Asia Pacific Equity Research 06 January 2011 Nothing But Net - Asia 2011 Internet Investment Guide
Upcoming SlideShare
Loading in...5
×
 

Asia Pacific Equity Research 06 January 2011 Nothing But Net - Asia 2011 Internet Investment Guide

on

  • 20,758 views

China Top Predictions for 2011 ...

China Top Predictions for 2011
(1) eCommerce to see wider adoption, driven by convenience, lower-price
alternatives to traditional retail, and improved trust & safety. Gross merchandise
volume (GMV) is expected to reach Rmb723B in 2011, or less than 4% of retail
sales.
(2) Social commerce. Expect social sites to be an emerging and important traffic
generator for eCommerce companies. Synergistic relationship between social
networks and commerce merchants will fuel growth for both segments.
(3) Game segment likely to see re-rating with good game titles launch. Highly
anticipated games in 2011 include Duke of Mountain Deer, World of Warcraft
Cataclysm, etc., which could generate greater player interest and, as such, sector rerating.
(4) Video advertising to prompt ad dollar shift from TV to internet. With the
recent IPO of Youku, a broader range of online video content, growing online video
user base, and a familiar ad format, TV advertisers are likely to accelerate the ad
budget shift from offline to online.
(5) Mobile internet to see increased competition. We expect internet leaders like
Baidu and Tencent to formally launch middle-ware products that could include thirdparty
application distribution platforms; compete with existing players OLNHUCWeb
DQGother mobile game platforms.
(6) Search continues to see solid growth, with wider market adoption. Baidu still
maintains dominance, other players such as Soso and Sogou still unlikely to gain
meaningful market share.
(7) Solid consumer spending trend supports good advertising segment growth.
Expect continued good macro environment to support consumer spending. We
believe the sector growth story remains intact: internet usage growth, particularly in
lower-tier cities, to drive ad budgets online.
(8) Expect transition from time-base pricing to CPM-base pricing t

Statistics

Views

Total Views
20,758
Views on SlideShare
20,732
Embed Views
26

Actions

Likes
6
Downloads
891
Comments
0

7 Embeds 26

http://www.weebly.com 12
http://www.4pull.net 5
http://nacuvasilica.blogspot.com 4
http://broadstlive.blogspot.com 2
http://socialcommercetoday.com 1
http://static.slidesharecdn.com 1
http://twitter.com 1
More...

Accessibility

Categories

Upload Details

Uploaded via as Adobe PDF

Usage Rights

© All Rights Reserved

Report content

Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

Cancel

Asia Pacific Equity Research 06 January 2011 Nothing But Net - Asia 2011 Internet Investment Guide Asia Pacific Equity Research 06 January 2011 Nothing But Net - Asia 2011 Internet Investment Guide Document Transcript

