-quarter traffic growth since 2004. We believe that traffic gains are sustainable as the company pursues efficient and targeted marketing, as online shopping penetration rises, and as consumers become more value-oriented in a weak economy. Furthermore, we believe that repeat business accounts for only slightly over 20% of revenue and non-diamond jewelry for ~10%. Given NILE’s high customer satisfaction levels, we believe repeat purchases will continue to climb. • We think international market development will be a priority. At the end of 3Q’07, int’l revenues were only ~7% of total revenue. This is markedly lower than other e-commerce companies such as Amazon and eBay where int’l revenue accounts for ~45% and ~51%, respectively. With the opening of the Ireland operations center, the launch of localized websites in Canada and the UK, planned product introductions, and a more integrated marketing program within the next 1-2 years, we believe intl markets will be a large growth driver in 2008 and 2009. • 2008 Drivers. In our view, the following factors will drive NILE shares in 2008: (1) top-line strength from discounted diamond pricing, (2) increased focus on int’l markets, and (3) operating margin expansion from increased leverage. • Maintaining 4Q07 estimates. We maintain our 4Q’07 revenue, EBITDA, and EPS estimates of $114.3M, $12.8M, and $0.44 (Y/Y growth of 26%, 32%, and 27% respectively). Our current and newly introduced 2009 estimates are in the table below:Table 74: Blue Nile Estimates Snapshot$ in millions, except per share dataBlue Nile 4Q07E F07E F08E F09E F07E Y/Y F08E Y/Y F09E Y/YJPMorgan Revenue 114.32 321.68 388.45 453.79 27.9% 20.8% 16.8% EBITDA 12.80 30.42 36.20 43.83 35.7% 19.0% 21.1% EPS 0.44 1.03 1.23 1.50 14.1% 19.0% 22.1%Consensus Revenue 113.52 321.10 391.43 464.01 21.9% 18.5% EBITDA 12.53 29.27 36.25 45.70 23.8% 26.1% EPS 0.44 1.04 1.30 1.63 25.0% 25.4%Source: JPMorgan estimates, Company data, and Bloomberg 129
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Our Estimates and Outlook for 2008 Our updated 2008 estimates call for Y/Y revenue, EBITDA, and EPS growth of 20.8%, 19.0%, and 19.0%, respectively. Specifically, we are modeling 2008 revenues, EBITDA, and GAAP EPS of $388.5M, $36.2M, and $1.23 (from $384.0M, $36.8M, and $1.22). We believe that the company will intensify its focus on international efforts in 2008, with an emphasis on its UK and Canadian websites. We believe that management has been encouraged with the early response to the sites and will now invest more heavily in growing these ventures. With the opening of the Ireland operations center, the launch of localized websites in Canada and the UK, planned product introductions, and a more integrated marketing program within the next 1-2 years, we believe intl markets will be a more significant growth driver in 2008. Our Estimates and Outlook for 2009 Our newly introduced 2009 estimates call for revenue, EBITDA, and EPS growth of 16.8%, 21.1%, and 22.1%, respectively. Specifically, we are modeling 2009 revenues, EBITDA, and GAAP EPS of $453.8M, $43.8M, and $1.50. We expect top-line growth to continue to be driven by international expansion and believe that the company might start to look at markets outside the UK and Canada. In addition, we expect operating margins to continue to expand due to increased leverage as we believe many of the existing assets can be used to support international expansion. Valuation and Rating Analysis On a P/E basis, NILE trades at 60.4x our F’08 GAAP EPS estimate of $1.22 vs. its e- commerce peers, which trade at 38.1x F’08 estimates. We do not think there is additional multiple expansion opportunity at this time and we maintain our Neutral rating. Risks to Our Rating Blue Nile is highly dependent on its diamond and jewelry suppliers, and it would be difficult for the company’s business model to tolerate large price fluctuations in the price to acquire diamonds and jewelry. Blue Nile faces competition from both offline and online competitors, who operate in different spaces in the jewelry market. Online competitors include: diamond.com, amazon.com, walmart.com, mondera.com, and Ashford. Changes to Internet regulations regarding the collection of state and local taxes could negatively impact Blue Nile’s business, as consumers save a significant amount of money by purchasing jewelry over the Internet. A substantial number of Blue Nile’s shares are owned by insiders, giving NILE management significant voting leverage. Additionally, if the management decided to sell the stock then it could create selling pressure on the stock. If the company successfully executes its international business strategy or gains market share in the US from traditional retailers, our estimate could prove to be too conservative.130
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 75: NILE Annual Income Statement$ in millions, except per share data 2006 2007E 2008E 2009ETotal Revenue 251.6 321.7 388.4 453.8Cost of Revenue 200.7 256.2 309.0 360.4 Pro forma FAS123R adjustment Pro forma Cost of Revs 200.7 256.2 309.0 360.4Gross Profit (Rpt) 50.9 65.4 79.4 93.4Gross Profit (Pforma) 50.9 65.4 79.4 93.4Gross Margin (Rpt) 20.2% 20.3% 20.4% 20.6%Gross Margins (PF) 20.2% 20.3% 20.4% 20.6%SG&A 34.3 42.7 52.0 60.8Restructuring - -FAS 123R Stock based compensation 4.0 5.9 6.3 7.1Total Expenses 34.3 42.7 52.0 60.8Total Recurring Expenses 30.3 36.8 45.7 53.7Operating Profit (Reported) 16.6 22.7 27.4 32.6Operating Profit (Pro Forma) 20.6 28.6 33.7 39.7Operating Margin (Reported) 6.6% 7.1% 7.1% 7.2%Operating Margin (Pro Forma) 8.2% 8.9% 8.7% 8.8%EBITDA 22.4 30.4 36.2 43.8 EBITDA Margin 8.9% 9.5% 9.3% 9.7% Y/Y EBITDA Growth 13.4% 35.7% 19.0% 21.1%Other Income (Expense) 3.4 3.9 4.4 6.0Total Other 3.4 3.9 4.4 6.0Income Before Taxes (Reported) 20.0 26.6 31.8 38.6Income Before Taxes (Pro Forma) 24.1 32.5 38.1 45.7Income Taxes (Rpt) 6.9 9.3 11.2 13.6Income Taxes (Pforma) 8.4 11.4 13.4 16.1 Tax Rate 34.5% 35.1% 35.2% 35.2% Pforma Tax Rate Inc From Ops After Taxes (Rpt) 13.1 17.3 20.6 25.0 Inc From Ops After Taxes (PF) 15.7 21.1 24.7 29.6Extraordinary Item - -Reported Net Income 13.1 17.3 20.6 25.0Pro Forma Net Income 15.7 21.1 24.7 29.6Reported EPS 0.76 1.03 1.23 1.50Pro Forma EPS 0.90 1.26 1.47 1.78Diluted Shares 17.3 16.7 16.8 16.7 0.14 0.23 0.24 0.28% of Total Revenue 15% 36% 19% 22%Cost of Revenue 79.8% 79.7% 79.6% 79.4%Gross Profit 20.2% 20.3% 20.4% 20.6%SG&A 13.6% 13.3% 13.4% 13.4%Y/Y ChangeTotal Revenue 23.8% 27.9% 20.8% 16.8%Cost of Revenue 27.0% 27.6% 20.6% 16.6%SG&A 26.6% 24.5% 21.8% 16.9%Source: Company reports and JPMorgan estimates. 131
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 76: NILE Quarterly Income Statement$ in millions, except per share data FY 2006 FY 2007E FY 2008E Q1-06 Q2-06 Q3-06 Q4-06 Q1-07 Q2-07 Q3-07 Q4-07E Q1-08E Q2-08E Q3-08E Q4-08ETotal Revenue 50.7 56.9 53.2 90.7 67.9 72.1 67.4 114.3 83.5 88.0 81.5 135.5Cost of Revenue 40.3 45.6 42.8 72.0 54.7 57.2 54.0 90.4 66.6 70.0 65.0 107.4 Pro forma FAS123R adjustment 0.0 0.0 0.0 0.0 Pro forma Cost of Revs 40.3 45.6 42.8 72.0 54.7 57.2 54.0 90.4 66.6 70.0 65.0 107.4Gross Profit (Rpt) 10.4 11.3 10.4 18.7 13.2 14.9 13.4 23.9 17.0 17.9 16.5 28.0Gross Profit (Pforma) 10.4 11.4 10.5 18.7 13.2 14.9 13.4 23.9 17.0 17.9 16.5 28.0Gross Margin (Rpt) 20.5% 19.9% 19.6% 20.6% 19.5% 20.7% 19.8% 20.9% 20.3% 20.4% 20.2% 20.7%Gross Margins (PF) 20.5% 20.0% 19.6% 20.6% 19.5% 20.7% 19.8% 20.9% 20.3% 20.4% 20.2% 20.7%SG&A 7.7 7.7 8.3 10.6 9.6 9.9 9.7 13.5 11.7 12.0 12.6 15.7RestructuringFAS 123R Stock based compensation 0.8 0.9 1.2 1.2 1.3 1.4 1.4 1.8 1.3 1.4 1.6 2.0Total Expenses 7.7 7.7 8.3 10.6 9.6 9.9 9.7 13.5 11.7 12.0 12.6 15.7Total Recurring Expenses 6.9 6.9 7.1 9.4 8.3 8.5 8.3 11.7 10.4 10.6 11.0 13.7Operating Profit (Reported) 2.7 3.6 2.2 8.1 3.7 5.0 3.6 10.4 5.3 6.0 3.8 12.3Operating Profit (Pro Forma) 3.5 4.5 3.4 9.3 5.0 6.4 5.0 12.2 6.6 7.4 5.4 14.3Operating Margin (Reported) 5.3% 6.3% 4.1% 9.0% 5.4% 7.0% 5.4% 9.1% 6.3% 6.8% 4.7% 9.1%Operating Margin (Pro Forma) 6.9% 7.9% 6.3% 10.3% 7.3% 8.9% 7.4% 10.7% 7.9% 8.4% 6.7% 10.6%EBITDA 3.9 5.0 3.8 9.7 5.4 6.8 5.4 12.8 7.2 8.0 6.0 15.0 EBITDA Margin 7.8% 8.7% 7.2% 10.7% 7.9% 9.5% 8.0% 11.2% 8.6% 9.1% 7.4% 11.1% Y/Y EBITDA Growth -1.2% 17.5% 5.2% 22.4% 36.9% 37.4% 41.9% 31.9% 33.1% 17.0% 11.2% 17.4%Other Income (Expense) 1.0 1.0 0.7 0.8 1.2 0.8 1.0 1.0 1.1 1.1 1.1 1.1Total Other 1.0 1.0 0.7 0.8 1.2 0.8 1.0 1.0 1.1 1.1 1.1 1.1Income Before Taxes (Reported) 3.7 4.6 2.8 8.9 4.9 5.8 4.6 11.4 6.4 7.1 4.9 13.4Income Before Taxes (Pro Forma) 4.5 5.5 4.0 10.1 6.2 7.2 6.0 13.2 7.7 8.5 6.5 15.4Income Taxes (Rpt) 1.3 1.5 1.0 3.2 1.7 2.1 1.6 4.0 2.2 2.5 1.7 4.7Income Taxes (Pforma) 1.6 1.8 1.4 3.6 2.2 2.6 2.1 4.6 2.7 3.0 2.3 5.4 Tax Rate 35.5% 31.7% 35.6% 35.5% 34.9% 35.4% 35.0% 35.0% 35.2% 35.2% 35.2% 35.2% Pforma Tax Rate 35.6% 32.3% 35.6% 35.5% 34.9% 35.4% 35.0% 35.0% 35.2% 35.2% 35.2% 35.2% Inc From Ops After Taxes (Rpt) 2.4 3.1 1.8 5.8 3.2 3.8 3.0 7.4 4.1 4.6 3.2 8.7 Inc From Ops After Taxes (PF) 2.9 3.7 2.6 6.5 4.0 4.7 3.9 8.6 5.0 5.5 4.2 10.0Extraordinary ItemReported Net Income 2.4 3.1 1.8 5.8 3.2 3.8 3.0 7.4 4.1 4.6 3.2 8.7132
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com FY 2006 FY 2007E FY 2008E Q1-06 Q2-06 Q3-06 Q4-06 Q1-07 Q2-07 Q3-07 Q4-07E Q1-08E Q2-08E Q3-08E Q4-08EPro Forma Net Income 2.9 3.7 2.6 6.5 4.0 4.7 3.9 8.6 5.0 5.5 4.2 10.0Reported EPS 0.13 0.18 0.11 0.34 0.19 0.23 0.18 0.44 0.24 0.27 0.19 0.52Pro Forma EPS 0.16 0.21 0.16 0.39 0.24 0.28 0.23 0.51 0.29 0.33 0.25 0.60Diluted Shares 18.2 17.6 16.7 16.8 16.5 16.6 16.9 16.9 16.9 16.9 16.7 16.7% of Total RevenueCost of Revenue 79.5% 80.1% 80.4% 79.4% 80.5% 79.3% 80.2% 79.1% 79.7% 79.6% 79.8% 79.3%Gross Profit 20.5% 19.9% 19.6% 20.6% 19.5% 20.7% 19.8% 20.9% 20.3% 20.4% 20.2% 20.7%SG&A 15.2% 13.6% 15.5% 11.7% 14.1% 13.7% 14.5% 11.8% 14.0% 13.6% 15.5% 11.6%Q/Q changeTotal Revenue -30.8% 12.3% -6.4% 70.4% -25.2% 6.2% -6.6% 69.7% -26.9% 5.3% -7.3% 66.2%Cost of Revenue -29.3% 13.0% -6.0% 68.2% -24.1% 4.6% -5.5% 67.5% -26.4% 5.2% -7.1% 65.2%SG&A -11.8% 0.5% 6.8% 27.9% -9.6% 3.6% -1.7% 38.4% -13.3% 2.3% 5.6% 24.4%Y/Y ChangeTotal Revenue 14.9% 29.9% 26.8% 23.9% 34.0% 26.7% 26.5% 26.0% 23.0% 22.0% 21.0% 18.5%Cost of Revenue 17.1% 34.7% 30.7% 26.3% 35.6% 25.4% 26.1% 25.5% 21.8% 22.5% 20.4% 18.8%SG&A 25.8% 25.3% 36.7% 21.0% 24.1% 27.9% 17.8% 27.6% 22.3% 20.7% 29.6% 16.5%Source: Company reports and JPMorgan estimates. 133
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 77: NILE Annual Balance Sheet$ in millions 2006 2007E 2008E 2009EAssetsCash and cash equivalents 78.5 135.3 192.0 246.5Restricted cash 0.1 - - -Marketable securities 19.8 - - -Accounts receivable 1.6 2.2 2.1 2.0Inventories 14.6 18.3 18.6 19.0Deferred income taxes 0.6 0.7 0.7 0.7Prepaids and other current assets 0.7 4.1 2.2 (0.1)Total Current Assets 116.0 160.7 215.6 268.2Property and equipment, net 3.4 6.8 8.3 6.6Intangible assets, net 0.3 0.3 0.3 0.3Deferred income taxes, net 2.0 3.0 2.0 2.0Other assets 0.1 0.1 0.1 0.1Total Long Term Assets 5.8 10.1 10.6 9.0Total Assets 121.8 170.8 226.3 277.2LiabilitiesAccounts payable 66.6 74.3 100.2 122.2Accrued liabilities 7.5 8.0 13.1 17.9Accrued marketing - - - -Current portion of deferred rent 0.2 0.2 (0.1) (0.6)Current portion of note payable to related party - - - -Current portion of subordinated notes payable - - - -Current portion of capital lease obligations - - - -Total Current Liabilities 74.3 82.6 113.1 139.6Deferred rent, less current portion 0.7 0.6 0.6 0.6Note payable to related party, less current portion - - - -Capital lease obligations, less current portion - - - -Redeemable convertible preferred stock - - - -Total Long Term Liabilities 0.7 0.6 0.6 0.6Total Liabilities 74.9 83.2 113.7 140.2Shareholder EquityPreferred stock - - - -Common Stock 0.0 - - -Additional Paid in Capital 115.8 - - -Deferred compensation (0.2) - - -Accumulated deficit 6.7 - - -Treasury stock (75.4) - - -Total Equity 46.9 87.6 112.6 136.9Total Liabilities + Equity 121.8 170.8 226.3 277.2Source: Company reports and JPMorgan estimates.134
