Pivotal Research: Madison and Wall 4 13-12


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Welcome to Pivotal Research’s “Madison & Wall”. The title refers to our work which sits at the intersection between the advertising industry and the financial world. We hope you’ll find these brief notes useful for their contrast to the hyperbole that pervades much of the chatter at that location.

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Pivotal Research: Madison and Wall 4 13-12

  1. 1. PIVOTAL U.S. Equity Research Internet / Advertising Pivotal Research GroupMadison & Wall April 13, 2012A Recurring Review of Topics Affecting Advertising-Supported MediaWelcome to Pivotal Research’s “Madison & Wall”. The title refers to our work which Brian Wieser, CFAsits at the intersection between the advertising industry and the financial world. We 212-514-4682hope you’ll find these brief notes useful for their contrast to the hyperbole that brian@pvtl.compervades much of the chatter at that location.BEWARE OF GEEKS BEARING GIFSCloud computing paired with social media increasingly empowers smallcompanies to credibly threaten giants. Expect more early-stage companies toplay to this trend, extracting billions of dollars in the process, and causingsome concern that Facebook’s capital needs may be durably higher thanpreviously expected. Pivotal Research Group 853 Broadway, Suite 1406 New York, NY 10003 Important Disclosures Are Located In The Appendix
  2. 2. BEWARE OF GEEKS BEARING GIFSCloud computing paired with social media increasingly empowers small companies to crediblythreaten giants. Expect more early-stage companies to play to this trend, extracting billions ofdollars in the process, and causing some concern that Facebook’s capital needs may be durablyhigher than previously expected.Fear is a powerful motivator. In a world of fickle tastes and conditional loyalties, anyone depending upontaste and loyalty is correct to be fearful. In this context, it is unremarkable that Facebook announced thisweek that it is purchasing Instagram for consideration of approximately $1 billion (the percentage of cashand stock is as yet unknown).Instagram is a social photo sharing app for mobile devices. Its business model was oriented towardsgenerating revenue from advertising and tool licensing. The company is private, having raised $7.5 millionto date – not including a round of funding that closed immediately in advance of the acquisitionannouncement – and likely generating de minimus revenue. Founded two years ago, the companyreportedly had one million registered users by December 2010 which grew to approximately 30 millionearlier this year.We’ve previously highlighted that Facebook and Google are locked in a capital spending arms race, aseach company seeks to offer up services with low latency, high speeds and fat storage. Both companiesare each spending hundreds of millions of dollars new data centers every year. In total, we estimateFacebook will spend around $2 billion each year on capital expenditures, compared with Google (whosearchitecture and business needs are much greater given its heavy reliance on video delivery andprocessing of data across the web) at a figure that should approach $6 billion each year by 2017. WhileGoogle has a history of making frequent and sometimes sizeable acquisitions appropriate for its businessmix, Facebook’s history had until now suggested smaller acquisitions were its only area of focus, as thecompany tended towards “acqui-hires” (whereby a small company would be bought primarily to bring thatcompany’s founder into Facebook).There are many small companies with tens of millions of users, which in turn have only required limitedamounts of capital. Some of these small companies will be able to create the conditions under whichlarger potential acquirers will fear the strategic disadvantage they may face if they don’t possess certaincapabilities and their director competitors do. There are many instances of failure in this regard (Bebocomes to mind) but also some successes (Google’s Doubleclick, no less). This possibility that acompetitor will succeed enough to create a wedge against a competitor, even if remote, is enough of arationale to justify spending significantly to secure an asset and keep it out of the competitor’s hands.We saw this play out across dozens of acquisitions that were made in the middle of the last decade,primarily with each of Google, Microsoft, AOL and Yahoo as potential buyers. Fear could be used (rightly,as it turned out) to compel each to spend billions and billions of dollars on early stage companies. It reallyonly benefitted Google. What’s different now is that the next generation of companies which can drive thisfear are able to do so for significantly less capital than ever before. This means that increasing numbersof small companies are now able to establish themselves as credible threats to incumbent web-basedcompanies.Facebook was right to buy Instagram given the very plausible threat that Facebook would have faced ifInstagram were otherwise bought by Google to drive all of this fast growing traffic to its own socialnetwork, Google+. But how many more Instagrams will there be? An extra billion dollars of acquisitionsevery year would equate to a reduction of approximately $10 billion of valuation for the Facebook underour assumptions. It’s possible that the company will “only” need $1 billion on building out data centers andlike functions every year, and so $1 billion in acquisitions could implicitly be incorporated into our modelalready. But it is becoming increasingly clear that fear of loss of dominant market share, the openlycompetitive markets on the web, and the trends enabling small companies to succeed will requireincumbents to continue spending real money – usually unprofitably – every year. -2- Brian Wieser 212-514-4682 Pivotal Research Group
  3. 3. Appendix: Important DisclosuresAnalyst CertificationI, Brian W. Wieser, hereby certify that the views expressed in this research report accurately reflect mypersonal views about the subject company and their securities. I further certify that I have not receivedand will not receive direct or indirect compensation related to specific recommendations or viewscontained in this research report.Legal DisclaimersPivotal Research Group LLC is an independent equity research company and is neither a broker dealernor offers investment banking services. Pivotal Research Group LLC is not a market maker for anysecurities, does not hold any securities positions, and does not seek compensation for investmentbanking services. The analyst preparing this report does not own any securities of the subject companyand does not receive any compensation directly or indirectly from investment banking services.Stock RatingsPivotal Research Group LLC assigns one of three ratings based on an expectation of absolute total return(price change plus dividends) over a twelve month time frame. The ratings are based on the followingcriteria:BUY: The security is expected to have an absolute return in excess of 15%.HOLD: The security is expected to have an absolute return of between plus and minus 15%.SELL: The security is expected to have an absolute return less than minus 15%.Ratings DistributionPivotal Research LLC currently provides research coverage of 16 companies, of which 75% are ratedBUY, 19% are rated HOLD, 0% are rated SELL and 6% are unrated. Our company does not offerinvestment banking services. This data is accurate as-of March 29, 2012.Price Chart and Target Price HistoryOther DisclaimersInformation contained in this report has been prepared from sources that are believed to be reliable andaccurate but are not guaranteed by us and do not represent a complete summary or statement of allavailable data. Additional information is available upon request. Furthermore, information and opinionsexpressed are subject to change without notice and we are under no obligation to inform you of suchchange.This report is has been prepared solely for our institutional clients. Ratings and target prices do not takeinto account the particular investment objectives, financial and/or tax situation, or needs of individualinvestors. Investment decisions should take into account all available information, not just that which iscontained in this report. Furthermore, nothing contained in this report should be considered an offer orsolicitation by Pivotal Research Group LLC to buy or sell any securities or other financial instruments.Past performance is not indicative of future performance and estimates of future performance containedin this report are based on assumptions that may not be realized.Material in this report, except that which is supplied by third parties, is Copyright ©2012, by PivotalResearch LLC. All rights reserved. No portion may be reproduced, sold, or redistributed in any formwithout express written consent of Pivotal Research Group LLC. -3- Brian Wieser 212-514-4682 Pivotal Research Group
  4. 4. Commission Sharing ArrangementsPivotal Research Group LLC has commission sharing arrangements (CSA) with numerous broker-dealers. Please contact Jeff Shelton at 212-514-4681 for further information. Additional Information Available Upon Request -4- Brian Wieser 212-514-4682 Pivotal Research Group