  • Asia Pacific Equity Research 06 January 2011 Nothing But Net - Asia 2011 Internet Investment Guide China Internet AC Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com J.P. Morgan Securities (Asia Pacific) Limited Japan Internet AC Hiroshi Kamide (81-3) 6736 8602 hiroshi.kamide@jpmorgan.com JPMorgan Securities Japan Co., Ltd. Korea Internet AC Sungmin Chang, CFA (82-2) 758-5719 sungmin.chang@jpmorgan.com J.P. Morgan Securities (Far East) Ltd, Seoul Branch US Internet Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com J.P. Morgan Securities LLC This report is an excerpt of “Nothing But Net: 2011 Internet Investment Guide", published on Jan 3, 2011 See page 178 for analyst certification and important disclosures, including non-US analyst disclosures. J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
  • Dick Wei Asia Pacific Equity Research (852) 2800-8535 06 January 2011 dick.x.wei@jpmorgan.com Table of Contents China: Top Predictions for 2011...................................................................... 5 China Internet Market Overview...................................................................... 6 Online Advertising ......................................................................................... 10 Display Advertising........................................................................................ 15 Online Search................................................................................................ 16 Online Video.................................................................................................. 25 Social Networking.......................................................................................... 30 Miniblog Platform........................................................................................... 33 eCommerce................................................................................................... 34 Online Gaming .............................................................................................. 44 Japan Internet Market Overview ................................................................... 57 Korea: Sector Summary................................................................................ 81 Companies Alibaba.com Limited ...................................................................................... 85 Baidu.com ..................................................................................................... 89 China Finance Online.................................................................................... 95 Netease ......................................................................................................... 99 Shanda Games ........................................................................................... 103 Shanda Interactive Entertainment Ltd......................................................... 107 Sina Corp .................................................................................................... 111 Sohu.Com ................................................................................................... 115 Tencent ....................................................................................................... 119 The9 Limited................................................................................................ 123 DeNA (2432) ............................................................................................... 127 Gree (3632) ................................................................................................. 135 Mixi (2121)................................................................................................... 143 Rakuten (4755)............................................................................................ 149 Yahoo Japan (4689).................................................................................... 163 Daum........................................................................................................... 175 The authors acknowledge the contribution of Gon Suk Lee of J.P. Morgan Securities (Far East) Ltd, Seoul Branch,Ritesh Gupta of J.P. Morgan India Private Ltd, and Yusuke Maeda of J.P. Morgan Securities Japan Co., Ltd to this report . 2 2
  • Dick Wei Asia Pacific Equity Research (852) 2800-8535 06 January 2011 dick.x.wei@jpmorgan.com Sector Overview 3 3
  • Dick Wei Asia Pacific Equity Research (852) 2800-8535 06 January 2011 dick.x.wei@jpmorgan.com 4 2
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com China China Top Predictions for 2011 (1) eCommerce to see wider adoption, driven by convenience, lower-price alternatives to traditional retail, and improved trust & safety. Gross merchandise volume (GMV) is expected to reach Rmb723B in 2011, or less than 4% of retail sales. (2) Social commerce. Expect social sites to be an emerging and important traffic generator for eCommerce companies. Synergistic relationship between social networks and commerce merchants will fuel growth for both segments. (3) Game segment likely to see re-rating with good game titles launch. Highly anticipated games in 2011 include Duke of Mountain Deer, World of Warcraft Cataclysm, etc., which could generate greater player interest and, as such, sector re- rating. (4) Video advertising to prompt ad dollar shift from TV to internet. With the recent IPO of Youku, a broader range of online video content, growing online video user base, and a familiar ad format, TV advertisers are likely to accelerate the ad budget shift from offline to online. (5) Mobile internet to see increased competition. We expect internet leaders like Baidu and Tencent to formally launch middle-ware products that could include third- party application distribution platforms; compete with existing players UCWeb other mobile game platforms. (6) Search continues to see solid growth, with wider market adoption. Baidu still maintains dominance, other players such as Soso and Sogou still unlikely to gain meaningful market share. (7) Solid consumer spending trend supports good advertising segment growth. Expect continued good macro environment to support consumer spending. We believe the sector growth story remains intact: internet usage growth, particularly in lower-tier cities, to drive ad budgets online. (8) Expect transition from time-base pricing to CPM-base pricing to accelerate in 2011, but remain gradual, driven by user-segregation and better online ad- serving/tracking technology. Yet, leading portals will still benefit from their own brand influence. (9) 2011 Rmb appreciation to improve sector profitability. Expect sector margins to have very slight improvements from Rmb appreciation, as only a small portion of costs are in US dollars (game licensing fee, overseas video/sports content fee, and some servers, etc.). Benefits to come from translation gains from Rmb-denominated EPS to US$-denominated EPS. (10) More IPOs likely in 2011. We expect investors will likely continue to look for growth investment opportunities in 2011. We think China’s internet segment offers good secular growth, as well as a number of sizable private companies. We believe more new listings are likely. 5 141
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com China Internet Market Overview Internet penetration still low at 31% China’s internet population grew at a rapid pace in 2010, increasing 24% Y/Y to 420M by June 2010, or at a penetration rate of 31.2%, according to China Internet Network Information Center (CNNIC). Since late 2008, China has the world’s largest internet user base. This strong growth in recent years has been driven by factors such as robust GDP growth, lower-priced computers, more affordable telecom connection fees, government support for internet usage, and low-cost entertainment aspects. China Internet Users and Penetration Rate 600 534 40% 494 454 35% 500 420 384 30% 400 338 298 25% 300 253 20% 210 200 137 162 15% 103 111 123 80 87 94 10% 100 34 46 59 68 5% 0 0% Dec-10E Dec-11E Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11E Number of China Internet Users (Left, millions) Penetration Rate as % of Total Population (Right) Source: CNNIC J.P. Morgan estimates. Further, rural internet populations continued to adopt the internet in 1H10 with a 7.8% growth rate. Rural Internet Penetration Reached 16.0% from 11.7% in One and a Half Years 60% 48.6% 50% 35.2% 40% 30% 19.7% 16.0% 20% 11.7% 10% 3.1% 0% Dec-06 Dec-08 Jun-10 Penetration Rate (Urban Population) Penetration Rate (Rural Population) Source: CNNIC. 6 143
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com How much more growth? Despite this rapid growth, China's internet penetration rate of about 31% of the population is still well below that of developed markets like the US, Japan, and Korea (over 70%). We expect internet users to grow by around 17.7% Y/Y in 2011 to reach ~534MM, or the penetration rate to reach ~39% of the population by the end of 2011. We draw the parallel between internet penetration and mobile phone penetration in China. We observe that in recent years internet penetration has lagged mobile phone penetration by around four to five years. This gives us confidence that internet penetration will likely continue to grow in the future, with lower-cost connection fees and equipment costs. China Internet and Mobile Phone Users 900 800 700 600 500 400 300 200 100 0 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Mobile phone users (Mn) Intenet users (Mn) Mobile users shifted 4.5 years Source: CNNIC, Ministry of Industry and Information Technology (MIIT), J.P. Morgan estimates. Broadband and Mobile continue rapid growth According to CNNIC, the number of users with broadband internet access grew 28% Y/Y to 346M (90% of total users) by the end of 2009, and to 364MM (87% of total users) by June 2010. Broadband Internet Users in China Broadband Internet Users as % of Total Internet Users 400 346 364 100% 85% 91% 94% 90% 87% 319 75% 78% 270 80% 66% 300 214 163 60% 200 122 77 91 40% 100 20% 0 0% Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Broadband Users (Mn) Broadband users as % of total Internet users Source: CNNIC. Source: CNNIC. 7 144
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com According to the latest MIIT data, the number of broadband subscriber lines reached 123.2 million by October 2010. Broadband Subscriber Penetration by Number of Broadband Lines 2005 2006 2007 2008 2009 2010* Broadband subscribers (MM) 37.5 51.9 66.5 83.4 105.0 123.2 Population Penetration (%) 2.9% 4.0% 5.1% 6.4% 7.9% 9.0% Households Penetration (%) 9.1% 12.5% 16.1% 20.0% 24.0% 28.2% Source: CNNIC, Ministry of Industry and Information Technology (MIIT), J.P. Morgan estimates. Note: Data as of October 2010. Internet access device The number of mobile internet users increased by 78% Y/Y to 277M by Jun-10, as per CNNIC. The number of mobile internet users was 66% of all internet users and 33% of all mobile users. We expect mobile internet usage to increase significantly once 3G penetration increases amongst consumers. Methods of Accessing by Device 80% 73.6% 65.9% 70% 60% 50% 36.8% 40% 30% 20% 10% 0% Desktop Laptop Mobile Phone Source: CNNIC (Jun-10). Home has become preferred place to access the internet Given the increase in internet-accessible computers, broadband penetration, and per capita wealth, the home has become the preferred place for most users to access the internet, with more than four-fifths of all internet users accessing the internet from home. The number of people accessing the internet from the office also increased to 33% at the end of 1H10 from 30% in late 2009. Main Access Locations 100% 88.40% 80% 60% 33.60% 33.20% 40% 20% 0% Home Internet Café Company Source: CNNIC (Jun-10). 8 145
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Average time spent online remains stable CNNIC’s Jun-10 survey showed users spent an average of 19.8 hours per week online. This was up from 18.7 hours per week six months earlier. While the overall average online time per user remains stable, we note old users likely spend more time online than new users. We also note that internet usage has more than doubled compared to the 9.8 hours per week spent online in December 2002. Average Time Spent Online Hours/week 25 18.6 19.0 18.7 19.8 20 15.9 16.5 16.9 16.2 16.6 18.0 13.0 13.4 12.3 13.2 14.0 15 9.8 10 5 0 Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- 02 03 03 04 04 05 05 06 06 07 07 08 08 09 09 10 Av erage Accessing Time Per Week Source: CNNIC (Jun-10). Media is the most popular internet use According to the Jun-10 CNNIC survey, online music is the most popular use of the internet, with 82.5% of internet users accessing online music. Online news is also popular, with 78.5% usage, while search engine use was 76.3%. Online payment and online shopping have seen fast growth with 36.2% and 31.4% user increases in six months by June 2010, respectively. Internet Usage by Category Service type % of surveyed use the service Users in millions Online Music/download 82.5% 346.5 News 78.5% 329.7 Search engine 76.3% 320.5 Instant messaging ( chat room, QQ, ICQ) 72.4% 304.1 Online Games 70.5% 296.1 Online movie (include download)/Video 63.2% 265.4 Email 56.5% 237.3 Blog 55.1% 231.4 Social Networking 50.1% 210.4 Online literature 44.8% 188.2 Online shopping 33.8% 142.0 BBS/forum 31.5% 132.3 Online payment 30.5% 128.1 Online banking 30.5% 128.1 Online stock trading 15.0% 63.0 Online travel reservation 8.6% 36.1 Source: CNNIC (Jun-10). Chinese mobile users cite chat as the most used function while accessing the internet with their phones. Mobile search is chosen by 48.4% of mobile users while listening/downloading music was the third most popular activity with 45.3% users. 9 146
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Chat Is the Most Used Application on Mobile 70% 61.5% 60% 48.4% 45.3% 43.3% 50% 35.5% 40% 30% 21.1% 20.4% 16.0% 20% 6.1% 10% 0% Mobile Chat Mobile Online music Mobile Mobile Online mobile Mobile Video Mobile email Mobile Search listening or Literature community game Payment downloading Source: CNNIC (Jun-10). Online Advertising Maintain positive view on 2011 and longer-term online ad market growth We expect the rising number of internet users and increasing times spent on the internet will continue to drive online ad allocation. Lower computer prices, declining connection fees, higher influence of online media, and government support should continue to drive internet growth in China. Time spent on internet per users should accelerate from the increased penetration of smartphones and tablets. Increasing Time Spent on Internet per User per Week 21 19.8 20 18.7 19 18 18 16.6 17 16.2 16 15 Dec-07 Dec-08 Jun-09 Dec-09 Jun-10 Time Spent Online (In Hr/Week) Source: CNNIC. The total online ad market still accounts for a relatively small portion of China’s overall advertising market (expected to be around 15.8% in 2011). We forecast the online ad market to witness 23% YoY growth in 2011, to reach Rmb30B (or US$4.4B) and 31% YoY growth in 2012 to reach Rmb39.3B (US$5.8B). China search ad is still ~50% of Search ads continue to grow faster than brand ads the total online ad market. This We expect search advertising to continue to see stronger growth than brand compares with around 67% in advertising in 2011. From a top-down perspective, search ad is ~61% of the total the US online ad market in China in 2011E. This compares with ~70% in the US. As such, we still see room for growth. From a bottom-up perspective, we expect market drivers to be: 1) increasing user adoption of search, 2) higher SME advertisers’ adoption of pay-for-performance advertising, 3) search usage to increase with the growing eCommerce market, and 4) use of search ads as a brand advertising tool. 10 147
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com China Online Advertising Market Forecast from 2006 to 2012E 2006 2007 2008 2009E 2010E 2011E 2012E Brand Advertising (RMB M) 3,377 4,559 6,428 6,942 9,025 11,462 14,442 Search Advertising (RMB M) 1,442 2,851 5,309 7,213 12,015 18,427 24,751 Other Online Format (RMB M) 109 122 135 135 135 135 135 Total Online ad market (RMB M): 4,928 7,533 11,872 14,290 21,175 30,023 39,328 Total Online ad market (US$M) 621 999 1,721 2,083 3,100 4,448 5,826 Growth Rate (Rmb, %) 54.6% 60.8% 72.3% 21.1% 48.8% 43.5% 31.0% Total China ad market (Rmb M) 105,712 116,422 139,707 142,501 165,301 190,096 216,709 Growth Rate (Rmb, %) 16.5% 10.1% 20.0% 2.0% 16.0% 15.0% 14.0% Ad market as % of GDP 0.48% 0.44% 0.46% 0.42% 0.42% 0.44% 0.45% Online ad as % of Total ad market 4.7% 6.5% 8.5% 10.0% 12.8% 15.8% 18.1% Source: iResearch, CNNIC, J.P. Morgan estimates. Note: Growth rates are in Rmb terms. Online advertising: top-down perspective Internet usage growth – same old story, but is that what is driving the online ad spending growth expected in 2011? We expect China's internet user base to grow around 20% CAGR (2009–11) to reach a penetration rate of 39% by the end of 2011, up from the current penetration rate of 31%. Drivers for the sector include lower-priced computers, more affordable telecom connection fees, government support of internet usage, and low-cost entertainment alternative. We believe if the number of internet users grows 20% Y/Y (or roughly equal to the increase in media consumption), a minimum of 20% Y/Y growth in online brand ad spending should be achievable, given: 1) higher number of hours spent online per user, 2) the internet can reach a broader audience in smaller cities in China, 3) more measurable and lower cost compared with traditional media like TV, 4) general inflation in advertising rates, and 5) GDP growth should also drive overall ad spending up. U.S. advertising spending = 2% of GDP vs. China’s 0.5% Ad spend as a percentage of GDP in China is still below the US level; as such, we still believe advertising in China can grow at least in line with GDP. Online ads should grow even faster. Online advertising: bottom-up perspective The few sectors that we believe are likely to see fast growth next year are: autos, FMCG (Fast Moving Consumer Goods), and eCommerce. China Government’s drive to push consumption in the country should continue to help drive retails sales. As a result, the advertising industry should benefit from this trend. Automobiles advertising outlook for 2011 Driver 1: Increased auto ad dollars In 2011, we believe the auto sales environment will become more competitive with less government subsidies and oversupply. Our China Autos Analyst Frank Li suggests that auto sales for personal vehicles will decline to 15% YoY in 2011 vs. 29% in 2010E. However, excess capacity build-up over the last few years will also lead to higher competition which, in turn, should help drive up marketing expenses by auto makers. Driver 2: Increased online allocation We believe that with an affluent internet population growing, more measurable results, and lower rates vs. TV, automobile companies will continue to increase 11 148
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com budget allocations to online advertising. Currently ~7.3% of automobiles’ advertising budget is allocated online in China, according to iResearch. iResearch expects auto online advertising spending to increase to 10.9% by 2013. In addition, we believe more advertising budget will be directed to drive product sales (through advertising particular models, driving traffic for test drives) rather than general branding exercise. In our opinion, a product-specific campaign would be more effective over the internet as Chinese consumers tend to do a lot of their own research before their first car purchase. Driver 3: Geographic expansion in autos sales As we believe lower-tier cities will see faster autos sales in the next few years, we believe advertisers would also be well served by investing more on the internet for nationwide customer reach (rather than magazine and newspapers, which have limited geographic coverage). Real estate advertising Worst is over, 2011 to be a better year In 2010, the private real estate market was quite weak due to a series of restrictive measures to curb investment demand and housing price growth. Real estate advertising saw a big downturn in 1H10 as a result. We expect the reverse trend that begun in 2H10 to continue in 2011. Although we expect the government to maintain its tightening stance in 2011, the policy theme should shift from curbing demand to pushing out more housing supply while limiting price increases. We believe such a situation will benefit advertising demand. A geographic diversification story beyond Beijing, Shanghai All the major leading portals including Sohu, CRIC, and Baidu have been increasing their presence in Tier 2/Tier 3 cities, which should drive up the advertising allocation to internet from these cities. Currently, online ad spending in lower-tier cities is around 50% or less compared to Tier-1 cities. Online eCommerce advertising We believe the fast-growing eCommerce market will prompt eCommerce companies to increase spending online. In addition, with rising competition and fight for market share, eCommerce companies will be aggressive in online ad spending. In addition to general brand building through banner advertising, we expect eCommerce companies to increase spending on search as well. For eCommerce merchants, other attractive ad formats would be ads in social networking websites. Financial services advertising Investment funds increased their overall ad budgets in late 2007 and 2008; however, we’ve seen a significant pullback in 2009. With a better macro environment, we think these advertisers will likely come back in 2010 and 2011. These advertisers likely advertise with leading portals such as Sina and Sohu for stronger brand influence. We expect new drivers for the finance segment over the next few years could be insurance companies, personal banking, brokerage and wealth management advertisements. 12 149
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Fast-moving consumer goods Historically, these advertisers allocated less spending online. We expect the trend to continue to change with more allocation online, given a large internet population, a wider online demographic, and more integrated marketing campaign required to differentiate a brand. Furthermore, we believe with an increasing trend in luxury retailing, the internet would offer very cost-effective advertising. We note that brands like Cartier have begun advertising online. China - Number of Households with Assets Above US$1 Million 800 697 609 529 600 453 437 417 400 305 223 179 141 200 0 2003 2004 2005 2006 2007 2008 2009 2010E 2011E 2012E China - Number of households w ith assets abov e US$1 million Source: ACMR. Telecom sector spending We expect telcos will continue to invest in advertising in order to drive 3G adoption (government-mandated strategy) and higher competition in the space with operators trying to recoup their capex spending. Good growth in CCTV auctions Every year on November 18 (last year on November 8), CCTV (China Central Television) holds an advertising auction for the next year’s prime time ad resources on CCTV channels. This important event auctions off ~15% of the country’s total TV ad spending and sets the tone for ad growth in the coming year. In November 2010, CCTV reported prime time ad auction revenue of Rmb12.67B, up 15.52% Y/Y: This is slightly above industry expectations of around 15%. We see the following implications: (1) while advertisers are generally cautiously optimistic about 2011’s outlook, the auction results suggest consensus (hundreds of advertisers participated) is more optimistic than cautious; (2) with the CCTV auction setting a positive tone, the online brand ad rate is likely to achieve >20% growth; (3) published rates for leading portals and other media are likely to increase good next year. We continue to expect the online branded ad segment to benefit from decent 2011 overall ad market growth as well as increased online ad allocation. Industry segments The top bidders were from the food and beverage sectors, home appliances, as well as finance and security. There was also an increased presence by the auto and tourism industries. 13 150
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com We look at absolute dollar amounts of ads sold at the auction. The table below shows the auction results growth rate vs. online brand ad growth rate (in Rmb terms). CCTV Auction Results vs. Online Brand Ad Growth Year CCTV Prime time YoY Growth Online Brand Number of times (X): [Online Auction Revenue Ad Growth Brand Ad Growth / CCTV (Rmb billion) Auction Growth Ratio] 2003 3.31 26% 102% 3.9 2004 4.41 33% 72% 2.2 2005 5.25 19% 37% 2.0 2006 5.87 12% 45% 3.8 2007 6.80 16% 35% 2.2 2008 8.03 18% 41% 2.3 2009 9.26 15% 8% 0.5 2010 10.97 19% 30% 1.6 2011E 12.67 16% 27% 1.7 Source: CCTV, Zenith Optimedia. Note: J. P. Morgan current estimates. 14 151
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Display Advertising We forecast overall ad spending to see ~27% growth in 2011 For 2009, brand advertising growth was only around 8%, the lowest rate in the past few years. In 2010, the branded ad segment grew around 30%. For 2011, we expect the growth rate to be slightly lower than last year. Factors driving 2011 display ad spend include: On the positive side: 1) accelerated shift from offline to online given higher awareness in video sites and social network sites, 2) higher CCTV and satellite TV rates makes online ad a lower rate alternatives, and 3) improving ad serving technology in China. On the negative side: 1) lack of major events in 2011, 2) higher revenue base in 2010, and 3) higher competition among leading players. Longer term, we remain positive on the online display ad outlook, given the continuing increase in internet usage, higher cost effectiveness, and more measurable results for advertisers. Further, our China economics team expects consumer spending growth to accelerate in the next few years, which should also support the growth of branded advertising. China Branded Ad Segment Forecast 2006 to 2012E 2006 2007 2008 2009E 2010E 2011E 2012E Branded Advertising (RMB M) 3,377 4,559 6,428 6,942 9,025 11,462 14442 Branded Advertising (US$ M) 426 605 932 1,012 1,321 1698 2140 Growth rate (Rmb, %) 45% 35% 41% 8% 30% 27% 26% Branded ad as % of ad market 3.2% 3.9% 4.6% 4.9% 5.5% 6.0% 6.7% Source: J.P. Morgan estimates. Expect vertical sites to gain more market share Video and SNS portals such as Youku, and Tudou have gained significant traffic over the last few years. Additionally, industry-focused websites such as Soufun and CRIC are also gaining good traffic. While these sites have driven eyeballs and ad dollars away from traditional portals, we still expect leading portals to hold dominant user market share and to gain revenue market share, given: 1) Sina and Sohu are the leading news sites in China with strong brand awareness –other news sites do not have a similar level of media influence; 2) portals are also aggressively expanding horizontally to offer SNS, blogs and video services. Online Brand Ad Market Share Trend for Leading Portals Year 2006 2007 2008 2009E 2010E 2011E 2012E Market share of key portal players* (%) 62% 62% 63% 58% 59% 60% 60% Source: Company reports, Bloomberg estimates, J.P. Morgan estimates. * Includes: Sina, Sohu, NetEase, Tencent (Bloomberg estimates for Tencent). 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 online games, mobile blogs and Wireless Value Added Services. Online advertising is the most established online business in China (since the late 1990s), and regulations and boundaries are well understood by industry players. 15 152
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com We believe the leading portals have strict internal compliance departments and automated content scans to ensure contents are in compliance with government standards. In addition, leading portals have gained trusts and have an existing relationship with the government. 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 still only a small portion of their revenues come from User Generated Contents, which could be subject to government regulation. Online Search Still in early high-growth stage The search advertising market in China is expected to grow 53% Y/Y in 2011, as per our estimates, to reach Rmb18.4B (US$2.7B). We believe search advertising is still in an early high-growth stage in China, driven by: 1) rising internet penetration, 2) significant growth in websites and pages, 3) higher search usage (due to greater mass of web content), and 4) large number of SMEs (with small ad budgets) turning to search advertising (due to the higher ROI). China Search Market Forecast 2006 2007 2008 2009E 2010E 2011E 2012E Avg. Internet users (Mn) 123 162 253 338 420 494 577 Number of search (Bn) 81 116 181 254 334 429 521 Coverage 17% 21% 24% 25% 32% 34% 35% Click through rate 22% 25% 25% 24% 22% 22% 22% Price per click (Rmb) 0.34 0.42 0.45 0.45 0.50 0.56 0.60 P4P Search Market (Rmb M) 1,062 2,472 4,945 6,849 11,644 18,048 24,364 P4P Search Market (US$ M) 134 328 717 999 1,705 2,674 3,610 Growth rate (Rmb, %) 110% 133% 100% 39% 70% 55% 35% Total Search Market (Rmb M) 1,442 2,851 5,309 7,213 12,015 18,427 24,751 Total Search Market (US$ M) 182 378 770 1,052 1,759 2,730 3,667 Growth rate (Rmb, %) 70% 98% 86% 36% 67% 53% 34% Search ad as % of total ad market 1.4% 2.4% 3.8% 5.1% 7.3% 9.7% 11.4% Source: CNNIC, J.P. Morgan estimates. Note: Excluding distributor discount. How big can China’s search market grow? Using various comparisons to the US and Korean search market, we estimate China’s search market could reach US$3B-US$4.6B by 2013 This compares to our current 2013 forecast of US$3.4B and US search market 2009 size of US$15B. Please also refer to the chart below for analysis of market size comparison with the US and Korean markets. Other factors that could lead to positive surprise to our forecast include faster-than- expected inflation and RMB appreciation. China search market size potential analysis If we use Korea and US as a proxy for online search market growth rate and growth potential, we see more upside possible upside to our base case forecast. We present five different scenarios for our forecast: Scenario 1: We compared search market size as a percentage of nominal GDP in China and the US. We shifted US search market size as a percentage of nominal GDP six years to estimate China search market size in 2010-2014. We think the market will reach US$3.0B and US$4.6B in 2011 and 2012, respectively. 16 153
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Scenario 2: We compared search market size as a percentage of nominal GDP in China and Korea. We shifted Korea search market size as a percentage of nominal GDP five years to estimate China’s search market size in 2010-2014. We think the market will reach US$3.0B and US$4.5B in 2011 and 2012, respectively. Scenario 3: We compared search market growth rate in China and US. We shifted the US search market growth rate six years to estimate China’s search market size in 2010-2014, and think the market will reach US$3.0B and US$4.3B in 2011 and 2012, respectively. Scenario 4: We compared search market growth in China and the US and shifted 2003-2008 CAGR of US search market growth six years to estimate China’s search market size in 2010-2014. We think the market will reach US$2.3B and US$3.4B in 2011 and 2012, respectively. Scenario 5: We compared search market size as a percentage of personal consumption in China and the US. We shifted US search market size as a percentage of personal consumption five years to estimate China’s search market size in 2010- 2014. We think the market will reach US$2.1B and US$3.0B in 2011 and 2012, respectively. Five Scenarios for China’s Search Market Size Estimate US$M 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 2008 2009 2010E 2011E 2012E 2013E 2014E China Search Ad Market Size (US$ M) (Scenario 1) China Search Ad Market Size (US$ M) (Scenario 2) China Search Ad Market Size (US$ M) (Scenario 3) China Search Ad Market Size (US$ M) (Scenario 4) China Search Ad Market Size (US$ M) (Scenario 5) Source: iResearch, World Bank, J.P. Morgan estimates. 17 154
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Competitive landscape Baidu continued to gain more market share from Google China. Baidu market share reached 72.8% by revenue in 3Q10 vs.64.9% in 3Q09. Sogou and Soso both expanded markets here slightly to 1.2% and 1.0%, respectively. Google’s market share declined to 24.6% in 3Q10 vs. 31.2% in 3Q09. Baidu has successfully expanded its search revenue market share by more than 10 percentage points since 1Q09. Google is still having trouble with its advertising agencies. We expect Baidu to at least continue to maintain its current share. Baidu Gaining Market Share Consistently (by Revenues) 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 Baidu 62.3% 63.6% 64.9% 64.0% 67.8% 70.8% 72.9% Google 33.0% 32.5% 31.2% 32.8% 29.5% 27.3% 24.6% Sogou 1.2% 0.9% 1.0% 1.2% 1.0% 0.8% 1.2% SoSo 1.5% 1.2% 1.0% 0.6% 0.8% 0.6% 1.0% Others 2.0% 1.8% 1.8% 1.3% 0.9% 0.5% 0.4% Source: iResearch. In addition to gaining search market share, the company significantly reduced the gap between its volume and search market share. We expect this to further reduce with time. Baidu Search Market Share (by volume of search queries) 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 Baidu 74.1% 75.7% 77.0% 77.1% 75.3% 80.2% NA Google China 20.9% 19.8% 17.9% 17.5% 18.4% 14.1% NA Others 5.0% 4.5% 5.1% 5.4% 6.3% 5.7% NA Difference in marketshare* 15.1% 14.1% 13.1% 18.7% 11.3% 10.2% Source: iResearch. * means difference in search volume and search revenue market share. Soso and Sogou will take longer to become a challenge to Baidu Tencent’s Soso and Sohu’s Sogou have been working on developing their own search technologies. We believe they will not be a potential threat to Baidu for the medium term, as we believe the technology of these two search engines is still behind that of Baidu. Soso and Sogou’s total market share was 2.2% in 3Q10 as per iResearch. In mid-2010, Sogou and its related technology (pinyin, toolbar, etc) was spin off as a separate business entity. Alibaba Group and related persons invested in Sogou. Alibaba launches eCommerce search Alibaba joined with Microsoft to launch a beta version of search site Etao. Etao aims to drive traffic for Alibaba’s Taobao.com. The search results displayed in groups include Taobao listings, links to related online forums, information websites, and web search results provided by Microsoft’s Bing in the same order. While Etao has the potential to become a eCommerce focus search engine, we do not expect Etao to be successful as a general search engine. We note that in 2007, Baidu announced that it would introduce its own e-commerce platform called Youa to compete with Taobao. Taobao responded by blocking Baidu from searching goods on its website. 18 155