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 78: NILE Annual Cash Flow$ in millions 2006 2007E 2008E 2009EOperating Cash FlowsNet income 13.1 17.3 20.6 25.0Depreciation and amortization 1.9 1.8 2.5 2.9Loss on asset retirement 0.0 (0.0) - -Stock-based compensation expense 4.4 5.9 6.3 7.1Warrant based interest expense - - - -Restructuring charges - - - -Deferred income taxes 2.7 (1.1) (1.0) (1.0)Tax benefit from exercise of stock options 2.7 6.2 - -Excess tax benefit from exercise of stock options (0.2) (1.6) - -Changes in working capital 15.9 20.0 32.2 28.5 Receivables, net 0.2 (0.6) 0.1 0.1 Inventories (2.9) (1.8) (0.3) (0.4) Prepaid expenses and other assets 0.1 (2.8) 1.9 2.3 Accounts payable 16.5 21.7 25.9 22.1 Accrued liabilities 2.2 3.5 5.1 4.9 Deferred rent (0.2) (0.1) (0.4) (0.5)Cash From Operations 40.5 48.5 60.7 62.5FCF 38.6 43.5 56.7 54.5 27.8% 12.6% 30.4% -3.7%Investing Cash FlowsPurchases of property and equipment (1.9) (5.1) (4.0) (8.0)Proceeds from sales of property and equipment 0.0 0.0 - -Transfers to restricted cash 0.0 0.1 - -Purchase/Sale of marketable securities 23.0 19.8 - -Cash From Investing 21.1 14.8 (4.0) (8.0)Financing Cash FlowsProceeds from sale of common stock, net of issuance costs - - - -Proceeds from sale of mandatorily redeemable convertible preferred stock, net of issuance - - - -costsRepurchase of restricted and common stock (57.4) (13.5) - -Proceeds from stock option exercises 2.3 5.4 - -Excess tax benefit from exercise of stock options 0.2 1.6 - -Net repayments on line of credit - - - -Payments on subordinated notes payable - - - -Payments on capital lease obligations 0 - -Payments on note payable to related party 0 - -Payment on note payable 0 - -Proceeds from warrant and stock option exercises 0 - -Cash From Financing (55.0) (6.6) - -Net Increase (decrease) in cash 6.6 56.8 56.7 54.5Beginning Cash 72.0 78.6 135.3 192.0Ending Cash 78.6 135.3 192.0 246.5Source: Company reports and JPMorgan estimates. 135
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com CNET Networks, Neutral ($8.90) While we believe the CPM growth rate will accelerate in F’08 after a soft F’07, we expect some of the challenges CNET faced in F’07 to persist in the coming year. • Core audience unlikely to grow. We continue to believe that much of the audience for CNET’s core tech vertical is tech savvy and thus already online. As such, the rising tide of continued growth in Internet penetration is not likely to significantly raise the tech sites’ audience. comScore data suggests US users for CNET’s core sites are growing at half the pace of overall US Internet users. (See Figure on next page). • Non-tech verticals outpacing core CNET. Third-party metrics suggest growth at sites such as GameSpot is significantly exceeding that of the core tech vertical. However, we believe it will take time for CNET to drive CPMs at non-tech sites to levels similar to those of core CNET, as the company builds out ad sales forces familiar with those verticals. • Sale of WebShots removes a growth drag. CNET’s sale of WebShots to American Greetings was a positive step, allowing the company to focus on creating and nourishing successful brands. We expect the company to continue to reevaluate its brands and sites going forward. • CPMs appear poised to rise. On a positive note, we think that, after an influx of inventory pressured CPMs in F’07, ad pricing for graphical ads is likely to start growing at a faster pace in F’08 than it has in the past year. • 2008 Drivers. In our view, the following factors will drive the stock in 2008: (1) CPM pricing trends for graphical ads; (2) usage trends at CNET’s core sites; (3) usage uptake at newer CNET verticals; (4) CNET’s ability to monetize non-tech sites; and (5) CNET’s ability to monetize its non-US traffic. • Maintaining Q4’07 and F’07 estimates. We continue to expect CNET to post revenue, EBITDA and EPS of $122M, $36M and $1.29, respectively, in 4Q, and $411M, $82M and $1.12, respectively, for the full year. Table 79: CNET Estimates Snapshot $ in millions, except per share data CNET Y/Y 4Q07E F07E F08E F09E F07E F08E F09E JPM Revenue 122.1 410.9 450.8 494.0 5.9% 9.7% 9.6% EBITDA 36.3 81.9 99.6 117.7 86.1% 21.7% 18.1% EPS 1.29 1.12 0.14 0.22 NM NM 57.1% Consensus Revenue 122.5 410.8 449.4 486.0 5.9% 9.4% 8.2% EBITDA 33.3 70.1 91.5 96.8 59.4% 30.5% 5.8% EPS 1.29 1.12 0.14 0.21 NM NM 56.6% Source: Company reports, FactSet, JPMorgan estimates.136
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Our Estimates and Outlook for 2008 We expect F’08 to see a continuation of many of the trends that CNET encountered in F’07: User growth at core site is slowing The core, tech-focused CNET brand attracts an audience that is tech-savvy, and as such we continue to believe that this core audience has long been online – and increased secular Internet use is unlikely to translate into rapid user growth for the core site. ComScore data for the last two years supports this view: Figure 82: Core CNET user growth below Internet usage growth CAGR, 4Q05 - 4Q07 4% 4% 3% 2% 2% 1% 0% CNET US Internet Source: comScore Networks, JPMorgan Estimates Non-tech sites still in early stages Aside from GameSpot, we believe CNET’s non-tech verticals are still in the early stages of their growth. As such, while we think there is significant promise from these sites, we do not expect significant monetization from them in the near term. Slightly adjusting estimates We think the sale of WebShots suggests CNET is willing to look critically at all of the parts of its portfolio of sites. Further, we are encouraged by the company’s efforts to build relationships with advertisers in non-tech areas and the investments CNET is making outside the US. Additionally, we are more positive on broader CPM growth in the graphical ad market than we were coming into F’07. As such, we now expect F’08 revenue of $451M, up from $444M previously, representing 12% Y/Y growth after adjusting for the sale of WebShots. At the same time, we think higher investment in new products will lead to somewhat lower profitability – we now estimate EBITDA of $100M, from $103M previously. We see F’07 EPS of $0.14, compared to our previous $0.16 estimate. Our Estimates and Outlook for 2009 We are introducing our F’09 estimates for CNET, as follows: we expect 11% revenue growth in F’09, to $494M. We believe profitability will improve due to increased scale and improved pricing, with operating margins rising to 23.8%, from 22.1% in F’08. As such, we are projecting EBITDA of $118M, up 18% Y/Y, and EPS of $0.22. 137
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com By F’09, we think some of CNET’s non-tech verticals will likely be able to contribute more meaningfully, although we think it is likely that there will be some misses in addition to the hits. Further, as online advertising matures in markets outside the US and UK, we think F’09 could be the year when monetization at the company’s international sites improves, although we think it is unlikely to reach parity with US and UK monetization in the foreseeable future. Valuation and Rating Analysis On an EV/EBITDA basis, CNET trades at 13.7x our F’08 EBITDA estimate of $99.6M, in line with a 12.1x for its peer group. Given the secular challenges, we think multiple expansion is unlikely, and as such, we maintain our Neutral rating. Risks to Our Rating CNET is highly dependent on the performance of the online advertising industry. During the recent quarter, the majority of CNET’s revenues came from its Marketing Services business segment. The advertising industry is very susceptible to overarching economic conditions, making a large portion of CNET’s revenues vulnerable to general economic risk. Changes in the competitive landscape or new regulations could also significantly impact CNET’s main revenue stream, presenting a downside risk to our rating. On the contrary, should CNET grow at a faster rate than the online industry or further improve its contribution margins, our outlook could prove to be too conservative. Also, if the company further improves its operating margins, the stock could outperform its peers.138
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 80: CNET Annual Income Statement$ in millions, except per share data FY-06 FY-07E FY-08E FY-09EMarketing services 337.3 363.2 405.3 450.4Licensing 50.3 47.6 45.5 43.7Total Revenue 387.7 410.9 450.8 494.0Cost of Revenue 162.2 166.0 170.9 180.5Gross Profit 225.5 244.9 279.9 313.5Gross Margin 58.2% 59.6% 62.1% 63.5%Sales and Marketing 94.7 106.2 117.7 126.7General and Administrative 50.3 56.8 62.6 69.1Unusual Inc./Expense 13.7 7.8 - -Depreciation 22.8 28.4 36.7 40.8Amort.Intangibles 11.9 12.4 12.8 12.8Asset Impairment 2.8 19.0 - -Stock Compensation 19.8 19.9 23.3 24.0Total Expenses 216.1 250.4 253.1 273.4Total Recurring Expenses 145.0 162.9 180.3 195.8Operating Profit (Reported) 9.4 (5.6) 26.8 40.1Operating Profit (Pro Forma) 80.5 81.9 99.6 117.7Operating Margin (Reported) 2.4% -1.4% 6.0% 8.1%Operating Margin (Pro Forma) 20.8% 19.9% 22.1% 23.8%EBITDA 80.5 81.9 99.6 117.7Realized gain on sale of investments 0.6 2.2 - -Interest Income 4.9 3.3 2.0 2.0Interest Expense (5.0) (5.3) (5.6) (5.6)Other, Net (0.5) 2.4 - -Total Other, Reported (0.1) 2.7 (3.6) (3.6)Total Other, Pro Forma (0.6) 0.5 (3.6) (3.6)Income Before Taxes 9.3 (2.9) 23.2 36.5Income Taxes 1.5 (175.8) 1.5 2.1Tax Rate 15.7% nm 6.4% 5.7%Income After Taxes 7.9 172.9 21.7 34.4Extraordinary Item (0.0) - - -Reported Net Income 7.8 172.9 21.7 34.4Reported EPS 0.05 1.12 0.14 0.22Diluted Shares 152.3 153.3 154.7 155.9% of Total RevenueMarketing services 87.0% 88.4% 89.9% 91.2%Licensing 13.0% 11.6% 10.1% 8.8%Sales and Marketing 24.4% 25.8% 26.1% 25.7%G&A 13.0% 13.8% 13.9% 14.0%Q/Q changeMarketing servicesLicensingG&AY/Y ChangeMarketing services 8% 12% 11%Licensing -5% -4% -4%Total Revenue 15% 6% 10% 10%Sales and Marketing 21% 12% 11% 8%G&A 14% 13% 10% 10%Source: Company reports and JPMorgan estimates. 139