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Government-backed search team (1) During August 2010, Xinhua News Agency and China Mobile announced plans to set up a new search engine company. (2) People’s Daily Newspaper group launched new search engine, goso.cn. The search engine is led by former Olympics Ping Pong Champion Deng Ya Ping. We do not expect these government-backed search companies to gain meaningful traction in the market. However, the move could lead to the government’s closer monitoring of the search engine industry in China. Baidu Phoenix Nest latest update The full Phoenix Nest transition happened in December 2009. While the Phoenix Nest launch led to a significant revenue increase for Baidu in 1H10, we expect Phoenix Nest to continue to bring benefits to Baidu. One of Baidu’s key initiatives is to continue to improve Phoenix Nest performance in the long term. Baidu application platform: announced in September 2010 To enhance user’s search experience, Baidu launched an applications library which allows third-party offerings in the library to launch directly on Baidu rather than moving to another website. These third-party applications appear in search results when a user is looking for certain specific queries such as those related to games, music, etc. Baidu estimates that 30% of search queries in China are for applications rather than information. Baidu estimates that 30% of The company currently has more than 400 applications under this library. Baidu and search queries in China are for third-party application providers will split revenues in a ratio of 30:70. Baidu’s applications rather than information application will be based around music, e-books, games, and videos. Open platform strategy allows apps developers or book writers to submit content through open.baidu.com. This initiative is part of the larger “box computing” initiatives by the company. We believe this step could drive up search volumes in the future. Developers or book writers can get revenue from: 1) direct content purchase, 2) embedded ads. Currently Baidu has 400+ partners which give Baidu content, info and apps. Baidu is not specific about revenue sharing with apps developers. We think this will be one potential strategy. Searches that led to downloadable apps or content: 三重门 – This is the name of popular fiction. Users can buy e-books directly from results link. Publishers or writers can put their own books online. In the future, there is no need to go to Amazon or DangDang. 坦克大战 – A basic online game. Users can download this game or other games on the list of recommendations. 金山毒霸 – Kingsoft anti-virus software. Links to download right away. 豆瓣电台 – Online radio station. Users can listen to radio directly on Baidu’s page. 19 156
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com 新三国 – A popular soap opera. Video links have been verified by Baidu for high- quality content. 开心网/126 邮箱 – NetEase mail box or SNS site. Users can directly login on Baidu page. Currently Tencent is not a partner with Baidu Open Platform. As such, users can't log in QQ mailbox “QQ 邮箱" directly from Baidu page. Aladdin: to search the hidden web As announced on the last conference call, there has been an ongoing R&D effort aimed at uncovering useful parts of the hidden web in order to enrich search results for Baidu users. This is an ongoing effort by the company’s R&D team. The service was launched in mid-April. The site is: http://aladin.baidu.com/. As a part of Project Aladdin, Baidu launched the beta version of an open data sharing platform on April 15, 2010. The new platform allows webmasters and developers to submit data to Baidu in order to generate direct search results for dynamic information. Mobile search: Baidu still leads in market share Mobile search is still in an early growth phase. Google partners with China Mobile to be their default search engine on WAP website. We believe Baidu’s traffic from mobile devices is around 10% of its total traffic. However, revenue only accounts for 1-2%. We are encouraged to see Baidu demand leading market share in mobile search as well, according to Analysys. Baidu is also building more mobile search applications (e.g., Baidu Palm) to expand its usage. During 2010 Baidu World, Baidu showcased 3-D maps and various mobile features: voice search, map search new version of Baidu Palm and input method. While there were no discussions on Baidu mobile phone OS, Baidu discusses various potential applications to help search users obtain content easier on a large number of mobile phone platforms. Baidu also plans to work with web masters to help them make webpages more easily displayed on mobile phones. Mobile Search Market Share by PV Company Market share (%) Baidu 33.7% Google China 19.5% 3GYY 14.1% YiCha.cn 14% Others 18.7% Source: Analysys International. Baidu’s brand zone Baidu provides additional marketing services to some of its key customers. Key customers can engage in integrated search marketing services across Baidu platform. Baidu charges extra fixed fee for an integrated campaign with Brand Zone. The company has reported strong growth from Brand Zone in 2010. 20 157
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com For example, “Meng Niu” Milk product advertises across different properties on Baidu. We compared the search results between “Meng Niu” Milk that uses brand zone services and “Wan Da Shan” milk that is not using the services. When we search "Meng Niu” Milk using Baidu Knows and Baidu Web Search, "Meng Niu” brand zone comes first with detailed company information, such as the company’s brand logo, weblink, recent events, etc. When we search “Wan Da Shan” Milk, the company related information is less. “Meng Niu” Milk also has banner advertise in Baidu News. Search usage vs. advertiser readiness vs. monetization To better understand the growth potential of China’s Internet search market, we think it would be useful to look at the search space from three different perspectives: 1) search users, 2) advertisers, and 3) search monetization/market size. We view search usages and advertiser readiness as the two main drivers for the monetization of the online search market. Search Monetization Driven by Both Search Usage and Advertising Readiness Source: J.P. Morgan. Search market outlook: usage Like the US, online search in China provides users with personalized information. As 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 and e-Government will continue to gain popularity. Growing usage in China The latest statistics from CNNIC show that the number of users in China has reached 420M as of June 2010. We expect usage in China to continue to grow, driven by such factors as: • Entertainment tool. Digital entertainment, such as MP3, movies, etc., can be downloaded from the web virtually free of cost or at a very low cost. Online games—LAN-based (local area network), MMORPG (massively multiplayer online role playing games), or casual board and chess games—are also low-cost alternatives to offline entertainment. Internet in general is a low-cost form of entertainment—internet café access costs about Rmb2-3 per hour vs. Rmb40 for a movie. • Communication tool. Migrant workers (about 10% of total population, or 140 million people in China, are floating population) as well as relocated white-collar workers visit internet cafés after work to use instant messenger and e-mail, or to 21 158
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com play games or watch movies. Despite the government constantly monitoring these services, blogs and bulletin board services have also increased in popularity in China—they serve as channels for the Chinese to express their personal views and communicate with others. • Information source. Most traditional media is still tightly controlled by the government. The Internet offers an alternative information source that users seem to find 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 boost internet usage. Apart from growth in the number of users, the time spent online per week as well as the number of days online per week is on the rise. Users turning to search in China With information on the internet ever expanding, it is natural that users turn to search engines to organize the high volume of information. As a result, the number of searches in China is expected to more than double from 2009 to 2012. According to the 2010 CNNIC report, more than 76% of internet users use search engines. Search market outlook: advertisers’ readiness 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. Hence, continuous education and marketing are required to drive market growth. 1. 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, there were 43 million SMEs in China. These SMEs are mainly 39 million individual businesses (small businesses registered with some government departments). Statistics from the State Administration for Industry & Commerce (SAIC) 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 the SAIC, there were 4.3 million larger-size SMEs (registered directly with the SAIC). The total number of websites in China is 2.8M (as of Jun 2010). 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 1.7M. We do not think the market is saturated Based on Baidu’s 3Q10 active marketing customers of 272,000, the company’s penetration among larger SMEs is 6%. Hence, we believe the market is far from reaching a saturation point. 22 159
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Number of SMEs by Different Segments Source: SAIC, J.P. Morgan estimates. 2. eCommerce should be another growth driver While C2C eCommerce has seen good adoption over the past 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 face to face) through increased online and offline marketing, and larger product selection; 2) improved trust and safety features by eCommerce sites; and 3) more regulated online payment infrastructure. In the US, eCommerce companies are leading users for paid search advertising. We believe a similar trend will emerge in China too, as paid search is an effective method for targeting prospective buyers who already have items in mind. We expect paid search to benefit from eCommerce growth in the future. 3. 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 become more sophisticated. 4. 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, or CE.Net) and Hichina (net.cn, acquired by Alibaba.com) provide one-stop services for SMEs—domain name registration, web hosting, website design, and promotions (mainly through search engine optimization, 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. 5. 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 23 160
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com 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, may simply 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 that of 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 users and advertisers growth. Higher search usage 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 will conduct more searches, thus leading to higher usage. This cycle should continue, and lead to market size expansion. Monetization Increase Driven by Self-Fueling Cycle Source: J.P. Morgan. 24 161
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Traffic Breakdown in Baidu.com Domain Domain Name Traffic breakdown baidu.com 44.5% Image search is the third-largest tieba.baidu.com 14.5% search channel after web page and image.baidu.com 13.5% Tiebar. MP3 search continues to zhidao.baidu.com 8.4% lose dominance hi.baidu.com 3.5% mp3.baidu.com 3.3% video.baidu.com 2.8% baike.baidu.com 1.6% zhangmen.baidu.com 1.6% news.baidu.com 1.2% Source: Alexa.com. As of Oct 21, 2010. Online Video Online video has seen strong growth in China with the number of users growing to ~300M monthly users by end of September 2010, representing ~83% of total internet subscribers, according to CNNIC. Growing Online Video Users in China (users in millions 300 265 240 250 222 202 200 180 161 150 100 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Source: CNNIC. Driving factors for growth of China Online video services include: (1) Existing media companies are not commercially driven. Existing TV broadcaster or cable operators are tightly controlled by the government. Contents broadcast schedule many times are not commercially driven. As such, contents may not be tailor to viewers’ interests. As such, alternative online video would be well adopted by viewers. (2) Availability of large amounts of content were not broadcasted. There are large numbers of television stations and movie production companies across the country. Many of the content produced were not properly shown due to an under developed media distribution system in China. For example, out of approximately 12,000 television episodes produced each year, fewer than half are ultimately broadcast. Similarly, fewer than one-third of the approximately 450 movies produced in 2009 were released in theaters. (3) Multiple delivery platform enhances user experience. While Video Online Demand service has advantages over viewing scheduled TV programs, leading online video companies also make content available on different devices such as 25 162
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com mobile devices (phones, tablets), and internet-enabled TV. The wider choice of device allows users to enjoy content anytime in different platforms. Online Video Advertising Revenues in China 200% 13.1 14 12 150% 8.6 10 8 100% 5.4 6 2.9 50% 4 1.4 0.1 0.3 0.6 2 0% 0 2006 2007 2008 2009 2010E 2011E 2012E 2013E Online Video Adv ertising Rev enues (Rmb Bn, RHS) Grow th Rate (in %, LHS) Source: iResearch. Industry outlook for 2011 Profitability still many quarters away In terms of content, most video portals in China operate on a mix of “Youtube" (user generated content) and “Netflix” (professional content) in China. While US video portals which mostly have user generated content or news clips as their top content, Chinese video portals have more viewership of licensed content such as movies, drama, etc. As a result, Chinese companies often pay a high content licensing fee in order to procure premium content to retain users. Similar to the media market worldwide, both ad-supported and subscription-based models are used in China. The ad-supported model is by far more popular in China. Similar to media market Most of the video sites in China monetize by 1) in-video advertisements, 2) worldwide, both ad-supported program/channel sponsorship by brand advertisers, or 3) affiliate advertising from and subscription-based models are used in China. The ad- text-based ads by search engines. supported model is more popular by far in China Some players such as Tudou have also launched premium content service for which users will have to pay a fixed subscription fee. Content costs on the rise From Youku’s prospectus, the average license fee for television serial drama increased in 2009 by more than 200% vs. 2008, and such fees have increased in 9M10 by more than 100% as compared to 2009. The average license fee for movies has also increased in 9M10 by more than 90% vs. 2009. In-house produced contents also slightly help control content costs and build brand Youku and Tudou also have their own content development department creating popular movies and dramas. In addition, this content helps to further solidify branding of leading video sites. Industry still focused on “land grabbing,” profitability still quarters away As most of the online video players are focused on gaining market share rather than profitability, we believe content inflation will continue. However, this should be 26 163
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com slightly eased by reduced demand for exclusivity of content from online video players. While advertisers are still gradually adopting online video advertising, with high content and bandwidth costs, we expect profitability in the sector could still be many quarters away. Online video should drive ad dollar shift from TV Television accounted for 39.1% of overall advertising expenditures in China, according to ZenithOptimedia. We expect that online video should accelerate TV ad spend to move toward brand advertising due to its similarity of format with television. In addition, online video offers attractive user profiles (from a higher income and young adults demographics perspective) and targeted advertising than TV. As per CR-Nielsen, in September 2009, Chinese online video users spent 23.4 hours per week on average watching online videos, which is approximately six hours more than they spent viewing television. Additionally, a CNNIC 2009 China Internet user video behavior study found that online video is the only media viewing choice for 16.4% of the total online population in China. Thirty percent of online video Young demographics/more affluent population viewers have a college degree or China’s online video market offers more attractive and targeted user demographics higher level of education, vs. traditional television market in terms of users’ age, level of education and whereas only 14% of the potential spending power. Online video viewers in China, on average, are younger television audience is similarly than traditional television viewers, but slightly older than the overall internet educated, according to CNNIC and CSM Media Research population. According to iResearch, close to 80% of the online video viewers are between 18 and 40 years of age and only 8% of online video viewers are below the age of 18. Moreover, 30% of online video viewers have a college degree or higher level of education, whereas only 14% of the television audience is similarly educated, according to CNNIC and CSM Media Research. Cost-effective advertising SARFT (The State Administration of Radio, Film and Television) in 2009 published a new “Act No. 61” which considerably limited the advertising inventory on TV especially on prime-time. This has also led to significant price rise by TV operators over last 2 years. The advertising rates for 2011 have gone up further by 20%-60% for CCTV and other satellite channels. In contrast, video advertising site has lower CPM, and offers more dispersed and targeted advertising options to brand advertisers in a similar format. Competitive landscape Video portals in China face stiff competition from both standalone video portals as well as integrated portals such as Baidu, Sina and Sohu. We profile some of the key players here. Youku Youku is the leading online video player in China. As per iResearch, it commands 40% (largest) share of time spent on watching videos online in 2Q10. As of September 30, 2010, their video content library contained more than 2,200 movie titles, 1,250 television serial drama titles, and over 231,000 hours of other professionally produced content, including 194 variety shows. The company had 27 164
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com total revenues of Rmb153.6M in 2009, and Rmb234.6M in 9M10. Net losses were Rmb182.3M and Rmb167.0M in 2009 and 9M10, respectively. The company listed on Nasdaq in December 2010. Tudou Tudou is the second-largest online video portal in China. As of 3Q10 end, the company had a content library of more than 36.3M video clips. The company also started providing mobile video services channel on China Mobile. Tudou has been shrinking the losses. It had had total revenues of Rmb113.2M and Rmb224.8M in 2009 and 9M10, respectively. The company had total losses of Rmb144.8M and Rmb83.7M in 2009 and 9M10, respectively. Sohu video Sohu has a separate video channel on its website. This channel provides users free access to extensive and varied video content, including popular domestic and overseas movies and TV dramas, in-house produced online talk shows, exclusive celebrity interviews, live webcasts, on-demand sports games, and user-generated video clips. Sohu is the third largest player in terms of online video views in China, as per iResearch. 3Q10 Market Share Based on Total Effective Time 3Q10 Market Share Based on Revenue Spent Watching Online Video in China Others, 16.9% Pheonix , 1.0% Others, 5.1% Youku, 22.5% Joy .cn, 1.0% CNTV, 2.5% Joy , 2.9% Sina Video, 2.9% Xunlei Kankan, 56.com, 4.3% Youku, 39.6% 3.2% Ku6, 6.1% Sina Video, 3.5% Xunlei Kankan, PPLiv e, 5.3% Tudou, 18.5% 5.8% Ku6, 5.6% Sohu Video, 9.0% CNTV, 6.1% Sohu Video, 6.4% PPStream, 8.9% Toudu, 22.8% Source: iResearch. Data as of 3Q10. Source: Analysys. Data as of 3Q10. 28 165
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com China Video Portal Data (Monthly Data for Oct 2010) Total Unique Visitors (000) Total Minutes (MM) YOUKU.COM 77,439 YOUKU.COM 1,620 Tudou Sites 65,817 Tudou Sites 1,297 KU6.COM 62,719 KU6.COM 747 PPS.TV 49,406 PPS.TV 3,171 56.COM 35,702 56.COM 306 SINA Video 30,760 SINA Video 322 IFENG.COM 30,417 IFENG.COM 1,712 SOHU.COM TV 24,487 SOHU.COM TV 455 JOY.CN 16,646 JOY.CN 436 CNTV.CN 13,298 CNTV.CN 129 QIYI.COM 12,780 QIYI.COM 113 PPLIVE.COM 2,934 PPLIVE.COM 5 SMGBB.CN 2,594 SMGBB.CN 13 IMGO.TV 1,216 IMGO.TV 6 Average Daily Visitors (000) Average Minutes per Usage Day YOUKU.COM 9,538 YOUKU.COM 5.5 Tudou Sites 7,762 Tudou Sites 5.4 KU6.COM 6,482 KU6.COM 3.7 PPS.TV 12,363 PPS.TV 8.3 56.COM 2,857 56.COM 3.5 SINA Video 2,875 SINA Video 3.6 IFENG.COM 4,809 IFENG.COM 11.5 SOHU.COM TV 2,444 SOHU.COM TV 6.0 JOY.CN 1,570 JOY.CN 8.9 CNTV.CN 1,055 CNTV.CN 4.0 QIYI.COM 862 QIYI.COM 4.2 PPLIVE.COM 202 PPLIVE.COM 0.8 SMGBB.CN 162 SMGBB.CN 2.6 IMGO.TV 80 IMGO.TV 2.3 Source: Comscore. 29 166
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Social Networking Social networking has a long and successful presence in China, notably by the success of Tencent. The social networking trend in China is quite similar to that of the US. Companies earn their revenues through a mix of social games, selling virtual items as well as from brand advertising. Key trends for 2011: social commerce We expect social networking companies tobe a key beneficiary of the rising eCommerce trend in China. With increasing time spent on social networks connecting with friends, these sites would be increasingly important traffic generators for eCommerce companies. In addition to basic brand advertising and friends referrals, social network companies help promote products through integrated product marketing such as themed games to promote products or onsite avatars to build brand awareness. Revenue generation for SNS websites can be broken down into three types: (1) Banner advertising: Nearly half of the advertising revenues are generated from putting up banner advertisements on various locations on the site: e.g., profile pages of the users. (2) Integrated marketing: Many companies promote themselves by putting virtual items associated with their brands in game applications. (3) Fan pages: Another way of advertising on social networks is through fan pages. We estimate this accounts for nearly a quarter of social network advertising in China. SNS Game Market Size 3000 2,850 2500 2000 1,632 1500 780 1000 420 240 500 0 2009 2010 2011E 2012E 2013E SNS Games Market Size (Rmb Mn) Source: Analysys. SNS users already cross 200M mark As per CNNIC, the number of SNS users reached the 210 million mark (up 19.6% YoY) in Jun-2010. Currently 51% of China internet users are using social networks up from 46% users, a year ago. In 1H10, revenue for China’s SNS market was RMB 489 million, with growth of 19.4% YoY. Favorable demographic distribution As per CNNIC, more than half of Chinese users spend around 1 hour on SNSs, 22.6% spend up to 2 hours per day, and 12.8% are logged on for more than 2 hours. 30 167
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com 59.1% of Chinese SNS users have a college degree and above, 34% higher than other Chinese internet users. Frequency of Logging Onto Social Networking Websites Not ev ery w eek 26% Once a w eek or less 40% More than Once 16% Once per day 18% Source: CNNIC. Users by Access Method Only using mobile 8% Only using Ov erlapping users computer 39% 53% Source: CNNIC. Competitive landscape The four major social networks in China are: Qzone: Qzone of Tencent is the largest social networking portal in China. Tencent's leadership in instant messaging and casual gaming helps Qzone capture a dominant share in the social networking market. The company reported 481M user accounts at the end of 3Q10. Qzone is perceived to be more popular among teenagers than college students and office-goers. However, we believe Qzone covers a wide range of users that resemble general internet users in China. The company earns most its revenues from fees charged to users for upgrading to premium features such as social games, avatars, etc. The company also launched a portal named Xiaoyou, which focuses on college students.. . 31 168
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com 51.com: 51.com has more users from lower-tier cities. By the end of 2009, the company had 178M registered users and 40M+ monthly unique users. In April 2010, 51.com achieved breakeven. Most of its revenues generate from revenue shares from 20+ SNS games. The second tranche of revenues are from users’ payments. The third tranche of revenues are from advertising. Giant Interactive has a 25% stake in 51.com. 2011 outlook Expect healthy growth from Advertising and Social Gaming We expect social networking websites to gain a greater more share of online brand advertising revenues. Social networking provides: (1) more innovative ways of brand promotions such as virtual items, fan pages, etc. (2) more targeted user base, which is young and has higher disposable incomes. Additionally, we expect SNS to be a key beneficiary of rising eCommerce spending. Social gaming should benefit as leading websites such as Qzone open. This should lead to a higher number of social applications on there portals, which would ultimately drive higher revenues. The number of users should also see healthy double-digit growth. Analysys Data forecasts the social gaming market to grow more than 86% YoY in 2011. We expect Tencent to be a key beneficiary of the rising social networking trend in China. With the traffic Tencent commands thanks to its QQ platform, we believe it can attract the best of the applications with even less revenue sharing. 32 169
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Miniblog Platform Mini blog platform has added another dimension to social networking in China. Sina has seen a lot of success through its mini-blog. Miniblog registered users on Sina’s platform were close to 50M at the end of 3Q10 compared with Twitter monthly unique users of 190 million in mid-2010, according to Twitter COO Dick Costolo. Sina has been witnessing an addition of 10M users every month. Netease also had close to 9M users at the end of 3Q10. Tencent, Sohu and other sites are catching up with their own mini-blogs. Easy access from mobile phones Miniblog platform should also see more popularity from users accessing the internet from mobile devices. Currently 45% of active mini-blogs on Sina platform are accessed through mobile devices. With strong growth in mobile internet usage, mini- blog usage is likely to further increase. A celebrity broadcasting platform Microblog traffic in China is centered around VIP accounts. Sina currently has around 20,000 VIP accounts which are verified by Sina. Most of the traffic revolves around following favorite movie stars, business leaders, etc. Monetization model becomes visible Sina recently discussed various monetization methodologies during different phases of Weibo development. Direct monetization (CPM base model) from brand advertisers is expected to begin on a larger scale in late 2011. Indirect monetization or platform strategy to kick off in late 2011. Platform strategy refers to local SMEs open storefront on Weibo and revenue sharing with third-party apps developers. Sina’s Weibo Monetization Model Brand Adv Platform Model Brand Product Line Indirect Monetization Direct Monetization • Interaction with Weibo • Weibo.com – Open API • Internally developed apps • Integrate online and offline • Rmb 200M fund to support • SME marketing and services events third party developers Source: Company data, J.P. Morgan. 33 170
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com eCommerce eCommerce is in fast growth stage in China eCommerce usage has seen rapid growth, but it still only penetrated 30.2% of total internet users in China with around 109M users in 2010, according to iResearch. We believe there is a high potential for further growth in eCommerce. The internet has become an emerging sales and marketing channel for retail sellers. China eCommerce transaction The China eCommerce transaction value is estimated to account for 3.4% of total value is estimated to account for retail sales in 2010 and is expected to grow to 6.5% of total retail sales in 2013. 3.4% of total retail sales in 2010 and is expected to grow to 6.5% of total retail sales in 2013 China eCommerce Market Size by GMV Rmb B 1,400 1,269 7% 1,200 994 6% 1,000 5% 800 723 4% 600 476 3% 400 263 2% 56 128 200 5 16 26 1% 0 0% 2004 2005 2006 2007 2008 2009 2010E 2011E 2012E 2013E B2C+C2C, ex cluding B2B (Rmb B) As a % of Total Retail Sales (%) Note: Transaction for virtual goods and online utility payment are not included. Source: iResearch (2010). Factors driving growth of online shopping in china Large number of internet users: China now has the largest internet population in the world with a penetration rate of more than 30%. China already has the largest number of Internet users in the world. Additionally, increasing penetration of internet-enabled mobile phones is also driving up time spent on the internet. Rising trust in online transactions: (1) Credible eCommerce companies have helped to improve China’s online shopping ecosystem and to decrease fraud and bad transactions in online shopping. (2) Well-known retail brands are starting to sell products online, with many users having good online purchasing experiences. (3) Well-developed payment alternatives. Chinese online shoppers have adopted online banking payment as well as third-party payments (such as Alipay and Tenpay) based on their good experiences. Rising disposable incomes: As per NBSC (National Bureau of Statistics of China), China’s GDP per capita has grown at a CAGR of 15.4% from 2005 to 2009, reaching US$3,714.2 in 2009. We believe the rise in disposable income should continue in coming years. Additionally, with rapid urbanization and more people transitioning to an affluent class, online eCommerce should see faster growth. Government thrust on pushing consumption-led growth: Chin’s consumption is 34.5% of GDP vs. 70.1% of GDP in United States. With the Chinese government pushing the growth model to shift from investment and exports-led growth to consumption-driven growth, we expect it to take many structural steps to boost consumption. 34 171
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Fast Growth of China Online Shopping Users 300 34.6% 36.2% 40.0% 32.4% 245 250 30.2% 213 26.2% 26.8% 28.4% 180 30.0% 200 145 150 109 20.0% 80 100 55 10.0% 50 0 0.0% 2007 2008 2009 2010E 2011E 2012E 2013E Online Shopping Users (M) As a % of Totla Internet Users (%) Source: iResearch (2010). B2C eCommerce enjoys significant growth in 2010 Players converging to marketplace model B2C eCommerce in China can be categorized into B2C retailers and B2C marketplace operators by business model. In 2010, we have seen: (1) Leading C2C eCommerce operators expand and develop the B2C eCommerce marketplace (such as Taobao expanding to Taobao Mall), (2) B2C retailers began to introduce third-party merchants to their platform, (3) B2C sites emerge as a new sales and promotion channel for retail brands. China B2C eCommerce Market Size by GMV Rmb B 250 120% 110% 201 103% 100% 200 90% 80% 150 118 71% 60% 100 62 40% 31 50 15 20% 0 0% 2009 2010E 2011E 2012E 2013E B2C eCommerce GMV (Rmb B) YoY Grow th (%) Note: B2C marketplace is not included. Source: iResearch (2010). China internet giants focus on developing B2C eCommerce marketplace (1) Taobao started B2C eCommerce in 2008. The company announced the independent domain name for Taobao Mall in Nov 2010, following with a series of promotion events. Since its launching, Taobao Mall has earned a high reputation and recorded the highest transaction value of Rmb1B on Nov 11 2010. (2) Tencent upgraded its “QQ members store” to “QQ Mall” in Mar 2010 to leverage its C2C Paipai experience to B2C eCommerce. 35 172
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com (3) Baidu launched “Lekutian," an online B2C marketplace, jointly with Japanese eCommerce leader Rakuten in June 2010. China portals entered B2C eCommerce market, still at an early stage (1) Sina started B2C eCommerce around 10 years ago, but Sina Mall is still struggling to attract customers under tough competition. (2) NetEase also started B2C eCommerce 10 years ago. NetEase started to focus more on its eCommerce sector this year and launched B2C marketplace in December 2010. B2C retailers start to mix B2C marketplace model with their online retailing model The leading B2C retailers such as Dangdang and Vancl have introduced third-party merchants to their B2C platform. 360Buy is also preparing to open its platform to third-party sellers. These companies have seen the demands from third-party merchants to use well-established B2C platforms as a sales and marketing channel. Self-established logistics B2C eCommerce companies have endeavored to build their own logistical systems, including warehouses and logistics centers. We believe well-built logistics is one of the key factors for further growth of B2C eCommerce. (1) B2C eCommerce operators can lower delivery cost, shorten delivery time and expand to tier-2 and tier- 3 cities. (2) B2C companies can shorten processing time on returned goods to improve user experiences. In addition, incumbent delivery companies and logistics services are not sophisticated. Popular online selling products are apparel, media products such as books and music, cosmetics and IT products. These are the products that B2C retailers are focusing on. We have seen: (1) Dangdang and Joyo-Amazon that are well-known for online books selling, (2) 360Buy that emphasizes online IT and electronics products selling, and (3)Vancl that is a well-recognized online apparel seller. Leading B2C players in China 360Buy, Dangdang, Joyo Amazon are the three leading B2C retailers, while Taobao Mall is the leading B2C marketplace operator in China. We have summarized some facts about these companies below. China B2C Retailers Market Share by GMV in 3Q10 Coo8.com, 1.1% Others, 26.9% New 7, 1.3% Mecox Lane, 2.2% Redbaby , 2.3% icson.com, 3.1% New egg, 4.4% Vancl, 5.3% 360Buy , 35.6% Joy o Amazon, 8.9% Dangdang, 8.9% Source: iResearch (2010). 36 173
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Leading B2C Players in China (Taobao Mall, 360Buy and Joyo Amazon) B2C Marketplace B2C Retailers Taobao Mall 360Buy Joyo Amazon Business Description 1. The largest B2C marketplace in 1. The largest B2C retailer in China in 1. The third-largest B2C retailer in China in terms of transaction value. terms of transaction value. China in terms of transaction value. 2. Around 15k merchants sell products 2. Well-known for its 3C (computer, 2. Supported by international B2C giant with 20k brands. communication, consumer electronics) Amazon. 3. Merchants need to pay gurantee products. 3. Well-known for its media products money of Rmb 10,000 to open a store 3. Expand to sell various products, sales such as books and music. in Taobao Mall. Besides that, Taobao including books, cosmectics, household 4. Expand to sell software products, Mall charges annual service fee of Rmb products and etc. electronic goods, toys, household 6,000 and online transaction technical 4. Announce to offer group buying products, cosmetics, jewelry, watches fee of 1% ~ 5% as of transaction value products from Dec 20, 2010. and baby products, etc. per transaction. Registered Members 170M in 2009 (Including Taobao C2C) 14M+ in 2010 n/a Revenue/GMV (2009 estimated) Rmb 208.3B (GMV) Rmb 10.2B (GMV) n/a Payment 1. Alipay Katong payment: link with 1. Cash-on-delivery 1. Cash-on-delivery and mobile POS debit card, time saving for online 2. Online Banking Payment payment payment 3. Credit card payment 2. Online Banking Payment 2. Credit card payment 4. Third-party payment: Alipay, Tenpay 3. Credit card payment 3. Online banking Payment and 99Bill 3. Third-party payment: Alipay and 4. Alipay 5. Mobile payment PayEase 5. Consumer card payment 6. Installment payment 7. Remittance 6. Cash-on-delivery 7. Remittance 8. Banking Account Transferring 8. Banking Account Transferring 9. Amazon gift card payment Logistics Third-party logistics companies. Taobao 1. Five logistics centers are in Beijing, 1. Nine self-established logistics started to establish its own distribution Shanghai, Guangzhou, Chengdu and centers in Beijing, Suzhou, Guangzhou, center and invested in one logistics Wuhan. Self-established logistics Chengdu, Wuhan, Shenyang, Xi'an, company in 2010. networks reach 24 cities. Xiamen. 2. Cooperate with third-party logistics 2. Free of charge for delivery service. companies. 3. Cooperate with third-party logistics companies. History 1. B2C marketplace started in2008. Founded in 2004. 1. Founded in 2000. 2. Taobao Mall with independent 2. Acquired by Amazon in 2004. domain name was launched in Nov 2010. Source: Company reports, J.P. Morgan. 37 174
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Listed Leading B2C Players in China (Dangdang and Mecox Lane) B2C Retailers Dangdang Mecox Lane Business Description 1. The second-largest B2C retailer in China in terms of 1. A B2C retailer to offer fashion products through its website transaction value. and physical stores in China. 2. Well-known for its its media products sales such as books 2. The products include apparel and accessories, home and music. products, beauty and healthcare products and other products, 3. Expand to sell various products, including cosmetics, under its own brands of Euromoda and Rampage as well as electronic goods, household products, baby products and etc. selected 3rd party brands. 4. Invite third-party merchants to sell general merchandize at 3. Invite third-party merchants to sell products at its "plug-and- Dangdang platform under its marketplace program. play" platform. Registered Members 1. Active customers were 6.8M for the nine months ended Sep 1. Active online customers were 2.1M as of June 2010. 30, 2010. 2. Average daily unique visitors of the company’s website: 671k 2. Average daily unique visitors were 1.6M in Sep 2010. in June 2010. Revenue (FY09) Rmb 1.5B Rmb 1.2B Payment 1. Cash-on-delivery: cover 750+ cities and towns in China 1. Cash-on-delivery: cover 100+ cities in China 2. Online Banking Payment 2. Online Banking Payment 3. Credit card payment 3. Third-party payment: Alipay, Tenpay, and 99Bill 4. Third-party payment: Alipay, Tenpay, 99Bill, PayEase and 4. Credit card payment UnionPay 5. Remittance 5. Remittance 6. Banking Account Transferring 6. Banking Account Transferring 7: Dangdang gift coupon payment Logistics 1. Ten self-established logistics centers: two central logistics 1. Centralized logistics center in Shanghai, other three in centers in Beijing, eight regional logistics centers in five major Beijing, Chengdu and Guangzhou. Warehouse space totals cities outside Beijing. Warehouse space totals 180k square around 58.7k square meters and can handle 50k orders per meters and can handle 165k+ orders per day. day. 2. Cooperate with 104 third-party inter-city transportation 2. Cooperate with third-party logistics companies. companies and courier companies. History 1. Founded in 1999. 1. Founded in 1996. 2. Listed on NYSE in Dec 2010. 2. Listed on NASDAQ in Nov 2010. Source: Company reports, J.P. Morgan. B2C marketplace transaction service fees Third-party merchants at B2C marketplace need to pay: (1) “guarantee money”, (2) a percentage of sales per transaction as real-time technical service fee, and (3) annual technical service fee to B2C marketplace operators. We present the transaction service fees that the key B2C marketplace operators charge. 38 175
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com B2C Marketplace Transaction Service Fees Taobao Mall Lekutian Dangdang QQ Mall Guarantee Money Rmb 10,000 Rmb 15,000 Rmb 3,000 - Rmb 10,000 Rmb 20,000 Real-time Technical Service Fee Ratio Fashion & Accessories 5% 4.5% 4% 0 Outdoors 5% 4.5% 4% 0 Home & Decor 5% 4.5% 4% 0 Water Heater 2% 4.5% nm 0 Bathroom Warmer 2% 4.5% nm 0 Shaving Razor 2% 4.5% nm 0 Baby nm 0 Infant Formula 2% 1.5% nm 0 Children's Wear 5% 4.5% nm 0 Intelligence Toys & Baby Carrier & 5% 4.5% nm 0 Child Cot & Schoolbag Diapering 2% 1.5% nm 0 Cosmetics 4% 3.5% nm 0 Jewelry 2% 1.5% 2% 0 Gold 1% 0.6% nm 0 Natural Jade 5% 4.5% nm 0 Natural Pearls 5% 4.5% nm 0 Natural Amber 5% 4.5% nm 0 Electronics & Technology 2% 1.5% 1-2% 0 Electronics Parts nm nm 4% 0 Home Appliance nm nm 2% 0 Motors 2% 1.5% 2% 0 Foods & Health Care Products 2% 1.5% nm 0 Tea Drink & Vegetable Drink 1% 0.6% nm 0 Cooking Oil & Food Grains 1% 0.6% nm 0 Books, Movies & Music 2% 1.5% nm 0 Serivces, such as Tickets, Internet 2% 1.5% nm 0 Serivces and etc. Virtual Recharge nm 0.6% nm 0 Annual Technical Service Fee Rmb 6,000 0 1) SKU<500, Rmb 300/month, 0 2) 500<SKU<1,000, Rmb 500/month 3) 1,000<SKU<2,000, Rmb 1,000/month 4) SKU>2,000, Rmb 2,000/month Source: Company reports, J.P. Morgan. 39 176
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Group Buying: A Hot Trend in China Too Group buying market size grows from zero to Rmb980M in one year The group buying eCommerce model originated from the U.S.'s GroupOn and became popularized in China in 2010. We have seen the emergence of hundreds of independent group buying sites, as well as sites launched by China's key internet players such as Tencent, Baidu, Sina, and Sohu. According to Analysys, a leading internet industry research firm in China, the group buying market size is around Rmb980M in 2010 and is expected to reach Rmb3,800M in 2013.  Classification of group buying categories: Location-based Group Buying Sites and Products-based Nationwide Group Buying Sites。  Main customers: Young, white-collar workers and college students aged 20-35, who would like to try fresh things.  Major products: Entertainment products such as movie tickets and karaoke coupons, restaurant coupons, beauty & hair salon coupons, travel & hotel coupons, etc.  Major cities: Tier-1 cities, such as Beijing, Shanghai, Guangzhou, Shenzhen, Changsha, Xi’an, Hangzhou, Chengdu, Wuhan and Tianjin. China Group Buying Market Size by Transaction Value Rmb M 4,000 3,800 3,000 2,620 2,000 1,650 980 1,000 0 2010E 2011E 2012E 2013E Group Buy ing Transaction Value (Rmb M) Source: Analysys (2010). Number of Group Buying Sites in China Beijing Shanghai Guangzhou Shenzhen Changsha Xi'an Hangzhou Chengdu Wuhan Tianjin Others Total # of Sites 473 183 77 75 65 56 53 52 49 44 537 1,664 Note: The statistics is as of Nov. 2010. Source: 2010 Group Buying Industry Credit Research Report, Internet Society of China. Factors driving growth of group buying market in china 1. Cheap price. Many small- to medium-sized merchants use group buying sites as a promotion channel and offer high discount price to attract customers. The 60%-90% discount price is very attractive. 2. Attractive products. Group buying sites offer products that are attractive to young people with low prices, such as cake-making class coupons, laser gun game coupon, etc. 40 177
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com 3. Customer’s adoption of online payment method. Online banking payments and third-party online payments are the major payment methods for group buying sites. Chinese customers, especially the ones in tier-1 cities, have increased their trust in online payment with their online shopping experiences. 4. A new promotion channel for small- to medium-size merchants. With increasing internet usage, group buying sites can help small- to medium-size merchants to attract new customers from internet users. The promotion cost of using group buying sites is relatively smaller than that of print media. 2011 Outlook for group buying market 1. Consolidation. We believe we will see consolidation in the group buying sector. Because of low entry barriers, hundreds of group buying sites emerged in a short period of time. We observe that the group buying market is in disorder and the user experiences are poor. We think that the group buying sites serving low-quality products will be acquired by bigger sites or go bankrupt. 2. Combination with Portals, eCommerce Sites, Living Social Sites and SNS Sites. Group buying sites and other internet sites could complement each other’s advantage. Portals and SNS sites have large user basees. eCommerce sites can provide products for group buying. Living social sites have the networks of local merchants. Vise versa, group buying services can improve user experiences for the above sites. Select Group Buying Sites in China Lashou Meituan Dingping Tuan QQ Tuan Juhuansuan http://www.lashou.com/ http://www.meituan.com/ http://t.dianping.com/ http://tuan.qq.com/ http://ju.taobao.com/ Launching Date Sep, 2009 Mar, 2010 June, 2010 July, 2010 Mar, 2010 Networks 100+ Cities 12 Cities 7 Cities 11 Cities Products based nationwide site Business Description 1. Lashou is the first and Meituan is the leading Dingping Tuan is QQ Tuan is launched by Juhuansuan is launched largest group buying site group buying site in China. launched by Tencent. QQ Tuan also by Taobao, Alibaba's in China. It plans to Dingping.com, a well- offers group buying subsidiary on expand to 200-300 cities known living social site products only for QQ eCommerce. It is a by 2011. in China. members with lower product based group 2. Lashou is trying to add discount price. buying site, covering more functions to its across whole China group buying site, such rather than location as "Check-in" and SNS based. games. Source: Company reports, J.P. Morgan. 41 178
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com SNS and Microblogs: Help Drive Social eCommerce We observe that social networking sites (SNS) and microblogs are the new channels to promote online shopping products and social living information. Click “sharing” to share the information of online shopping products Sharing links with SNS and microblogs’ labels are located under or above the product picture at online shopping malls and group buying sites. SNS and micro- blogs include the most popular ones,Tencent micro-blog and Sina microblog. Netizens can also click to copy the URL and paste it to MSN or QQ or their emails. Click “forward” to share social living information Same as the link at online shopping sites, the links to SNS and mirco-blogs are also located under or above the picture of social living information at social living site. It is generally straightforward for a user to forward a Cafe’s information at Dingping.com to a Sina Microblog. First step: the user selects the Cafe and clicks Sina Microblog label under the picture of the Cafe. Second step, at the pop-out webpage the user can log into Sina Microblog and click “forward.” Third step, the user can check that the Cafe information has been published on Sina’s Microblog. Leading C2C Players in China Taobao, the eCommerce subsidiary of Alibaba, is the leading online marketplace operator in China. Taobao reached registered members of 170M by 2009 and is one of the world’s Top 20 most visited websites. Paipai is Tencent’s C2C marketplace and ranks second, leveraging Tencent’s large IM user base. China C2C eCommerce Market Share by GMV in 3Q10 Eachnet, 3.6% Paipai, 11.6% Taobao , 84.8% Note: 1. Taobao includes GMV from both Taobao C2C shopping mall and Taobao Mall. 2. Paipai includes GMV from both C2C Paipai and QQ Mall. Source: iResearch (2010). 42 179
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Leading B2B Players in China The B2B eCommerce sector has seen stable growth in 2010. Alibaba is still the leading player, with market share of 57% in 3Q10. China B2B eCommerce Market Share by Revenue in 3Q10 Others, 16.2% Toocle, 1.0% DHgate.com, 1.8% My steel.com, 2.6% GlobalMarket, 3.3% Made-in-China.com, Alibaba, 57.0% 3.4% HC360, 4.1% Global Resources, 10.7% Source: iResearch (2010). China’s Leading B2B Players Alibaba Global Resources HC International Business Description Alibaba operates the leading online B2B Global Sources is a leading B2B media HC International offers both online and marketplace in China. company and a primary facilitator of trade offline B2B services in China. 1. International marketplace, Chinese with Greater China. The company's principal 1. Online marketplace: Mai-Mai-Tong (买 marketplace, Japanese marketplace, and business is to provide services that allow 卖通) global wholesale marketplace. global buyers to identify suppliers and 2. Offline marketing products: HC Trade 2. Ali loan: outstanding portfolio of Rmb 20B- products, and enable suppliers to market their Catalogues, HC Yellow Page Directory, Rmb 30B. products to a large number of buyers. Industrial Market Research 3. Acquisition: acquired AliSoft, HiChina, Vendio, Auctiva, and OneTouch as a part of "Work at Alibaba" strategy. Registered Members 1. International marketplace: 15M Mainland China registered online users and Online marketplace Mai-Mai-Tong - # of paying users of China Gold supplier magazine readers: 2M+ - Registered users (2009): 10M members: 108.6k - Mai-Mai-Tong IM users: 7M - # of paying users of Int'l Gold Suppliers: 11k 2. Chinese marketplace: 42M - # of China Trust Pass members: 631.3k Revenue 1. Generate revenue from (1) membership 1. Generate revenue from (1) online and 1. Generate revenue from (1) subscription payment (2) value-added services other media services (2) exhibitions fee from online services (2) advertising - 2010E: Rmb 5,452M (US$801.8M) - 2009: US$174.5M income from industry portals, trade - 2009: Rmb 3,875M (US$569.9M) 2. Revenue breakdown (FY09) catalogues, yellow page directories and 2. Revenue breakdown (FY09) - Online and other media services: 66.1% printed periodicals (3) hosting of trade - International marketplace: 62.1% a) Online services: 48.9% exhibitions and business seminars (4) - Chinese marketplace: 36.5% b) Print services: 17.2% customer-specific market research reports - Others: 1.4% - Exhibitions: 31.6% - 2009: Rmb 317.7M (US$46.7M) 2. Revenue breakdown (FY09) - Online services: 40% - Trade catalogues and yellow page directories: 36% - Market research and analysis: 16% - Seminars and other services: 8.1% Margin (FY09) - Gross Margin: 86.2% - Gross Margin: 36.7% - Gross Margin: 52.5% - Operating Margin: 26.6% - Operating Margin: 9.2% - Operating Margin: 0.56% - Profit Margin: 26.1% - Profit Margin: 9.2% - Profit Margin: 0.67% History Founded in 1999. Founded in 1971. Founded in 1992. Source: Company reports, Bloomberg, J.P. Morgan. 43 180
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Online Gaming Growth outlook remains robust The online gaming sector continued to see good growth in 2011, with ~23% Y/Y growth to reach Rmb35.9B (~US$5.3B), as per our estimates. The MMORPG segment (~84% of total gaming market) expected to growth ~21% Y/Y in 2011 to reach ~US$4.4B, as per our estimates, with the launch of few key games next year with different genre, such Final Fahe. The casual and social game segments are likely to benefit from SNS sites opening up their platforms for new social games. Overall for 2011, we expect companies with strong operating and marketing capabilities and healthy game pipelines to continue to benefit from the market’s growth. China MMORPG Market Forecast 2006 2007 2008 2009 2010E 2011E 2012E MMORPG gamers (million) 25.5 37.0 53.3 66.6 77.7 91.5 106.7 Game users penetration 18.6% 17.6% 17.9% 18.1% 18.5% 18.5% 18.5% Average ARPU per month (Rmb) 19.7 21.3 23.7 25.8 26.6 27.1 27.6 Market size (Rmb million) 6,043 9,463 15,125 20,608 24,767 29,738 35,380 MMORPG Market size (US$M) 762 1,255 2,192 3,005 3,626 4,406 5,242 Growth Rate: 27% 65% 75% 37% 21% 21% 19% Source: J.P. Morgan estimates. China Casual and Social Game Market Forecast 2006 2007 2008 2009 2010E 2011E 2012E Casual game players (million) 32.6 47.3 68.1 88.5 102.9 122.8 145.1 Casual players penetration 23.8% 22.5% 22.8% 24.0% 24.5% 24.8% 25.2% APRU per month (Rmb) 2.7 2.9 3.2 3.5 3.8 4.2 4.6 Market size (Rmb million) 1,044 1,634 2,589 3,669 4,694 6,158 8,005 Casual Market size (US$M) 132 217 375 535 687 912 1,186 Growth Rate: 52% 65% 73% 43% 28% 33% 30% Source: J.P. Morgan estimates. China Total Game Market Forecast 2006 2007 2008 2009 2010E 2011E 2012E Total Game Market size (Rmb million) 7,086 11,097 17,714 24,277 29,460 35,896 43,386 Total Game Market size (US$M) 893 1,472 2,568 3,539 4,313 5,318 6,428 Growth Rate: 30% 65% 74% 38% 22% 23% 21% Source: J.P. Morgan 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 (2009-12E CAGR of 17%). 2) Upside in gamer penetration, which is still less than one-third of Korea’s penetration (also below HK and Taiwan), with additional gamers coming particularly from lower-tier cities. 3) Increasing broadband penetration, with 364MM broadband internet users as of Jun-10, or 87% of total internet users; CAGR of ~47% over the last five years. 4) Efforts of game companies – new genre, better quality, more innovative games and more effective promotions to continue to attract players; also, success of the free- to-play (item-based sales) model (contributing ~79.4% of industry revenues in 2009, up from ~76.2% in 2008, as per IDC estimates). 44 181
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com 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. 2011 -- Look for companies with product specific drivers With market growth slowing down from the high double-digit level a few years ago, we expect more intense competition among leading game companies. We look for companies with game-specific drivers going into 2011. Key MMORPG Games in 2011 We expect new games launching in 2011 to lead industry growth. In 2010, we think only “Dragon Nest,” launched by Shanda Games in late July, performed well with PCU of 700k+. In 2011, a few key games we will watch for are Changyou and Giant Interactive to release “Duke of Mountain Deer” and “ZT Online II” in 1H11, respectively. Netease may launch Blizzard’s “WoW: The Catastrophe” as well as “Starcraft II”, but it still depends on the approval procedures of China-related bureaus. Final Fantasy XIV will also be a game to watch which will be launched by Shanda Games. Key MMORPG New Games in 2010 and 2011 Game Chinese Title Genre Visual Dimensions Game Operator Game Developer Launch Date Dragon Nest 龙之谷 Action 3D Shanda Games Eyedentity Games Jul-10 (acquired by Shanda Games in 2010) Duke of Mountain 鹿鼎记 Martial arts 3D Sohu Changyou Sohu Changyou 1. Expect to be Deer adventure launched in 1H11 2. Started closed beta testing in Dec- 10. ZT Online II 征途2 Martial arts 2D Giant Interactive Giant Interactive 1. Expect to be adventure launched in 1H11 2. Started unlimited closed beta testing in Nov-10. Final Fantasy XIV 最终幻想14 Fantasy 3D Shanda Games Square-Enix Shanda Games announced the acquisition of an exclusive license for the game in Sep-10. World of Warcraft: 魔兽世界:大灾变 Fantasy 3D NetEase Blizzard The new version has The Catastrophe been launched in other countries except mainland China in Dec-10. Source: Company reports, J.P. Morgan estimates. 45 182
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Comparison of Leading Games and Game Companies Market Share of Leading Online Gaming Companies by Revenue 2007 2008 2009 First Nine Months of 2010 Tencent 6% 11% 20% 29% Shanda 17% 16% 18% 14% NetEase 14% 12% 12% 15% Sohu Changyou 2% 7% 7% 7% Perfect World 5% 7% 8% 8% Giant Interactive 12% 8% 5% 4% Kingsoft 3% 3% 3% 2% NetDragon 5% 3% 2% 2% The9 10% 8% 3% 0.3% Others 25% 23% 21% 18% Source: Company reports, iResearch, J.P. Morgan estimates. Leaders in MMOG Quarterly Active Paying Accounts (Free-to-Play Model) (In '000s) 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 Tencent 921 2,713 3,684 5,024 5,960 6,919 8,377 8,304 8,518 8,526 9,243 Sequential growth 194.7% 35.8% 36.4% 18.6% 16.1% 21.1% -0.9% 2.6% 0.1% 8.4% Shanda 4,110 4,239 5,189 5,889 7,189 8,580 9,060 9,420 9,620 9,640 9,190 Sequential growth 3.1% 22.4% 13.5% 22.1% 19.3% 5.6% 4.0% 2.1% 0.2% -4.7% Sohu Changyou 1,514 1,807 2,006 1,981 2,270 2,390 2,400 2,400 2,400 2,790 2,610 Sequential growth 19.4% 11.0% -1.2% 14.6% 5.3% 0.4% 0.0% 0.0% 16.3% -6.5% Perfect World 1,701 1,530 1,610 1,546 1,464 1,877 1,643 2,188 1,670 1,433 1,274 Sequential growth -10.1% 5.2% -4.0% -5.3% 28.2% -12.5% 33.2% -23.7% -14.2% -11.1% Giant Interactive 1,447 1,760 937 1,290 1,236 1,204 1,108 1,138 1,373 1,435 1,497 Sequential growth 21.6% -46.8% 37.7% -4.2% -2.6% -8.0% 2.7% 20.7% 4.5% 4.3% Source: Company reports, J.P. Morgan estimates. Leaders in MMOG Quarterly ARPU per Active Paying Accounts (Free-to-play Model) (In Rmb) 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 Tencent 68 33 33 78 81 83 88 90 98 99 101 Sequential growth -51.0% -0.3% 136.3% 3.3% 2.6% 5.5% 2.3% 9.7% 0.1% 2.5% Shanda 156 164 149 149 132 126 130 135 106 105 106 Sequential growth 5.4% -9.3% 0.4% -11.8% -4.5% 3.6% 3.5% -21.1% -0.9% 0.4% Sohu Changyou 192 176 177 194 179 186 190 196 201 184 214 Sequential growth -8.3% 0.8% 9.6% -7.9% 3.9% 2.2% 3.2% 2.6% -8.5% 16.3% Perfect World 151 188 196 225 244 237 266 223 306 292 323 Sequential growth 24.5% 4.3% 14.8% 8.4% -2.9% 12.2% -16.2% 37.2% -4.6% 10.6% Giant Interactive 325.1 285.9 282.1 272.7 299.7 300 259.4 240.5 220 223 225 Sequential growth -12.1% -1.3% -3.3% 9.9% 0.1% -13.5% -7.3% -8.5% 1.4% 0.9% Source: Company reports, J.P. Morgan estimates. Game software industry typically not correlated with macroeconomic growth; thus, should be less vulnerable in an economic slowdown Historically, the game software industry has not been significantly correlated with macroeconomic growth. For instance, in developed markets such as the US, the videogame software industry has historically exhibited cyclicality driven by game hardware launches (consoles, handheld devices). These, in turn, result from technological advances by the hardware manufacturers – in terms of faster processing devices with superior graphics and game play capabilities – typically every four to five years, which creates the need for newer software and also drives consumer demand. As a result, the game software industry is relatively less vulnerable in an economic slowdown, compared to other industries and software segments. 46 183
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com US Game Software Leading Companies’ Revenue Growth vs. US GDP (Nominal) Growth 70% 7% 60% 6% 50% 5% 40% 4% 30% 3% 20% 2% 10% 1% 0% 0% 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Game Company Rev enues US GDP grow th rate Source: DataStream. Note: Correlation coefficient: -0.19 (weak correlation). 1) Leading US game software companies’ revenue growth based on total revenue of Electronic Arts, Activision, THQ and Take Two. 2) Prior game platform cycles were 1995-2000 and 2000-05; current console cycle started in 2005 (Xbox 360 launch). In addition to the above, in recent times, other aspects contributing to potentially greater resilience of the gaming sector have been: 1) the increasing acceptance of gaming among a wider demographic (e.g., games being seen as a family entertainment avenue, including women and children); 2) increasing penetration of the internet and more broadband connections driving online gaming; 3) emergence of innovative business models such as free-to-play online games and in-game advertising making gaming more affordable for consumers; and 4) greater variety of games (e.g., casual games such as music and dancing games) to appeal to diverse tastes. 47 184
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com The Rise of Social Gaming What is social gaming? Social gaming is a new form of gaming which is closer to casual games in complexity level accompanied by community features and frequent updates. Sticky platform What really makes social games sticky is the amount of user-engagement that these games have. Users start engaging in a virtual life with the game. For example: Many users playing Farmville actually start feeling like farmers, they are involved with choosing crops, sowing seeds, providing nutrients, and then harvesting at the right time. Many users often set alarms to wake up at the right time for harvesting. Game companies keep adding new items making users' farming better, which keeps the user interested in the game continuously. Social games are quite different from traditional MMORPG games in the sense that they are not heavy on strategy, do not have heavy graphics, and have no high hardware requirements. They differ from casual games in the sense that they have more community-based features and are more frequently updated. Increasingly, social games find their popularity amongst advanced gamers, casual gamers, and people who have traditionally been non-gamers. How social gaming is different from casual gaming? 1) Social gaming has community features: a) people can track the progress of their friends trough SNS platform, b) can be played with both online and offline friends. 2) The development team is continuously involved, making updates frequently. As social games do not have a lot of graphic interface, their updates are more frequent than MMORPGs. 3) The SNS platform assists in doing viral marketing for the game. Members are aware of actions of other friends in the game, which again gives birth to a sense of competitiveness and makes the platform stickier. What’s unique about social gaming in China? Social games in China are quite similar to the popular ones on Facebook. For most of the popular games in China such as farm and aquarium games, the concept has been adapted from Facebook and other English-based social networking websites. However, Chinese social games are supposed to be more competitive and have some added features like stealing items. We believe the social gaming trend will continue to pick up in China because 1) community features add to the stickiness of social games, 2) social games attract new sets of users who were traditionally non-gamers or did not have time to do heavier games (such as housewives), 3) better stickiness and monetization vs. casual games. 48 185
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com China SNS Game Market Forecast 3,000 109.2% 2,850 85.7% 1 2,500 75.0% 0.8 2,000 1,632 74.6% 0.6 1,500 780 0.4 1,000 420 240 0.2 500 0 0 2009 2010E 2011E 2012E 2013E SNS Game Market Size (Rmb M) YoY Grow th (%) Source: Analysys. Social gaming proves to be a goldmine for Tencent With the rising popularity of social games on Facebook and other Chinese websites, Tencent introduced many new social gaming applications with more interactive functionalities such as farming, aquarium, etc. to increase user stickiness. The company has adopted a mixed content sourcing strategy where it is sourcing the popular games like social farm from third-party vendors while also working in-house to keep the game launch pipeline green. As social games are simple, they are expected to have smaller life cycles and continuous churn of new games becomes necessary. The success of social games on Qzone led to a rise in the number of users from 150M in 4Q08 to 481M in 3Q10. The revenues have also gone up to 35.1% YoY in 3Q10 to reach Rmb580M. We estimate daily active users on Chinese SNS websites playing social games to be comparable to the number of active users on Facebook (500M+ active users). Qzone Continues Stable Growth 500 459 481 400 428 388 300 305 200 228 183 100 131 138 150 115 0 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 Qzone Activ e Users (M) Source: Company reports. Social gaming – a big opportunity for China game publishers China internet companies focus on an open platform strategy, which should help developers publish their social games. • Tencent announced its open platform strategy after “QQ vs. 360 war.” Tencent’s SNS open platform is still in open beta testing, but it already becomes a popular 49 186
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com channel for third-party application developers to publish their SNS games at Qzone. “Skyscraper,” a popular third-party game at Qzone developed by Kingnet, recorded 70M game users, according to Kingnet’s CEO. • The9 invested in Openfeint, a mobile game platform developer and operator, in July 2010. In December 2010, The9 signed a five-year license to use OpenFeint's mobile social gaming network software in China. The OpenFeint software is one of the most successful mobile social gaming network software for iOS and Android devices in the US. More than 13,000 mobile game developers are registered to integrate OpenFeint's SDK into their games and there are over 50 million registered users and approximately 4,000 games in the Apple App Store and Google Market running on OpenFeint's platform. We believe Chinese social game developers will grow fast with the popularity of SNS and social games in China as in other countries. In the US, key social game developers such as Zynga and Playfish have been attracting large numbers of players to their games. Zynga has more than 320M registered users, according to an article by GamesBeat. Playfish was acquired by Electronic Arts for approximately US$275M in cash and approximately $US25 M in equity retention arrangements. In addition, Playfish will receive additional variable cash consideration, up to a maximum of US$100M, contingent upon the achievement of certain performance milestones through December 31, 2011. 50 187
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Summary of Gaming Regulations in China Summary of historical gaming regulations The General Administration of Press and Publication (GAPP) has been the key regulatory body since online games were introduced 10 years ago. This is because online games were assumed to be publications by online game companies, and, as such, they turn to GAPP for approvals. On July 11, 2008, the State Council issued “Three Regulations” outlining responsibilities of various government bodies (including Ministry of Culture [MoC] and GAPP) in the regulation of animation, online gaming, and the cultural market in general. Even after this regulation, GAPP and the MoC both conduct their own approval process independently. On September 7, 2009, China's State Commission Office for Public Sector Reform issued a notice clarifying responsibilities of various government bodies in the regulation of animation, online gaming, and the cultural market in general. According to this notice, MoC is the key regulatory body, responsible for market planning, management of the industry, project development, conferences, and market oversight for the animation and online gaming industries. By the end of 2009, all the transition in responsibility should be complete. MoC gets involved - released “Interim Measures for Online Games” in 2010 In late September 2009, MoC held a meeting with leading games companies stating that MoC will be the key regulatory body. MoC released “Interim Measures for Online Games” on June 3, 2010, after about two years of preparation. The implementation of “Interim Measures” began on August 1, 2010. News about the rules was reported on Sina.com on June 22, 2010. The key points are: - Detailed the requirements (registered capitals of no less than Rmb10M, etc.) for online game companies to obtain “Online Culture Operating Permit.” MoC is responsible for reviewing online game content. However, games have already been approved by other departments (GAPP), no separate review is required by MoC. - Application process: If there is a change in operator for imported games in China, the game needs to be re-approved. For domestic developed games, the game needs to be filed with MoC within 30 days of operation. If game content is substantially changed, the game needs to be re-filed with MoC. - No illegal game content which are considered as negative to Chinese culture, society, etc. Games should include details for suitable age groups. No gambling items in game allowed. - Real name registration for players. Online game companies are required to implement “anti-addiction system” (time limits) for minors. - Virtual game currencies: (1) cannot be used for payment, other physical product purchases, or other non-game product purchases, (2) game operators to keep record 51 188
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com of game currencies trading for at least 180 days, (3) data for game currencies types/prices/total amount issued to be filed with MoC. - If a game ceased to operate for 30 days, operators will return money to gamers. There are fines for non-compliance, and potential criminal charges. Regulations on virtual currency and virtual items trading platform Separation of online game operators that issue virtual currencies and online game items trading platform MoC and the Ministry of Commerce (MOFCOM) jointly issued a notice regarding strengthening the administration of online game virtual currency on June 4, 2009. The notice prohibits businesses that issue online game virtual currency from providing services that would enable the trading of such virtual currency. “Interim Measures” regulates virtual game currency and virtual currency trading platform - Virtual game currencies cannot be used for other payments instead of online game products and services. Virtual game currency issuers cannot issue virtual currencies for the purpose of occupying the prepaid capital. The record of purchasing virtual game currencies should be kept for at least 180 days. Data for virtual game currency types/price/total amount issued should be filed with MoC-related bureaus. - Virtual online game currency trading platform cannot provide trading service for: 1) minors, and 2) online games that are not approved or filed with MoC. The trading platform should require real name registration for buying/selling parties and the registration information should match bank account information. The trading and account information should be kept for at least 180 days. Online Gaming Primer What are online games? Broadly speaking, we can separate online games into two segments: 1) casual games, and 2) serious games/MMORPG. Causal games are easy to play and only require brief tutorials. Some examples are puzzles, board games, and some old arcade games. Demographics for casual games are diverse: they cut across age groups (from young children to senior citizens) and are equally split across genders. Very often, these games are free. What is a MMORPG online game? These are more complex games with a large number of scenes, multiple players and characters. Serious game players are also more committed to the games than casual players. They usually comprise young adults or teens who spend more than 10 hours per week on online games. The most popular games that account for most of China’s online game revenues (~84% of total online gaming market, as per our estimates) are Massively Multiplayer Online Role Playing Games (MMORPG). These games are not simply about shooting and killing or finding treasures and saving the princess, as in some other games. MMORPG are community-based and players can interact with other players, form coalitions with acquaintances to fight battles, make villages more livable, and even have virtual marriages. 52 189