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 81: CNET Quarterly Income Statement$ in millions, except per share data FY 2006 FY 2007E FY 2008E 1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 4Q07E 1Q08E 2Q08E 3Q08E 4Q08EMarketing services 71.2 79.8 80.7 105.7 80.1 85.5 87.6 110.0 87.3 94.9 95.4 127.6Licensing 12.4 12.6 12.6 12.7 12.0 11.7 11.9 12.1 11.4 11.1 11.3 11.7Total Revenue 83.7 92.4 93.3 118.4 92.1 97.2 99.5 122.1 98.7 106.0 106.8 139.3Cost of Revenue 39.5 38.6 40.1 44.0 41.7 40.5 40.9 42.8 42.3 42.0 41.4 45.1Gross Profit 44.2 53.8 53.2 74.3 50.4 56.7 58.6 79.2 56.4 64.0 65.4 94.2Gross Margin 52.8% 58.2% 57.0% 62.8% 54.7% 58.3% 58.9% 64.9% 57.1% 60.4% 61.2% 67.6% Sales and Marketing 22.1 23.8 22.3 26.5 25.1 26.8 26.8 27.5 27.8 29.9 28.6 31.3 General and Administrative 12.1 11.1 12.4 14.7 13.5 13.7 14.1 15.5 14.8 14.9 15.7 17.1 Unusual Inc./Expense - 1.4 5.8 6.5 4.4 2.9 0.4 0.1 - - - - Depreciation 4.8 5.3 5.9 6.9 7.5 7.0 6.8 7.2 8.5 8.9 9.4 9.9 Amort.Intangibles 2.7 2.7 3.2 3.2 3.2 3.2 3.3 2.7 3.2 3.2 3.2 3.2 Asset Impairment - - 1.4 1.4 - - 19.0 - - - - - Stock Compensation 4.8 4.6 5.0 5.4 5.2 4.1 4.7 6.0 5.7 5.4 6.1 6.1Total Expenses 46.5 49.0 56.0 64.6 58.9 57.6 75.1 58.8 60.0 62.3 63.0 67.7Total Recurring Expenses 34.2 35.0 34.7 41.2 38.6 40.5 40.9 43.0 42.6 44.8 44.3 48.5Operating Profit (Reported) (2.3) 4.8 (2.8) 9.7 (8.5) (1.0) (16.5) 20.4 (3.7) 1.7 2.3 26.5Operating Profit (Pro Forma) 10.0 18.8 18.5 33.1 11.8 16.2 17.7 36.3 13.7 19.2 21.0 45.7Operating Margin (Reported) -3% 5.2% -3.0% 8.2% -9% -1.0% -16.5% 16.7% -3.7% 1.6% 2.2% 19.0%Operating Margin (Pro Forma) 11.9% 20.4% 19.8% 28.0% 12.8% 16.6% 17.8% 29.7% 13.9% 18.1% 19.7% 32.8%EBITDA 10.0 18.8 18.5 33.1 11.8 16.2 17.7 36.3 13.7 19.2 21.0 45.7 Realized gain on sale of investments 0.5 - 0.1 - - 1.6 0.6 - - - - - Interest Income 1.2 1.3 1.6 0.9 0.6 0.9 1.0 0.7 0.5 0.5 0.5 0.5 Interest Expense (0.7) (0.7) (0.7) (3.0) (1.3) (1.3) (1.2) (1.4) (1.4) (1.4) (1.4) (1.4) Other, Net 0.1 (0.1) (0.0) (0.5) 0.3 (0.2) 0.9 1.5 - - - -Total Other, Reported 1.1 0.5 0.9 (2.7) (0.4) 1.0 1.2 0.8 (0.9) (0.9) (0.9) (0.9)Total Other, Pro Forma 0.6 0.5 0.9 (2.7) (0.4) (0.6) 0.7 0.8 (0.9) (0.9) (0.9) (0.9)Income Before Taxes (1.2) 5.4 (1.9) 7.1 (8.9) 0.0 (15.2) 21.2 (4.6) 0.8 1.4 25.6Income Taxes 0.1 0.2 0.4 0.8 0.2 0.1 1.4 (177.5) 0.1 0.0 0.1 1.3 Tax Rate -6% 4% -22% 11% nm nm nm nm 5% 5% 5% 5% Income After Taxes (1.3) 5.2 (2.3) 6.3 (9.1) (0.1) (16.6) 198.7 (4.7) 0.7 1.4 24.3Extraordinary Item (0.0) - - - - - - - - - - -Reported Net Income (1.3) 5.2 (2.3) 6.3 (9.1) (0.1) (16.6) 198.7 (4.7) 0.7 1.4 24.3Reported EPS $ (0.01) $ 0.03 $ (0.02) $ 0.04 $ (0.06) $ (0.00) $ (0.11) $ 1.29 $ (0.03) $ 0.00 $ 0.01 $ 0.16140
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comDiluted Shares 148.7 152.8 149.8 152.6 150.4 151.3 151.7 154.0 154.3 154.6 154.9 155.2% of Total RevenueMarketing services 85.2% 86.4% 86.4% 89.3% 87.0% 88.0% 88.0% 90.1% 88.5% 89.5% 89.4% 91.6%Licensing 14.8% 13.6% 13.6% 10.7% 13.0% 12.0% 12.0% 9.9% 11.5% 10.5% 10.6% 8.4%Sales and Marketing 26.4% 25.8% 23.9% 22.4% 27.2% 27.6% 26.9% 22.5% 28.2% 28.2% 26.8% 22.5%G&A 14.5% 12.1% 13.3% 12.4% 14.7% 14.1% 14.1% 12.7% 15.0% 14.1% 14.7% 12.3%Q/Q changeMarketing services #DIV/0! 12.0% 1.1% 31.0% -24.2% 6.7% 2.4% 25.6% -20.6% 8.7% 0.5% 33.7%Licensing #DIV/0! 1.3% 0.5% 0.5% -5.7% -2.6% 2.4% 1.0% -5.7% -2.6% 2.4% 3.2%G&A -1.7% -8.1% 11.0% 18.7% -7.9% 1.1% 3.0% 10.1% -4.5% 1.0% 5.0% 9.2%Y/Y ChangeMarketing services 19% 14% 13% n/a 12% 7% 9% 4% 9% 11% 9% 16%Licensing 7% 15% 14% n/a -4% -7% -6% -5% -5% -5% -5% -3%Total Revenue 17% 14% 13% 14% 10% 5% 7% 3% 7% 9% 7% 14%Sales and Marketing 19% 21% 14% 26% 14% 13% 20% 4% 11% 11% 7% 14%G&A 12% -8% 1% 19% 11% 23% 14% 6% 9% 9% 11% 11%Source: Company reports and JPMorgan estimates. 141
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 82: CNET Annual Balance Sheet$ in millions FY-06 FY-07E FY-08E FY-09EAssets Cash/Equivalents 31.3 125.4 178.7 241.1 Marketable Debt Sec. 30.4 16.0 16.0 16.0 Marketable Equity - - - - Acct. Receivable 90.4 97.7 111.4 121.3 Other Current 10.4 12.2 13.9 15.2 Dfrd. Income Tax - - - -Total Current Assets 162.6 251.2 320.0 393.5 Restricted Cash 2.2 1.6 1.6 1.6 Debt Sec. Investment 13.9 0.5 0.5 0.5 Equity Invest. - - - - Prop. & Equip., Net 72.6 71.8 71.8 71.8 Other Assets 15.6 14.2 14.2 14.2 Dfrd. Income Taxes - - - - Intangibles, Net 34.8 37.6 37.6 37.6 Goodwill 133.2 101.5 101.5 101.5Total Assets 434.9 478.3 547.1 620.7Liabilities Accounts Payable 10.1 11.0 12.5 13.6 Line of Credit 60.0 60.0 60.0 60.0 Accrued Liabilities 80.4 79.3 90.5 98.5 Cur. Port. LT Debt 13.8 3.3 3.3 3.3 Tax Related - - - - Dfrd. Tax Liabs. - - - - Bank Overdraft - - - -Total Current Liabs 164.2 153.7 166.4 175.5 LTD 4.5 2.8 2.8 2.8Total Long Term Debt 4.5 2.8 2.8 2.8 Other Liabilities 0.7 4.1 4.1 4.1Total Liabilities 169.4 160.6 173.4 182.5Shareholder Equity Common Stock 0.0 - 0.0 0.0 Paid in Capital 2,857.2 - 0.0 0.0 Other Equity (11.4) - 0.0 0.0 Conv. Pref. Stock & Deferred Stock Comp - - 0.0 0.0 Accumulated Deficit (2,550.1) - 0.0 0.0 Treasury Stock (30.5) - 0.0 0.0Total Equity 265.3 317.7 373.8 438.2Total Liabilities + Equity 434.9 478.3 547.1 620.7Source: Company reports and JPMorgan estimates.142
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 83: CNET Annual Cash Flow Statement$ in millions FY-06 FY-07E FY-08E FY-09EOperating Cash Flows Net Income 7.8 172.9 21.7 34.4 Depreciation & Amort 34.7 40.8 49.5 53.6 Stock compensation expense 19.8 19.9 23.3 24.0 Deferred Taxes - (177.5) - - Fair Value Remeasurement Non-Cash Items - (0.1) - - Noncash Interest (0.6) (0.1) - - Goodwill Impairment 2.8 19.0 - - Loss-Sale of Assets 0.3 - - - Debt Retirement - - - - Extraordinary Loss - - - - Doubtful Accounts 2.5 1.6 - - Gain on Sale of Business (0.3) - - - Investment Sales & Equity Loss (0.6) (2.2) - -Working Capital (4.6) 0.1 - -Cash From Operations 61.8 73.7 94.5 112.0FCF 29.0 42.7 48.5 57.7Investing Cash Flows Purch.-Mktbl. Secs. - - - - Purch.- Mktbl. Debt (45.5) (9.4) - - Proc. Mktbl. Debt 57.6 38.7 - - Proc. Mktbl. Equity - 1.6 - - Release of restrictions on cash 0.1 0.6 - - Other Investing 3.1 2.5 - - Capital Expenditures (32.8) (31.0) (46.0) (54.3) Cash Acq. & Asset Sales, Net (14.5) 5.4 - -Cash From Investing (32.1) 8.5 (46.0) (54.3)Financing Cash Flows Pmt from Sharehold notes - (0.0) - - Net borrowing on credit facility - (0.0) - - Pmt from Employee stk plan - - - - Purch./Sale of Stock - - - - Payments-Cap. Leases - - - - Debt, Net (62.9) - - - Common/Options/ESOP 7.3 11.7 4.7 4.7Cash From Financing (55.7) 11.6 4.7 4.7Net Increase (decrease) in cash (25.9) 93.8 53.3 62.5Foreign Exch Effects 1.4 0.2 - -Beginning Cash 55.9 31.3 125.4 178.7Ending Cash 31.3 125.4 178.7 186.5Source: Company reports and JPMorgan estimates. 143
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com eBay, Overweight ($34.49) After Y/Y listings declines in the first nine months of F’07, 4Q’07 saw reaccelerated listings growth, and the company has made several incremental structure and pricing changes intended to strengthen the core site. We maintain our optimistic outlook as we see continued RPL and listings growth in F’08 and F’09, and believe the PayPal franchise’s increasing off-eBay penetration remains a growth driver for the company. • PayPal is a catalyst for growth. PayPal is no longer just a lubricant for the eBay marketplace; in the first three quarters of ’07, 41.5% of PayPal TPV was off-eBay, a rise of over 650 bps Y/Y. We think this trend is likely to continue, and thus we are projecting PayPal revenue to grow 25% in F’08 and 23% in F’09, even as eBay GMV rises 10% in both years. • Will eBay experiment with site structure? The company has made public statements suggesting alternative fee schedules for the core site may be considered, possibly shifting toward lower listing fees and higher final- value fees. We believe the ’06 shift in Stores listings has ensured that eBay will make changes very tentatively and after experimentation. Additionally, we expect revenue loss from the introduction of lower listing fees will be offset by higher final value fees and faster listings growth. As such, we expect neutral near-term impact from site structure changes. • Strong growth from StubHub!, ad revenues and classifieds. We believe eBay’s businesses outside the core marketplace are poised for continued strength in F’08. We think the international expansion of StubHub! presents a significant growth opportunity, and we believe eBay is likely to start reaping increased rewards as its advertising deal with Google matures. • 2008 Drivers. In our view, the following factors will drive the stock in 2008: (1) RPL improvements; (2) impact of promotions and price changes on marketplace ecosystem; (3) growth in non-GMV businesses; (4) improved int’l PayPal penetration; (5) growing PayPal presence off-eBay. • Maintaining 4Q’07 and F’07 estimates. Our listings tracking and conversations with sellers give us confidence in our 4Q’07 revenue, EBITDA and pro forma EPS estimates of $2.19B, $726M and $0.40. For the full year, we expect $7.68B, $2.55B and $1.48, respectively. Table 84: eBay Consensus Snapshot $ in millions, except per share data EBAY Y/Y 4Q07E F07E F08E F09E F07E F08E F09E JPM Revenue 2,193 7,685 9,007 10,506 28.7% 17.2% 16.6% EBITDA 811 2,863 3,337 3,754 1.6% 17.7% 13.9% EPS 0.40 1.48 1.70 1.98 41.2% 14.6% 16.7% Consensus Revenue 2,136 7,632 9,031 10,603 27.8% 18.3% 17.4% EBITDA 823 2,915 3,392 3,848 16.4% 16.4% 13.5% EPS 0.40 1.49 1.66 1.94 41.8% 11.6% 16.9% Source: Company reports, FactSet, JPMorgan estimates.144
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Key Financial Metrics and Forecasts The following tables summarize our revenue forecast by business segment as well as our estimate for Y/Y growth in key auction metrics. Table 85: eBay Revenue Forecast by Segment $ in millions 2006A 2007E 2008E 2009E Gross Merchandise Volume (GMV) 52,473 59,384 65,362 71,573 % change Y/Y 18% 13% 10% 10% Payment revenue 1,402 1,817 2,278 2,805 eBay online revenue 4,203 5,206 5,795 6,439 Total Transaction revenue 5,605 7,023 8,073 9,244 3rd party advertising revenue 172 294 424 572 Skype 193 368 510 690 Total Online Revenue 5,970 7,685 9,007 10,506 Source: Company reports and JPMorgan estimates Table 86: eBay Auction Metrics forecasts Auctions in millions 2006A 2007E 2008E 2009E Auctions (M) 2,366 2,374 2,499 2,670 % change Y/Y 0.4% 5.3% 6.8% GMV/Auction $ 22.17 $ 25.06 $ 26.18 $ 26.83 % change Y/Y 13.1% 4.4% 2.5% eBay Online Revenue / Auction $ 1.78 $ 2.19 $ 2.32 $ 2.41 % change Y/Y 23.5% 5.7% 4.0% Source: Company reports and JPMorgan estimates Our Estimates and Outlook for 2008 With the marketplace changes resulting from the August 2006 price rebalancing fully anniversaried, we think eBay is poised to follow roughly flat F’07 Y/Y listings growth with 5% Y/Y listings growth in F’08. At the same time, we think the company can improve revenue per listing 6% Y/Y in F’08. We think PayPal revenues can grow 25% Y/Y (after a projected 30% Y/Y growth rate in F’07). As such, we are now modeling F’08 revenue of $9.0B, up ~$10M from our previous estimate. We are projecting ~36 bps operating margin erosion, to 31.9%, and EBITDA of $3.0B, up from $2.97B. We are raising our pro forma F’08 EPS estimate for eBay to $1.70, from $1.68 previously. Our Estimates and Outlook for 2009 For F’09, we expect eBay’s marketplace improvements to help generate a healthier buyer-seller ecosystem, driving a slight acceleration in listings growth, to 7% Y/Y. At the same time, we think RPL growth is likely to slow somewhat, and we are projecting RPL up 4% Y/Y in F’09. In part, we expect slower RPL growth as the rate of increase moderates at non-GMV businesses such as StubHub! as they reach greater size. Likewise, we expect PayPal revenue growth to slow slightly in F’09, to 23%. Our forecast calls for F’09 revenue of $10.5B, EBITDA of $3.41B and pro forma EPS of $1.98. We expect operating margin erosion of ~60 bps, driven by gross 145
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com margin pressure from a revenue mix that tilts more heavily toward lower-gross- margin PayPal revenue. Valuation and Rating Analysis On an EV/EBITDA basis, eBay trades 12.7x our F’08 estimate, compared to its peers at 18.0x F’08 estimates. We think such a discount is unwarranted.. We thus reiterate our Overweight rating. Risks to Our Rating Risks associated with our Overweight rating include: barriers to international expansion, competition from sponsored search vendors, the company’s dependence on eBay Motors, competition from hardline retailers, risks associated with patent litigation, and valuation risks. International expansion is a concrete part of eBay’s growth strategy. As the company continues to grow outside the U.S., it may face regulatory challenges and/or markets that make its business less profitable than it is in the U.S. or other countries where it is already established. Thus far, we believe eBay’s international expansion has been carried out in a strategic and timely manner. eBay also faces risks from hardline retailers. Although the bulk of eBay’s revenues come from the beginning and end of the retail life cycle, with each passing quarter, the percentage of revenue it earns from the in-season retail and fixed price sales continues to increase. This puts the company in competition with traditional retailers and other e-tailers, including Amazon.com, Wal-Mart, BestBuy, and Home Depot. Failure to meet these challenges could lead to relative stock price underperformance.146
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 87: EBAY Annual Income Statement$ in millions, except per share data FY FY FY FY 2006A 2007E 2008E 2009EGross Merchandise Volume (GMV) $52,473.0 $59,383.5 $65,361.8 $71,573.3 % Change Y-Y 18% 13% 10% 10% % Change Q-Q Payment revenue 1,401.8 1,817.1 $2,278.4 $2,805.0 eBay online revenue 4,203.3 5,206.0 $5,794.5 $6,438.6 Total transactions 5,605.2 7,023.0 $8,073.0 $9,243.7 3rd party advertising revenue 171.8 293.7 $424.3 $572.1 Skype 192.8 368.0 $510.0 $690.0 End-to-end Services - - - -Total Online Revenue 5,970 7,684.7 $9,007.3 $10,505.8Offline revenue - - - -Total revenue 5,969.7 7,684.7 9,007.3 10,505.8Cost of revenue 1243.1 1,770.0 2,164.9 2,637.4COGS pro forma adjustment -11.3 (27.5) - -Gross Profit 4726.7 5,914.6 $6,842.4 $7,868.4Gross Profit (pro forma) 4759.6 5,942.2 $6,842.4 $7,868.4Pro Forma Gross Margin 79.7% 77.3% 76.0% 74.9%Sales and Marketing 1654.7 1,958.9 2,232.0 2,550.9Product Development 494.7 641.2 807.7 921.1General and Admin. 941.2 1,162.9 1,217.3 1,394.2Amort., Payroll Taxes, merger other 213.1 1,598.7 228.0 228.0Total Operating Expenses 3303.7 5,361.7 4,485.1 5,094.2Pro forma op ex adjustments:Sales & marketing (96.55) (64.49) - -Product development (81.49) (56.77) - -G&A (106.39) (83.39) - -Payroll exp on empl stock options (5.32) (5.36) - -Amort of acqd assets (214.9) (1,557.1) - -Total (504.68) (1,895) (512) (512)Pro forma operating expenses 2799.0 3,466.6 3,973.1 4,582.2Operating Profit (reported) 1423.0 552.9 2,357.3 2,774.2 Operating Margin (reported) 23.8% 7.2% 26.2% 26.4%Operating Profit (pro forma) 1960.6 2475.5 2869.3 3286.2 Operating Margin (pro forma) 32.8% 32.2% 31.9% 31.3%Interest and other income, net 130.0 137.4 165.0 195.0Interest Expense (5.9) (13.0) (14.0) (14.0)Net Interest Income 124.1 124.3 151.0 181.0Pro forma adjustment - - - -Pro forma interest 124.1 124.3 151.0 181.0Impairment of Equity Investments - - - -EBITDA 2,284.9 2,862.9 3,337.3 3,754.2Y/Y Growth 23% 25% 27% 12%IBT(reported) 1,547.1 677.3 2,508.3 2,955.2IBT(pro forma) 2,084.7 2,599.9 3,020.3 3,467.2Income Taxes 421.4 405.5 591.5 679.7Pro forma adjustment 116.6 - -Pro forma tax 591.5 558.6 724.9 832.1 - - -Minority Interest (0.0) - - -Pro forma entry - - - -Pro forma minority interest - - - - - - - -Charitable contribution - - - -Other non-cash charges - - - - - - - - 147
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com FY FY FY FY 2006A 2007E 2008E 2009ENet Income (reported) 1,125.6 271.8 1,916.8 2,275.5Net Income (pro forma) 1,493.3 2,041.3 2,295.4 2,635.0FASB Adjustment net of TaxesReported Net Income Adj. for FASB123 1,125.6 271.8 1,916.8 2,275.5Pro Forma NI Adj. for FASB 123 1,493.3 2,041.3 2,295.4 2,635.0EPS (reported) 0.79 0.19 1.42 1.71EPS (pro forma) 1.05 1.48 1.70 1.98Reported EPS Adj. for FASB123 0.79 0.19 1.42 1.71EPS (pro forma) y/y 22% 41% 15% 17%GAAP Diluted Share count 1,425.5 1,373.0 1,352.0 1,330.0Pro Forma Diluted Outstanding Shares 1,425.5 1,377.6 1,352.0 1,330.02As a % of RevenuePayment revenue 23.5% 23.6% 25.3% 26.7%eBay online revenue 70.4% 67.7% 64.3% 61.3%Third Party Advertising revenue 2.9% 3.8% 4.7% 5.4%Skype Revenue 3.2% 4.8% 5.7% 6.6%Total online revenue 100.0% 100.0% 100.0% 100.0%Offline Revenue 0.0% 0.0% 0.0% 0.0%Cost of goods sold 20.8% 23.0% 24.0% 25.1%Sales & marketing 27.7% 25.5% 24.8% 24.3%Product development 8.3% 8.3% 9.0% 8.8%G&A 15.8% 15.1% 13.5% 13.3%Total operating expenses 55.3% 69.8% 49.8% 48.5%Operating income (reported) 23.8% 7.2% 26.2% 26.4%Operating income (pro forma) 32.8% 32.2% 31.9% 31.3%Net income (reported) 18.9% 3.5% 21.3% 21.7%Net income (pro forma) 25.0% 26.6% 25.5% 25.1%Tax Rate 27.2% 59.9% 23.6% 23.0%Pro forma tax rate 28.4% 21.5% 24.0% 24.0%Year-Over-Year GrowthPayment revenue 39.9% 29.6% 25.4% 23.1%eBay online revenue 23.5% 23.9% 11.3% 11.1%Third Party Advertising revenue 39.3% 70.9% 44.5% 34.8%End-to-end services revenue NM NM NM NMCommunications Revenue 90.9% 38.6% 35.3%Total online revenue 31.1% 28.7% 17.2% 16.6%Offline RevenueSales & marketing 34.4% 18.4% 13.9% 14.3%Product development 50.7% 29.6% 26.0% 14.0%G&A 59.1% 23.6% 4.7% 14.5%Total operating expensesOperating income (pro forma) 21.4% 26.3% 15.9% 14.5%Source: Company reports and JPMorgan estimates.148
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 88: EBAY Quarterly Income Statement$ in millions, except per share data FY 2006 FY 2007E FY 2008E Q1-06 Q2-06 Q3-06 Q4-06 Q1-07 Q2-07 Q3-07 Q4-07E Q1-08E Q2-08E Q3-08E Q4-08EGross Merchandise Volume (GMV) $12,504.0 $12,896.0 $12,639.0 $14,434.0 $14,281.0 $14,464.0 $14,395.0 $16,243.5 $15,754.4 $15,913.1 $15,649.5 $18,044.8 % Change Y-Y 17.9% 18.5% 17.0% 20.2% 14.2% 12.2% 13.9% 12.5% 10.3% 10.0% 8.7% 11.1% % Change Q-Q 4.1% 3% -2% 14% -1% 1% 0% 13% -3% 1% -2% 15% Payment revenue 328.2 330.7 340.0 403.0 419.0 432.3 448.0 517.8 541.7 538.3 553.9 644.5 eBay online revenue 990.5 997.1 1,017.3 1,198.4 1,211.5 1,236.8 1,267.5 1,490.1 1,402.5 1,387.9 1,360.6 1,643.6 Total transactions 1,318.7 1,327.8 1,357.3 1,601.4 1,630.5 1,669.1 1,715.4 2,007.9 1,944.1 1,926.3 1,914.5 2,288.1 3rd party advertising revenue 36.6 38.8 41.3 55.1 60.5 76.2 77.0 80.0 90.1 108.9 111.7 113.6 Skype 35.2 44.2 50.0 63.4 77.1 89.1 96.8 105.0 115.0 125.0 130.0 140.0 End-to-end Services - - - - - - - - - - - -Total Online Revenue 1,390.4 1,410.8 1,448.6 1,719.9 1,768.1 1,834.43 1,889.2 2,192.9 2,149.2 2,160.2 2,156.2 2,541.7Offline revenue - - - - - - - - - - - -Total revenue $1,390.4 $1,410.8 1,448.6 $1,719.9 $1,768.1 $1,834.4 $1,889.2 $2,192.9 $2,149.2 $2,160.2 $2,156.2 $2,541.7Cost of revenue 278.6 292.5 315.7 356.3 393.7 416.8 446.5 513.0 512.3 517.4 525.9 609.4COGS pro forma adjustment (9.5) (7.6) (8.0) (7.9) (8.8) (9.6) (9.1)Gross Profit 1,111.9 1118.3 1132.9 1,363.6 1,374.4 1,417.6 1,442.7 1,679.9 1,636.9 1,642.8 1,630.3 1,932.4Gross Profit (pro forma) 1,121.3 1125.9 1140.9 1,371.5 1,383.2 1,427.2 1,451.8 1,679.9 1,636.9 1,642.8 1,630.3 1,932.4Pro Forma Gross Margin 80.6% 79.8% 78.8% 79.7% 78.2% 77.8% 76.8% 76.6% 76.2% 76.0% 75.6% 76.0%Sales and Marketing 400.6 398.0 394.8 461.3 443.3 477.8 485.2 552.6 533.0 555.2 554.1 589.7Product Development 119.1 124.0 120.4 131.2 137.6 147.9 164.9 190.8 191.3 196.6 196.2 223.7General and Admin. 215.4 222.9 227.2 275.7 278.4 283.5 287.4 313.6 298.7 295.9 284.6 338.0Amort., Payroll Taxes, merger other 54.25 62.00 51.47 45.40 47.35 51.55 1,442.8 57.0 57.0 57.0 57.0 57.0Total Operating Expenses 789.2 806.9 793.9 913.7 906.6 960.7 2380.4 1114.0 1080.0 1104.7 1092.0 1208.4Pro forma op ex adjustments:Sales & marketing (24.72) (27.06) (23.15) (21.61) (19.20) (23.1) (22.19) - - - - -Product development (20.70) (22.99) (19.01) (18.79) (16.00) (19.4) (21.37) - - - - -G&A (28.92) (27.72) (23.36) (26.39) (28.00) (27.5) (27.89) - - - - -Payroll exp on empl stock options (2.32) (1.61) (0.47) (0.92) (1.78) (1.3) (2.28) - - - - -Amort of acqd assets (51.92) (62.00) (51.47) (49.54) (51.89) (56.9) (1,448.3)Total (128.59) (141.38) (117.46) (117.25) (116.87) (128.20) (1,522.0) (128.00) (128.00) (128.00) (128.00) (128.00)Pro forma operating expenses 660.6 665.5 676.4 796.5 789.7 832.5 858.4 986.0 952.0 976.7 964.0 1080.4Operating Profit (reported) 322.6 311.4 339.0 449.9 467.8 456.9 -937.7 565.9 556.9 538.1 538.4 724.0 Operating Margin (reported) 23.2% 22.1% 23.4% 26.2% 26.5% 24.9% -49.6% 25.8% 25.9% 24.9% 25.0% 28.5%Operating Profit (pro forma) 460.7 460.4 464.493 575.0 593.5 594.7 593.4 693.9 684.9 666.1 666.4 852.0 Operating Margin (pro forma) 33.1% 32.6% 32.1% 33.4% 33.6% 32.4% 31.4% 31.6% 31.9% 30.8% 30.9% 33.5%Interest and other income, net 25.8 25.6 41.2 37.4 30.0 34.0 38.4 35.0 40.0 40.0 40.0 45.0Interest Expense (0.7) (0.9) (0.6) (3.7) (4.5) (2.7) (2.7) (3.0) (3.5) (3.5) (3.5) (3.5) 149
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comNet Interest Income 25.0 24.7 40.7 33.7 25.5 31.2 35.6 32.0 36.5 36.5 36.5 41.5Pro forma adjustment - - - - - - - - - - - -Pro forma interest 25.0 24.7 40.7 33.7 25.5 31.2 35.6 32.0 36.5 36.5 36.5 41.5Impairment of Equity Investments - - - - - - - - - - - -EBITDA 529.7 539.2 547.8 668.2 683.2 683.2 685.6 810.9 801.9 783.1 783.4 969.0Y/Y Growth 26% 16% 21% 30% 29% 27% 25% 21% 17% 15% 14% 19%IBT(reported) $347.6 $336.1 $379.7 $483.6 $493.3 $488.1 ($902.1) $597.9 $593.4 $574.6 $574.9 $765.5IBT(pro forma) $485.7 $485.1 $505.2 $608.7 $619.0 $625.9 $629.1 $725.9 $721.4 $702.6 $702.9 $893.5Income Taxes 99.4 86.1 98.8 137.1 116.1 112.3 33.6 143.5 142.4 137.9 135.1 176.1Pro forma adjustment 43.4 48.3 38.9 41.0 42.3 42.5 31.7Pro forma tax 142.8 134.4 137.8 176.5 158.4 154.8 65.3 180.0 173.1 168.6 168.7 214.4Minority Interest (0.00) (0.00) (0.00) (0.00) - - - - - - - -Pro forma entry - - - - - - - - - - - -Pro forma minority interest - - - - - - - - - - - - - - - - - - - - - - - -Charitable contribution - - - - - - - - - - - -Other non-cash charges - - - - - - - - - -Net Income (reported) 248.3 250.0 280.9 346.5 377.2 375.8 (935.6) 454.4 451.0 436.7 439.8 589.4Net Income (pro forma) 342.9 350.7 367.4 432.2 460.5 471.1 563.8 545.9 548.3 534.0 534.2 679.0FASB Adjustment net of Taxes -Reported Net Income Adj. for FASB123 248.3 250.0 280.9 346.5 377.2 375.8 (935.6) 454.4 451.0 436.7 439.8 589.4Pro Forma NI Adj. for FASB 123 342.9 350.7 367.4 432.2 460.5 471.1 563.8 545.9 548.3 534.0 534.2 679.0EPS (reported) 0.17 0.17 0.20 0.25 0.27 0.27 (0.69) 0.33 0.33 0.32 0.33 0.44EPS (pro forma) 0.24 0.24 0.26 0.31 0.33 0.34 0.41 0.40 0.40 0.40 0.40 0.51Reported EPS Adj. for FASB123 0.17 0.17 0.20 0.25 0.27 0.27 (0.69) 0.33 0.33 0.32 0.33 0.44EPS (pro forma) y/y 20% 10% 28% 29% 39% 40% 59% 29% 20% 16% -3% 27%GAAP Diluted Share count 1,437.6 1,435.8 1,426.1 1,402.7 1,384.3 1,379.7 1,354.8 1,373.3 1,370.0 1,350.0 1,348.0 1,340.0Pro Forma Diluted Outstanding Shares 1,437.6 1,435.8 1,426.1 1,402.7 1,384.3 1,379.7 1,373.3 1,373.3 1,370.0 1,350.0 1,348.0 1,340.02As a % of RevenuePayment revenue 23.6% 23.4% 23.5% 23.4% 23.7% 23.6% 23.7% 23.6% 25.2% 24.9% 25.7% 25.4%eBay online revenue 71.2% 70.7% 70.2% 69.7% 68.5% 67.4% 67.1% 68.0% 65.3% 64.2% 63.1% 64.7%Third Party Advertising revenue 2.6% 2.8% 2.9% 3.2% 3.4% 4.2% 4.1% 3.6% 4.2% 5.0% 5.2% 4.5%Skype Revenue 2.5% 3.1% 3.5% 3.7% 4.4% 4.9% 5.1% 4.8% 5.4% 5.8% 6.0% 5.5%Total online revenue 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%Offline Revenue 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Cost of goods sold 20.0% 20.7% 21.8% 20.7% 22.3% 22.7% 23.6% 23.4% 23.8% 24.0% 24.4% 24.0%Sales & marketing 28.8% 28.2% 27.3% 26.8% 25.1% 26.0% 25.7% 25.2% 24.8% 25.7% 25.7% 23.2%Product development 8.6% 8.8% 8.3% 7.6% 7.8% 8.1% 8.7% 8.7% 8.9% 9.1% 9.1% 8.8%G&A 15.5% 15.8% 15.7% 16.0% 15.7% 15.5% 15.2% 14.3% 13.9% 13.7% 13.2% 13.3%Total operating expenses 56.8% 57.2% 54.8% 53.1% 51.3% 52.4% 126.0% 50.8% 50.3% 51.1% 50.6% 47.5%Operating income (reported) 23.2% 22.1% 23.4% 26.2% 26.5% 24.9% -49.6% 25.8% 25.9% 24.9% 25.0% 28.5%150