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com MMORPG games are very dynamic; game developers and operators always extend the map, create new weapons and run special virtual events. Typically, operators have a new release every month and a major upgrade once a year—and users can download them free of cost. What is a casual game? Casual games are online games that are typically less evolving compared with MMORPG games. Players typically only spend less than 30 minutes per game session. The content and depth is much simpler, and requires fewer skills or less training to play the games. Casual games can be broadly classified into 1) board and chess games, and 2) advanced casual games. Board and chess games, as the name suggests, are board games, chess, different types of card games, and other traditional games put online. These are viewed more as commodity products, and difficult to differentiate from competitors. As such, monetization is typically lower. Advanced casual games are online games that have more depth and content compared with board and chess games. However, they are not as involved as MMORPG. Gamers spend less than an hour per game session. Successful advanced casual games are typically more innovative, and bring in new ideas to the market space. The popular advanced casual games include: Cross Fire, QQ Speed, QQ Dancer, Audition, Crazy Racing, CSOnline, AVA, etc. Successful casual games generate more revenue compared to board and chess games. The revenue model for casual games is in-game item sales. Typical game items are: avatars (virtual clothing, accessories, and decorative products), tools (i.e., virtual golf clubs to play golf), weapons, special features (i.e., ability to see competitors’ cards in card games), and membership (priority access to game servers, and “members only” games). Casual and MMORPG are complementary rather than competing products We believe casual games and MMOPRG satisfy needs of players at different times. For example, if a player has 15 minutes to kill, they likely would turn to casual games, but if a player has a few hours everyday, playing a simple casual game is likely to become too boring. Therefore, this same player could play both types of games at different times, depending on his or her availability and needs. We believe new innovative advanced casual games attract non-game players to online games and further expand the gamer base. We observe this from the demographic differences between casual games and MMORPG games. These additional players could perhaps become MMORPG gamers down the road, if they find online gaming interesting. 53 190
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Gender Breakout of Online Gamers in China Age Breakout of Online Gamers in China Abov e 50, 7.1% Below 11, 0.7% Female, 14.6% 41-50, 12.1% 11-20, 24.8% 31-40, 14.2% Male, 85.4% 21-30, 41.2% Source: IDC (2009). Source: IDC (2010). Do gamers have time to play both advanced casual and MMORPG? In China, the market trend is to develop advanced casual games that are more complex and involved, and, as such, these casual games consume more time compared with before. Investors are concerned that this would reduce spending on MMORPG games. We believe this may be true, but the effects on MMORPG should be minimal, in our opinion. First, it is not uncommon for users to play multiple games, so users can play both MMORPG and casual games during the same day. Second, an expanded casual game user base should also bring new users to MMORPG. Online games—a sticky business In online games, players build a strong community with other game players. They communicate through instant messengers in the game. Once players have been playing for a certain period, they start building their seniority and respect within the gaming community, as well as their stock of accumulated weapons. As such, fair play becomes very important. Hacking not only demoralizes players but also seems to cause “community unrest” and to threaten the “social order” in the game space. Game operators hire game masters or ‘GMs’ who patrol the game space to check for unfair practices, and remove those users who violate the rules. Leaving the game means severing ties with the community, as well as giving up weapons and armors accumulated over time. As such, players have proved to be quite loyal to the games. A well-run game is therefore very sticky, and the operators’ goal is to make their game stickier. To further increase user loyalty, game operators organize special events in the virtual space, as well as organize offline promotions and parties. One good example is Lineage in Korea, which was launched in Korea about six years ago and remains one of the top games in the country. Any piracy issues in online games? Online games are designed to get around the piracy issue. There are two sets of software – server software and client software. Server software is installed inside game companies’ servers. The game server is designed to protect against hackers trying to copy or alter the server software. Client software is distributed free of charge and can be downloaded from a game operator's site at any time. Since client 54 191
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com software is free, unlike game consoles where game software is charged a fee, there is no reason to make pirated copies. As such, piracy problems are very limited. What are pirated servers? This refers to the situation where the main server software is stolen from game companies or the server software is being reverse-engineered. In this situation, “criminals” put stolen/pirated server codes on home-run servers and charge users a lower fee than authentic servers to play the game on their servers. These are referred to as “pirated” servers. Games that are operated widely across the globe are more prone to being pirated. This is because game developers need to distribute a source code to outside game local operators, and as such, there is a higher chance of the source code being leaked out. For example, Mir2, Aion, and Lineage are well known for having pirated servers in China. NetEase, which develops its games in-house, has not seen any pirated server issues. Also, new games have more security features to protect the server software from being pirated. For example, we have not noted any pirated servers for World of Warcraft. What are hacking tools software? Hacking in online games typically refers to special (purchased or self-written) programs that run on players’ PCs. With these special hacking tools, game players can, for example, get infinite lives, nuke all the adjacent players, or take tools from others. Hacking demoralizes other players and results in their leaving the game. To tackle the issue, online game operators can: 1) amend the actual game software, 2) hire more game masters to patrol the virtual community, and 3) bar hacking players from playing the game. The first option is the most effective way to deal with the problem. However, as many online game operators only purchase games from other developers and do not have access to the source code, there could be a time delay in addressing a particular hacking issue. In fact, this is a fairly frequent issue raised by operators in China, and has led to the decline of some early online games. Economy of games We believe the required number of concurrent users is low for a MMORPG game to break even. Excluding development costs or licensing fees, a game can achieve an operational breakeven at 4,000-5,000 average concurrent users. With relatively low breakeven user numbers, we believe the number of MMORPG game titles will continue to grow. However, many of these will likely be small-scale games that we expect will target niche audiences, much like different types of movies: action-adventure, science-fiction, martial arts, war, mystery, medieval, etc. 55 192
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Estimated Gross Income of a MMORPG Under Various Concurrent Users Case 1 Case 2 Case 3 Average concurrent users 1,000 4,000 10,000 Active paying users 11,000 44,000 110,000 ARPU per users (RMB): 9 9 9 Revenue after distributor’s discount 79,200 316,800 792,000 Number of servers 3 4 9 Monthly server amortization & bandwidth cost 16,375 21,833 49,125 Game masters and other labor cost 48,000 64,000 144,000 Marketing and promotion 55,440 110,880 158,400 Other operating expenses 47,520 95,040 158,400 Gross Net Income (88,135) 25,047 282,075 Source: J.P. Morgan estimates. Note: Excluding development cost, amortization of licensing fee or revenue sharing with game developer. How fast would a game decline from its peak? As a rule of thumb, typical popular MMOPRG games reach their peak in around three years. The rate of decline from the peak varies depending on different factors. Some games decline at a faster rate compared with others. For example, we noted Mu, operated by 9Webzen, experienced a step function (around 50% drop each step) type of sharp fall, mainly due to hacking and cheating tools, while Mir 2 declined 30% Q/Q in 3Q05, mainly due to pirated servers. We believe the rate of decline from the peak varies, depending mainly on these factors: 1) hacking or pirated server issues, 2) ongoing promotion and user activities, and 3) availability of upgrade packs. Some of the Korean games have still maintained a high level of usage for over 10 years. Revenues for Long-Running Korean Online Games (In KRW M) 60,000 50,000 40,000 30,000 20,000 10,000 0 05 05 07 04 06 06 07 08 08 09 09 10 10 3Q 1Q 3Q 1Q 3Q 1Q 3Q 1Q 3Q 1Q 3Q 1Q 3Q Lineage 1 Lineage 2 Source: Company reports. 56 193
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Japan Japan Internet Market Overview Broadband the Norm – Mobile Surfing Taking Over Japan has enjoyed relatively high bandwidth availability since CY’02, and with it high internet usage from both fixed line and mobile. Internet Penetration Rate million, % 120 100.0 90.0 100 73.0 75.3 78.0 70.8 72.6 80.0 57.8 64.3 66.0 70.0 80 46.3 60.0 60 50.0 40.0 40 30.0 20 20.0 10.0 0 0.0 CY'01 CY'02 CY'03 CY'04 CY'05 CY'06 CY'07 CY'08 CY'09 Internet subscribers (LHS) Broadband service (LHS) Mobile subscribers (LHS) Penetration rate (RHS) Source: J.P. Morgan based on MIC's Survey of "Telecommunications Usage Trend Survey 2009" and "Number of Broadband Service Contracts, Etc." Note: Broadband service is a sum of FTTH, DSL, CATV, and FWA. Since CY’00 we can see that users have become more accustomed to surfing the net via both PC and mobile. In April 2010 according to Nielsen Online, 46% of users accessed the net in this manner; back in April 2000 access via only PC stood at 84%. We believe that with greater smartphone penetration going forward, this trend whereby mobile substitutes for PC usage will continue. Internet User Population Trend via PC and Mobile million 80.0 70.0 9.2 7.9 8.1 11.3 11.2 60.0 50.0 12.4 12.4 10.2 31.0 33.8 8.2 30.7 35.6 40.0 28.5 4.8 14.1 17.8 22.4 23.1 30.0 1.3 5.7 20.0 2.2 33.1 26.2 25.9 26.5 27.9 26.3 31.6 10.0 18.8 21.2 24.2 23.7 0.0 Apr-00 Apr-01 Apr-02 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 PC only PC & mobile Mobile only Source: J.P. Morgan based on Nielsen Online Internet Base Survey. 57 195
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Internet User Population Trend, Access Via PC at Home million 60.0 51.6 48.3 48.6 50.0 44.7 41.1 36.9 40.0 21.2 21.9 23.7 30.8 19.7 27.1 18.1 30.0 24.3 16.2 13.2 20.0 15.4 10.5 11.6 8.5 6.1 25.0 27.0 26.7 27.8 10.0 20.7 23.0 3.2 13.9 15.4 17.6 5.4 9.2 0.0 Apr-00 Apr-01 Apr-02 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Male Female Source: J.P. Morgan based on Nielsen Online NetView. With regard to the gender split of internet users, we have also seen a gradual increase in the female user population for PC traffic. Internet Penetration by Age and Gender, Access via PC at Home million, % 14.8 60 ov er 18.4 30% 8% 5.1 55-59 5.2 37% 20% 4.4 50-54 4.4 62% 36% 3.9 45-49 3.9 69% 52% 4.1 4.0 70% 40-44 64% 4.4 35-39 4.3 58% 68% 4.9 4.8 58% 30-34 71% 4.2 25-29 4.1 52% 63% 3.8 20-24 3.6 49% 58% 2.7 2.6 46% 16-19 46% 1.9 13-15 1.8 55% 57% 6.6 6.3 27% 2-12 25% Male Population Female Population Penetration Penetration Source: J.P. Morgan based on Nielsen Online NetView (Apr 2010). The most active internet users are in the 30-to-44 age group, which is in line with the most active users on eCommerce sites. Advertising on major portals would be greatly influenced by this key demographic group. However, internet penetration is currently fastest in the elderly population (aged 60 and over). 58 196
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Internet Penetration by Age and Gender, Access via Mobile million, % 14.8 60 ov er 18.4 8% 4% 5.1 55-59 5.2 20% 16% 4.4 50-54 4.4 24% 27% 3.9 45-49 3.9 42% 34% 4.1 4.0 55% 40-44 44% 4.4 35-39 4.3 54% 52% 4.9 4.8 58% 30-34 60% 4.2 25-29 4.1 59% 70% 3.8 20-24 3.6 81% 72% 2.7 2.6 75% 16-19 76% 1.9 13-15 1.8 26% 48% 6.6 6.3 4% 2-12 4% Male Population Female Population Penetration Penetration Source: J.P. Morgan based on Nielsen Online NetView (Apr 2010). When comparing user demographics for mobile internet users, unsurprisingly the core age category is younger than PC internet users, with the 16-to-24 age group being the main users, where penetration is almost 80%. Smartphone Penetration % 11.5% 11.4% 14% 10.2% 12% 9.6% 8.6% 8.3% 8.0% 10% 7.1% 6.4% 6.4% 6.3% 8% 5.9% 5.3% 5.2% 5.0% 4.7% 4.5% 4.3% 4.2% 4.1% 6% 2.5% 2.4% 2.4% 4% 2% 0% 13-15 16-19 20-24 25-29 30-34 35-39 40-44 45-49 50-54 55-59 60 Total ov er Male Female Source: J.P. Morgan based on Nielsen Online Internet Base Survey (June 2010). Although smartphone penetration is still low (5.9% according to Nielsen Online), usage rates are relatively high among men in their 30s, and females in their late 20s and early 30s. 59 197
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Internet Advertising Japan online ad spend 11.9% of We estimate that the online advertising market will resume a healthier growth profile total ad spend in CY’09 Y/Y for CY’10 and CY’11, as online media gains more share from traditional mass media and pricing rises. Although this is nothing new, this does bode positively for Yahoo Japan as the leading net property for advertising spend. Internet Advertising Expenditure ¥ billion, % CY’06 CY’07 CY’08 CY’09 CY’10E CY’11E CY’12E Internet ad expenditure 363.0 459.1 537.3 544.8 595.5 651.4 705.5 PC 324.0 397.0 446.0 441.7 481.8 524.1 564.9 Ad placements 231.0 268.8 288.5 270.7 293.7 317.2 339.4 Search ads 93.0 128.2 157.5 171.0 188.1 206.9 225.5 Mobile 39.0 62.1 91.3 103.1 113.7 127.3 140.6 Ad placements 39.0 53.6 74.3 80.7 88.0 97.6 107.4 Search ads 0.0 8.5 17.0 22.4 25.8 29.6 33.2 Y/Y Internet ad expenditure - 26.5% 17.0% 1.4% 9.3% 9.4% 8.3% PC - 22.5% 12.3% -1.0% 9.1% 8.8% 7.8% Ad placements - 16.4% 7.3% -6.2% 8.5% 8.0% 7.0% Search ads - 37.8% 22.9% 8.6% 10.0% 10.0% 9.0% Mobile - 59.2% 47.0% 12.9% 10.3% 11.9% 10.5% Ad placements - 37.4% 38.6% 8.6% 9.0% 11.0% 10.0% Search ads - - 100.0% 31.8% 15.0% 15.0% 12.0% Source: Dentsu, J.P. Morgan estimates. Domestic internet advertising spend is expected to continue gaining market share against traditional mass media, as seen with historic trends. 60 198
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Domestic Advertising Expenditure by Media Type ¥ billion, % CY’05 CY’06 CY’07 CY’08 CY’09 Value Total ad expenditure 6,824 6,940 7,019 6,693 5,922 Newspapers 1,038 999 946 828 674 Magazines 484 478 459 408 303 Radio 178 174 167 155 137 TV 2,041 2,016 1,998 1,909 1,714 Satellite media 49 54 60 68 71 Internet 378 483 600 698 707 Sales promotion 2,656 2,736 2,789 2,627 2,316 Composition Newspapers 15.2% 14.4% 13.5% 12.4% 11.4% Magazines 7.1% 6.9% 6.5% 6.1% 5.1% Radio 2.6% 2.5% 2.4% 2.3% 2.3% TV 29.9% 29.1% 28.5% 28.5% 28.9% Satellite media 0.7% 0.8% 0.9% 1.0% 1.2% Internet 5.5% 7.0% 8.6% 10.4% 11.9% Sales promotion 38.9% 39.4% 39.7% 39.3% 39.1% Y/Y Total ad expenditure - 1.7% 1.1% -4.7% -11.5% Newspapers - -3.8% -5.2% -12.5% -18.6% Magazines - -1.3% -4.0% -11.1% -25.6% Radio - -1.9% -4.2% -7.3% -11.6% TV - -1.2% -0.9% -4.4% -10.2% Satellite media - 11.7% 10.8% 12.1% 4.9% Internet - 27.8% 24.4% 16.3% 1.2% Sales promotion - 3.0% 1.9% -5.8% -11.8% Source: J.P. Morgan based on Dentsu. Note: Internet advertising includes product expenditure. Domestic Advertising by Media (CY’05) Domestic Advertising by Media (CY’09) News paper News paper Magazine 15.2% Magazine 11.4% 5.1% 7.1% Sales promotion Sales promotion Radio 38.9% 39.1% 2.3% Radio 2.6% TV Internet 28.9% 5.5% TV Satellite media 29.9% Internet 0.7% Satellite media 11.9% 1.2% Source: J.P. Morgan based on Dentsu. Source: J.P. Morgan based on Dentsu. Comparison with US market US online ad spend 14.3% of The US market size for online advertising was $22.7B in CY’09, according to the total ad expenditure in CY’09 Interactive Advertising Bureau (IAB). The US online market is three times the size of the Japanese market spend, online advertising made up 14.3% of total advertising spend, larger than Japan at 11.9%. 61 199
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com U.S. Advertising Expenditure by Media Type $ billion, % CY’04 CY’05 CY’06 CY’07 CY’08 CY’09 TV 49.3 53.9 72.4 71.3 68.2 62.1 Newspapers 46.2 47.9 51.2 48.6 34.4 24.6 Internet 9.6 12.4 16.9 21.2 23.4 22.7 Y/Y 32.1% 29.2% 36.3% 25.4% 10.4% -3.0% Radio 20.7 21.7 20.8 19.8 17.2 14.0 Consumer magazines 12.4 12.9 24.6 13.8 12.7 10.0 Others 63.5 70.6 62.5 18.6 31.0 25.6 Composition (%) TV 24.4% 24.6% 29.1% 36.9% 36.5% 39.1% Newspapers 22.9% 21.8% 20.6% 25.1% 18.4% 15.5% Internet 4.8% 5.7% 6.8% 11.0% 12.5% 14.3% Radio 10.3% 9.9% 8.4% 10.2% 9.2% 8.8% Consumer magazines 6.1% 5.9% 9.9% 7.1% 6.8% 6.3% Others 31.5% 32.2% 25.2% 9.6% 16.6% 16.1% Source: IAB Internet Ad Revenue Report; PricewaterhouseCoopers. U.S. Internet Ad Revenues by Industry % CY’08 (1) CY’09 (2) (2) - (1) Retail 22.0% 20.0% -2.0ppt Telecom 15.0% 16.0% 1.0ppt Financial services 13.0% 12.0% -1.0ppt Automotive 12.0% 11.0% -1.0ppt Computing 10.0% 10.0% 0.0ppt Consumer packaged goods 6.0% 6.0% 0.0ppt Leisure travel 6.0% 6.0% 0.0ppt Entertainment 4.0% 4.0% 0.0ppt Pharma & healthcare 4.0% 4.0% 0.0ppt Media 3.0% 4.0% 1.0ppt Others 5.0% 7.0% 2.0ppt Total 100.0% 100.0% - Source: IAB Internet Ad Revenue Report; PricewaterhouseCoopers. Sector-wise spending is focused on retail, telecom and financial services – different from Yahoo Japan’s core exposure to financial services, auto, cosmetics/toiletries and real estate. The IAB Internet Advertising Revenue Report shows that revenues were recovering +11.3% Y/Y in 1H CY’10 in the U.S. Comparison with China market China online ad spending made In CY’09 the China online ad market was US$2.1B, growing about 21% Y/Y and up 10% of total ad expenditure in making up 10% of total advertising spend. Compared to the US and Japanese CY’09 markets the size remains relatively small. 62 200
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Internet Advertising Expenditure CY’09 - U.S., Japan and China $ billion 25.0 30.0% 20.0 20.4% 20.0% 15.0 10.0% 10.0 0.0% 5.0 1.2% -3.0% 0.0 -10.0% U.S. Japan China Internet Ads Spend (LHS) Y/Y (RHS) Source: J.P. Morgan Asia Research, Dentsu, and IAB “Internet Advertising Revenue Report”. Note: Currency based on end-December, 2009. Comparison of Traffic and Sales for Key Domestic Internet Names Company Code Monthly visitors Monthly page views Sales (Apr-Jun 2010) Sales per PV Sales per visitors (month) (month) Registered Unique users PC Mobile PC (¥ M) Mobile (¥ M) (¥) (¥) users (M) (M) (B) (B) Mixi 2121 20.7 14.1 5.2 24.3 4,013.0 - 0.05 94.87 Cookpad 2193 0.4 9.4 - - 2,207.0 - - 77.93 Kakaku.com 2371 - 27.6 0.6 0.1 3,561.6 - 1.60 43.05 DeNA 2432 19.9 - - 71.6 - 24,193.0 0.11 404.63 Gourmet 2440 7.1 20.0 0.8 - 5,902.0 - 2.34 98.37 Navigator Gree 3632 20.6 - 0.4 35.4 - 10,940.0 0.10 177.11 Dwango 3715 17.4 - 2.3 - 6,931.0 - 1.02 132.47 Yahoo Japan 4689 24.0 224.2 40.9 7.9 70,506.0 - 0.48 104.81 Cyber Agent 4751 9.9 - 7.5 7.1 1,940.0 - 0.04 65.45 Rakuten 4755 41.4 - - - 41,300.0 - - 332.69 Source: J.P. Morgan based on companies’ data. Note: Unique users refer to the # of accessing users in a month. Rakuten visitors refers to both PC and mobile ads combined; sales refer to total net services (EC, travel, and portal media). Cyber Agent refers to Ameba business. DeNA refers to Mobage mobile portal. Dwango refers to Nico Nico Douga video site. Data as of end-June 2010. eCommerce The size of the Japanese B2C eCommerce market is estimated to be ¥4.5T, which is approximately 3.3% of the entire domestic retail market, worth ¥135.0T. However, in the core internet user demographic (i.e., 30-to-40 age group), eCommerce makes up a greater proportion of individual retail activity. Internet shopping also now dominates the non-store retail channel (such as phone, television and catalog mail order), with around 60% market share. 63 201
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Trend of Domestic BtoC ECommerce Market ¥ billion % 5,000 145.2% 160% 4,500 140% 4,000 120% 3,500 3,000 80.1% 80.9% 85.4% 100% 2,500 80% 2,000 60% 64.8% 1,500 40% 1,000 25.4% 22.1% 17.0% 13.1% 20% 500 19.4% 0 0% CY'00 CY'01 CY'02 CY'03 CY'04 CY'05 CY'06 CY'07 CY'08 CY'09 BtoC (retail & service, LHS) Y/Y(RHS) Source: J.P. Morgan based on METI Surveys on eCommerce Market Size. Note: CY’00 to CY’04 are based on J.P. Morgan assumption. Online shopping is dominated by Rakuten, Amazon Japan and Yahoo Japan. The number of items for sale shows that the leaders have taken a long tail approach. Number of Items for Sale Rakuten Amazon Japan Yahoo Shopping Yahoo Auction 65,706,254 items 28,566,407 items 36,295,435 items 22,490,000 items Source: J.P. Morgan based on company data. Note: Rakuten and Amazon Japan data as of Oct. 15, 2010, Yahoo Shopping Oct. 28, and Yahoo Auction end-Sep. 2010. The marketplace model (virtual shop tenants operating on a platform) has been very successful in Japan, as seen by the number of merchants active on Rakuten and Yahoo Japan. Number of Merchants Rakuten Yahoo Shopping Yahoo Auction 35,681 stores 17,834 stores 17,393 stores Source: J.P. Morgan based on company data. Note: Rakuten data as of Oct. 15, 2010; Yahoo Shopping and Yahoo Auction end-Sep. 2010. 64 202
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Survey – Most Recent Online Shopping Site Used via PC Manufacturer direct sales Unknow n Rakuten Books 7% 4% 9% Niche e-tailer 8% Real w orld retailer net store Rakuten Mall 8% 30% Other online mall operators Catalogue sales 4% companies Yahoo! Shopping 9% Amazon Japan 8% 13% Source: J.P. Morgan based on Fujitsu Research. Service comparisons between leader Rakuten and Amazon Japan We believe the key differences in the services offered by Rakuten and Amazon Japan are:  Amazon Japan has greater flexibility to offer customer experience improvements for shopping online (such as same-day delivery, private brands), given its key role as a retailer with the necessary infrastructure in place.  Rakuten’s strength lies in product selection and the ability to offer different online services within the group, such as travel and financial services, in addition to auction. Comparisons of Rakuten and Amazon Japan Rakuten Amazon Japan Characteristic Shopping model All marketplace (online mall tenants) Primary retailer, with growing third party sellers Third party sellers Mainly retailers and individuals Include manufacturers Own brands None Javari Amazon Basic Free delivery On select items and books On all items Same-day delivery None Yes - on select items 24 hour delivery Yes - on select 'Rakuten 24' service Yes - pending stock availability eBook sales None Via Kindle eBook reader Fulfillment services Yes - on select 'Rakuten 24' service For in-house and third party sellers using Fulfillment services Point program Rakuten Points Amazon Points - but not applicable to all items Auction items Available None Group buying Available None Settlement and delivery None Lawson at convenience store Gift card availability None Available Credit card services Rakuten Point Club card No Source: J.P. Morgan based on company website. 65 203
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com There has been a growing emphasis by Amazon Japan on its third-party seller base, as it aims to diversify its products on offer. A comparison of marketplace fees highlights the following:  Rakuten has an initial fee and fixed monthly charge, which provides an incentive that attracts many mall operators.  Amazon Japan has a smaller monthly fee for large sellers, but its cost structure is more complex. The seller has the option for fulfillment to be carried out by Amazon Japan. We think Rakuten’s brand and cost structure is likely to prove attractive to individuals and small businesses—especially for first timers. 66 204
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Participation Costs for Marketplace Sellers Rakuten Ichiba Standard plan Ganbare! Plan Light plan Mega-shop plan Monthly fixed fee ¥ 52,500 20,475 41,790 105,000 Number of items registered for sale Item 20,000 5,000 5,000 No limit Variable commission % 2.0~4.0% 3.5~6.5% 3.5~5.0% 2.0~4.0% Contract period 1 yr 1 yr 3 mos 1 yr Payment method Once in 6 mos Yearly Once in 3 mos Once in 6 mos Initial joining fee ¥ 33,600 33,600 33,600 33,600 Yahoo! Shopping Store Regular plan Master plan Royal plan Monthly fixed fee ¥ 20,790 31,290 52,290 Number of items registered for sale Item 200,000 200,000 200,000 Variable commission % 3.0~4.5% 2.1~3.9% 1.9~3.7% Contract period 6 mos 1 yr 1 yr Payment method Payable at 1 mos. - - Initial joining fee ¥ 21,000 21,000 21,000 Amazon Market Place (Japan) Large plan Small plan Monthly fixed fee ¥ 4,900 - Basic contract ¥ - ¥100 per transaction System charge % - - Number of items registered for sale Item No limit, All 21 categories Category limits in place, max ¥ 1 mn price tag Variable commission % 21 categories: 8~20% 15 categories: 8~15% Others are un-registerable Per transaction sales fee (domestic sales) ¥ 4 categories: ¥30~140 Other categories: free 15 categories: ¥30~140 Others are un-registerable Initial joining fee ¥ - - eBay Auction-style format listings -- Insertion fees Starting or reserve price Insertion fee $0.01 - $0.99 Free (up to 100 listings) $1.00 - $9.99 $0.25 $10.00 - $24.99 $0.50 $25.00 - $49.99 $0.75 $50.00 - $199.99 $1.00 $200.00 or more $2.00 -- Final value fees Final sale price Final value fee Item not sold No fee $0.01 - $50.00 9.0% of sale price (maximum charge $50.00) $50.01 - $1,000.00 9.0% of sale price (maximum charge $50.00) $1,000.01 or more 9.0% of sale price (maximum charge $50.00) Fixed price format listings -- Insertion fees Buy It Now price Insertion fee $0.99 or higher $0.50 -- Final value fees Final sale price Final value fee Item not sold No fee $0.99 - $50.00 8~15% of the final sale price $50.01 - $1,000.00 8~15% of the initial $50.00, plus 5~9% of the remaining final sale price balance $1,000.01 or more 8~15% of the initial $50.00, plus 5~9% of the next $50.01-$1,000.00, plus 2% of the remaining final sale price balance Source: J.P. Morgan based on company websites. Note: Tax included. Data as of end-Sept. 2010. 67 205
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com SNS in Japan Background Japanese SNS sites first Western social networking services such as Friendster and MySpace began in 2003, appeared in 2003, the same time making an impact as the concept of expansive online communities took hold. It was as US/European counterparts around the same time that numerous small special-interest SNS sites were emerging in Japan, but the two generalist sites that began to build major user bases were: Mixi and Gree both began in  Mixi—Initially an online PC service with an invitation-only user registration February 2004 format. Began in February 2004, with a mobile service starting in September 2004.  Gree—Commenced as a PC service with open registration to users in February 2004, launching a mobile service in December 2004 which became the mainstay service. Mobile SNS and gaming content Japan’s user-generated content sites were predominantly in the form of blogs (online spurred user adoption diaries) and forums (such as 2Channel). User adoption of SNS however was relatively swift, in part due to the convenience factor offered by mobile access, and with the more recent introduction of social gaming content. Key characteristics The defining characteristics of Japanese SNS sites are as follows: Key Characteristics of Japanese SNS Potential user audience Estimate 40M (50% of 15 to 64 age group), 30% of national population Current user penetration Estimated 50% - 60% of potential user audience User growth 35% Y/Y (at Sept 2010) Gender split Dependent on site, overall evenly split between male and female User age group distribution - Under 20 years old - 18% - 20 years to 30 years old - 41% - 30 years and above - 41% Age group with highest ARPU 30 years old and over PC SNS usage Less than 5% of total user traffic Mobile SNS usage Over 95% of total user traffic – driven by gaming content Popular settlement method for virtual currency Mobile carrier settlement Mobile SNS sales split Virtual goods and gaming content - 80% Advertising - 20% PC SNS sales split Virtual goods and gaming content - 20% Advertising - 80% Social graph Predominantly virtual; real identification rarely used Source: Companies' data, J.P. Morgan estimates. 68 206
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com User Demographics Traffic Per Platform Under 20 PC SNS 18.0% usage 5.0% Over 30 41.0% Mobile SNS usage 20 to 30 95.0% 41.0% Source: Company data, J.P. Morgan estimates. Source: Company data, J.P. Morgan estimates. Sales Split 20.0% 80.0% 80.0% 20.0% Mobile SNS sales split PC SNS sales split Vitual goods and gaming content Advertising Source: Company data, J.P. Morgan estimates. From the above, we believe there are two key issues that face the SNS industry:  The focus on the mobile platform means that the advertising market remains small, although it remains a growth area. The leaning toward virtual social graphs and user behavior focused on gaming also limits its appeal as advertising media.  The key earnings driver is virtual goods and gaming content. We believe that the SNS market (both advertising and social gaming) is worth around ¥200B in CY’10 growing at 185% Y/Y, with DeNA (40%), Gree (25%) and Mixi (5%) making up around 70% of total market share. We believe growth will slow drastically to 15% Y/Y in CY’11, a marked slowdown as both user numbers and ARPU growth domestically begin to flatten with market saturation. Social gaming Social games are simple-to-play titles that were inherently free to play, encouraged Gree pioneered social gaming in 2007 user interaction, and introduced pay-to-play virtual items for sale to enhance game play experience – a common ‘freemium’ model whereby a basic web service is offered for free, while charging for premium offerings. Gree was the first SNS to successfully pioneer the concept of mobile social gaming in 2007. 69 207
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Current market leader DeNA The latecomer to social gaming was DeNA’s ‘Mobage’ mobile site, which originally commenced social gaming in started as a standard publishing mobile gaming portal in February 2006. The site 2009 changed into a SNS service later that year with the introduction of avatars, with the company launching its social gaming service in October 2009. Structure of SNS Services The basic structure of an SNS consists of the following:  User profile – either real (e.g. real name) or virtual (e.g. pet name) personal data  Posting diary entries/blog posts  Compile and share a list of contacts – allowing users to search and connect to each other  Joining specialist interest communities The key aim is to be able to stay in touch with your contacts and to allow for ease of communication as well as the ability to behave as a group in a virtual setting. Service overview Domestic mobile SNS sites have evolved to become a generalist destination site like a portal, as they have expanded the services on offer: SNS Service Overview Service Comments Social networking functionalities - User profiles Mostly pet names and pseudonyms on domestic SNS sites - Blogs Online diary entries - Friends/contacts List of users on your personal network - Groups/communities Joining special interest forums - Mail function Used as email/messaging service - Avatars Virtual characters, which can be 'dressed up' usually for a fee Games In-house developed as well as third party. Use of Flash and Java programming. - Casual games Staple basic puzzle games, generally a free service - Social games Key earnings driver for DeNA and Gree - - Core gaming content More akin to traditional videogame titles, subscription fee service Virtual currency Prepaid currency to purchase virtual items, primarily for gaming content User generated content All uploaded by individual users for general consumption - Photos Uploading pictures - Novels - Music Artist profiles and fan clubs Entertainment and information Content generally found on a PC portal services content - News - Weather - Transport/access search - Search - Reference data Equivalent to ‘Wiki’ pages - Horoscopes - Celebrities content Premium services Additional services for PC site access, such as additional data storage capabilities Source: J.P. Morgan based on company data. 70 208
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Domestic SNS a de facto mobile Apart from the wealth of content on offer, the key difference between Japanese and service overseas SNS services is the focus on the mobile platform versus the PC. We believe this occurred due to the following factors:  Early adapters of mobile services were the younger under 30 demographic, whose net usage behavior was skewed to handset usage rather than PC, thereby meeting their needs. Fast, affordable data  The fall in pricing for packet download fees via carrier competition, and the introduction of fixed pricing plans made heavy mobile usage more affordable. Convenient carrier billing  Ease of purchase of virtual currency via carrier settlement made it more convenient to transact. Social Gaming Primer Revenue structure Key points related to the revenue model for social gaming are as follows:  The ‘pay-to-play’ revenue model is a valid approach to online gaming, as users tend to reward for quality content after first being able to assess its worth via the free-to-play environment.  Games on offer can be in-house developed by the SNS operator, or by third-party developers. An open platform allows for greater product diversity.  Virtual currency is required to purchase game items—a common method to acquire currency is via carrier settlement, credit card, or prepaid money available at convenience stores. Social Game Monetization Model SAP games User acquires Purchase 30% Commissions 70% paid to ¥ x currency game items recognized SAP In-house game application 10%~15% All revenue Carrier commissions recognized Source: J.P. Morgan assumption. Note: SAP stands for Social Application Provider, a developer of a social game application. Why social gaming can be highly profitable The success of social gaming comes from two key angles:  The relatively low barrier to entry into the market via low development costs.  Low priced download titles and free-to-play item sale titles are meeting the needs of gamers, and replacing demand for mid-tier quality software from the traditional videogame industry. 71 209
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com  The launch of a social gaming title is the start of on ongoing development cycle, where the game can be fine-tuned and improved ‘on the go' with direct customer feedback. We set out the basic cost structure for developing and operating a social gaming title. Social Gaming—Initial Cost Estimates Initial development costs ¥10M - ¥30M Server costs Around 25% of revenue generated (15% for hardware, 10% for tuning) Marketing costs Usually low, apart from flagship titles that can use TV advertising Source: J.P. Morgan estimates. Traditional Videogame Platforms—Illustrative Development Cost Estimates Game Platform Cost Nintendo DS ¥10.0M - ¥50.0M Sony PSP ¥10.0M - ¥75.0M Wii Upwards of ¥0.4B PlayStation 3/Xbox 360 Upwards of ¥1.0B Source: J.P. Morgan estimates. We are making a generalization of development costs for traditional video gaming software, which can range significantly in scale and budget. However, social gaming titles involve a relatively small outlay of cost to start up and operate. The key attractions here are that:  Marketing costs are relatively low, as internet content there is greater emphasis on viral marketing and user feedback  The ability to exceed breakeven point is relatively easy, resulting in a potentially high margin earnings stream. The key variables in the revenue structure of a typical social game are as follows: Social Gaming Titles—Typical Factors Affecting Revenues Revenue Variables Range Participation rate of total registered user base 2% - 6% Typical monthly ARPU range for registered users ¥50 - ¥300 Monthly ARPPU (Average Revenue Per Paying ¥1,000 - ¥5,000 User) range Game shelf life/lifetime value period 3 month to 12 months typically; average 6 months For reference – typical pricing range of handheld software Nintendo DS software ¥2,800 - ¥4,800 PSP software ¥5,040 - ¥6,090 Source: Company data, J.P. Morgan estimates. 72 210
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com From this, we can surmise that a simplified game title revenue model is: Gross revenue = Number of registered users × Participation rate × ARPU × Shelf life Less the following costs to derive profit:  Server fees and game tuning = gross revenue × around 25%  Marketing costs  Initial development fee  Carrier and platform provider commissions Therefore, it is possible to exceed the breakeven point in a comparatively short period of time and generate earnings over the longer term through this model. Also, titles can be cancelled if proven to be unsuccessful, with no negative residual issues such as reducing pricing or scrapping inventory. Cost drivers The initial cost driver for social gaming is staffing cost related to engineers and creators developing a game title. After release the key cost drivers are marketing spend to promote the title, and server costs as user traffic increases. Marketing is a user acquisition Marketing costs in the early-to-mid cycle stages of a game title release can be viewed cost – must balance with ARPU as a user acquisition cost—the cost and investment required to win new users, as well as keeping old ones active. Despite growth in user traffic generated by gaming content, traffic growth is limited and marketing costs are a necessary tool to encourage user activity. Monthly ARPU and Avg. Monthly User Acquisition Costs (UAC) Trends (CY’10) ¥/person 1,200 956 1,000 800 679 550 549 600 469 357 372 367 400 292 209 176 187 192 200 66 63 13 58 89 0 Jan-Mar Apr-Jun Jul-Sep Jan-Mar Apr-Jun Jul-Sep Jan-Mar Apr-Jun Jul-Sep mixi DeNA GREE ARPU UAC Source: J.P. Morgan based on company data. Note: Number of users is calculated by taking the average of the current and the last quarter end. 73 211
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com ARPU and User Acquisition Cost—Y/Y Growth (CY’10) ¥/person ARPU Y/Y UAC Y/Y Mixi Jan-Mar 65.5 9.1% 209.3 2909.1% Apr-Jun 63.1 10.7% 13.3 100.9% Jul-Sept 58.0 0.6% 89.4 3555.5% DeNA Jan-Mar 292.3 69.9% 550.3 25.9% Apr-Jun 356.9 186.1% 678.8 196.1% Jul-Sept 371.8 234.1% 956.1 211.6% Gree Jan-Mar 175.8 20.6% 367.2 246.7% Apr-Jun 186.9 22.4% 468.7 182.7% Jul-Sept 192.2 16.9% 549.4 284.6% Source: J.P. Morgan based on company data. Social application providers The SNS sites act as a platform for social network game developers (called Social Application Providers, or SAP) to plug in game applications on the sites, with the view of generating revenues either by virtual items sales or generating advertising income for traffic generated. Major overseas players include Zynga, Electronic Art's subsidiary Playfish, Disney’s Playdom, RockYou!, and other key players on the Facebook PC platform such as CrowdStar , 6 Waves (based in Hong Kong), and Digital Chocolate Inc. We view major PC browser-based game companies as a cluster of new entrants into the social gaming market—key players here are Germany's Bigpoint and Gameforge, France’s Gameloft, UK’s Mind Candy and Jagex. Key SAP companies in Japan are as follows:  CyberAgent (4751): A leading online advertising agency and blog site, has established three dedicated subsidiaries to social gaming  KLab: IT services firm with social gaming content  Cave (3760): A PC online game operator branching out into smartphone social gaming Foreign SNS Presence in Japan Foreign SNS sites are not virtual Foreign SNS sites tend to focus on real social graphs, and we believe this has been communities, unlike Japanese the overriding factor in their lack of popularity in Japan where users prefer greater SNS sites privacy. The exception has been the social networking and microblogging service Twitter.  Facebook—The largest global SNS platform provided by Facebook Inc. Nielsen Netview estimates that there are two million Facebook PC users in Japan as of September 2010.  Twitter—Twitter is a mini-blog service provided by Twitter Inc. Nielsen Netview estimates that there are 11.1M Twitter PC users in Japan as of September 2010. We believe that there is more user activity on the mobile platform, especially with the adoption of smartphones. 74 212
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Internet Usage Rates (September 2010) Monthly Reach Monthly Average Average usage visitors (%) Pageviews pageviews duration (M) (M) (PV) (minutes) Mixi 9.6 15.8 3,369 353 206 Twitter 11.1 18.4 841 76 41 Facebook 2.1 3.4 119 57 36 Source: Nielsen Netview , J.P. Morgan. Note: Reach is calculated as the number of monthly visitors divided by the potential domestic internet user audience. Overseas Expansion—An Assessment of Growth Prospects Assessing competitive forces The SNS market is a developing growth business and is therefore a target of both start-ups and mature businesses aiming to take advantage of its user traffic growth. With reference to Michael Porter’s Five Forces model to assess the competitive landscape of SNS and social gaming, we conclude that despite the potential growth prospects, it is rapidly becoming an overcrowded and highly competitive space. Competitive Forces Analysis Competitive Forces Rating Commentary Barriers to entry LOW Initial investment (time and cost) low for application development No technology barriers to develop social games/SNS Threat of new entrants HIGH - Individuals can easily develop content and self-publish - PC browser-game developers targeting smartphone market - Traditional video gaming companies adopting to social gaming Bargaining power of buyers HIGH Users can choose to ignore or embrace new games Switching costs are virtually zero Bargaining power of suppliers MEDIUM Application developers choose the most successful SNS platform to provide content The lack of quality content results in quickly falling user traffic Competitive rivalry HIGH SNS sites spend user acquisition costs to attract new users Existing users need to be continually engaged to remain customers Conclusion A highly competitive environment Source: J.P. Morgan estimates.  Barriers to entry: Physically and technologically low barriers to build a SNS/social gaming applications; know-how over game development and tuning can be gained over time.  Threat of new entrants: Substitution risk is high for social gaming developers as new entrants appear from PC browser-game market and the traditional video- gaming players.  Bargaining power of buyers: End users can choose and decide whether a game is worth playing or not, impacting future monetization.  Bargaining power of suppliers: Social gaming developers can choose to place their content on SNS platforms of choice. Less popular SNS sites are not seen as desirable given less user traffic generated.  Competitive rivalry: It is much easier to make and release a game with available authoring tools, and with self-publishing distribution channels such as the Apple App Store and Android Markets. This has thrown the door wide open to new 75 213
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com entrants, and localized players are all beginning to look at the global picture for growth opportunities in the SNS market. With overseas markets expected to be a new growth opportunity, we believe that this view overlooks the intensifying competitive forces involved. Overseas M&A activity Domestic SNS players and leading social application developers are eager to explore and build overseas growth opportunities. DeNA acquired US company ngmoco in October 2010, but there have been other transactions taking place. Recent M&A Activity in Social Gaming Space Company Acquirer/investor Price Date Daily Average Users Playdom Disney $563M + $200M earn-out Jul-10 4.6M Playfish Electronic Arts $300M + $100M earn-out Jul-09 7.7M Chillingo Electronic Arts Less than $20M Oct-10 NA ngmoco DeNA $303M + $100M earn-out Oct-10 NA Astro Ape DeNA NA Sept-10 NA Gameview Studios DeNA NA Sept-10 NA IceBreaker US Inc DeNA NA Oct-09 NA Slide.com Google $182M Aug-10 NA Unoh Zynga Japan NA Aug-10 NA Source: Company reports and J.P. Morgan estimates. The key difference between DeNA and other deals undertaken is that the company is acquiring firms with a focus on the smartphone platform e.g. content on iPhone and/or Android, as opposed to the PC. Although this approach may buy time for DeNA versus competitors also diversifying into smartphones, we believe this will not be a major competitive advantage over the medium term. Differences in ARPU DeNA has highlighted a major difference between social gaming markets in Japan and the West: (1) Compared to Facebook, DeNA estimates that its ARPU is 30 times higher and (2) compared to Zynga, DeNA estimates that its ARPU is 15 times higher. ARPU difference is significantly affected by the type of community (virtual or social). DeNA operates on a mobile platform, with a virtual community social graph; Facebook and Zynga are PC-based with a real social graph. Japanese mobile user behavior is adapted to mobile gaming, and virtual user interaction fosters gaming activity. Conversely, we believe that operating a SNS with a real social graph will not be a conductive environment to really drive gaming behavior to the levels seen in Japan. 76 214
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Monthly ARPU Comparison (July-September 2010E) ¥/person 400 372 350 300 250 200 157 150 100 58 50 0 mixi DeNA GREE Source: J.P. Morgan based on company data. Domestically, Mixi’s ARPU is lower than its peers due to:  Revenue driver remains advertising.  Users on the Mixi SNS mostly go to the site for communication purposes, as opposed to social gaming, which is the main draw for DeNA and Gree. Smartphone Adoption—New Distribution Channels International Data Corporation (IDC) estimates that global smartphone shipments will grow 55.4% Y/Y in CY’10, from 173.5M units in CY’09 to 269.6M units. Growth is expected to continue at 24.5% Y/Y in CY’11. This is a factor that would drive SNS and social gaming companies to see smartphones as new distribution systems for their services, rather akin to video gaming software makers that took the 'multiplatform' approach for their game titles.  IDC expects that Symbian will be the leading operating system by 2014, followed by Android. Worldwide Converged Mobile Device Operating System Market Shares and 2010-2014 Growth Operating System 2010E Market Share 2014E Market Share 2014E/2010E Change Symbian 40.10% 32.90% -18.00% BlackBerry OS 17.90% 17.30% -3.50% Android 16.30% 24.60% 51.20% IOS 14.70% 10.90% -25.80% Windows Mobile 6.80% 9.80% 43.30% Others 4.20% 4.50% 8.30% Source: IDC Worldwide Quarterly Mobile Phone Tracker, September 7, 2010 While there is a positive outlook from a market growth perspective for smartphones, we are drawn to the competitive threats involved despite the Apple iOS and Android platforms being perceived as a ‘green-field’ site. 77 215
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Competition in the Smartphone Game Application Market PC browser / SNS game developers - Zy nga Domestic social - Play dom application profiders - Play fish - Cy ber Agent - RockYou - Cav e - Crow dStar iPhone Apple iOS / Android Domestic feature phone SNS SNS platforms Traditional videogame - DeNA - Facebook companies - GREE - My Space - Capcom - mix i - KONAMI - Square Enix - Tecmo Koei - Namco Bandai Source: J.P. Morgan based on company data. We feel that in order for smartphone penetration overseas to result in (1) a major hike in user activity on SNS sites and (2) widespread adoption of social gaming content, the following environment is necessary:  Social gaming content has high penetration rates in Japan, as the social graphs are virtual—overseas SNS sites which have real social graphs will have to replicate this level of activity, or  With compelling content on offer, virtual SNS sites need to be built with virtual communities, offering a new service compared to real social graph SNS. A current proxy would be Microsoft's Xbox Live online gaming service on the console. We do however believe that social gaming will be appealing to a niche audience overseas, which in terms of scale may still present an attractive new market for Japanese companies to target. 78 216
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Major Smartphone Platform Distribution Channels Android App Store Windows Marketplace Ovi Store BlackBerry App Palm App Catalog Market for Mobile World Operator Google Apple Microsoft Nokia Research In Motion Palm Start date Oct-08 Jul-08 Sep-09 May-09 Apr-09 Jul-09 OS/Runtime Android OS iPhone OS Windows OS Symbian OS BlackBerry OS WebOS Apps offered 55,000 85,000 1,000 10,000 6,000 1,000 Users (M) 20 100 NA Over 100 41 5 Charge methods Credit Credit charge Credit charge Credit charge, SMS charge Credit charge Credit charge charge carrier charge, adding charge Revenue % (operator) 30% 30% 30% 30% 20% 30% Revenue % (developer) 70% 70% 70% 70% 80% 70% App name Android app iPhone app Windows Mobile app Symbian app, Java app Java app WebOS app WRT widget, Flash app App development Java Objective-、 .Net C/C++, Java, JavaScript Java JavaScript/CSS/HT language C/C++ FlashLite 1.0, 1.1, 2.0, 2.1, 3.0 ML Site name for Android iPhone Dev Windows Mobile Forum Nokia BlackBerry Developer Palm Developer developers Market Center developer Center Zone Network Source: J.P. Morgan, based on "Internet White Paper 2010" (Impress Japan). Overseas Social Gaming Networks Description Platform OpenFeint Social gaming platform, with DeNA as a passive investor iOS, Android Plus+ ngmoco's social game platform iOS, soon Android Gameloft Live Gameloft's mobile gaming network with 1.5 million users iOS, Android Score∞p Funded by European VCs Target Partners and Earlybird iOS, Android AGON Online Operated by Aptocore founded in 2008 iOS Crystal Platform devised by Chillingo, now acquired by Electronic Arts iOS Social Gaming Network A game developer on iOS for multiplayer games iOS, soon Android Source: J.P. Morgan based on company data. 79 217
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Valuation Table Company Yahoo CYBER Kakaku. Gourmet Weighted Rakuten Mixi DeNA Gree Japan AGENT com Navigator avg. Code 4689 4755 2121 2432 3632 4751 2371 2440 Currency JPY JPY JPY JPY JPY JPY JPY JPY - Market cap (¥B) 1,853.3 893.4 68.3 420.7 243.1 115.1 137.3 30.9 - Share price (¥) 31,950 68,200 441,500 2,954 1,069 177,900 474,000 118,900 - Liquidity (daily) ($M/day) 33.1 27.4 9.5 113.4 56.8 44.3 10.9 1.6 - P/E (X) F’10E 19.9 24.8 37.1 12.7 14.4 17.9 29.9 17.7 20.5 (X) F’11E 18.2 21.6 28.6 11.0 12.7 14.5 23.7 13.6 18.1 (X) F’12E 16.9 19.4 21.9 11.4 11.5 13.1 20.1 13.8 16.6 Div. yield (%) F’10E 1.0 0.1 0.0 1.6 0.5 1.5 0.6 1.7 0.8 (%) F’11E 1.4 0.1 0.0 1.8 0.5 1.8 0.7 1.7 1.0 (%) F’12E 1.5 0.1 0.0 1.8 0.5 2.0 0.8 1.7 1.1 EV/EBITDA (X) F’10E 9.3 13.7 11.1 6.7 7.5 7.2 15.2 5.1 10.1 (X) F’11E 8.6 12.3 9.5 5.8 6.6 6.0 12.1 4.6 9.1 (X) F’12E 8.0 11.2 7.7 6.0 6.0 5.3 10.0 4.6 8.4 EV/sales (X) F’10E 5.4 3.1 3.3 3.4 4.0 0.9 7.6 1.0 4.4 (X) F’11E 5.1 2.8 2.7 2.8 3.4 0.8 6.3 0.9 4.0 (X) F’12E 4.8 2.7 2.2 2.7 3.0 0.7 5.4 0.9 3.8 P/B (X) F’09A 6.0 4.4 4.7 12.2 11.8 4.5 13.7 2.7 6.9 Price movt. (%) 1 month 6.2 7.1 4.1 21.1 6.9 12.7 13.1 -1.7 - (%) 3 month 9.0 7.6 -0.5 9.3 -22.1 18.5 3.5 7.6 - (%) 6 month -11.8 9.8 2.1 14.7 -25.2 38.8 26.8 9.1 - (%) 1 year 14.1 -3.7 -40.7 56.2 -7.1 6.2 32.6 -40.2 - Efficiency of capital ROE (%) F’10E 26.2 16.2 11.9 63.9 55.9 17.9 37.7 13.8 29.8 ROA (%) F’10E 18.8 2.0 9.3 29.0 31.7 - 26.6 - - ROCE (%) F’10E 43.4 11.4 23.2 102.5 94.2 23.6 45.0 25.9 44.6 Source: Company data, Bloomberg and J.P. Morgan estimates. Note: Yahoo Japan, Rakuten, Mixi, DeNA and Gree are based on J.P. Morgan estimates. CyberAgent, Kakaku.com and Gourmet Navigator are based on Bloomberg consensus estimates. Share prices as of December 29, 2010. 80 218
  • Sungmin Chang, CFA Global Equity Research (82-2) 758-5719 03 January 2011 sungmin.chang@jpmorgan.com Korea Korea Sector Summary We recommend investors switch from NHN to Daum for internet exposure based on Daum’s superior growth outlook and valuation merit. We believe Daum is currently oversold due to overblown concerns on the Overture impact as well as its small market cap. As a result, Daum is currently trading at a deep discount to market leader NHN, despite the fact that it has a better growth outlook and its revenue consists of only search and display ad compared to NHN which generates about 30% of revenue from the lower multiple business of internet gaming. As Overture concerns fade and Daum continues to generate superior earnings over the next few quarters, we believe the valuation discount will disappear and this will drive continued outperformance for Daum. Divergent Growth Momentum Daum has been gaining market share in both search and display from 2008 based on improved service quality and renewed focus on core businesses. Given basic traffic volume that amounts to over 70% of NHN’s, we believe Daum’s growth momentum has more legs. Daum currently targets to increase its search market share to 30% by 2012 from the current 22%, while it has been raising pricing for both search and display ad more aggressively than NHN on the back of a big pricing gap. Search Ad Revenue Growth Display Ad Revenue Growth % 120 % 110 100 90 80 70 Daum Daum 60 50 40 30 20 NHN 10 NHN 0 (10) (20) 1Q 06 2Q 06 3Q 06 4Q 06 1Q 07 2Q 07 3Q 07 4Q 07 1Q 08 2Q 08 3Q 08 4Q 08 1Q 09 2Q 09 3Q 09 4Q 09 1Q 10 2Q 10 3Q 10 1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 Source: Company data. Source: Company data. Overture Impact As NHN defects Overture, which is a middleman between portals and advertisers, to internalize the intermediary platform business, Daum faces potential losses in advertiser pool. Such defection is seen as a threat, as it will likely lower clearing prices at Overture. While Daum was guiding for a maximum 20% decline in pricing over the next two years, its view has changed to a more positive one recently based on interaction with resellers. This means overall pricing pressure may turn out to be substantially smaller than previous guidance suggested, in which case there is room for positive earnings revisions from the Street over the next few months. 81 219
  • Sungmin Chang, CFA Global Equity Research (82-2) 758-5719 03 January 2011 sungmin.chang@jpmorgan.com Positive Mobile vs. Negative SNS Impact in 2011 The internet sector is a very dynamic space where consumer preferences can change on a whiff. As such, the recent surge in popularity of SNS services such as Facebook and Twitter are negative developments for NHN and Daum in that they could lure away traffic in the longer term. For now, however, we think the impact is limited due to a relatively small user base for these new services but the longer-term impact will depend on how NHN and Daum can protect their traffic base by offering their own SNS services to satisfy consumer needs. Mobile service, on the other hand, provides new growth momentum, as smartphone penetration is headed for over 30% in 2011E. As consumers increasingly access web on the move, this should create additional demand for Internet portals down the road. In this space, Daum is also leading NHN for now on the back of earlier investments in mobile content. . 82 220
  • Dick Wei Asia Pacific Equity Research (852) 2800-8535 05 January 2011 dick.x.wei@jpmorgan.com Companies 83
  • Dick Wei Asia Pacific Equity Research (852) 2800-8535 05 January 2011 dick.x.wei@jpmorgan.com 84 2
  • Global Equity Research 03 January 2011 Neutral Alibaba.com Limited 1688.HK, 1688 HK China Price: HK$15.00 Slowdown in Customer Growth Limits Near-term Stock Price Target: HK$16.00 Upside We remain Neutral on Alibaba with a Dec-11 PT of HK$16. We expect Internet China’s marketplace to grow at a faster rate than the international marketplace AC Dick Wei in 2011. Value-added services should also continue to gain more revenue (852) 2800-8535 share in 2011. dick.x.wei@jpmorgan.com  International marketplace net-adds to continue to be slow: With Ritesh Gupta higher fee Rmb30K annual fee package launch next year, and Alibaba’s (91-22) 6157 3307 ritesh.z.gupta@jpmorgan.com plan to slow down new customer net adds, 2011 membership net-adds are likely to see slow growth. We forecast around 4K quarterly net-adds in J.P. Morgan Securities (Asia Pacific) Limited 2011. China marketplace revenues accounted for ~34% of total revenues in Price Performance 2010. We expect China marketplace’s share to increase with the increase in the domestic eCommerce market. We currently expect China’s marketplace 20 to grow 36% YoY vs. the international marketplace expected growth rate of HK$ 16 20% YoY in 2011. 12  Future monetization potential on Alibaba platform: AliExpress Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 (international transaction base platform) saw GMV (gross merchandise 1688.HK share price (HK$ volume) up 3 times QoQ in 3Q10. AliLoan program cumulative loan MSCI-Cnx (rebased) amounts reached Rmb20 M. Both could lead to longer-term monetization YTD 1m 3m 12m potential. AliLoan could start monetization as soon as 1H10. International Abs -24.8% 2.9% -13.4% -24.6% expansion is still in the early stages. India and Turkey are the key potential Rel -26.0% 5.3% -12.8% -27.7% target markets for the company.  Company to execute “Work at Alibaba” strategy in 2011. “Meet at Alibaba” has been the company strategy for many years. Alibaba offers SMEs access to Alibaba’s marketing services (annual fee to marketplace, VAS for keywords, etc.) in order to meet with potential buyers. The newly added “Work at Alibaba” strategy will help SMEs to reduce operating costs by offering them more value-added services.  2011 drivers: (1) Increasing monetization of value-added services, (2) Good growth in China marketplace from growth of local eCommerce market, (3) Improvement in operating margins from leverage over SG&A expenses. Reuters: 1688.HK; Bloomberg: 1688 HK Rmb in millions, year-end December FY09 FY10E FY11E FY12E FY09 FY10E FY11E FY12E Net sales 3,875 5,452 6,761 8,302 ROE (%) 20.3 23.2 22.8 21.4 52-week range HK$12.3-19.6 Operating profit 1,073 1,561 2,124 2,674 ROIC (%) 18.0 20.9 20.5 19.1 Shares outstg 5,039Mn EBITDA 1,280 2,002 2,602 3,269 GAAP dil. EPS (RMB) 1Q 2Q 3Q 4Q Avg daily volume 9.6Mn Pre-tax profit 1,176 1,732 2,365 2,989 EPS FY09 0.05 0.05 0.05 0.06 Avg daily value US$21.4Mn Net profit 1,013 1,423 1,933 2,444 EPS FY10E 0.06 0.07 0.07 0.07 Index (HSI) 22,969 Diluted EPS (Rmb) 0.20 0.28 0.37 0.46 EPS FY11E 0.08 0.09 0.10 0.10 Free float 19% P/E (x) 60.3 43.3 32.9 26.4 1M 3M 12M Dividend yld 0% Adjusted EPS (Rmb) 0.24 0.34 0.43 0.53 Absolute perf. (%) 0.0 -12.0 -23.4 Market cap US$8.9Bn Adjusted P/E (x) 50.4 35.6 28.0 22.6 Relative perf. (%) 0.8 -14.7 -30.2 Price target HK$16 EV/EBITDA 43.5 27.8 21.4 17.0 Cash (Rmb M) 7,216 10,770 14,376 23,501 Date of price Dec 29, 2010 P/B (x) 12.2 8.6 6.5 5.0 Equity (Rmb M) 5,018 7,253 9,696 16,535 Y/E BPS (Rmb) 0.98 1.41 1.86 2.42 Source: Company reports, Bloomberg and J.P. Morgan estimates. * Note: Adj. EPS excludes share-based compensation expense.
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Our Estimates and Outlook for 2011 and 2012 We are maintaining our F’11 revenue and adjusted EPS estimates of Rmb6.8 B and Rmb0.43, respectively. Our F’12 estimates call for revenue and adjusted EPS estimates of Rmb8.3 B and Rmb0.53, respectively. Dec-11 Price Target of HK$16 Our price target is based on DCF valuation of HK$16 (WACC = 12%, with terminal growth of 0%). Our PT of HK$16 implies 32.4x FY11E, and 26.2 FY12E diluted adjusted EPS, or 38.1x FY11E, and 30.6x FY12E diluted reported EPS. Our PT implies 1.1x PEG (based on 2011E P/E and 2012E EPS growth). We note that on a forward P/E basis, Alibaba has historically traded at high multiples since its IPO. To date, the company has not traded below a forward P/E of 20x even during market lows. We also use P/FCF ratio as a reference to set our Dec-11 price target. At HK$16, Alibaba trades at 19.1x 2012E P/FCF, in line with the current valuation of other China Internet market leaders, such as Baidu, Tencent. We believe a higher multiple for Alibaba can be justified, given: (1) Alibaba’s leadership in the China B2B market (60% market share); (2) strong cash position to get through current downturn and use cash to gain market share; and (3) upside in earnings from new initiatives and currently free VAS. Maintain Neutral While the company has a strong platform for future growth and monetization, we believe there could be near-term downside risks from: (1) slowdown in China’s exports, (2) new “Work at Alibaba” pricing strategy could be risky. We maintain our N, given the high valuation and high volatility of the stock. Risks to Our Rating and PT Downside risks include (1) slowdown in Gold Supplier and China Trustpass customer growth, (2) VAS does not gain good traction as expected in both marketplaces, and (3) global macro fundamentals turn negative. Upside risks include (1) better-than-expected Gold Supplier and China Trustpass customer growth due to the company’s strong execution and strong export market growth, (2) VAS penetration rate grew faster than expected, (3) new VAS such as Aliloan, (4) share buybacks, and (5) RMB appreciation. 86 314
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Alibaba—DCF Model (base-case scenario) FY10E FY11E FY12E FY13E FY14E FY15E FY16E FY17E FY18E FY19E FY20E Sales growth 40.7% 24.0% 22.8% 23.1% 22.0% 21.4% 18.0% 18.1% 15.2% 13.2% 11.2% EBIT margin 28.6% 31.4% 32.2% 33.4% 33.5% 33.6% 33.6% 33.6% 32.6% 31.6% 30.6% NOPAT margin 22.6% 24.7% 25.3% 26.2% 26.3% 26.3% 26.9% 26.9% 26.1% 25.3% 24.5% Year end net fixed assets turns 6.77 6.98 7.19 7.47 7.74 8.04 7.50 7.50 7.50 7.50 7.50 Year end net working capital turns (1.4) (1.3) (1.3) (1.3) (1.3) (1.3) (1.3) (1.3) (1.3) (1.3) (1.3) Year end net other assets turns 14.95 18.54 22.77 28.04 34.20 41.51 40.00 40.00 40.00 40.00 40.00 Cash operating taxes as % of EBIT 20.9% 21.5% 21.5% 21.5% 21.6% 21.7% 20.0% 20.0% 20.0% 20.0% 20.0% Year end Invested Capital turns (1.95) (1.74) (1.75) (1.70) (1.68) (1.65) (1.64) (1.64) (1.64) (1.64) (1.64) Source: J.P. Morgan estimates. DCF Sensitivity Analysis Terminal Growth (%) 0% 1% 2% 3% 4% 5% 6% 7% 9.0% 22.7 22.9 23.1 23.4 23.9 24.6 25.7 27.9 10.0% 20.0 20.0 20.1 20.2 20.4 20.6 20.8 21.3 11.0% 17.8 17.8 17.8 17.8 17.8 17.8 17.8 17.8 WACC 12.0% 16.0 16.0 15.9 15.9 15.8 15.7 15.6 15.5 13.0% 14.5 14.5 14.4 14.3 14.3 14.2 14.0 13.8 14.0% 13.3 13.2 13.2 13.1 13.0 12.9 12.7 12.6 15.0% 12.2 12.2 12.1 12.0 12.0 11.8 11.7 11.5 Source: J.P. Morgan estimates. 87 315
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Alibaba.com: Summary of financials Rmb in millions, year-end December Income statement Ratio analysis FY08A FY09A FY10E FY11E FY12E %, year-end December FY08A FY09A FY10E FY11E FY12E Revenues 3,002 3,875 5,452 6,761 8,302 Gross Margin 87.0 86.2 83.4 83.1 83.2 Cost of goods sold 391 534 907 1,145 1,392 EBITDA margin 41.9 32.0 35.4 37.5 38.6 Gross profit 2,612 3,340 4,546 5,616 6,910 Operating Margin 39.3 27.7 28.6 31.4 32.2 R&D expenses 194 384 544 582 706 Net Margin 39.7 26.1 26.1 28.6 29.4 SG&A expenses 1,416 2,034 2,532 3,045 3,696 R&D/sales 6.5 9.9 10.0 8.6 8.5 Others -178 -151 -92 -135 -166 SG&A/Sales 47.2 52.5 46.4 45.0 44.5 Operating profit (EBIT) 1,180 1,073 1,561 2,124 2,674 EBITDA 1,258 1,241 1,929 2,536 3,203 Sales growth 38.8 29.1 40.7 24.0 22.8 Interest income 239 141 177 241 315 Operating Profit Growth 46.8 -9.1 45.5 36.1 25.9 Interest expense 0 0 0 0 0 Net profit growth 23.3 -15.1 40.5 35.8 26.5 Investment income (exp.) -16 -37 -6 0 0 EPS (Reported) growth 17.9 -15.3 39.2 31.8 24.4 Non-operating income (exp.) 0 0 0 0 0 Earnings before tax 1,404 1,176 1,732 2,365 2,989 Tax 210 163 309 433 545 Net debt to total capital -133.1 -143.8 -148.5 -148.3 -144.2 Net income (reported) 1,193 1,013 1,423 1,933 2,444 Net debt to equity -133.1 -143.8 -148.5 -148.3 -144.2 Net income (adjusted) 1,373 1,213 1,733 2,271 2,859 Rmb Asset Turnover 38.0 41.0 42.3 39.9 38.9 EPS (Reported) 0.24 0.20 0.28 0.37 0.46 Working Capital Turns (X) 0.8 0.9 1.0 0.9 0.8 EPS (Adjusted) 0.27 0.24 0.34 0.43 0.53 ROE 27.8 20.3 23.2 22.8 21.8 BPS 0.98 0.98 1.41 1.86 2.42 ROIC 23.3 18.0 20.9 20.5 19.6 DPS 0.00 0.18 0.00 0.00 0.00 ROIC (net of cash) -64.1 -53.0 -52.1 -47.7 -46.6 Diluted shares outstanding (MM) 5,055 5,068 5,116 5,272 5,360 Balance sheet Cash flow statement FY08A FY09A FY10E FY11E FY12E FY08A FY09A FY10E FY11E FY12E Total cash 6,612 7,216 10,770 14,376 18,349 Net income 1,193 1,013 1,423 1,933 2,444 Accounts receivable 0 0 0 0 0 Depr. & amortization 76.6 119 151 209 280 Inventories 0 0 0 0 0 Change in working capital 431 926 1,064 1,326 1,126 Others 508 926 944 1,240 1,491 Other -132 175 309 337 414 Current assets 7,121 8,143 11,714 15,616 19,840 Cash flow from operations 1,569 2,234 2,947 3,805 4,264 LT investments 32 4 -2 -2 -2 Capex -267 -411 -209 -406 -498 Net fixed assets 376 783 806 969 1,154 Others -2,835 -261 204 33 33 Others 365 527 365 365 365 Cash flow from investing -3,102 -671 -5 -373 -465 Total assets 7,893 9,457 12,883 16,947 21,357 Free cash flow 1,302 1,823 2,738 3,399 3,766 Equity raised/ (repaid) -79 -70 171 171 171 Liabilities Debt raised/ (repaid) 0 0 0 0 0 ST loans 0 0 0 0 0 Other 12 0 440 1 1 Payables 16 24 30 38 46 Dividends paid 0 -888 0 0 0 Others 2,803 4,073 5,149 6,762 8,133 Cash flow from financing -67 -958 611 172 172 Total current liabilities 2,818 4,097 5,179 6,801 8,178 Long term debt 0 0 0 0 0 Net change in cash -1,600 604 3,553 3,604 3,972 Other liabilities 106 342 451 451 451 F/X & term deposits change 2,939 0 0 0 0 Total liabilities 2,925 4,439 5,630 7,251 8,629 Beginning total cash 5,274 6,612 7,216 10,770 14,376 Shareholders' equity 4,968 5,018 7,253 9,696 12,728 Ending total cash 6,612 7,216 10,769 14,375 18,348 Source: Company data and J.P. Morgan estimates. *Note: Adjusted earnings exclude share-based compensation expense. 88 316
  • Global Equity Research 03 January 2011 Overweight Baidu.com BIDU, BIDU US Price: $100.01 2011 To Be Another Year of Solid Growth Price Target: $120.00  2011 to be another year of solid growth: We expect Baidu’s revenues to Internet see 57% Y/Y growth to reach $1.83B in FY’11. We believe medium-term AC Dick Wei revenue drivers are: (1) continued gradual improvement in monetization (852) 2800-8535 from Phoenix Nest, (2) secular trend in growth of search usage and search dick.x.wei@jpmorgan.com advertising in China, (3) growth in eCommerce–related advertising, (4) J.P. Morgan Securities (Asia Pacific) Limited increasing mobile search usage, and (5) upside from contextual advertising. Ritesh Gupta As a result, we believe ARPU growth will be faster than advertiser number (91-22) 6157 3307 growth. ritesh.z.gupta@jpmorgan.com  FY’10 margin expansion to remain intact in FY’11: Baidu’s operating J.P. Morgan India Private Limited margins expanded in 2010 to 50.3% vs. 38.0% in FY09 driven by lower Imran Khan TAC, and leverage over bandwidth and operating expenses. We expect the (1-212) 622-6693 company to be able to maintain this margin level in 2011. However, further imran.t.khan@jpmorgan.com expansion will be limited with the potential increase in contextual search J.P. Morgan Securities LLC advertising. Our 2011 operating margin forecast is 50.3%. Price Performance  Rising eCommerce trend may add upside: Baidu should also benefit from 110 the growing B2C eCommerce market in China. Increasing competition among B2C eCommerce companies and strong growth in eCommerce sales $ 70 volume should help drive search ad demand on Baidu’s platform. Baidu has 30 already seen fast growth in eCommerce–related search demand – during Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 3Q10, Baidu reported the number of online retail advertisers doubled Y/Y. BIDU share price ($) NASDAQ Composite (rebased)  Maintain OW with Dec-11 PT of US$120: Our price target implies 53.3x YTD 1m 3m 12m FY11E, and 39.7x FY12E diluted adjusted EPS, on the back of 53% and Abs 141.7% -7.7% -4.4% 136.2% 35% EPS growth for FY11E and FY12E, respectively, or 1.3x PEG (based Rel 126.2% -13.3% -16.6% 119.7% on 2012E P/E and long-term growth of 30%). Risks to our PT include slower-than-expected revenue growth and a potential macro slowdown. Positive on market potential: Using various references to the US and Korea search markets, we estimate China’s search market size could reach US$3B-US$4.6B by 2013. This compares to our current 2013 forecast of US$3.4B and US search market 2009 size of US$15B. Reuters: BIDU, Bloomberg: BIDU US US$ in millions, year-end December US$MM, YE-Dec FY09 FY10E FY11E FY12E FY09 FY10E FY11E FY12E Net Sales 651.4 1,168.0 1,828.7 2,514.2 ROE (%) 40 53 48 40 52-Week range US$38.5-115.2 Operating Profit (EBIT) 235.1 573.9 887.3 1,212.6 ROIC (%) 39 53 47 39 Shares Outstg 348Mn EBITDA 296.0 654.0 993.4 1,350.7 Qtr GAAP EPS (US$) 1Q 2Q 3Q 4Q Avg daily value US$996M Pre Tax Profit 246.5 585.0 910.1 1,250.8 EPS FY09 0.08 0.16 0.21 0.18 Avg dly volume 10.7Mn Reported Net profit 217.5 507.4 790.1 1,073.7 EPS FY10E 0.20 0.35 0.45 0.45 Index (NASD) 2,667 Reported EPS (US$) 0.62 1.45 2.21 2.98 EPS FY11E 0.42 0.53 0.62 0.64 Free float 75% P/E (x) 158.6 68.5 44.7 33.2 1M 3M 12M Dividend Yld (%) 0% Adj. EPS * 0.66 1.49 2.25 3.02 Abs. Perf.(%) -9.7 -3.3 132.6 Market Cap US$34.5B Adj. P/E (x) 149.9 66.7 44.0 32.8 Rel. Perf.(%) -14.9 -15.5 115.2 Price Target US$120 EV/EBITDA 115.3 52.2 34.4 25.3 Cash 671 1,172 2,101 3,315 Price Date Dec 29, 2010 P/B (x) 49.5 27.7 16.3 10.5 Equity 696 1,243 2,117 3,278 Y/E BPS (US$) 2.0 3.6 6.1 9.4 Source: Company data, J. P. Morgan estimates, Bloomberg. * Note: Excluding share-based compensation expense. Pricing data as of 29 December 2010.