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comOperating income (pro forma) 33.1% 32.6% 32.1% 33.4% 33.6% 32.4% 31.4% 31.6% 31.9% 30.8% 30.9% 33.5%Net income (reported) 17.9% 17.7% 19.4% 20.1% 21.3% 20.5% -49.5% 20.7% 21.0% 20.2% 20.4% 23.2%Net income (pro forma) 24.7% 24.9% 25.4% 25.1% 26.0% 25.7% 29.8% 24.9% 25.5% 24.7% 24.8% 26.7%Tax Rate 28.6% 25.6% 26.0% 28.4% 23.5% 23.0% -3.7% 24.0% 24.0% 24.0% 23.5% 23.0%Pro forma tax rate 29.4% 27.7% 27.3% 29.0% 25.6% 24.7% 10.4% 24.8% 24.0% 24.0% 24.0% 24.0%Year-Over-Year GrowthPayment revenue 44.5% 39.4% 41.7% 35.4% 27.7% 30.7% 31.7% 28.5% 29.3% 24.5% 23.7% 24.5%eBay online revenue 27.7% 21.6% 21.6% 23.6% 22.3% 24.0% 24.6% 24.3% 15.8% 12.2% 7.3% 10.3%Third Party Advertising revenue 27.5% 34.0% 43.6% 49.1% 65.3% 96.2% 86.5% 45.2% 49.0% 43.0% 45.0% 42.0%End-to-end services revenueCommunications RevenueTotal online revenue 34.8% 29.9% 31.0% 29.4% 27.2% 30.0% 30.4% 27.5% 21.6% 17.8% 14.1% 15.9%Offline Revenue NM NM NM NM NM NM NM NM NM NM NM NMSales & marketing 47.6% 38.6% 34.4% 21.9% 10.7% 20.0% 22.9% 19.8% 20.2% 16.2% 14.2% 6.7%Product development 61.4% 73.1% 52.6% 26.3% 15.6% 19.3% 36.9% 45.4% 39.0% 32.9% 19.0% 17.2%G&A 57.9% 72.4% 57.5% 51.7% 29.3% 27.2% 26.5% 13.7% 7.3% 4.4% -1.0% 7.8%Total operating expenses NM NM NM NM NM NM NM NM NM NM NM NMOperating income (pro forma) 25.4% 13.3% 18.0% 28.3% 28.8% 29.2% 27.8% 20.7% 15.4% 12.0% 12.3% 22.8%Source: Company reports and JPMorgan estimates. 151
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 89: EBAY Annual Balance Sheet$ in millions FY FY FY FY 2006 2007E 2008E 2009EAssetsCash and cash equivalents 2,662.8 3,927.5 6,939.4 10,330.7ST investments in marketable securities 542.1 (453.9) (453.9) (453.9)Accounts receivable, net 393.2 482.4 559.2 649.7Funds receivable 399.3 614.0 711.7 826.9Other assets 973.2 1,396.4 1,396.4 1,396.4Total current assets 4,970.6 5,966.5 9,152.8 12,749.9Investments 277.9 455.3 455.3 455.3Property and equipment, net 998.2 1,069.6 909.6 749.6Intangible assets, net 7,227.3 6,822.9 6,822.9 6,822.9Other assets, net 20.1 87.3 87.3 87.3Total assets 13,494.0 14,401.6 17,427.9 20,865.0Liabilities and stockholders equityAccounts payable 83.4 131.6 152.5 177.2Funds payable 1,160.0 1,535.1 1,779.2 2,067.3Deferred Revenue 129.0 153.5 177.9 206.7Short term debt - - - -Taxes payable 464.4 101.2 101.2 101.2Other current liabilities 681.7 1,319.6 1,319.6 1,319.6Total current liabilities 2,518.4 3,241.0 3,530.4 3,872.1Debt - - - -Deferred taxes 31.8 592.4 592.4 592.4Other long term 39.2 48.9 48.9 48.9Total liabilities 2,589.4 3,882.2 4,171.7 4,513.3 - - -Stockholders equity: - - -Common stock - - -Accumulated deficit - - -Other equity - - -Total stockholders equity 10,904.6 10,519.3 13,256.2 16,351.6Total L&S 13,494.0 14,401.6 17,427.9 20,865.0Source: Company reports and JPMorgan estimates.152
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 90: EBAY Annual Cash Flow Statement$ in millions FY FY FY FY 2006A 2007E 2008E 2009E OPERATING CASH FLOWSNet Income 1,125.6 271.8 1,916.8 2,275.5Depreciation 544.6 601.9 640.0 640.0Amortization - - - -Stock based comp expense related to stock options and purchases 317.4 317.2 340.0 340.0Tax Benefit 148.6 192.9 120.0 120.0Excess tax benefit from stock-based compensation (161.4)Impairment - - - -Minority Interest 0.0 - - -Doubtful Accounts/Losses 227.2 257.7 200.0 200.0Other - 1,390.9 - -Changes in Working Capital (23.2) (399.8) (34.9) (14.2)Accounts Receivable (169.8) (157.60) (76.73) (90.56)Fund Receivable (146.9) (212.32) (97.66) (115.26)Other (433.4) (516.08) - -Deferred Tax (181.1) (68.93) - -Accounts Payable 33.0 45.57 20.93 24.70Funds Payable 575.1 358.72 94.14 138.14Accrued Charges (31.0) 2.97 - -Deferred Revenue 47.9 24.80 24.41 28.81Income Taxes 283.0 123.08 - - Cash From Operations 2,247.8 2,563.5 3,181.9 3,561.3 % Chg Y-Y 11.8% 14.0% 24.1% 11.9%FCF 1,732.3 2,067.5 2,611.9 3,001.3 % Chg Y-Y 3.6% 19.3% 26.3% 14.9% INVESTING CASH FLOWSCapital Expenditures (515.4) (496.0) (570.0) (560.0)Net Investment 797.0 48.5 - -ST Investment Purch. - - - -ST Investments Mat. - - - -Acquisitions (43.9) (320.2) - -Purchase of intangibles and other non current assets (8.8) 5.5 - - Cash From Investing 228.9 (762.2) (570.0) (560.0) FINANCING CASH FLOWSCommon Stock Issued 313.5 365.2 - -Excess tax benefit from stock-based compensation - -Shares Repurchased (1,666.5) (1,170.7) - -Payment of headquarters facility lease obligation - - -Long Term Debt - - - - Cash From Financing (1,260.7) (736.5) - -Foreign Exch Effects 133.3 199.9 - -Net Change In Cash 1,349.2 1,264.8 2,611.9 3,001.3Cash at Beginning 1,313.5 2,662.7 3,927.5 6,539.4Cash at End 2,662.7 3,927.5 6,539.4 9,540.7Source: Company reports and JPMorgan estimates. 153
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Expedia, Overweight ($32.56) We are maintaining our Overweight rating on Expedia. We continue to see mid-teen revenue growth in F’08 as the company benefits from its customer rewards program, entrance into new international markets, and growth of its media and advertising arm. As the business is somewhat counter-cyclical, we believe EXPE will benefit from the increased available inventory and discounted pricing in a weakening US economy. • We expect 2008 revenue growth to be driven by international market expansion. We expect F’08 European gross bookings to grow 26% Y/Y to $5.2B on top of F’07E growth of 38%. We believe that the company will focus on expanding inventory into secondary and tertiary markets as well as on expansion into Asia. We also believe as the company increases selection, it may enjoy improved conversion rates. • The Media and Advertising arm will become a more significant growth driver. We see TripAdvisor and its related properties (BookingBuddy and SmarterTravel) benefiting the company two-fold. First, the business will contribute to top-line growth as TripAdvisor organic growth rates are currently over 60% Y/Y. Secondly, the businesses serve as a hedge to increasing online marketing costs and Expedia is now able to share in the upside of this. • We expect OIBA margins to decline 70 bps in F’08. We believe management will increase selling and marketing spend to increase its share. Technology and content spend will also likely increase as the company protects its market share through innovation. Finally, facilities expense is expected by the company to increase by $16M in F’08 due to relocation expenses. • 2008 Drivers. In our view, the following factors will drive EXPE shares in 2008: (1) first full year of comping lower air revenues as a result of GDS renegotiations, (2) increased int’l inventory, which should drive conversion and market share gains, and (3) rising travel marketing spend on media and advertising unit. • Maintaining 4Q07 estimates. We maintain our 4Q’07 revenue, EBITDA, and EPS estimates of $642.8M, $177.0M, and $0.24 (Y/Y growth of 21%, 11%, and 21% respectively). Our current and newly introduced 2009 estimates are in the table below:Table 91: Expedia Financial Snapshot$ in millions, except per share data Expedia 4Q07E F07E F08E F09E F07E Y/Y F08E Y/Y F09E Y/Y JPMorgan Revenue 642.76 2,642.77 3,006.30 3,317.53 18.1% 13.8% 10.4% EBITDA 176.98 724.63 807.71 887.16 18.8% 11.5% 9.8% EPS 0.24 0.96 1.17 1.36 38.0% 21.4% 16.1% Consensus Revenue 642.86 2,646.54 3,019.64 3,367.52 14.1% 11.5% EBITDA 182.09 719.62 820.34 945.01 14.0% 15.2% EPS 0.24 0.96 1.19 1.55 24.0% 30.3%Source: JPMorgan estimates, Company data, and Bloomberg154
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Our Estimates and Outlook for 2008 We are adjusting our F’08 revenue estimate to $3.01B and our full-year EPS estimate to $1.17, representing Y/Y revenue and EPS growth of 14% and 21%. We expect most of the revenue growth to be driven by the international market where we see gross bookings growth of 26% Y/Y. Furthermore, we note that this is the first year that the company is fully comping air revenue declines as a result of GDS renegotiations. Thus, the company faces easy domestic comparisons with 1H’07 gross bookings growth of only 4.5% Y/Y vs. 3Q’07 growth of 13.4%. We expect OIBA margins to decline 70 bps in F08 due to increased selling and marketing and technology and content expenses and a one-time expense associated with relocation. Figure 83: Domestic Unique Visitor Trends on EXPE Properties thousands 21,500 16,500 11,500 6,500 1,500 Sep- Oct- Nov - Dec- Jan- Feb- Mar- Apr- May - Jun- Jul- Aug- Sep- Oct- Nov - 2006 2006 2006 2006 2007 2007 2007 2007 2007 2007 2007 2007 2007 2007 2007 EXPEDIA.COM* Tripadv isor Sites HOTELS.COM HOTWIRE.COM Source: comScore and JPMorgan estimates Our Estimates and Outlook for 2009 We are introducing F’09 revenue and EPS estimates of $3.32B and $1.36, which represents 10% and 16% Y/Y growth, respectively. Again, we expect much of the revenue growth to stem from European gross booking increases, which we model as slowing to 18% on a Y/Y basis due to maturation of the market and increased competition. Domestically, we expect Y/Y gross booking growth to slow to 5% from 8% in the prior year, due to lower growth in shifts from offline spend and increased competition. We expect OIBA margins to decrease another 10 bps Y/Y as selling and marketing expenses rise. Valuation and Rating Analysis We believe Expedia is undervalued given the potential for international growth, signs of a successful domestic turnaround, and increased advertising revenue opportunities. On an EV/EBITDA basis, Expedia trades at 12.8x our F’08 EBITDA estimate of $808 million, versus its peers at 19.1x. As such, we rate the stock Overweight. Risks to Our Rating The company’s shares could underperform if the company is unable to (1) withstand the competitive threat that the travel suppliers and travel search engines pose, (2) achieve a high ROI on selling and marketing investments, (3) successfully complete the turnaround of the core Expedia brand, and (4) achieve further expansion into international markets. 155
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 92: EXPE Annual Income Statement$ in millions, except per share dataINCOME STATEMENT 2006 2007E 2008E 2009E North America 12,737 13,814 14,887 15,632 Europe 3,001 4,130 5,205 6,163 Other 1,424 1,786 2,101 2,398Total Gross Bookings 17,162 19,730 22,194 24,192 % North America 74% 70% 67% 65% % Europe 17% 21% 23% 25% % Other 8% 9% 9% 10%Y/Y Growth North America 5.6% 8.5% 7.8% 5.0% Europe 19.3% 37.6% 26.0% 18.4% Other 46.5% 25.4% 17.6% 14.1%Total GB 10.4% 15.0% 12.5% 9.0%Total Revenue 2,237.6 2,642.8 3,006.3 3,317.5Revenue as a % GB 13.0% 13.4% 13.5% 13.7%Cost of Revenues 494.2 548.9 623.7 682.7Gross Profit 1,743.3 2,093.9 2,382.6 2,634.8Gross Margin 78% 79.2% 79.3% 79.4%Selling and Marketing expense 770.3 973.7 1,116.5 1,242.3General and Administrative expense 252.8 293.3 331.3 360.9Technology and Content 121.3 160.7 197.1 222.5Amortization of non-cash distributing & mktg 9.6 - - -Amortization of non-cash compensation expense - - - -Amortization of intangibles 110.8 77.9 64.0 60.0Stock Based Compensation 80.3 62.2 65.0 65.0Depreciation expense 9.0 - - -Extraordinary Items 47.0Total Operating Expenses 1,392.0 1,567.8 1,773.9 1,950.7Total Operating Expenses (Pro forma) 1,144.3 1,427.6 1,644.9 1,825.7Operating Profit 351.3 526.1 608.7 684.2Operating Profit (Pro forma) 599.0 666.2 737.7 809.2Operating Margin 15.7% 19.9% 20.2% 20.6%Operating Margin (Pro forma) 26.8% 25.2% 24.5% 24.4%EBITDA 609.8 724.6 807.7 887.2OIBA 599.0 666.2 737.7 809.2OIBA Margin 26.8% 25.2% 24.5% 24.4%Net Interest Income 14.8 (6.3) - -Write-off of long-term investment - - - -Other 18.8 (13.5) - -Equity Income of Unconsolidated Affiliates - - - -EBT (Earnings Before Taxes) 384.9 506.3 608.7 684.2EBT (Earnings Before Taxes - Pro forma) 613.8 659.9 737.7 809.2Minority Interest Income (0.5) 1.3 2.0 2.0Income Tax Expense (139.5) (202.6) (243.5) (260.0)Tax Rate 35% 40% 40% 38%Net Income (Reported) 244.9 305.0 367.2 426.2Net Income (Pro Forma) 388.5 395.6 442.6 501.7EPS (Reported) 0.70 0.96 1.17 1.36EPS (Pro Forma) 1.10 1.23 1.39 1.58Sharecount 352.2 317.7 314.0 314.0Source: Company reports and JPMorgan estimates.156
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 93: EXPE Quarterly Income Statement$ in millions, except per share data 1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 4Q07E 1Q08E 2Q08E 3Q08E 4Q08E North America 3,522 3,445 3,104 2,666 3,559 3,723 3,519 3,013 3,915 3,984 3,765 3,223 Europe 780 752 792 677 1,032 1,035 1,163 900 1,334 1,306 1,457 1,108 Other 347 368 365 344 425 466 465 430 507 550 545 499Total Gross Bookings 4,649 4,565 4,261 3,687 5,016 5,224 5,147 4,343 5,756 5,840 5,768 4,830 % North America 76% 75% 73% 72% 71% 71% 68% 69% 68% 68% 65% 67% % Europe 17% 16% 19% 18% 21% 20% 23% 21% 23% 22% 25% 23% % Other 7% 8% 9% 9% 8% 9% 9% 10% 9% 9% 9% 10%Y/Y Growth North America 10.3% 7.5% 2.0% 1.6% 1.1% 8.1% 13.4% 13.0% 10.0% 7.0% 7.0% 7.0% Europe 12.7% 12.4% 23.0% 32.7% 32.3% 37.6% 46.8% 33.0% 29.3% 26.2% 25.3% 23.0% Other 72.6% 41.5% 46.6% 31.3% 22.5% 26.6% 27.4% 25.0% 19.2% 18.1% 17.3% 16.0%Total GB 13.8% 10.5% 8.2% 8.6% 7.9% 14.4% 20.8% 17.8% 14.8% 11.8% 12.1% 11.2%Total Revenue 493.9 598.5 613.9 531.3 550.5 689.9 759.6 642.8 644.7 782.6 859.4 719.6Revenue as a % GB 10.6% 13.1% 14.4% 14.4% 11.0% 13.2% 14.8% 14.8% 11.2% 13.4% 14.9% 14.9%Cost of Revenues 116.1 126.9 131.3 120.0 120.4 143.0 150.5 135.0 141.2 161.2 170.2 151.1Gross Profit 377.8 471.6 482.7 411.3 430.1 546.9 609.1 507.8 503.5 621.4 689.3 568.5Gross Margin 76.5% 78.8% 78.6% 77.4% 78.1% 79.3% 80.2% 79.0% 78.1% 79.4% 80.2% 79.0%Selling and Marketing expense 195.8 195.2 212.1 167.2 219.0 253.1 276.6 225.0 256.6 287.2 313.7 259.1General and Administrative expense 63.7 62.3 59.1 67.7 68.5 68.7 75.7 80.3 79.3 78.3 85.9 87.8Technology and Content 29.8 29.9 31.4 30.2 38.2 38.0 44.0 40.5 48.3 47.0 55.0 46.8Amortization of non-cash distributing & mktg 8.2 0.6 0.7 0.1 - - - - - - - -Amortization of non-cash compensation expense - - - - - - - - - - - -Amortization of intangibles 30.2 30.1 26.6 23.9 21.2 19.5 18.6 18.6 16.0 16.0 16.0 16.0Stock Based Compensation 23.9 17.2 16.4 22.7 15.9 14.0 14.4 18.0 16.0 15.0 15.0 19.0Depreciation expense 9.0 - - - - - - - - - - -Extraordinary Items - - 47.0 - - - - - - - - -Total Operating Expenses 351.6 335.3 393.4 311.7 362.8 393.3 429.3 382.4 416.2 443.4 485.6 428.6Total Operating Expenses (Pro forma) 289.3 287.4 302.7 265.0 325.7 359.8 396.3 345.8 384.2 412.4 454.6 393.6Operating Profit 26.2 136.3 89.3 99.5 67.3 153.6 179.8 125.4 87.3 177.9 203.6 139.9Operating Profit (Pro forma) 88.5 184.2 180.0 146.2 104.4 187.1 212.8 162.0 119.3 208.9 234.6 174.9Operating Margin 5.3% 22.8% 14.5% 18.7% 12.2% 22.3% 23.7% 19.5% 13.5% 22.7% 23.7% 19.4%Operating Margin (Pro forma) 17.9% 30.8% 29.3% 27.5% 19.0% 27.1% 28.0% 25.2% 18.5% 26.7% 27.3% 24.3%EBITDA 108.6 195.8 146.2 159.2 118.8 200.7 228.1 177.0 136.3 225.9 252.6 192.9OIBA 88.5 184.2 180.0 146.2 104.4 187.1 212.8 162.0 119.3 208.9 234.6 174.9OIBA Margin 17.9% 30.8% 29.3% 27.5% 19.0% 27.1% 28.0% 25.2% 18.5% 26.7% 27.3% 24.3%Net Interest Income 1.7 6.6 4.8 1.7 (3.9) 0.7 (1.1) (2.0) - - - -Write-off of long-term investment 157
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com 1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 4Q07E 1Q08E 2Q08E 3Q08E 4Q08EOther 3.7 10.5 2.9 1.7 (5.5) 5.9 (13.9)Equity Income of Unconsolidated Affiliates - - - -EBT (Earnings Before Taxes) 31.6 153.3 97.1 103.0 57.9 160.2 164.8 123.4 87.3 177.9 203.6 139.9EBT (Earnings Before Taxes - Pro forma) 90.2 190.8 184.9 147.9 100.5 187.7 211.8 160.0 119.3 208.9 234.6 174.9Minority Interest Income 1.4 (1.6) (0.4) 0.1 0.5 0.0 0.3 0.5 0.5 0.5 0.5 0.5Income Tax Expense (9.7) (56.2) (37.7) (35.9) (23.6) (64.1) (65.5) (49.3) (34.9) (71.2) (81.5) (55.9)Tax Rate 31% 37% 39% 35% 41% 40% 40% 40% 40% 40% 40% 40%Net Income (Reported) 23.3 95.5 59.0 67.1 34.8 96.1 99.6 74.5 52.9 107.3 122.7 84.4Net Income (Pro Forma) 57.0 118.2 117.2 96.2 59.3 114.0 123.1 99.2 71.6 125.4 140.8 104.9EPS (Reported) 0.06 0.27 0.17 0.20 0.11 0.30 0.32 0.24 0.17 0.34 0.39 0.27EPS (Pro Forma) 0.15 0.32 0.34 0.28 0.18 0.35 0.39 0.31 0.23 0.39 0.44 0.33Sharecount 365.2 359.1 341.1 343.6 323.7 320.2 312.8 314.0 314.0 314.0 314.0 314.0Source: JPMorgan estimates and Company report158
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 94: EXPE Annual Balance Sheet$ in millions 2006 2007E 2008E 2009EASSETSCash and Cash Equivalents 853.3 501.4 1,361.2 2,306.4Restricted Cash and Cash Equivalents 11.1 20.7 23.0 23.0Marketable Securities - - - -Accounts and Notes Receivable 211.4 317.9 417.9 509.9Receivables from IAC and Subsidiaries - - - -Deferred Income Taxes 4.9 0.3 0.3 0.3Other Current Assets 102.0 143.3 183.3 223.3Total Current Assets 1,182.7 983.6 1,985.7 3,062.9Goodwill 5,861.3 5,912.9 5,912.9 5,912.9Intangible Assets, Net 1,028.8 988.5 988.5 988.5Long-Term Investments and Other 59.3 89.0 89.0 89.0Property, Plant and Equipment, Net 137.1 152.9 189.2 228.1Total Assets 8,269.2 8,127.0 9,165.4 10,281.5LIABILITIESAccounts Payable, Trade 720.7 849.0 1,219.0 1,629.0Deferred Merchant Bookings 466.5 549.5 719.5 874.5Deferred Revenue 10.3 13.8 13.8 13.8Income Tax Payable 30.9 52.5 52.5 52.5Deferred income taxes - - - -Short term borrowings - - - -Other Current Liabilities 171.7 196.9 196.9 196.9Total Current Liabilities 1,400.1 1,661.6 2,201.6 2,766.6Long Term Debt 500.0 500.0 500.0 500.0Credit Facility 500.0 500.0 500.0Other Long-Term Liabilities 4.7 104.1 104.1 104.1Deferred Income Taxes 369.3 362.4 362.4 362.4Derivative liabilities 29.0 - - -Minority Interest 61.8 62.6 62.6 62.6Total Liabilities 1,864.9 3,190.6 3,730.6 4,295.6INVESTED EQUITYInvested Capital - - - -Accumulated Other Comprehensive Income - - - -Total Invested Equity 5,904.3 4,936.3 5,434.7 5,985.9LIABILITIES AND INVESTED EQUITY 8,269.2 8,127.0 9,165.4 10,281.5Source: Company reports and JPMorgan estimates. 159
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 95: EXPE Annual Cash Flow Statement$ in millions 2006 2007E 2008E 2009ECASH FLOW FROM OPERATIONSNet Income 244.9 305.0 367.2 426.2Adjustments to Reconcile Cash to Income - - - -Depreciation and Amortization 48.8 58.4 70.0 78.0Amortization of non-cash distributing & mktg - - - -Amortization of non-cash compensation expense - - - -Amortization of intangibles & stock-based comp 200.7 140.2 129.0 125.0Deferred Income Taxes (10.7) (3.3) - -Unrealized gain on derivative instrument (8.1) 5.9 - -Equity in Losses of Unconsolidated Affiliates (2.5) 4.1 1.2 1.2Minority Interest in Income of Subsidiaries 0.5 (1.1) (1.2) (1.2) Other 1.1 3.4 - - Impairment of Intangible Asset 47.0 - - - Foreign exchange gain/loss (37.2) (18.7) - -Changes in Current Assets and Current Liabilities - - - -Accounts and Notes Receivable (32.1) (94.4) (100.0) (92.0)Prepaids and Other Assets (20.7) (38.7) (40.0) (40.0)Accounts Payable and Accrued Liabilities 59.9 (6.1) 140.0 160.0Accounts Payable, merchants 63.2 221.1 230.0 250.0Deferred Revenue 3.2 3.4 - -Deferred Merchant Bookings 59.5 83.0 170.0 155.0Other, Net - - - -Net Cash Provided by Operating Activities 617.4 662.2 966.2 1,062.1Free Cash Flow (FCF) 524.8 565.6 859.9 945.2CASH FLOW FROM INVESTINGAcquisitions, Net of Cash Required (32.5) (59.6) - -Capital Expenditures (92.6) (96.6) (106.3) (116.9)Purchase of Marketable Securities - - - -Proceeds from Sale of Marketable Securities - - - -Increase in Long-Term Investments & Notes Rec. (1.5) (29.7) - -Proceeds from Sale of Business 13.2 - - -Other, Net - - - -Net Cash Provided by Investing Activities (113.5) (185.9) (106.3) (116.9)CASH FLOW FROM FINANCINGTransfers to IAC - - - -Short term borrowings (231.0) 500.0 - -Proceeds from issuance of long term debt 495.3 - - -Proceeds from Sale of Subsidiary Stock, inc. Options 36.6 48.1 - -Changes in Restricted Cash 4.6 (10.6) - -Principal payments on long term obligations - - - -Treasury stock activity (295.7) (1,396.0) - -Other, Net - (0.8) - -Net Cash Provided by Investing Activities 9.8 (859.4) - -Effect of FX on Cash & Equivalents 42.1 31.2 - -Net Increase in Cash & Equivalents 555.9 (351.9) 859.9 945.2Cash & Equivalents at Beginning of Period 297.4 853.3 501.4 1,361.2Cash & Equivalents at End of Period 853.3 501.4 1,361.2 2,306.4Source: Company reports and JPMorgan estimates.160