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Key Drivers for 2011 On the monetization side We expect three major revenue drivers: (1) Continued improvement in Phoenix Nest algorithm will likely increase Baidu’s search monetization potential. We believe both click through and coverage ratios will gradually increase, driven by better quality ads being served in more search results. In addition, large numbers of customers will also lead to keyword pricing increase. As such, we believe the company is likely to see higher revenue per search next year. (2) Upside from eCommerce advertisers: eCommerce in China is expected to experience strong growth over the next few years, with online B2C retailers offering a wide selection of good-quality products at low prices. Logistics, as well as trust and safety, have improved significantly over the past year. We expect competition among eCommerce merchants likely to increase, and as a result an increase in advertising spending on search. Indeed, Baidu has already seen the number of eCommerce advertisers double Y/Y during 3Q10. We believe the eCommerce segment could account for a double-digit percentage of revenues for Baidu in 2011. (3) Contextual advertisements are likely to be another growth driver in the medium term. The company has been investing its R&D capability to improve its contextual search technology. We note that a significant portion of Google China’s revenue comes from contextual search. Contextual advertisements will create a win-win situation for Baidu as well as content providers who have not been able to monetize their content properly. On search queries side We believe the search market in China is still in the early stages of growth as (1) internet penetration still has good upside, (2) increasing amount of Chinese content is available online, (3) higher reliance on search in daily life. To further enhance users’ search experience, the company focuses on box computing initiatives. (1) Open Data platform (Aladdin) providing users with more dynamic and comprehensive information. (2) Open Application platform to provide users with their more common application–related needs such as web-based games, eBooks, software, etc. Thirty percent of general search queries on Baidu are applications related. We believe improvements in search quality should further increase the number of search queries per user. Cost side Baidu Union optimization: The company’s new revenue-sharing policy has been effective in enhancing Baidu Union's traffic quality and lowering traffic acquisition costs in 2010. Contextual ads to increase TAC in 2011: However, a decrease in TAC from currently search box-related traffic would be balanced by a rise in payouts related to contextual advertising. Contextual advertising usually has higher payout ratios for third-party websites. If contextual becomes very successful, TAC could move up 90 318
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com back to the low teens level as a percentage of revenue. We currently forecast TAC at 10% of revenues in 2011. New Businesses The Video and eCommerce businesses are still in the early stages of growth. We believe the company could maintain its strategy of taking a minority stake in new businesses by providing traffic. We believe the company could make more acquisitions over the next two to three years, when the revenue growth rate slows. Active Online Marketing Customers and Average Quarterly Spending Trend 1Q08 2Q08 3Q08 4Q08 2Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10E Active Online Mktg. Customers 161,000 181,000 194,000 197,000 185,000 203,000 216,000 223,000 221,000 254,000 272,000 282,880 QoQ Chg. (%) 3.9% 12.4% 7.2% 1.5% -6.1% 9.7% 6.4% 3.2% -0.9% 14.9% 7.1% 4.0% YoY Chg. (%) 43.8% 41.4% 35.7% 27.1% 14.9% 12.2% 11.3% 13.2% 19.5% 25.1% 25.9% 26.9% Avg Qtly Spending / Customer (Rmb) 3,557 4,432 4,733 4,576 4,379 5,402 5,918 5,652 5,852 7,533 8,292 8,541 QoQ Chg. (%) -3.2% 24.6% 6.8% -3.3% -4.3% 23.4% 9.5% -4.5% 3.6% 28.7% 10.1% 3.0% YoY Chg. (%) 45.1% 41.6% 36.4% 24.5% 23.1% 21.9% 25.0% 23.5% 33.6% 39.5% 40.1% 51.1% Source: Company reports, J.P. Morgan estimates. Quarterly TAC Trend Long-term TAC as % of Total Revenue 16.0% 16.0% 250,000 18% 14,000 18% 15.3% 15.3% 15.7% 9.1% 14.5% 16% 13.3% 8.9% 16% 13.2% 9.7% 12.7% 12,000 200,000 13.1% 11.8% 14% 14% 10,000 11.5% 12% 150,000 10.2% 12% 9.7% 10% 9.0% 8,000 10% 8% 100,000 6.3% 8% 6% 6,000 6% 50,000 4% 4,000 2% 4% 2,000 0 0% 2% 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10E 0 0% 2005 2006 2007 2008 2009 2010E 2011E TAC (LHS, Rmb '000s) TAC as % of rev enue (RHS, %) Total Rev enue (Left, RMB millions) TAC as % of total rev enue (Right) Source: Company reports, J.P. Morgan estimates. Source: Company reports, J.P. Morgan estimates. 91 319
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Rating and Price Target We maintain our Overweight rating on Baidu as it remains one of the dominant market leaders in China’s online search market, which is still in an early high-growth stage. Google’s potential exit from China is likely to be beneficial to Baidu as well. With China’s search market around five to six years behind the US in terms of monetization, we believe the risks are on the upside that the search ad market could develop at a faster pace, with lack of other well-established offline SME marketing platforms and the network of distributors and sales agencies. We maintain our Dec 2011 price target of US$120. Our price target implies 53.3x FY11E, and 39.7x FY12E diluted adjusted EPS, on the back of 53% and 35% EPS growth for FY11E and FY12E respectively, or 1.3x PEG (based on 2012 P/E and long-term growth of 30%). (1) DCF valuation We use a 15-year DCF valuation for Baidu, with an estimated 17% long-term growth rate from 2020E-25E. Our nominal case DCF valuation is based on a WACC of 12% and 0% terminal growth. Based on the assumptions, our DCF valuation is US$120.4. We also performed some near-term revenue growth sensitivity analysis on a potential growth slowdown. Our current forecast implies 2012-2015E CAGR to be 30%. If we assume near-term growth to slow down to 25%, our DCF valuation is US$120, with a terminal growth rate at 3% Baidu—DCF Model FY10E FY11E FY12E FY13E FY14E FY15E FY16E FY17E FY18E FY19E FY20E Sales growth 77.2% 55.2% 37.5% 33.4% 31.0% 25.9% 22.0% 21.0% 20.0% 20.0% 20.0% EBIT margin 49.1% 48.5% 48.2% 46.2% 45.9% 45.4% 45.2% 45.2% 45.2% 45.2% 45.2% NOPAT margin 42.4% 41.9% 41.1% 39.3% 39.1% 38.7% 38.5% 38.5% 38.5% 38.5% 38.5% Year-end net fixed assets turns 5.0 6.3 6.9 7.0 7.0 7.0 7.0 7.0 7.0 7.0 7.0 Year-end net working capital turns -7.2 -7.5 -7.6 -7.0 -7.0 -7.0 -7.0 -7.0 -7.0 -7.0 -7.0 Year-end net other assets turns 22.5 35.6 49.0 30.0 30.0 30.0 30.0 30.0 30.0 30.0 30.0 Cash operating taxes as % of EBIT 13.7% 13.6% 14.8% 14.8% 14.8% 14.8% 14.8% 14.8% 14.8% 14.8% 14.8% Year-end Invested capital turns 9.5 18.2 30.7 30.0 30.0 30.0 30.0 30.0 30.0 30.0 30.0 Source: J.P. Morgan estimates. DCF Sensitivity Analysis Terminal growth (%) 0% 1% 2% 3% 4% 5% 6% 7% 10.0% 167.6 175.6 185.7 198.6 215.8 239.9 276.1 336.3 11.0% 140.9 146.5 153.2 161.6 172.4 186.9 207.1 237.4 WACC 12.0% 119.9 123.8 128.4 134.0 141.1 150.2 162.3 179.2 13.0% 103.1 105.8 109.0 112.9 117.7 123.6 131.2 141.4 14.0% 89.4 91.4 93.7 96.4 99.7 103.6 108.6 115.0 15.0% 78.2 79.6 81.3 83.2 85.5 88.2 91.6 95.8 Source: J.P. Morgan estimates. (2) PEG ratio analysis At our PT of US$120, Baidu trades at 1.3x PEG (based on 2012 P/E and long-term growth of 30%), or 1.5x PEG (based on 2011E P/E and 2012E EPS growth of 35%). 92 320
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com As a reference, the S&P 500 currently trades at 12x forward P/E with the next three- year CAGR of 7%, or a PEG of 1.7x. (3) Market size potential Using various references to the US and Korea search markets, we estimate China’s search market size could reach US$3B-US$4.6B by 2013. This compares to our current 2013 forecast of US$3.4B and US search market 2009 size of US$15B. Please also refer to the chart below for analysis of market size comparison with US/Korea market. Other factors that could lead to positive surprises to our forecast include faster-than- expected inflation and RMB appreciation. Risks to Our Rating and Price Target Downside risks to our rating and price target include: • Slower-than-expected online search growth: This would be due to Baidu’s execution, economic slowdown, government policy changes, fraudulent clicks causing a general decline in ROI, and availability of an alternative more effective advertising form. • Potential margin decline: While we expect Baidu to see a slight increase in TAC, upside surprise to TAC could come from a ramp-up of contextual search on affiliate sites and partnerships with new affiliate members. In addition, higher bandwidth cost increases, higher marketing expenses, and higher R&D could lead to a margin decline. • Large infrastructure-related expense: During the early phase of search advertising growth, Baidu could invest in servers and bandwidths more significantly than we forecast. While this would be a positive in the long term, the share price could be impacted in the near term due to lower earnings. • Unsuccessful new initiatives: Baidu began investments in Japan in 2007 with US$15million in expenses. The company also invested in a video site (Qiyi.com) and eCommerce site (JV with Rakuten). If these ventures were unsuccessful or required additional financing, Baidu could take an investment loss. 93 321
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Baidu: Summary of financials Income statement Ratio analysis US$ in millions, year-end December %, year-end December FY08 FY09 FY10E FY11E FY12E FY08 FY09 FY10E FY11E FY12E Revenues 465.5 651.4 1,168.0 1,828.7 2,514.2 Gross Margin 64.0 63.8 72.6 72.4 71.6 Cost of Goods Sold 167.5 235.8 320.4 504.4 713.9 EBITDA margin 45.4 45.4 56.0 54.3 53.7 Gross Profit 298.0 415.6 847.6 1,324.3 1,800.3 Operating Margin 34.3 36.1 49.1 48.5 48.2 R&D Expenses 36.2 55.9 97.5 157.2 216.3 Net Margin 32.8 33.4 43.4 43.2 42.7 SG&A Expenses 90.0 112.1 162.9 266.9 357.2 R&D/sales 7.8 8.6 8.3 8.6 8.6 Share-based Expense 12.2 12.6 13.3 12.8 14.1 SG&A/Sales 19.3 17.2 13.9 14.6 14.2 Operating Profit (EBIT) 159.6 235.1 573.9 887.3 1,212.6 EBITDA 211.4 296.0 654.0 993.4 1,350.7 Sales growth 100.9 39.9 79.3 56.6 37.5 Interest Income, net 6.9 4.8 9.1 22.3 37.6 Operating Profit Growth 119.7 47.3 144.1 54.6 36.7 Investment Income (Exp.) 0.0 0.0 0.0 1.0 1.0 Net profit growth 82.6 42.6 133.3 55.7 35.9 Other Income (Exp.) 2.9 6.7 2.1 0.6 0.6 Diluted EPS growth 82.5 42.4 131.7 53.0 34.7 Earnings before tax 169.4 246.5 585.0 910.1 1,250.8 Tax 16.9 29.0 77.7 120.0 177.1 Net Income (Reported) 152.5 217.5 507.4 790.1 1,073.7 Net debt to total capital -86.2 -96.4 -94.3 -99.3 -101.1 Net Income (Adjusted) * 164.8 230.2 520.7 803.0 1,087.9 Net debt to equity -86.2 -96.4 -94.3 -99.3 -101.1 US$ Diluted EPS (GAAP) 0.44 0.62 1.45 2.21 2.98 Asset Turnover 81.2 72.2 75.3 72.3 65.7 Adj. Diluted EPS * 0.47 0.66 1.49 2.25 3.02 Working Capital Turns (X) 2.1 1.6 1.6 1.4 1.1 BPS 1.3 2.0 3.6 6.1 9.4 ROE 44.3 40.1 53.5 47.7 40.3 DPS 0.0 0.0 0.0 1.0 1.0 ROIC 42.8 39.4 52.7 46.6 39.2 Shares Outstanding (Mn) 348 348 350 357 360 Balance sheet Cash flow statement US$ in millions, year-end December US$ in millions, year-end December FY08 FY09 FY10E FY11E FY12E FY08 FY09 FY10E FY11E FY12E Cash and cash equivalents 388 671 1,172 2,058 3,248 Net Income 153 218 507 790 1,074 Accounts receivable 14 24 39 57 76 Depr. & Amortisation 40 48 67 91 121 Inventories 0 0 0 0 0 Change in working capital 24 70 51 110 121 Others 14 15 48 69 93 Other 38 13 13 13 14 Current assets 415 709 1,259 2,184 3,416 Cash flow from operations 254 348 638 1,005 1,330 LT investments 2 2 8 7 7 Capex / Investments -59 -82 -159 -147 -191 Net fixed assets 129 146 233 286 355 Others -34 0 -5 0 0 Other LT assets 28 44 52 50 50 Cash flow from investing -93 -82 -164 -147 -191 Total assets 573 902 1,551 2,528 3,829 Free cash flow 195 267 480 858 1,139 Liabilities Equity raised/ (repaid) -9 17 18 59 72 ST loans 0 0 0 0 0 Debt raised/ (repaid) 0 0 0 0 0 Payables 62 110 128 194 270 Other 4 -3 1 0 0 Others 62 95 179 260 347 Dividends paid 0 0 0 0 0 Total current liabilities 124 205 307 454 617 Cash flow from financing -5 14 19 59 72 Long term debt 0 0 0 0 0 Other liabilities 0 1 1 1 1 Net change in cash 176 283 501 886 1,189 Total liabilities 124 206 308 455 618 Beginning cash 211 388 671 1,172 2,058 Shareholders' equity 450 696 1,243 2,074 3,211 Ending cash 388 671 1,172 2,058 3,248 Source: Company data and J.P. Morgan estimates. *Note: Excluding share-based compensation expenses. 94 322
  • Global Equity Research 03 January 2011 Neutral China Finance Online JRJC, JRJC US Price: $6.64 Remain Neutral on Lack of Near-term Price Drivers Price Target: $8.30  While the company has established good checks on its operating Internet expenses to reduce losses, we believe the company still lacks a product Dick Wei AC that could strengthen its revenue quality in the medium term. (852) 2800-8535 dick.x.wei@jpmorgan.com  Business Still Lacks New Drivers: We believe China Finance Online is J.P. Morgan Securities (Asia Pacific) Limited still lacking a product that could drive their revenues. While the Ritesh Gupta company has been working on a few new products, these new products (91-22) 6157 3307 are yet to be introduced to the market place. In addition, existing ritesh.z.gupta@jpmorgan.com products are also negatively impacted due to rising competition and the J.P. Morgan India Private Limited IPO of its competitor in the A-share market (Grand Wisdom). Imran Khan (1-212) 622-6693  Weaker 2011 Outlook: JRJC still lacks new revenue drivers in the near imran.t.khan@jpmorgan.com term. A decline in cash revenues for 3Q10 and a muted outlook for next J.P. Morgan Securities Inc. quarter would mean weaker revenue recognition until 2Q11 due to amortization of subscription revenues. We recently revised down our Price Performance 2011 revenue estimate by 19% and adjusted our EPS estimate (ex share- 9.0 based expenses) by 40%. We are now also forecasting increased sales $ 7.5 and marketing and research and development expenses. 6.0  Dec-11 PT of US$8.3: Our DCF-based Dec-11 price target implies Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 67.3x/31.7x 2011E/2012E adjusted diluted P/E. Excluding net cash of JRJC share price ($) US$4.53 per diluted share, our PT implies 67.3x/31.7x 2011E/2012E NASDAQ Composite (rebased) adjusted diluted P/E. Downside risks to our PT include: (1) deterioration YTD 1m 3m 12m in domestic stock market activity, reducing demand for JRJC products, Abs -11.5% -16.4% -6.7% -11.5% Rel -27.0% -22.0% -18.9% -28.0% and (2) higher-than-expected product development expenses. Upside risks include: (1) the government announcing new policies or innovative products that could lead to higher spot/futures market activity, and (2) the company diversifying into other brokerage–related businesses. Reuters: JRJC; Bloomberg: JRJC US US$MM, Y/E Dec FY09 FY10E FY11E FY12E FY09 FY10E FY11E FY12E Net Revenue 53.6 59.2 54.7 59.2 ROE (%) 0.4 6.4 2.6 5.1 52-Week range US$6.8-9.1 Adj. Op. Profit * -1.8 3.6 1.1 4.7 ROIC (%) -0.8 5.0 1.3 3.7 Shares Outstg 22Mn GAAP Net Profit -6.2 2.1 1.0 4.4 Qtr GAAP EPS(US$) 1Q 2Q 3Q 4Q Avg daily volume 0.05Mn Adj. net profit * 0.4 6.6 3.0 6.4 EPS FY09 -0.01 -0.11 -0.05 -0.13 Avg daily value 0.4Mn Reported EPS (US$) -0.30 0.09 0.04 0.18 EPS FY10 E 0.01 0.02 0.06 0.01 Index (NASD) 2,667 P/E (x) nm 71.8 161.2 36.8 EPS FY11 E 0.01 0.01 0.01 0.01 Free float 52% Adj. EPS (US$) 0.02 0.28 0.12 0.26 1M 3M 12M Dividend Yld (%) 0% Adj. P/E (x) * 371.5 23.3 53.8 25.4 Abs. Perf.(%) -17.2 -6.7 -14.2 Market Cap US$146M EV/EBITDA (x) 33.2 6.2 13.6 6.3 Rel. Perf.(%) -22.3 -18.9 -31.6 Price Target US$ 8.3 P/B (x) 1.4 1.3 1.2 1.1 Cash (US$m) 107.5 105.9 112.4 130.8 Price Date Dec 29, 2010 Y/E BPS (US$) 4.6 5.0 5.6 6.2 Equity (US$m) 97.4 107.8 119.3 134.3 Source: Company reports, Bloomberg, J.P. Morgan estimates. * Note: Adjusted figures exclude share-based comps & one-off expenses.
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com 2011 and 2012 Outlook We expect 2011 revenues of US$54.7M (down 7.6% Y/Y) and adjusted EPS (excluding share-based expenses) of US$0.12 (down 56.7% Y/Y). Our 2012 revenue estimates are US$59.2M (up 8.3% Y/Y) and adjusted EPS of US$0.26 (up 112.2% Y/Y). Price Target, Valuation and Rating Analysis Maintain Neutral with our Dec-11 PT of US$8.3. Our DCF-based PT (WACC of 13%, terminal growth of 0%) of US$8.3 implies 67.3x/31.7x 2011E/2012E adjusted diluted P/E. Excluding net cash of US$4.53 per diluted share, our PT implies 65.7x/20.0x 2011E/2012E adjusted diluted P/E. Risks to Our Rating and Price Target Key downside risks include: (1) deterioration in domestic stock market activity (negatively affecting demand for JRJC’s products), (2) increase in competition in financial analysis software, and (3) larger-than-expected in-house investment in product development and database. DCF Model (Base case scenario) 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E Sales growth 10.4% -7.6% 8.3% 9.2% 11.7% 11.7% 11.7% 11.7% 11.7% 11.7% 11.7% EBIT margin -1.4% -1.7% 4.5% 10.8% 14.2% 14.6% 14.6% 14.6% 14.6% 14.6% 14.6% NOPAT margin -1.9% -2.3% 3.3% 8.0% 10.5% 10.8% 10.8% 10.8% 10.8% 10.8% 10.8% Year end net fixed assets turns 7.4 7.4 8.7 8.7 8.7 8.7 8.7 8.7 8.7 8.7 8.7 Year end net working capital turns (4.3) (5.1) (4.0) (4.0) (4.0) (4.0) (4.0) (4.0) (4.0) (4.0) (4.0) Year end net other assets turns 3.2 3.0 3.3 4.5 4.5 4.5 4.5 4.5 4.5 4.5 4.5 Cash operating taxes as % of EBIT -33.5% -33.0% 25.7% 25.7% 25.7% 25.7% 25.7% 25.7% 25.7% 25.7% 25.7% Year end Invested Capital turns 4.5 3.7 6.1 11.5 11.5 11.5 11.5 11.5 11.5 11.5 11.5 Source: J.P. Morgan estimates. DCF Sensitivity Analysis Terminal Growth (%) 0% 1% 2% 3% 4% 5% 6% 7% 10.0% 10.3 10.4 10.4 10.5 10.7 10.9 11.1 11.6 11.0% 9.5 9.5 9.5 9.6 9.6 9.7 9.8 9.9 WACC 12.0% 8.8 8.8 8.8 8.8 8.8 8.8 8.8 8.8 13.0% 8.3 8.3 8.3 8.2 8.2 8.2 8.1 8.1 14.0% 7.8 7.8 7.8 7.8 7.7 7.7 7.6 7.6 15.0% 7.5 7.4 7.4 7.4 7.3 7.3 7.2 7.2 16.0% 7.1 7.1 7.1 7.1 7.0 7.0 6.9 6.9 Source: J.P. Morgan estimates. 96 324
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com China Finance Online: Summary of financials Income statement Ratio analysis USD in millions, year-end December %, year-end December FY08 FY09 FY10E FY11E FY12E FY08 FY09 FY10E FY11E FY12E Revenues 56.2 53.6 59.2 54.7 59.2 Gross Margin 83.3 84.8 86.0 84.4 84.9 Cost of Goods Sold 9.4 8.1 8.3 8.5 9.0 EBITDA margin 40.1 2.5 12.0 5.9 11.7 Gross Profit 46.9 45.5 50.9 46.2 50.3 Operating Margin 22.8 -15.6 -1.4 -1.7 4.5 R&D Expenses 5.6 10.7 12.7 12.9 13.0 Net Margin 33.8 -11.6 3.6 1.8 7.5 SG&A Expenses 28.5 43.1 39.0 34.3 34.6 R&D/sales 9.9 20.0 21.5 23.5 22.0 Operating Profit (EBIT) 12.8 -8.4 -0.8 -0.9 2.7 SG&A/Sales 50.6 80.5 65.9 62.6 58.4 EBITDA 22.5 1.3 7.1 3.2 6.9 Interest Income 1.6 1.4 1.5 1.6 1.8 Sales growth 117.1 -4.7 10.4 -7.6 8.3 Interest Expense 0.0 0.0 0.0 0.0 0.0 Operating Profit Growth 185.0 -165.3 89.9 -9.8 387.2 Investment Income (Exp.) 0.0 0.0 0.0 0.0 0.0 Net profit growth 560.9 -132.7 134.3 -53.2 342.1 Non-Operating Income (Exp.) 1.8 0.4 1.6 0.4 0.4 EPS (Reported) growth -491.0 -135.1 -131.2 -55.4 338.1 Earnings before tax 16.2 -6.7 2.2 1.1 4.9 Tax 2.6 0.4 -0.3 -0.3 -0.7 Net Income (Reported) 19.0 -6.2 2.1 1.0 4.4 Net debt to total capital -101.1 -110.3 -98.3 -94.2 -97.4 Net Income (Adjusted) 26.6 0.4 6.6 3.0 6.4 Net debt to equity -101.1 -110.3 -98.3 -94.2 -97.4 USD: EPS (Reported) 0.84 -0.30 0.09 0.04 0.18 Asset Turnover 39.8 32.4 34.7 31.6 30.5 EPS (Adjusted) * 1.18 0.02 0.28 0.12 0.26 Working Capital Turns (X) 0.9 0.7 0.7 0.6 0.6 BPS 4.9 4.6 5.0 5.6 6.2 ROE 32.5 0.4 6.4 2.6 5.1 DPS 0.0 0.0 0.0 0.0 0.0 ROIC 30.5 -0.8 5.0 1.3 3.7 ADS Outstanding (Diluted, Mn) 19.8 21.0 21.5 21.4 21.5 Balance sheet Cash flow statement USD in millions, year-end December USD in millions, year-end December FY08 FY09 FY10E FY11E FY12E FY08 FY09 FY10E FY11E FY12E Cash and cash equivalents 97.5 107.5 105.9 112.4 130.8 Net Income 19.0 -6.2 2.1 1.0 4.4 Accounts receivable 2.9 5.4 16.1 15.7 17.6 Depreciation & Amortization 2.1 3.1 3.5 2.2 2.3 Inventories 0.0 0.0 0.0 0.0 0.0 Change in working capital -1.1 6.4 -9.6 -3.2 4.4 Others 12.7 20.8 20.6 18.0 20.1 Other 7.3 6.6 4.2 1.8 1.8 Current assets 113.1 133.7 142.6 146.1 168.5 Cash flow from operations 27.3 9.9 0.2 1.7 12.9 LT investments 1.5 1.5 1.5 1.5 1.5 Capex/investments -11.2 -6.9 0.3 -1.1 -1.2 Net fixed assets 8.6 10.3 8.0 7.4 6.8 Others 0.0 0.0 0.0 0.0 0.0 Others 18.0 20.2 18.6 18.2 17.7 Cash flow from investing -11.2 -6.9 0.3 -1.1 -1.2 Total assets 141.2 165.6 170.8 173.2 194.5 Free cash flow 16.1 3.0 0.5 0.6 11.6 Liabilities Equity raised/ (repaid) 2.5 0.6 3.8 8.5 8.5 ST loans 0.0 0.0 0.0 0.0 0.0 Debt raised/ (repaid) 0.0 0.0 0.0 0.0 0.0 Payables 7.0 21.7 24.8 19.3 20.8 Other 4.2 6.4 -5.9 -2.7 -1.8 Others 28.3 30.7 28.5 27.8 34.7 Dividends paid 0.0 0.0 0.0 0.0 0.0 Total current liabilities 35.4 52.4 53.3 47.1 55.5 Cash flow from financing 6.7 6.9 -2.0 5.9 6.7 Long term debt 0.0 0.0 0.0 0.0 0.0 Other liabilities 9.4 15.8 9.7 6.8 4.7 Net change in cash 22.8 9.9 -1.5 6.5 18.3 Total liabilities 44.8 68.2 63.0 53.9 60.2 Beginning cash 74.7 97.5 107.5 105.9 112.4 Shareholders' equity 96.5 97.4 107.8 119.3 134.3 Ending cash 97.5 107.5 105.9 112.4 130.8 Source: Company data and J.P. Morgan estimates. * Note: We have included 123R share-based compensation adjustments starting in 2006. 97 325
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com 98 326
  • Global Equity Research 03 January 2011 Overweight Netease NTES, NTES US Price: $36.07 Leading Game Developer in China. Starcraft 2, WoW Price Target: $45.00 Upgrade to Provide Growth in F'11 We see Netease as the top online game developer and operator in China, and Internet expect the company to see ~20% gaming revenue growth in 2011. Success of AC Starcraft 2, WoW Cataclysm, and other in-house games could drive the stock Dick Wei (852) 2800-8535 higher. dick.x.wei@jpmorgan.com  WoW and Fantasy WWJ to remain strong: Online games saw healthy J.P. Morgan Securities (Asia Pacific) Limited growth over the last two quarters for Netease. New "Perfect Beauty" and having Ritesh Gupta Jay Chou as spokesperson helped Fantasy WWJ drive good growth in 2Q11 and (91-22) 6157 3307 3Q11. WoW also saw good sequential growth with the launch of new expansion ritesh.z.gupta@jpmorgan.com pack “Wrath of Lich King” in 2011. We believe these games should continue to J.P. Morgan India Private Limited maintain their franchise with the launch of promotion events and new expansion Imran Khan packs. (1-212) 622-6693  Starcraft 2 may be launched in 2011: Netease has already submitted imran.t.khan@jpmorgan.com information and materials related to the game to relevant government J.P. Morgan Securities LLC authorities and the game is undergoing the review process. We expect that Price Performance Starcraft 2 may be launched in 2011. 40  Online advertising to benefit from new advertising placement system: We $ expect Netease to see healthy portal revenue growth of 26% next year. We 34 believe the company should benefit from improved awareness amongst 28 advertisers from: (1) sponsorship of Asian Games in Guangzhou, and (2) launch Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 of a new ad placement system which provides analytics for effectiveness of NTES share price ($) NASDAQ Composite (rebased) advertisements placed on Netease portal. Portal traffic on Netease is up 40% YTD as of the end of 3Q10. YTD 1m 3m 12m Abs -12.5% -5.6% -8.2% -2.9%  2011 outlook: We expect 2011 revenues to see 19.7% growth YoY to reach Rel -28.0% -11.2% -20.4% -19.4% US$947M. We expect gross margins to remain intact with slight improvement in operating margins on lower marketing expenses. Online Games should see 19.2% growth YoY in 2011 from continued performance of WoW and Fantasy WWJ. Launch of Starcraft 2 should be a key revenue driver for 2011, in our view. Netease has one of the strongest R&D teams and we expect the company to maintain its strength as a gaming franchise. Reuters: NTES; Bloomberg: NTES US (US$MM, Y/E Dec) FY09 FY10E FY11E FY12E FY09 FY10E FY11E FY12E Net Sales 550.2 789.7 946.6 1,055.7 ROE (%) 28.9 26.0 25.0 21.6 52-Week range (US$) 26.2-43.7 Operating Profit 296.3 359.3 441.8 496.5 ROIC (%) 27.3 24.7 23.5 20.1 Shares Outstg (MM) 130M EBITDA 322.0 409.2 506.0 570.5 GAAP Qtr EPS (US$) 1Q 2Q 3Q 4Q Avg daily volume 0.9M Pre Tax Profit 314.9 368.2 472.4 536.2 EPS FY09 0.47 0.53 0.44 0.64 Avg daily value US$31.4M Net Profit 269.0 311.8 393.3 441.0 EPS FY10E 0.51 0.55 0.66 0.68 Index (NASD) 2,667 Reported EPS (US$) 2.07 2.39 2.94 3.22 EPS FY11E 0.68 0.72 0.76 0.78 Free float (%) ~50% Reported P/E (x) 17.6 15.3 12.4 11.3 1M 3M 12M Dividend yld (%) 0% Adj. EPS (US$) 2.11 2.51 3.10 3.40 Abs. Perf.(%) -6.7 -8.7 -2.8 Market Cap US$4.7B Adj. P/E (x) 17.3 14.5 11.8 10.7 Rel. Perf.(%) -11.9 -20.9 -20.3 Price target (US$) US$45 EV/EBITDA 12.6 9.9 8.0 7.1 Price Date Dec 29, 2010 P/B (x) 4.1 3.2 2.5 2.0 Cash (US$MM) 1,046 1,519 2,004 2,544 Y/E BPS (US$) 8.8 11.4 14.7 18.3 Equity (US$MM) 1,087 1,429 1,891 2,404 Source: Company reports, Bloomberg, J.P. Morgan estimates. Note: We have included 123R share-based expense adjustments starting in 2006.
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com 2011 and 2012 Outlook We expect 2011 revenues of US$946.6M (up 19% Y/Y) and adjusted EPS (excluding share based expenses) of US$3.10 (up 23.4% Y/Y). We expect 2012 revenues of US$1,055.7M and adjusted EPS of US$3.40. Rating and Price Target OW with Dec-11 price target of US$45 We maintain our OW rating on Netease and recently rolled over our PT time frame to Dec-11 from Dec-10. Our PT is US$45 based on DCF valuation of US$45 (assuming WACC of 12.9% and 0% terminal growth). Our price target of US$45 implies 17.9x ’10, 14.5x ’11E, and 13.2x ‘12E diluted adjusted EPS. If we exclude cash of US$9.9 per share, our price target of US$45 implies 14.0x ’10, 11.3x ’11E, and 10.3x ‘12E ex-cash P/E. The company has a strong cash position of US$1.29B (US$9.9 per diluted share). Share Price Drivers We expect new game launches such as Starcraft 2 and WoW upgrade to Cataclys will be share price drivers for NetEase Risks to Our Rating and Price Target Downside risks to our price target include: intense competition resulting in a negative industry environment, delays in game launches, hacking or pirated server issues limiting user growth, and risks of losing operating rights for licensed games (such as WoW). NTES—DCF model (base case scenario) FY10E FY11E FY12E FY13E FY14E FY15E FY16E FY17E FY18E FY19E FY20E Sales growth 42.8% 19.7% 11.5% 10.1% 10.8% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% EBIT margin 45.5% 46.7% 47.0% 46.0% 45.4% 42.0% 40.0% 38.0% 36.0% 36.0% 36.0% NOPAT margin 38.2% 38.0% 37.6% 36.8% 36.3% 33.6% 32.0% 30.4% 28.8% 28.8% 28.8% Year-end net fixed assets turns 7.8 9.3 10.4 12.0 12.0 12.0 12.0 12.0 12.0 12.0 12.0 Year-end net working capital turns (4.4) (4.8) (4.9) (4.9) (4.9) (4.9) (4.9) (4.9) (4.9) (4.9) (4.9) Year-end net other assets turns 24.3 29.1 32.5 22.0 22.0 22.0 22.0 22.0 22.0 22.0 22.0 Cash operating taxes as % of EBIT 16.0% 18.6% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% Year-end Invested capital turns (17.1) (15.1) (12.7) (13.0) (13.0) (13.0) (13.0) (13.0) (13.0) (13.0) (13.0) Source: J.P. Morgan estimates. DCF sensitivity analysis Terminal growth (%) 0% 1% 2% 3% 4% 5% 6% 7% 9.9% 57.3 59.3 61.8 64.9 69.2 75.2 84.3 99.6 10.9% 52.3 53.8 55.5 57.7 60.5 64.3 69.6 77.6 11.9% 48.2 49.3 50.5 52.1 54.0 56.5 59.9 64.6 WACC 12.9% 44.8 45.6 46.5 47.6 49.0 50.7 52.9 55.9 13.9% 41.9 42.5 43.2 44.0 45.0 46.2 47.7 49.7 14.9% 39.4 39.8 40.4 41.0 41.7 42.6 43.7 45.0 15.9% 37.2 37.6 38.0 38.5 39.0 39.7 40.4 41.4 Source: J.P. Morgan estimates. 100 328
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Netease: Summary of financials Income statement Ratio analysis Rmb in millions, year-end December %, year-end December FY08 FY09 FY10E FY11E FY12E FY08 FY09 FY10E FY11E FY12E Revenues 2,938 3,757 5,364 6,420 7,159 Gross Margin 81.4 74.9 68.2 68.2 68.4 Cost of Goods Sold 546 943 1,707 2,044 2,261 EBITDA margin 63.3 57.7 50.0 51.1 51.8 Gross Profit 2,392 2,814 3,657 4,375 4,899 Operating Margin 60.2 53.9 45.5 46.7 47.0 R&D Expenses 185 220 280 356 394 Net Margin 50.6 48.9 39.5 41.5 41.8 SG&A Expenses 439 570 936 1,023 1,138 R&D/sales 6.3 5.9 5.2 5.5 5.5 Operating Profit (EBIT) 1,768 2,023 2,441 2,996 3,367 SG&A/Sales 14.9 15.2 17.5 15.9 15.9 EBITDA 1859 2167 2682 3282 3706 Interest Income 144.8 128.2 139.5 207.5 269.4 Sales growth 32.7 27.9 42.8 19.7 11.5 Interest Expense 0 0 0 0 0 Operating Profit Growth 46.6 14.5 20.6 22.7 12.4 Investment Income (Exp.) 1.5 0.4 0.2 0.0 0.0 Net profit growth 17.6 24.5 15.1 25.2 12.1 Non-Operating Income (Exp.) -163.5 -1.3 -79.0 0.0 0.0 EPS (Reported) growth 20.2 22.9 14.5 22.9 9.8 Earnings before tax 1,751 2,151 2,501 3,203 3,636 Tax -264 -314 -383 -536 -646 Net Income (Reported) 1,487 1,837 2,118 2,667 2,991 Net debt to total capital -101.8 -96.2 -106.3 -106.0 -105.8 Net Income (Adjusted) * 1,555 1,869 2,230 2,816 3,153 Net debt to equity -101.8 -96.2 -106.3 -106.0 -105.8 RMB EPS (Reported) 11.53 14.17 16.22 19.92 21.87 Asset Turnover 46.3 42.7 45.2 42.1 37.7 EPS (Adjusted) * 12.05 14.41 17.07 21.03 23.06 Working Capital Turns (X) 0.7 0.6 0.7 0.6 0.5 BPS 45.90 60.36 77.14 99.81 124.21 ROE 34.9 28.9 26.0 25.0 21.6 DPS 0.00 0.00 0.00 0.00 0.00 ROIC 30.1 27.3 24.7 23.5 20.1 Shares outstanding (MM) 125 129 129 127 130 Balance sheet Cash flow statement Rmb in millions, year-end December Rmb in millions, year-end December FY08 FY09 FY10E FY11E FY12E FY08 FY09 FY10E FY11E FY12E Cash and cash equivalents 5,613 7,141 10,316 13,615 17,278 Net Income 1,487 1,837 2,118 2,667 2,991 Accounts receivable 231 187 408 465 514 Depr. & Amortization 91 144 242 286 339 Inventories 0 0 0 0 0 Change in working capital 111 77 947 167 170 Others 129 645 224 264 292 Other 68 18 100 149 163 Current assets 5,974 7,973 10,949 14,344 18,085 Cash flow from operations 1,757 2,076 3,407 3,269 3,662 LT investments 0 0 0 0 0 Capex / investments -214 -602 -322 -289 -332 Net fixed assets 259 558 691 693 686 Others 0 0 0 0 0 Others 113 273 220 220 220 Cash flow from investing -214 -602 -322 -289 -332 Total assets 6,346 8,803 11,860 15,258 18,991 Free cash flow 1,543 1,473 3,085 2,980 3,330 Liabilities Equity raised/ (repaid) 453 40 54 318 334 ST loans 0 0 0 0 0 Debt raised/ (repaid) -642 0 0 0 0 Payables 320 582 1,132 1,257 1,385 Other 100 0 25 0 0 Others 510 796 993 1,132 1,251 Dividends paid 0 0 0 0 0 Total current liabilities 829 1378 2125 2389 2636 Cash flow from financing -88 40 79 318 334 Long term debt 0 0 0 0 0 Other liabilities 0 0 25 25 25 Net change in cash 1,455 1,513 3,164 3,298 3,664 Total liabilities 829 1,378 2,151 2,415 2,661 Beginning cash 4,159 5,613 7,141 10,316 13,615 Shareholders' equity 5,516 7,425 9,709 12,843 16,330 Ending cash 5,613 7,141 10,316 13,615 17,278 Source: Company data, J.P. Morgan estimates. * Adjusted EPS excludes share-based compensation expense. 101 329
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com 102 330
  • Global Equity Research 03 January 2011 Overweight Shanda Games GAME, GAME US Price: $6.33 2011 Could Mark a Turnaround Price Target: $8.00  2011 outlook: Shanda Games currently guides 4Q10 revenues to be 3% to 5% Internet higher sequentially in 4Q10. We expect Shanda Games could return to growth AC Dick Wei in 2011, particularly if Dragon Nest can continue to gain traction in 2011. F’11 (852) 2800-8535 could well mark the turnaround for Shanda Games: We expect the company dick.x.wei@jpmorgan.com to see double-digit growth on the top line. Dragon Nest has gotten a good J.P. Morgan Securities (Asia Pacific) Limited response from gamers. Another promising game in the F’11 pipeline is Final Fantasy XIV. Price Performance  Dragon Nest could be the second-largest game next year: Dragon Nest PCUs 11 have already touched 700K levels. We believe by next year the game could $ 8 reach 10% of total revenues for Shanda Games, or become the second-largest 5 game after Mir2, and to surpass Woool. We believe the revenues from new Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 games could ease the pressure from the potential decline in legacy games. GAME share price ($) NASDAQ Composite (rebased)  Acquisition of Eyedentity: The company acquired Eyedentity games for YTD 1m 3m 12m US$95M, which will save the company from paying royalties on Dragon Nest. Abs -40.6% 11.2% 19.4% -38.4% Additionally, this will also contribute some international revenues to Shanda Rel -56.1% 5.6% 7.2% -54.9% Games.  2011 pipeline healthy: Shanda Games maintains a healthy pipeline of 5 MMORPG games and one casual game for next year. We believe Final Fantasy XIV could be a popular game for Shanda. The game is licensed from Square Enix and has seen good response from gamers internationally.  We believe the company could also benefit from Final Fantasy XIV and other in-house games. Reuters: GAME, Bloomberg: GAME US US$ in millions, year-end December US$MM, YE-Dec FY09 FY10E FY11E FY12E FY09 FY10E FY11E FY12E Net Sales 703.3 655.8 727.8 825.4 ROE (%) 81 38 28 26 52-Week range US$5.0-11.0 Operating Profit (EBIT) 253.8 193.7 217.1 253.6 ROIC (%) 82 37 28 25 Shares Outstg 288Mn EBITDA 298.1 234.8 261.9 305.5 Qtr GAAP EPS (US$) 1Q 2Q 3Q 4Q Avg daily value US$ 6Mn Pre Tax Profit 282.4 229.5 251.2 294.6 EPS FY09 1.13 1.33 1.58 1.54 Avg dly volume 1.0Mn Reported Net profit 212.6 180.6 187.2 220.0 EPS FY10E 1.19 1.22 1.10 1.11 Index (NASD) 2,667 Reported EPS (US$) 0.75 0.62 0.62 0.72 EPS FY11E 1.08 1.11 1.14 1.20 Free float ~29% P/E (x) 8.4 10.2 10.2 8.8 1M 3M 12M Dividend Yld (%) 0% Adj. EPS * 0.82 0.68 0.66 0.77 Abs. Perf.(%) 11.1 13.7 -38.2 Market Cap US$1.82B Adj. P/E (x) 7.7 9.4 9.6 8.3 Rel. Perf.(%) 6.0 1.5 -55.7 Price Target US$8 EV/EBITDA 5.7 7.3 6.5 5.6 Cash 374 545 732 940 Price Date Dec 29, 2010 P/B (x) 4.4 3.0 2.3 1.8 Equity 413 616 803 1,023 Y/E BPS (US$) 1.4 2.1 2.8 3.6 Source: Company reports, Bloomberg, J. P. Morgan estimates, Bloomberg. * Note: Excluding share-based compensation expense.