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Google, Overweight ($710.84) We believe Google will continue to innovate at an industry-leading pace, which should spur continued market share gains. Additionally, international, which we are modeling to be up 42% in 2008, will continue to be an important theme. At 37.7x our F’08 GAAP EPS estimate of $18.94, we find Google’s valuation attractive. As such, we maintain our Overweight rating. • Volume growth and market share gains are likely. We think that paid clicks will grow 30% Y/Y as search volume increases and as Google continues to take market share. In addition to market share gain, coverage is expected to be up slightly (~40 bps) and relevancy is expected to be up high single digits. • International will be a more significant contributor in 2008. We believe Google’s vast international presence will enable the company to maintain industry-leading growth rates in 2008. We expect international gross revenues to reach almost 50% of total revenues in 2008, growing 42% Y/Y. We believe Western Europe will continue to outpace domestic growth. We believe monetization will be a key catalyst for international growth in 2008, as advertisers increasingly adopt paid search as a marketing vehicle. • Google apps will begin to ramp. We think web-based cloud computing will become more widely adopted in F’08 as it gains more mainstream appeal. Additionally, Googles introduction of a complete services package, including word processing, spreadsheets, and presentation capabilities for free, will likely appeal to customers. We estimate that the office productivity software market is ~$10.3B. Even a 10% market share would mean an additional $1B in revenue to Google. • 2008 Drivers. In our view, the following factors will drive GOOG shares in 2008: (1) continued monetization enhancements of search & contextual advertising platforms, (2) increased search market share, and (3) outsized growth in Western Europe and emerging markets. • Maintaining 4Q07 estimates. We maintain our 4Q’07 revenue, EBITDA, and EPS estimates of $3.45B, $2.01B, and $3.82 (Y/Y growth of 55%, 45%, and 16%, respectively). Our current and newly introduced 2009 estimates are in the table below:Table 96: GOOG Estimates Snapshot$ in millions, except per share dataGoogle 4Q07E F07E F08E F09E F07E Y/Y F08E Y/Y F09E Y/YJPMorgan Revenue 3,447.35 11,718.63 16,957.04 22,332.26 60.6% 44.7% 31.7% EBITDA 2,013.12 6,957.86 9,917.13 12,646.53 50.9% 42.5% 27.5% EPS 3.82 13.33 18.94 24.38 34.0% 42.1% 28.7%Consensus Revenue 3,453.65 11,649.28 16,406.75 21,279.55 40.8% 29.7% EBITDA 2,039.15 6,997.77 9,684.73 12,522.79 38.4% 29.3% EPS 3.84 13.36 17.97 22.75 34.5% 26.6%Source: JPMorgan estimates, Company reports, and Bloomberg 161
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Our Estimates and Outlook for 2008 We are raising our 2008 net revenue, EBITDA, and GAAP EPS estimates to $16.96B, $9.92B, and $18.94 from $16.30B, $9.58B, and $18.18. Our new estimates call for Y/Y revenue, EBITDA, and EPS growth of 45%, 43%, and 42%, respectively. In 2008, we are expecting Google to continue to make progress on the international front, both through search volume growth and increasing advertiser demand. We are modeling international gross revenue growth of 42% Y/Y to $11.1B in 2008. As we believe international growth will outpace domestic growth, we see international revenues representing ~49.4% of gross revenues in 2008, up from ~47.6% of gross revenue in 2007. We believe usage will be the most meaningful catalyst for international growth in 2008, as consumers in emerging markets continue to leverage the Internet at an accelerating pace Beyond international, we believe Google will generate above-average market share growth through continued volume share gains from its domestic competitors. We continue to believe that Google has the strongest brand in search. Google’s rapid innovation of new web offerings should lead to increased attention from consumers, which should contribute to sustained volume share growth in 2008. We think that paid clicks will grow 30% Y/Y as search volume increases and as Google continues to take market share. We believe that Google’s attempts to show meaningful revenue diversification are starting to come to fruition. We think web-based cloud computing will become more widely adopted in F’08 as it gains more mainstream appeal. Additionally, Googles introduction of a complete services package, including word processing, spreadsheets, and presentation capabilities for free, will likely appeal to customers. The product has become even more marketable to enterprise clients through the acquisition of Postini, an on-demand security and compliance solution. We estimate that the office productivity software market is ~$10.3B. Even a 10% market share would mean an additional $1B in revenue to Google. Our Estimates and Outlook for 2009 We are introducing above consensus 2009 estimates, which call for Y/Y revenue, EBITDA, and EPS growth of 32%, 27.5%, and 29%, respectively. Specifically, our F’09 revenue, EBITDA, and EPS estimates are $22.3B, $12.6B, and $24.38, respectively. In 2009, we are expecting search revenues to continue to show strong growth, despite decelerating from 2008 levels. We are modeling Google.com search volumes to grow ~25% in 2009, with RPM growth contributing an additional 8%. We believe international search revenues will make up 51% of total company revenues in 2009. Valuation and Rating Analysis We believe GOOG shares are fundamentally attractive due to secular industry growth trends, improving fundamentals in the international market, and expansion of new product categories, such as contextual ad and local search. Google remains an Overweight pick. Google trades at 21.4x its F’08E EBITDA vs. its large cap Internet162
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com peers at 18.0x. Given Googles higher growth rate, we think it deserves a premium. Hence, our OW rating. Risks to Our Rating Google has experienced very fast revenue growth over the past few years. Our Overweight rating is based on the assumption that Google will continue to be the market leader in the paid search space and will continue to enjoy strong revenue growth. If the content publishers like Yahoo! and Microsoft are able to gain market share through user defection from Google’s user base, then our rating could be too optimistic. However, we have not seen any trends that would support this argument thus far. Our Overweight rating is also predicated on the company’s success in the international market. If the company cannot successfully build out a larger international advertising base, it will not be able to increase its monetization rate abroad. Additionally, as Google continues to expand its business internationally, it may face regulatory hurdles that make the business climate less hospitable and potentially less profitable than the markets in which it currently operates. 163
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 97: GOOG Annual Income Statement$ in millions, except per share data FY FY FY FY 2006 2007E 2008E 2009EGross Revenue 10,604.9 16,455.1 22,479.5 28,531.9TAC 3,308.8 4,736.5 5,522.5 6,199.7TAC % 79.5% 84.6% 85.9% 86.2%Google websites 6,332.8 10,709.2 15,840.7 21,040.7Google Network websites 851.1 861.4 906.4 996.6Licensing and other Revenues 112.3 148.0 210.0 295.0Net Revenues 7,296.1 11,718.6 16,957.0 22,332.3Y/Y growth 81.3% 60.6% 44.7% 31.7%Q/Q growthCost of Revenues 898.6 1,722.4 2,800.2 3,822.7Gross Profit 6,397.5 9,996.2 14,156.9 18,509.6Gross Margins 87.7% 85.3% 83.5% 82.9%Contribution GMR&D 941.1 1,542.7 2,220.2 2,924.5Sales & Marketing 790.1 1,331.5 1,831.4 2,411.9General & Administrative 628.2 1,127.9 1,572.2 2,070.7Cost of revenues - - -Research and development - - -Sales and marketing - - -General and administrative - - -In process R&D chargeStock based compensation 458.1 818.3 880.0 880.0Settlement Attorney Fees (Lanes Gift) 30.0 - - -Contribution to Google Foundation - - - - -Total Expenses 3,746.1 6,542.8 9,303.9 12,109.7Operating Income 3,550.0 5,175.8 7,653.1 10,222.5Pro Forma Operating Income 4,008.1 5,994.1 8,533.1 11,102.5Operating Margins 48.7% 44.2% 45.1% 45.8%Pro Forma Operating Margins 54.9% 51.2% 50.3% 49.7%Interest Income (Expense) 461.0 582.3 740.0 740.0EBT 4,011.0 5,758 8,393 10,963Less Taxes 933.6 1,534 2,182 2,850Tax Rate 23% 27% 26.0% 26.0%EBITDA 4,610.0 6,957.9 9,917.1 12,646.5Margins 63.2% 59.4% 58.5% 56.6%EAT 3077.4 4,224.1 6,210.9 8,112.3Tax Benefit --> Stock Comp & Foundation 225.3 154.4 228.8 228.8Pro forma EAT 3278.9 4,888.0 6,862.1 8,763.5GAAP EPS 9.94 13.33 18.94 24.38Pro forma EPS 10.59 15.42 20.92 26.33Diluted Sharecount 309.5 317.0 328.0 332.8Source: Company reports and JPMorgan estimates.164
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 98: GOOG Quarterly Income Statement$ in millions, except per share data FY2006 FY2007E FY 2008E Q1 -06 Q2-06 Q3-06 Q4-06 Q1 -07 Q2-07 Q3-07 Q4-07E Q1 -08E Q2-08E Q3-08E Q4-08EGross Revenue 2,253.8 2,456.0 2,689.7 3,205.5 3,664.0 3,872.0 4,231.4 4,687.8 5,229.3 5,366.3 5,615.3 6,268.5TAC 722.7 785.2 825.3 975.6 1,125.0 1,150.0 1,221.0 1,240.4 1,355.5 1,355.0 1,358.2 1,453.8TAC % 77.8% 78.8% 79.6% 81.4% 83.6% 85.1% 83.9% 85.8% 85.8% 85.8% 86.0% 86.0%Google websites 1,297.3 1,432.5 1,626.0 1,977.0 2,282.1 2,486.3 2,734.8 3,206.1 3,604.4 3,737.0 3,981.1 4,518.1Google Network websites 205.6 211.4 211.8 222.2 220.3 202.1 233.7 205.3 224.3 224.3 221.1 236.7Licensing and other Revenues 28.1 27.0 26.7 30.6 36.5 33.6 41.9 36.0 45.0 50.0 55.0 60.0Net Revenues 1,531.0 1,670.8 1,864.4 2,229.9 2,538.9 2,722.0 3,010.4 3,447.4 3,873.8 4,011.3 4,257.2 4,814.8Y/Y growth 92.7% 87.6% 77.8% 72.8% 65.8% 62.9% 61.5% 54.6% 52.6% 47.4% 41.4% 39.7%Q/Q growth 18.7% 9.1% 11.6% 19.6% 13.9% 7.2% 10.6% 14.5% 12.4% 3.5% 6.1% 13.1%Cost of Revenues 179.1 201.6 221.3 296.7 341.0 402.6 437.5 541.2 627.6 661.9 706.7 804.1Gross Profit 1,351.9 1,469.3 1,643.1 1,933.2 2,197.9 2,319.4 2,572.8 2,906.1 3,246.2 3,349.4 3,550.5 4,010.7Gross Margins 88.3% 87.9% 88.1% 86.7% 86.6% 85.2% 85.5% 84.3% 83.8% 83.5% 83.4% 83.3%Contribution GM 87.0% 87.4% 88.1% 84.0% 83.9% 80.9% 81.1% 79.9% 78.5% 79.9% 78.4% 80.8%R&D 173.5 212.0 250.9 304.7 287.6 375.1 418.1 461.9 511.3 529.5 553.4 625.9Sales & Marketing 175.0 182.1 192.3 240.7 275.3 319.2 350.9 386.1 418.4 433.2 459.8 520.0General & Administrative 116.0 150.7 168.7 192.8 230.0 278.9 288.0 330.9 360.3 373.1 395.9 443.0Cost of revenuesResearch and developmentSales and marketingGeneral and administrativeIn process R&D charge - - - - - - - - - - - -Stock based compensation 114.7 109.1 99.9 134.4 183.9 241.5 198.0 195.0 205.0 215.0 225.0 235.0Settlement Attorney Fees (Lanes Gift) 30.0 - - - - - - - - - - -Contribution to Google Foundation - - - - - - - - - - - -Total Expenses 788.3 855.5 933.1 1,169.3 1,317.7 1,617.3 1,692.5 1,915.2 2,122.5 2,212.6 2,340.8 2,627.9Operating Income 742.7 815.4 931.3 1,060.6 1,221.2 1,104.6 1,317.8 1,532.1 1,751.3 1,798.7 1,916.4 2,186.8Pro Forma Operating Income 887.4 924.5 1,031.2 1,195.0 1,405.1 1,346.1 1,515.8 1,727.1 1,956.3 2,013.7 2,141.4 2,421.8Operating Margins 49% 49% 50% 48% 48% 41% 44% 44% 45% 45% 45% 45%Pro Forma Operating Margins 58% 55% 55% 54% 55% 49.5% 50.4% 50% 51% 50% 50% 50%Interest Income (Expense) 67.9 160.8 108.2 124.1 130.7 137.1 154.4 160.0 170.0 180.0 190.0 200.0EBT 811 976 1,040 1,185 1,352 1,242 1,472 1,692 1,921 1,979 2,106 2,387Less Taxes 218 255 306 154 350 317 402 465 500 514 548 621Tax Rate 27% 26% 29% 13% 26% 25% 27% 28% 26% 26% 26% 26%EBITDA 998.5 1,050.7 1,176.5 1,384.3 1,610.1 1,569.5 1,765.2 2,013.1 2,266.3 2,347.7 2,499.4 2,803.8Margins 65.2% 62.9% 63.1% 62.1% 63.4% 57.7% 58.6% 58.4% 58.5% 58.5% 58.7% 58.2% 165
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com FY2006 FY2007E FY 2008E Q1 -06 Q2-06 Q3-06 Q4-06 Q1 -07 Q2-07 Q3-07 Q4-07E Q1 -08E Q2-08E Q3-08E Q4-08EEAT 592.3 721.1 733.4 1,030.7 1,002.2 925.1 1,070.0 1,226.8 1,421.7 1,464.2 1,558.7 1,766.3Tax Benefit --> Stock Comp & Foundation 39.8 (3.2) 20.9 167.8 26.8 43.0 31.0 53.6 53.3 55.9 58.5 61.1Pro forma EAT 697.2 772.1 812.3 997.3 1,159.3 1,123.6 1,236.9 1,368.2 1,573.4 1,623.3 1,725.2 1,940.2GAAP EPS 1.95 2.33 2.36 3.29 3.18 2.93 3.38 3.82 4.37 4.48 4.74 5.34Pro forma EPS 2.29 2.49 2.62 3.18 3.68 3.56 3.91 4.26 4.84 4.96 5.24 5.86Diluted Sharecount 304.1 310.0 310.6 313.5 314.9 315.5 316.6 321.0 325.0 327.0 329.0 331.0% of RevenueGoogle website 85% 86% 87% 89% 90% 91% 91% 93% 93% 93% 94% 94%Network Partners 13% 13% 11% 10% 9% 7% 8% 6% 6% 6% 5% 5%R&D 11.3% 12.7% 13.5% 13.7% 11.3% 13.8% 13.9% 13.4% 13.2% 13.2% 13.0% 13.0%Sales & Marketing 11.4% 10.9% 10.3% 10.8% 10.8% 11.7% 11.7% 11.2% 10.8% 10.8% 10.8% 10.8%General & Administrative 7.6% 9.0% 9.0% 8.6% 9.1% 10.2% 9.6% 9.6% 9.3% 9.3% 9.3% 9.2%Q/Q GrowthR&D 10% 22% 18% 21% -6% 30% 11% 10% 11% 4% 5% 13%Sales & Marketing 13% 4% 6% 25% 14% 16% 10% 10% 8% 4% 6% 13%General & Administrative 2% 30% 12% 14% 19% 21% 3% 15% 9% 4% 6% 12%Y/Y GrowthR&D 218% 221% 192% 194% 166% 177% 167% 152% 178% 141% 132% 135%Sales & Marketing 211% 188% 183% 156% 157% 175% 182% 160% 152% 136% 131% 135%General & Administrative 203% 211% 182% 169% 198% 185% 171% 172% 157% 134% 137% 134%Total Expenses 124% 106% 80% 62% 67% 89% 81% 64% 61% 37% 38% 37%Contribution Margins 54% 51% 53% 51% 51% 40% 42% 44% 41% 52% 50% 51%Source: Company reports and JPMorgan estimates.166
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 99: GOOG Annual Balance Sheet$ in millions FY FY FY FY 2006E 2007E 2008E 2009ECash and Cash Equivalents 3,544.7 6,239.2 11,914.1 19,650.4Short term investments 7,699.2 7,980.9 7,980.9 7,980.9Accounts Receivable 1,322.3 2,068.4 2,888.9 3,702.0Income taxes receivable - - - -Deferred Income Tax 29.7 88.0 88.0 88.0Prepaid revenue share,expenses and other assets 443.9 689.5 963.0 1,234.0Total Current Assets 13,039.8 17,066.0 23,834.8 32,655.2 -Non-marketable equity securities 1,031.9 1,048.1 1,048.1 1,048.1Property, Plant, and Equipment 2,395.2 3,923.8 5,563.8 7,043.8Goodwill 1,545.1 2,277.4 2,277.4 2,277.4Intangible Assets 346.8 485.3 485.3 485.3Deferred income taxes, net - - - -Prepaid revenue share, expenses and other non current assets 114.5 170.1 170.1 170.1Total Assets 18,473.4 24,970.7 33,379.5 43,679.9Accounts Payable 211.2 265.5 529.6 678.7Accrued Compensation and benefits 351.7 568.1 553.7 709.5Accrued Expenses and other current liabilities 265.9 459.1 553.7 709.5Accrued revenue share 370.4 581.4 812.0 1,040.6Deferred revenue 105.1 167.3 233.7 299.5Income taxes payable 0.4 - - -Current portion of equipment leases - - - -Total Current Liabilities 1,304.6 2,041.5 2,682.7 3,437.8Long term portion of equipment leases - - - -Deferred revenue, long term 20.0 23.7 23.7 23.7Liability for stock options exercised early, long term - - - -Deferred income taxes 40.4 - - -Income taxes payable, long-term - - - -Other long term liabilities 68.5 91.0 91.0 91.0Total Long Term Liabilities 128.9 114.7 114.7 114.7 -Redeemable convertible, preferred stock warrant - - - - -Common stock 0.3 - 0 -Preferred stock - - 0 -Additional Paid in capital 11,882.9 - 0 -Note receivable from office/stockholder - - 0 -Deferred stock based compensation - - 0 -Accumulated other comprehensive income 23.3 - 0 -Retained Earnings 5,133.3 - 0 -Total Stockholders equity 17,039.8 22,814.5 30,582.1 40,127.4 -Total Liabilities & Equity 18,473.4 24,970.7 33,379.5 43,679.9Source: Company reports and JPMorgan estimates. 167
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 100: GOOG Annual Cash Flow Statement$ in millions FY FY FY FY 2006E 2007E 2008E 2009EOperating ActivitiesNet income 3,077.4 4,224.1 6,210.9 8,112.3Depreciation and Amortization 494.4 805.8 1,160.0 1,320.0Amortization of Warrants - - - -Amortization of Intangibles 77.5 157.9 224.0 224.0In process R&D 10.8 - - -Stock based compensation 458.1 818.3 880.0 880.0Excess tax benefit from stock-based award activity (581.7) (238.6) - -Other 1.7 (7.2) - -Changes in WC -Accounts Receivables (624.0) (559.4) - -Income taxes 398.4 431.0 - -Prepaid revenue share,expenses and other assets (289.2) (237.3) - -Accounts Payable 95.4 20.2 - -Accrued Expenses and other liabilities 291.5 206.5 - -Accrued revenue share 139.3 136.4 - -Deferred revenue 30.8 32.1 - -Tax Benefit from exercise Option - - - -Non Recurring Portion - - - -Net Cash provided by Operating Activities 3,580.5 5,790.0 8,474.9 10,536.3FCF 1,677.7 3,490.3 5,674.9 7,736.3Investing ActivitiesPurchase of PP&E (1,902.8) (2,299.6) (2,800.0) (2,800.0)Purchase of short term investments (26,681.9) (11,756.1) - -Maturities and sale of short term investments 23,107.1 11,519.0 - -Investments in non-marketable equity securities (1,019.1) (21.3) - -Acquisitions, net of cash acquired (402.4) (823.1) - -Change in other assets - - - -Net Cash used in Investing Activities (6,899.2) (3,381.2) (2,800.0) (2,800.0)Financing ActivitiesProceeds from issuance of convertible preference stock - - - -Proceeds from IPO/Public Offering 2,063.5 - - -Proceeds from exercise of stock options 321.1 19.1 - -Proceeds from exercise of warrants - - - -Payments of notes receivables from shareholders - - - -Excess tax benefits from stock-based award activity 581.7 238.6 - -Payment of Principal on capital leases and eqpt loans - - - -Net Cash provided by Financing Activities 2,966.4 257.7 - -Effect of Exchange rate changes 19.7 28.1 - -Net Increase (Decrease) in Cash & Equivalents (332.5) 2,694.5 5,674.9 7,736.3Cash and Cash Equivalents - Beginning 3,877.4 3,544.9 6,239.4 11,914.3Cash and Cash Equivalents - Ending 3,544.9 6,239.4 11,914.3 19,650.6Source: Company reports and JPMorgan estimates.168
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com HouseValues, Underweight ($2.94) As HouseValues’ businesses continue to be in transition, we believe it is strategically disadvantaged to weather the ongoing downturn in the real estate market. Despite a strong balance sheet ($74.5M net cash at the end of 3Q’07), we believe the company will continue to be impacted by weakness in the housing market and therefore maintain our Underweight rating. • Lead generation business – we expect ARPC to stabilize. As a result of the housing slowdown, SOLD has been shedding costumers at a rapid clip, losing 1,559 customers in 3Q’07 alone. We believe that a large number of customers lost were lower value customers. As a result, we expect ARPC to stabilize in 2008, at $410, from $403 in 2007. • Acquisition of Realty Generator could provide some upside to our F08 estimates. SOLD announced the acquisition of Realty Generator, a provider of marketing and technology solutions to real estate brokerage companies, in November ’07. While the acquisition was small, ~$10M, we expect it to be accretive to EBITDA in F’08 and the acquisition demonstrates that management is looking to diversify its product mix. • Acquisitions could continue. With $74.5M in cash at the end of 3Q07, and slow real estate markets depressing valuations in the space, we expect HouseValues’ to actively pursue acquisitions. • 2008 share price catalysts. We will look for the following as signs of an improving business model in 2008: (1) stabilization in ARPC, and (2) revenue generation of the Realty Generator acquisition. We would be concerned if we saw the following trends develop in 2008: (1) continued declines in ARPC, (2) accelerating customer losses, and (3) continued declines in U.S. home sales. • Tweaking 4Q estimates. We are maintaining our 4Q’07 revenue and EBITDA estimates of $12.3M and $1.6M, and modifying our 4Q07 EPS estimate from ($0.01) to $0.00. The table below outlines our current estimates, including our newly introduced 2009 estimates. Table 101: HouseValues Estimate Snapshot $ in millions HouseValues 4Q07 F07 F08 F09 F07 Y/Y F08 Y/Y F09 Y/Y JPMorgan Revenue 12.3 59.9 49.3 54.0 -36.7% -17.7% 9.6% EBITDA 1.6 3.4 7.4 8.1 -56.7% 118.6% 9.6% EPS 0.00 (0.09) 0.02 0.07 NM NM 376.1% Consensus Revenue 11.8 59.5 46.2 - -37.1% -22.4% NM EBITDA 1.6 3.4 7.4 - -56.6% 117.6% NM EPS (0.02) (0.10) (0.07) - NM NM NM Source: Company reports, FactSet and JPMorgan estimates. 169
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Key Financial Metrics & Forecasts The following table summarizes our estimates for HouseValues’ customer additions and average revenue per real estate customer through 2008. Table 102: SOLD Customer Metrics and ARPC Forecast 2005 2006 2007E 2008E 2009E Real Estate Customers 15,700 14,596 9,948 10,448 11,648 Net Customer Additions 5,068 (375) (5,745) 500 1,200 Y/Y growth 46.1% -2.3% -36.6% 5.0% 11.5% Average Revenue per Real Estate Customer 489.25 446.5 402.8 410 408 ARPC Growth Y/Y 10.4% -8.7% -9.8% 1.7% -0.5% Source: Company Reports and JPMorgan estimates Our Estimates and Outlook for 2008 Our updated 2008 estimates call for a Y/Y decline in revenues, down 17.7%, and Y/Y improvements in EBITDA, up 118.6%, as a result of cost savings initiatives, including the closing of a call center. Specifically, we are modeling 2008 revenues, EBITDA, and EPS of $49.3M, $7.4M, and $0.02. Our Estimates and Outlook for 2009 We are introducing 2009 estimates calling for revenue, EBITDA, and earnings of $54M, $8.1M, and $0.07. These estimates incorporate the following assumptions: (1) revenue per real estate subscriber will decline slightly in 2009, (2) a marginal revenue impact from the acquisition of Realty Generator, and (3) sustained margin improvements despite continued softness in the real estate market. Valuation and Rating Analysis On an EV/EBITDA basis, SOLD trades at 1.0x our F’08 EBITDA estimate of $7.4M, vs. peers at 20.5x. Despite this discount, we remain very concerned about SOLD’s longer-term growth outlook for two main reasons: • Even as the real estate market faces significant headwinds, the online real estate sector continues to become more competitive, with current players upgrading current offerings and new players entering the space. • Additionally, other players in the space with multiple product offerings have introduced lead-generation products that supplement other real estate offerings such as listing enhancement products. The company is likely to face increased competition from players such as Move, Inc., Homegain, LendingTree, ZipRealty, and Zillow as more advertising dollars shift online. Therefore, we believe the current discount is justified and SOLD could continue to face continued pressure on its cash balance and therefore, we maintain our Underweight rating.170
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.com Risks to Our Rating Our current estimates are based on the assumption that difficult real estate market conditions will persist during 2007 and 2008, which could impact HouseValue’s top and bottom lines. Inherent in our assumptions are continued customer churn and limited upside potential in revenue per customer. Should market conditions improve sooner than we anticipate, our estimates could prove to be too conservative. 171
  • Imran Khan North America Equity Research(1-212) 622-6693 02 January 2008imran.t.khan@jpmorgan.comTable 103: SOLD Annual Income Statement$ in millions, except per share data FY FY FY FY 2006 2007E 2008E 2009ERevenues 94.6 59.9 49.3 54.0House Values/Just Listed 62.2 59.9 49.3 54.0Other 12.3 - - -Sales & Marketing 61.8 38.7 30.3 33.2Technology and Product Development 13.0 8.7 6.0 6.6General & Admin 12.0 9.1 5.5 6.1Restruc. / Impairt of goodwill + intang. asstsDepreciation 5.2 5.3 6.0 3.6Amortization 1.1 0.7 1.6 2.0Stock based compensation 4.0 3.2 2.1 3.2Total Expenses 97.0 67.0 51.6 54.6Total Recurring Expenses 86.8 56.5 41.9 45.9Income from Operations (2.4) (7.1) (2.3) (0.6)Pro Forma Operating Income 7.8 3.4 7.4 8.1Operating Margins -2.6% -11.8% -4.6% -1.1%Pro Forma Operating Mar