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com 2011 and 2012 Outlook We expect Shanda Games to register US$727.8M (up 11.0% Y/Y) in revenues in 2011 while adjusted EPS (excluding share-based expenses) to be US$0.66 (down 1.8% Y/Y). 2012 revenues are expected to be US$825.4M (up 13.4% Y/Y) while adjusted EPS are expected to be US$0.77 (up 15.8% Y/Y). Rating, Price Target and Valuation Maintain OW with Dec-11 PT of US$8 Our PT is based on the historical 12-month midpoint of forward P/E of 10x. Our Dec-11 PT implies 12.1x 11E and 10.4x 12E diluted adjusted P/E. Excluding US$1.8 per share (or US$500M of cash), our PT implies 10.0x 11E and 8.7x 12E. We believe the stock is undervalued given its leading position in China online game space. As such, we maintain our OW rating on Shanda Games. We expect share price drivers to be few months away, with (1) stabilization of Mir 2 revenue, (2) upside from Dragon Nest and other new games. DCF valuation Our DCF valuation assumes 10-year revenue growth and 0% terminal growth. At a WACC of 12.1%, our DCF valuation is US$9. We believe DCF is a good reference to value the company. However, with risks in the game pipeline, we believe Shanda Games may not be able to trade at its DCF valuation. Risks to Our Rating and Price Target Risk to our price target include: (1) slower-than-expected revenue growth due to an aging game portfolio and Shanda Games fails to launch successful new games or new upgrade packs, (2) increased competition in the game industry, (3) larger-than- expected spending in marketing, overseas expansion or game sourcing, (4) disruption in the distribution contract with Shanda Interactive, and (5) regulatory changes that could impact the operation of existing games or delay new game launches. DCF model (base case scenario) FY10E FY11E FY12E FY13E FY14E FY15E FY16E FY17E FY18E FY19E FY20E Sales growth -6.8% 11.0% 13.4% 12.0% 12.3% 11.7% 10.0% 10.0% 10.0% 10.0% 10.0% EBIT margin 29.5% 29.8% 28.7% 28.4% 29.3% 29.4% 29.4% 28.9% 28.9% 28.9% 28.9% NOPAT margin 22.6% 21.8% 22.5% 22.4% 22.4% 22.4% 21.7% 21.3% 21.3% 21.3% 21.3% Year-end net fixed assets turns 21.9 16.9 13.0 10.2 8.8 8.1 7.80 7.80 7.80 7.80 7.80 Year-end net working capital turns (79.9) (68.0) (78.2) (76.9) (82.0) (86.5) (82.5) (82.5) (82.50) (82.50) (82.50) Year-end net other assets turns 6.0 6.7 7.6 8.5 9.5 10.6 10.6 10.6 10.64 10.64 10.64 Cash operating taxes as % of EBIT 23.4% 26.8% 26.7% 26.5% 26.2% 26.2% 26.2% 26.2% 26.2% 26.2% 26.2% Year-end Invested capital turns 5.0 5.2 5.1 4.9 4.9 4.8 4.8 4.8 4.8 4.8 4.8 Source: J.P. Morgan estimates. 104 332
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com DCF sensitivity analysis Terminal growth (%) 0% 1% 2% 3% 4% 5% 6% 7% 9.11% 12.3 12.8 13.5 14.4 15.7 17.6 20.7 26.8 10.11% 11.0 11.3 11.8 12.4 13.2 14.3 16.0 18.7 11.11% 9.9 10.1 10.5 10.9 11.4 12.1 13.1 14.5 WACC 12.11% 9.0 9.2 9.4 9.7 10.1 10.5 11.1 12.0 13.11% 8.2 8.4 8.6 8.8 9.0 9.3 9.7 10.3 14.11% 7.6 7.7 7.9 8.0 8.2 8.4 8.7 9.0 15.11% 7.1 7.2 7.3 7.4 7.5 7.7 7.9 8.1 Source: J.P. Morgan estimates. 105 333
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Shanda Games: Summary of financials Income statement Ratio analysis US$ in millions, year-end December %, year-end December FY08 FY09 FY10E FY11E FY12E FY08 FY09 FY10E FY11E FY12E Revenues 491 703 656 728 825 Gross Margin 55.9 59.8 58.9 59.9 60.6 Cost of Goods Sold 216 283 270 291 325 EBITDA margin 39.6 42.4 35.8 36.0 37.0 Gross Profit 274 420 386 436 500 Operating Margin 34.3 36.1 29.5 29.8 30.7 R&D Expenses 35 50 66 79 90 Net Margin 27.7 30.2 27.5 25.7 26.7 SG&A Expenses 71 117 126 140 157 R&D/sales 7.1 7.1 10.1 10.9 10.9 Share-based Expense 3 18 15 14 14 SG&A/Sales 14.6 16.6 19.2 19.2 19.0 Operating Profit (EBIT) 168 254 194 217 254 EBITDA 194 298 235 262 305 Sales growth 59.1 43.4 -6.8 11.0 13.4 Interest Income, net 5 4 8 12 16 Operating Profit Growth 102.6 51.0 -23.7 12.1 16.9 Investment Income (Exp.) 0 0 0 0 0 Net profit growth 72.9 56.4 -15.0 3.6 17.5 Other Income (Exp.) 1 25 28 22 25 Diluted EPS growth 72.9 54.9 -17.4 -0.8 16.9 Earnings before tax 174 282 230 251 295 Tax 36 63 45 58 68 Net Income (Reported) 136 213 181 187 220 Net debt to total capital -78.7 -89.7 -88.5 -91.2 -91.9 Net Income (Adjusted) * 139 231 196 201 234 Net debt to equity -78.7 -90.2 -88.5 -91.2 -91.9 US$ Diluted EPS (GAAP) 0.49 0.75 0.62 0.62 0.72 Asset Turnover 138.2 109.8 79.4 69.4 63.8 Adj. Diluted EPS * 0.50 0.82 0.67 0.66 0.77 Working Capital Turns (X) 10.0 3.9 1.6 1.2 1.0 BPS 0.6 1.4 2.1 2.8 3.6 ROE 91.3 80.5 38.1 28.3 25.6 DPS 0.0 0.0 0.0 0.0 0.0 ROIC 85.9 81.6 37.4 27.7 24.9 Shares Outstanding (Mn) 279 282 290 303 304 Balance sheet Cash flow statement US$ in millions, year-end December US$ in millions, year-end December FY08 FY09 FY10E FY11E FY12E FY08 FY09 FY10E FY11E FY12E Cash and cash equivalents 125 374 545 732 940 Net Income 136 213 181 187 220 Accounts receivable 64 62 91 105 116 Depr. & Amortisation 23 26 26 31 38 Inventories 0 0 0 0 0 Change in working capital 15 7 -33 6 5 Others 40 46 48 56 62 Other -7 25 19 19 20 Current assets 230 482 684 893 1,118 Cash flow from operations 166 271 192 244 283 LT investments 3 1 3 3 3 Capex / Investments -18 -61 -8 -44 -59 Net fixed assets 14 28 30 43 63 Others -3 2 -2 0 0 Other LT assets 108 129 109 109 109 Cash flow from investing -21 -59 -10 -44 -59 Total assets 355 641 826 1,048 1,294 Free cash flow 148 210 184 199 225 Liabilities Equity raised/ (repaid) -52 168 9 -14 -14 ST loans 0 2 0 0 0 Debt raised/ (repaid) 0 2 -2 0 0 Payables 14 14 14 16 18 Other -63 -65 -10 1 -3 Others 157 168 165 191 213 Dividends paid 0 -78 0 0 0 Total current liabilities 171 185 180 208 230 Cash flow from financing -115 28 -4 -12 -17 Long term debt 0 0 0 0 0 Other liabilities 4 6 4 4 4 Net change in cash 39 249 171 187 208 Total liabilities 176 190 184 212 234 Beginning cash 87 125 374 545 732 Shareholders' equity 159 413 616 803 1,023 Ending cash 125 374 545 732 940 Minority interests 20 30 26 33 37 Total Liabilities and Equity 355 633 826 1,048 1,294 Source: Company data and J.P. Morgan estimates. *Note: Excluding share-based compensation expenses. 106 334
  • Global Equity Research 03 January 2011 Shanda Interactive Overweight Entertainment Ltd SNDA, SNDA US Price: $39.60 New Businesses Shaping Up Well But Stock Price Still Price Target: $47.00 Hinges On Online Games  We expect Shanda Interactive to continue investing in its Shanda Online and Internet Shanda Literature businesses in 2011. Still, we think the stock price will largely AC Dick Wei depend on the performance of its gaming business, Shanda Games. (852) 2800-8535 dick.x.wei@jpmorgan.com  Good Shanda Online outlook: Shanda Online is an integrated service platform J.P. Morgan Securities (Asia Pacific) Limited providing total solutions to all kinds of accounts and application developers. The three core service modules are content delivery, promotion & payment, and Ritesh Gupta customer relationship management. Shanda Online is also working to include (91-22) 6157 3307 ritesh.z.gupta@jpmorgan.com the systematic integration of users’ personal information, preferences, messages, relationships. There are a total of 72 third-party providers working J.P. Morgan India Private Limited with Shanda Online. We expect the segment to see good traction in 2011, as Imran Khan Shanda continues to improve its presence in this area. (1-212) 622-6693 imran.t.khan@jpmorgan.com  Shanda Literature continues to see good traction: The Literature business J.P. Morgan Securities Inc. achieved solid sequential growth in 3Q10 by implementing its core strategy of establishing a complete copyright operation platform. In addition, Shanda Price Performance Literature (SDL) recently unveiled its Cloudary initiative, combining Shanda 65 Literature's rich IP library with the content from external parties. The Cloudary $ 50 offers a massive online collection of literary works. It brings together over 70 billion Chinese characters of literary content, 3 million copyrighted books and 35 more than 1000 electronic magazines and periodical publications. SDL Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 currently works with more than 100 publishers for its Cloudary initiatives. SNDA share price ($) NASDAQ Composite (rebased) Bambook has also been a decent success for SDL. YTD 1m 3m 12m  2011 outlook: We maintain our Overweight rating on Shanda, given its low- Abs -30.6% -1.0% 2.5% -23.4% valuation and high cash level. We maintain our view that: (1) Shanda Games’ Rel -46.1% -6.6% -9.7% -39.9% potential success is in its new games, (2) potentials exist in Shanda Online, Ku6 and other new ventures, and (3) the company continues to make synergetic investments to become a leading interactive entertainment provider in China, generating additional sources of revenues. Reuters: SNDA, Bloomberg: SNDA US (US$MM, Y/E - Dec) FY09 FY10E FY11E FY12E FY09 FY10E FY11E FY11E Net Sales 767.2 807.9 937.8 1,074.8 ROE (%) 25.1 8.6 8.2 8.7 52-week range US$36.3-59.9 Operating profit 298.5 141.6 155.4 180.6 ROIC (%) 22.5 7.7 7.6 8.1 Shares outstg. 69M EBITDA 367.1 226.2 246.0 287.0 Qtr GAAP Dil EPS (US$) 1Q 2Q 3Q 4Q Avg daily vol. 0.23M Net Profit 233.1 91.5 92.8 109.2 EPS FY09 1.02 1.18 1.27 1.40 Avg daily value US$9.2M Reprtd. EPS (US$) 3.38 1.36 1.31 1.53 EPS FY10E 0.90 0.56 0.51 0.53 Index (NASD) 2,667 P/E (x) 11.7 29.2 30.2 25.9 EPS FY11E 0.60 0.60 0.63 0.64 Free float 49% Adj. EPS (US$) * 3.74 1.83 1.68 1.90 1M 3M 12M Div yield (%) 0% Adj. P/E (x) 10.6 21.6 23.5 20.9 Absolute perf. (%) 0.4 3.6 -23.4 Market Cap US$2.7B EV/EBITDA 6.5 10.6 9.7 8.4 Relative perf. (%) -4.8 -8.7 -40.8 Price target US$47 P/B (x) 1.6 1.5 1.5 1.4 Cash & Equiv. (US$ M) 1,912 2,030 2,227 2,446 Price date: Dec 29, 2010 Y/E BPS (US$) 24.5 26.6 27.1 28.8 Equity (US$ M) 1,690 1,790 1,918 2,061 Source: Company data, Bloomberg, J.P. Morgan estimates. * Note: We have included share-based compensation adjustments starting in 2006.
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com 2011 and 2012 Outlook We expect Shanda Interactive to generate US$937.8M (up 16.1% Y/Y) in revenues for F’11 and adjusted EPS (exc. Share-based expenses) of US$1.68 for 2011. We expect F’12 revenues of US$1,074.8M (up 14.6% Y/Y) and adjusted EPS of US$1.90 (up 16.5% Y/Y). Rating, Price Target and Valuation Remain Overweight on Shanda We maintain our Overweight rating on Shanda, given its low valuation and high cash levels. We maintain our view that: (1) Shanda Games’s potential success is in its new games, (2) potentials exist in Shanda Online, Ku6 and other new ventures, and (3) the company continues to make synergetic investments to become a leading interactive entertainment provider in China, generating additional sources of revenues. Dec-11 price target of US$47 Our Dec-11 PT of US$47 is based on SOTP valuation. Our price target of US$47 implies 35.8x 2011E and 30.8x 2012E diluted adjusted EPS. Shanda has net cash (excluding Shanda Games cash) of US$1.259B (or US$18.2 per share). Excluding cash, our PT implies 22.0x 2011E and 18.8x 2012E P/E. Our PT of US$47 is based on SOTP valuation. We assume: (1) Value of Shanda Game of US$1.29B (given the large 70% stake Shanda owns, we believe it is reasonable to assume a liquidity discount of 20% from US$1.61 B, which is based on our Shanda Games PT of US$8 ). (2) Other non-game business (SDO, SDL, and others) of US$740M. We assume an 8x forward P/E multiple for the group of businesses. (3) Net cash level of US$1.4B (excluding Game cash and net of debt). We do not apply any discount to the cash level. While the company will likely invest its cash in new non-game businesses and as such reduce its cash level, we believe these new initiatives would create value in the longer term. DCF valuation of US$56.6 assumes a WACC of 11.9%, a 10-year revenue growth and 0% terminal growth. We believe DCF is a good tool to value the company. However, with risks in the game pipeline, we believe Shanda Games may not be able to trade at its DCF valuation. Shanda: SOTP Valuation Table SOTP valuation (US$M) At current GAME share price of US$6.3 At current GAME TP of US$8 Market value of Shanda Games (70% of GAME) 1,270 1,613 M.V. after applying 20% holding company discount: 1,016 1,290 Value of non-game initiatives: 738 738 Cash & ST investment at SNDA(excluding GAME cash)* 1,412 1,412 Debt at SNDA (153) (153) Sum: 3,013 3,287 Value per diluted share (US$): 42.6 46.5 Source: J.P. Morgan. 108 336
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Near-term share price drivers We expect the share price could still trade sideways, given lack of strong guidance from Shanda Games and new initiatives We expect share price drivers to be a few quarters away, with (1) better performance of Shanda Games, (2) non game initiatives see stronger-than-expected growth, (3) further synergetic investments to lead to higher value of Shanda Group. Risks to Our Rating and Price Target Downside risks include: (1) Existing games experiencing a significant decline from lack of new content or promotion; (2) new, big titles MMORPG seeing lower-than- expected gamer interest; (3) large investment do not provide near-term profitability, and (4) new investments fail to generate expected value. DCF Model (Base Case Scenario) FY10E FY11E FY12E FY13E FY14E FY15E FY16E FY17E FY18E FY19E FY20E Sales growth 5.3% 16.1% 14.6% 13.2% 12.7% 11.9% 12.0% 12.0% 12.0% 12.0% 12.0% EBIT margin 21.6% 19.4% 19.3% 18.9% 18.8% 18.9% 18.9% 18.9% 18.9% 18.9% 18.9% NOPAT margin 11.7% 14.7% 14.6% 14.3% 14.3% 14.3% 14.3% 14.3% 14.3% 14.3% 14.3% Year-end net fixed assets turns 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0 Year-end net working capital turns (4.0) (4.0) (4.0) (4.0) (4.0) (4.0) (4.0) (4.0) (4.0) (4.0) (4.0) Year-end net other assets turns 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 2.5 Cash operating taxes as % of EBIT 24.0% 24.0% 24.0% 24.0% 24.0% 24.0% 24.0% 24.0% 24.0% 24.0% 24.0% Year-end Invested capital turns 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 Source: Company data, J.P. Morgan estimates. DCF Sensitivity Analysis Terminal growth (%) 0% 1% 2% 3% 4% 5% 6% 7% 9.92% 67.3 70.1 73.6 78.1 84.1 92.5 105.2 126.7 10.92% 61.4 63.4 65.9 69.0 73.0 78.4 86.0 97.4 WACC 11.92% 56.6 58.1 59.9 62.1 64.9 68.5 73.3 80.1 12.92% 52.6 53.7 55.1 56.7 58.7 61.2 64.5 68.8 13.92% 49.3 50.2 51.2 52.4 53.9 55.7 57.9 60.8 14.92% 46.5 47.1 47.9 48.9 50.0 51.3 52.9 54.9 15.92% 44.1 44.6 45.2 45.9 46.8 47.8 48.9 50.4 Source: J.P. Morgan estimates. 109 337
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Shanda: Summary of financials Income statement Ratio analysis US$ in millions, year-end December %, year-end December FY08 FY09 FY10E FY11E FY12E FY08 FY09 FY10E FY11E FY12E Revenues 519 767 808 938 1,075 Gross Margin 71.9 71.7 61.9 61.6 61.8 Cost of Goods Sold 146 217 308 360 411 EBITDA margin 48.3 47.9 28.0 26.2 26.7 Gross Profit 374 550 500 577 664 Operating Margin 40.4 38.9 17.5 16.6 16.8 R&D Expenses 40 61 91 103 118 Net Margin 34.5 30.4 11.3 9.9 10.2 SG&A Expenses 124 191 267 319 365 R&D/sales 7.7 8.0 11.2 11.0 11.0 Operating Profit (EBIT) 210 299 142 155 181 SG&A/Sales 23.8 24.8 33.1 34.0 34.0 EBITDA 251 367 226 246 287 Interest Income 10.5 2.0 3.5 0.0 0.0 Sales growth 44.7 46.8 5.3 16.1 14.6 Interest Expense -4.1 -8.2 0.0 0.0 0.0 Operating Profit Growth 43.4 41.4 -52.6 9.7 16.3 Investment Income (Exp.) 1.2 6.2 0.0 0.0 0.0 Net profit growth -11.7 29.2 -60.8 1.4 17.7 Non-Operating Income (Exp.) 3.9 29.8 18.5 14.1 16.1 EPS (Reported) growth -2.1 36.4 -59.8 -3.3 16.5 Earnings before tax 221 328 164 169 197 Tax -40 -71 -47 -43 -49 Net Income (Reported) 179 233 91 93 109 Net debt to total capital -67.3 -95.4 -96.8 -100.4 -103.8 Net Income (Adjusted) 187 258 124 119 136 Net debt to equity -84.8 -104.1 -105.0 -108.3 -111.4 US$ EPS (Reported) 2.48 3.38 1.36 1.31 1.53 Asset Turnover 55.2 32.4 32.4 34.4 36.2 EPS (Adjusted) 2.59 3.74 1.83 1.68 1.90 Working Capital Turns (X) 1.3 0.7 0.5 0.5 0.5 BPS 7.7 24.5 26.6 27.1 28.8 ROE 34.9 25.1 8.6 8.2 8.7 DPS 0.0 0.0 0.0 0.0 0.0 ROIC 29.9 22.5 7.7 7.6 8.1 Shares Outstanding (Mn) 72 67 65 69 69 Balance sheet Cash flow statement US$ in millions, year-end December US$ in millions, year-end December FY08 FY09 FY10E FY11E FY12E FY08 FY09 FY10E FY11E FY12E Cash and cash equivalents 619 1,912 2,030 2,227 2,446 Net Income 179 233 91 93 109 Accounts receivable 5 17 19 22 24 Depr. & Amortisation 33 44 52 64 80 Inventories 0 7 9 11 12 Change in working capital 39 59 -2 32 26 Others 49 58 68 80 91 Other 10 49 58 60 65 Current assets 673 1,993 2,126 2,339 2,574 Cash flow from operations 261 384 199 250 280 LT investments 14 12 12 12 12 Capex/investments -33 -148 -46 -82 -94 Net fixed assets 45 70 64 81 95 Others -11 2 0 0 0 Others 209 289 290 290 290 Cash flow from investing -44 -146 -46 -82 -94 Total assets 941 2,366 2,492 2,722 2,971 Free cash flow 228 236 153 168 186 Liabilities Equity raised/ (repaid) 27 923 -24 8 8 ST loans and payables 0 2 0 0 0 Debt raised/ (repaid) 146 7 -2 0 0 Payables 8 15 24 28 30 Other -175 122 -9 21 25 Others 182 261 265 310 348 Dividends paid 0 0 0 0 0 Total current liabilities 190 279 288 338 379 Cash flow from financing -2 1,051 -35 29 33 Long term debt 146 151 151 151 151 Other liabilities 6 11 35 35 35 Net change in cash 215 1,290 118 197 219 Total liabilities 342 441 474 523 564 Beginning cash 404 622 1,912 2,030 2,227 Shanda Shareholders' equity 557 1,690 1,790 1,918 2,061 Ending cash 619 1,912 2,030 2,227 2,446 MI 42 234 227 282 346 Total liabilities and Equity 941 2,366 2,492 2,722 2,971 Source: Company data and J.P. Morgan estimates. *Note: Excluding share-based compensation expenses. 110 338
  • Global Equity Research 03 January 2011 Neutral Sina Corp SINA, SINA US Price: $70.31 Miniblog and Video Portal to Expand Portal Price Target: $68.00 Leadership. Remain Neutral on Valuation  Sina to remain as the leading portal in China: We maintain our view that Internet Sina should continue to be the leading portal in China. Secular online AC Dick Wei advertising growth and Sina’s leadership position should be positive drivers in (852) 2800-8535 the long run. However, we also note media segregation leading to market share dick.x.wei@jpmorgan.com loss to other verticals, online videos, and social network sites. J.P. Morgan Securities (Asia Pacific) Limited  Platform strategy playing out well: We believe video and microblogs should Ritesh Gupta continue to help maintain traffic share at Sina's portal. In terms of monetization, (91-22) 6157 3307 ritesh.z.gupta@jpmorgan.com we do not see much direct contribution from microblogs till end of next year. J.P. Morgan India Private Limited  Sina to maintain leadership in microblogging: Sina continued to maintain its Imran Khan leadership in microblogging with the number of miniblog users surpassing 50M (1-212) 622-6693 in 3Q10 vs. 20M last quarter. The company has been adding more than 10M imran.t.khan@jpmorgan.com users during the last two months. We expect Sina Miniblog to further solidify J.P. Morgan Securities LLC Sina’s media influences, and to help maintain long-term advertising revenue growth across both PC and mobile platforms. Price Performance  Sina expects to monetize Miniblog through: (1) brand advertising and SME 70 $ advertising, targeted by 2H11, and (2) revenue share from applications built 50 around microblog platform, targeted by 2012. Sina has set up an Rmb200M 30 Miniblog fund with venture capital from Sequoia, IDG, and DFJ to support Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 third-party developers to develop applications on SINA’s Miniblog platform. SINA share price ($) NASDAQ Composite (rebased)  Video strategy: Sina won live broadcasting rights to NBA matches for the next YTD 1m 3m 12m three years. NBA games are a popular sports event amongst Chinese youth and Abs 53.7% 7.9% 35.9% 57.2% should enhance the portal traffic from young users. The company also plans to Rel 38.2% 2.3% 23.7% 40.7% add more licensed content in Video for next year.  2011 outlook: We expect a healthy online advertising growth rate of 28% for 2011. Auto is expected to be strong, while the growth rate should moderate due to a higher base effect. The company expects healthy growth in advertising from growing eCommerce activities in China. In addition, FMCG and luxury goods- related advertising should also gain traction. Sina brand advertising should also benefit from increased traffic generation from video (includes NBA video) and some contribution from microblogs in 2H11. Reuters: SINA, Bloomberg: SINA US US$ in millions, year-end December FY09 FY10E FY11E FY12E FY09 FY10E FY11E FY12E Sales 353.9 382.5 467.9 585.6 ROE (%) 47.8 8.0 8.4 10.2 52-Week range US$32.0-76.4 Operating Profit (EBIT) 27.8 77.7 102.3 129.9 ROIC (%) 42.6 6.9 7.5 9.2 Shares Outstg. 67Mn EBITDA 81.9 114.3 140.7 173.9 Qtr GAAP EPS ($) 1Q 2Q 3Q 4Q Avg. daily vol. 1.5Mn Pre Tax Profit 415.7 99.7 123.5 169.2 EPS FY09 0.17 0.23 0.29 5.95 Avg. daily value US$105M Reported Net profit 407.4 89.0 104.0 143.0 EPS FY10E 0.30 0.31 0.40 0.34 Index (NASD) 2,667 Reported EPS (US$) 6.64 1.35 1.55 2.11 EPS FY11E 0.23 0.36 0.44 0.51 Free float 73% P/E (x) 10.6 52.1 45.5 33.3 1M 3M 12M Dividend Yld (%) 0% Adjusted EPS 7.26 1.71 2.00 2.56 Abs. Perf.(%) 13.8 35.5 57.6 Market Cap US$4.2B Adj. P/E (x) 9.7 41.1 35.1 27.4 Rel. Perf.(%) 8.7 23.3 40.1 Price Target US$68 EV/EBITDA 45.9 32.9 26.7 21.6 Price date Dec 29, 2010 P/B (x) 3.5 3.2 2.9 2.6 Cash 746 615 693 784 Y/E BPS (US$) 20.3 22.2 24.1 26.7 Equity 1,222 1,361 1,491 1,663 Source: Company data, Bloomberg, J.P. Morgan estimates. Note: We have excluded quarterly revenue of US$4.7M related to CRIC IPO starting 4Q09.
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com 2011 and 2012 Outlook We expect 2011 revenues to be US$467.9M (up 22.3% Y/Y) and adjusted EPS (excluding share based expenses) of US$2.00 (up 16.9% Y/Y). 2012 revenues are expected to be US$585.6M (up 25.2% Y/Y) and adjusted EPS of US$2.56 (up 28.2% Y/Y). Rating and Price Target Remain Overweight with Dec-11 PT of US$68 We remain Overweight with Dec-11 PT of US$68. Our PT is based on SOTP valuation of Sina’s organic business (valued at US$39.8), Weibo (valued at US$10), 33% holding in CRIC (valued at US$6), and gross cash of US$13. Value Weibo at US$664M We value Weibo based on 80M active Weibo users in 2012. In addition page view, we also include small revenue from revenue-sharing of third-party apps and other VAS to small to medium-sized enterprises. We estimate the business to generate net income of US$27M. We assign a 25x P/E, or a value of US$664M. Excluding equity income from CRIC, we value Sina business based on SOTP valuation (see table below). The mid-range of SOTP valuation is US$62. Excluding equity earnings from CRIC and excluding interest income, 11E/12E adjusted diluted EPS are US$1.51 and US$2.07, respectively. Excluding values of Weibo and CRIC, or at a share price of US$52, this implies Sina’s core business (excluding Weibo) is valued at 34.6x ’11E and 24.9x ’12E diluted adjusted P/E. Excluding gross cash of US$13, values of Weibo and CRIC, share price of US$39 implies Sina’s organic business is valued at 25.9x ’11E and 18.6x ’12E diluted adjusted P/E. We believe this is a fair P/E multiple, given a CAGR growth rate of roughly 25% over the next few years, or PEG ratio of around 1x. We value Sina’s 33% holding in CRIC based on the share price of US$10. This represents US$405M or US$6.1 per Sina share (with a 15% holding discount). As such, we value this part of the business at US$6.1. At our PT of US$68, this implies 34.0x/26.5x 11E/12E diluted adjusted P/E, or at ex- cash 30.0x/23.5x 11/12 P/E. The company has convertible debt of US$100M, but we believe looking at gross cash is more relevant, as dilution impacts from convertible debt has already been reflected in diluted share counts. Maintain our Neutral rating We maintain our Neutral rating on Sina due to: (1) high expected 2011 ad growth, (2) newly listed vertical sites and video sites could compete with Sina (and may limit revenue upside), and (3) cautious in assigning a large value to Miniblog, which will likely not contribute meaningful earnings until 2012 — such assigned value is likely to change at high beta. 112 340
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Sina to remain the leading portal in China We maintain our view that Sina should continue to be the leading portal in China. Secular online advertising growth and Sina’s leadership position should be positive drivers in the long run. However, we also note media segregation leading to market share loss to other verticals, online videos, and social network sites. Risks to Our Rating and Price Target Upside risks to our price target include better-than-expected online advertising growth and better-than-expected performance for Weibo. Downside risks to our price target include a decline in online ad gross margin, lower- than-expected growth in advertising spending in China, and competition with other Internet vertical sites. In addition, changes in regulations in wireless value-added space, as well as further declines in wireless-related revenue due to strong competition and regulatory changes are downside risks. 2011 Sum-of-the-parts valuation (2012E) Business lines Earnings (US$M)* Multiple (x) Value (US$M) Low- End Hi -End Low- End Hi -End Advertising 108.9 20 25 2,178.9 2,723.6 WVAS 12.2 10 15 121.5 182.3 Others 1.5 10 15 14.7 22.0 Weibo 664.5 664.5 Gross cash and investments 857.0 857.0 Total value* 3,836.6 4,449.4 Price per dil. share (US$) 57.1 66.2 Average Price (US$) 61.7 Source: J.P. Morgan. Note: * Exclude earnings contribution from CRIC. SINA—DCF model (base case scenario) 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E Sales growth 8.1% 22.3% 25.2% 22.6% 20.6% 18.8% 17.5% 16.7% 15.8% 15.5% 15.5% EBIT margin 23.9% 24.9% 25.1% 25.2% 25.2% 25.2% 23.2% 22.7% 22.7% 22.7% 21.8% NOPAT margin 17.5% 21.5% 21.6% 21.7% 21.8% 21.8% 20.0% 19.6% 19.6% 19.6% 18.8% Year end net fixed assets turns 27.4 15.0 15.0 15.0 15.0 15.0 15.0 15.0 15.0 15.0 15.0 Year end net working capital turns 1.4 1.5 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 Year end net other assets turns 0.5 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 Cash operating taxes as % of EBIT 13.8% 13.8% 13.8% 13.8% 13.8% 13.8% 13.8% 13.8% 13.8% 13.8% 13.8% Year end Invested Capital turns 0.4 1.0 1.2 1.2 1.2 1.2 1.2 1.2 1.2 1.2 1.2 Source: J.P. Morgan estimates. DCF sensitivity analysis Terminal Growth (%) 0% 1% 2% 3% 4% 5% 6% 7% 9% 60.3 63.0 66.6 71.3 78.0 87.9 104.5 137.6 10% 53.2 55.1 57.5 60.5 64.5 70.2 78.6 92.7 WACC 11% 47.7 49.0 50.6 52.6 55.1 58.5 63.3 70.5 12% 43.2 44.1 45.2 46.6 48.3 50.4 53.3 57.3 13% 39.6 40.2 41.0 41.9 43.0 44.4 46.2 48.7 14% 36.5 37.0 37.5 38.2 38.9 39.9 41.1 42.6 15% 34.0 34.3 34.7 35.2 35.7 36.3 37.1 38.1 Source: J.P. Morgan estimates. 113 341
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Sina Corp: Summary of financials Income statement Ratio Analysis US$ in millions, year-end Dec FY08A FY09A FY10E FY11E FY12E %, year-end Dec FY08A FY09A FY10E FY11E FY12E Revenues 370 354 383 468 586 Gross Margin 60.2 56.8 57.3 57.4 57.2 Cost of Goods Sold 147 153 163 199 250 EBITDA margin 24.9 15.1 26.3 26.7 26.6 Gross Profit 223 201 219 268 335 Operating Margin 20.2 9.2 20.3 21.9 22.2 R&D Expenses 28 30 31 36 47 Net Margin 21.8 115.1 23.3 22.2 24.4 SG&A Expenses 118 135 107 129 157 R&D/sales 7.7 8.4 8.2 7.7 8.0 Operating Profit (EBIT) 75 33 78 102 130 SG&A/Sales 32.0 38.1 28.0 27.6 26.9 EBITDA 92 53 101 125 156 Interest Income 17.7 8.1 8.3 7.0 9.6 Sales growth 50.2 -4.2 8.1 22.3 25.2 Interest Expense 0 0 0 0 0 Operating Profit Growth 46.2 -56.4 139.0 31.6 27.0 Investment Income (Exp.) 0.0 0.0 13.7 14.2 29.8 Net profit growth 39.7 405.2 -78.2 16.8 37.6 Non-Operating Income (Exp.) 2.4 375.1 0.0 0.0 0.0 EPS (Reported) growth 37.9 397.8 -79.7 14.5 36.5 Earnings before tax 95 416 100 123 169 Tax -14 -8 -11 -20 -26 #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0! Net Income (Reported) 81 407 89 104 143 Net debt to total capital -39.5 -49.0 -35.3 -37.4 -38.9 Net Income (Adjusted) * 94 445 113 134 174 Net debt to equity -45.8 -53.0 -37.9 -39.9 -41.2 US$ EPS (Reported) 1.33 6.64 1.35 1.55 2.11 Asset Turnover 44.9 21.9 22.6 25.6 29.2 EPS (Adjusted) * 1.56 7.26 1.71 2.00 2.56 Working Capital Turns (X) 0.7 0.5 0.5 0.5 0.6 BPS 11.10 20.29 22.16 24.12 26.72 ROE 17.0 47.8 8.0 8.4 10.2 DPS 0.00 0.00 0.00 0.00 0.00 ROIC 12.3 42.6 6.9 7.5 9.2 Shares Outstanding (Mn) 56 54 61 62 62 ROIC (net of cash) 24.2 79.9 11.1 11.3 14.5 Balance sheet Cash flow statement US$ in millions, year-end Dec FY08A FY09A FY10E FY11E FY12E US$ in millions, year-end Dec FY08A FY09A FY10E FY11E FY12E Cash and cash equivalents 383 746 615 693 784 Net Income 81 407 89 104 143 Accounts receivable 79 75 80 103 126 Depr. & Amortisation 17 21 23 22 26 Short-term investments 221 75 236 236 236 Change in working capital 5 22 -51 -7 -6 Others 9 22 28 36 44 Other 14 33 14 16 18 Current assets 692 919 958 1,068 1,189 Cash flow from operations 117 483 75 136 181 LT investments 0 581 633 661 721 Capex/investments -29 -5 -12 -20 -23 Net fixed assets 34 23 14 12 10 Others -14 -435 -213 -28 -60 Others 96 91 89 88 87 Cash flow from investing -43 -440 -225 -48 -82 Total assets 822 1,614 1,694 1,830 2,007 Free cash flow 88 478 63 116 158 Liabilities Equity raised/ (repaid) 10 -33 -3 10 11 ST loans 0 0 0 0 0 Debt raised/ (repaid) 0 0 0 0 0 Payables 1 2 6 8 10 Other 27 353 21 -19 -19 Others 94 123 78 101 124 Dividends paid 0 0 0 0 0 Total current liabilities 95 125 85 110 134 Cash flow from financing 37 320 18 -9 -8 Long term debt 99 99 99 99 99 Other liabilities 8 168 149 130 112 Net change in cash 112 363 -132 79 90 Total liabilities 202 392 333 339 345 Beginning cash 272 383 746 615 693 Shareholders' equity 621 1222 1361 1491 1663 Ending cash 383 746 615 693 784 Source: Company data, J.P. Morgan estimates. * Note: We have included share-based compensation adjustments starting 2006. 114 342
  • Global Equity Research 03 January 2011 Overweight Sohu.Com SOHU, SOHU US Price: $65.76 Potential Upside from Ad Margin and Games to Drive Price Target: $89.00 Share Price We maintain our Overweight rating on Sohu with a Dec-11 PT of US$89. We Internet expect advertising margin expansion and upside from DMD to be share price AC Dick Wei drivers for the stock in 2011. (852) 2800-8535 dick.x.wei@jpmorgan.com  Expect Sohu to maintain brand advertising market share: We expect Sohu J.P. Morgan Securities (Asia Pacific) Limited 2011 brand revenue to grow by 19%. Increased video monetization should help overall brand advertising revenues for Sohu, in over view. We expect autos, Ritesh Gupta (91-22) 6157 3307 fast-moving consumer goods, and eCommerce to be key segments to watch. ritesh.z.gupta@jpmorgan.com While real estate revenues should continue to be affected by new government J.P. Morgan India Private Limited policies and regulations, penetration into second-tier cities is likely to drive growth. Imran Khan (1-212) 622-6693  2011 to experience margin expansion in online advertising: With a positive imran.t.khan@jpmorgan.com macro environment, we believe Sohu should see margin expansion on the back J.P. Morgan Securities LLC of fixed portal costs. We expect online advertising margins in 2011 to expand to 61.1% from 60.5% in 2010E. We believe Sohu could see more margin leverage Price Performance in 2011, as the company plans to reduce spending on video and begin to get 80 more traction from video advertising. $ 60  Upside to come from online game business: Based on Street consensus, 40 Sohu’s game division (Changyou) currently trades at 8.3x ‘11 and 7.3x ’12 P/E. Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 We expect earnings upside could come from the launch of DMD (likely 1H’11), SOHU share price ($) NASDAQ Composite (rebased) while multiple expansion could come from re-rating of leading game companies given sustained long-term growth. At our PT, we assume the game segment YTD 1m 3m 12m trades at 8.5x ‘11/’12 P/E. Abs 13.5% -10.9% 8.4% 14.9% Rel -4.0% -17.7% -6.1% -2.5%  2011 stock price drivers: Earning upgrades potential may come from: (1) stronger trend in online video monetization; (2) launch of Duke of Mountain deer generates strong interest amongst online gamers. Re-rating could happen from the multiple expansion of the online gaming sector through sustained solid growth by online gaming companies in 2011. Reuters: SOHU, Bloomberg: SOHU US US$MM, YE-Dec FY09 FY10E FY11E FY12E FY09 FY10E FY11E FY12E Net Sales 515.2 606.6 736.5 877.1 ROE (%) 38.9 31.2 29.7 27.4 52-Week range US$40.1-80.9 Operating Profit (EBIT) 204.4 223.0 268.6 322.7 ROIC (%) 38.1 30.7 28.8 26.4 Shares Outstg 38M EBITDA 238.0 313.6 327.1 387.4 Qtr GAAP EPS (US$) 1Q 2Q 3Q 4Q Avg daily value US$55M Pre Tax Profit 210.2 226.4 279.6 337.5 EPS FY09 1.15 0.79 0.88 0.75 Avg dly volume 1.2M Reported Net profit 147.8 144.3 197.0 237.5 EPS FY10E 0.73 0.82 1.01 0.94 Index (NASD) 2,667 Reported EPS (US$) 3.57 3.49 4.64 5.51 EPS FY11E 0.97 1.15 1.23 1.30 Free float 45% P/E (x) 17.8 18.2 13.7 11.6 1M 3M 12M Dividend Yld (%) 0% Adj. EPS * 3.99 4.13 5.39 6.28 Abs. Perf.(%) -12.8 7.9 12.2 Market Cap US$2.41B Adj. P/E (x) 16.0 15.4 11.8 10.1 Rel. Perf.(%) -18.0 -4.4 -5.3 Price Target US$89 EV/EBITDA 9.0 6.8 6.5 5.5 Cash 563.8 651.3 889.0 1,163.7 Price Date Dec 29, 2010 P/B (x) 4.1 3.2 2.5 2.0 Equity 609.8 799.5 1,048.5 1,341.2 Source: Company data, Bloomberg, J.P. Morgan estimates. * Note: We have included share-based compensation expense adjustments starting in 2006.
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Our Estimates and Outlook for 2011 and 2012 We are maintaining our F’11 revenue and adjusted EPS estimates of $736.5M and $5.39, respectively. Our F’12 estimates call for revenue and adjusted EPS estimates of $877.1M and $6.28, respectively. Rating and Price Target We maintain our Dec-11 PT of US$89. Our PT implies 21.5x 2010E, 16.5x 2011E and 14.2x 2012E diluted adjusted P/E, or 25.5x 2010E, 19.2x 2011E, and 16.2x 2011E GAAP P/E. Our price target is based on the midpoint of our sum-of-the-parts valuation of US$78-US$99.4. As a reference, our Dec-11 DCF value for Sohu is US$81, based on a 10-year DCF forecast, WACC of 12%, and terminal growth rate of 0%. Sohu’s portal At the mid-point of our SOTP valuation, portal is valued at US$1.3B, which we think is relatively low, compared with Sina at US$2.5B and Soufun at US$1.4B. Given Sohu’s brand name and content investment, we believe Sohu’s portal could see a higher valuation. However, due to Sohu’s portal recent content investments, we believe Sohu's portal cannot demand a higher value in the near term. Online games Based on Street consensus, Sohu’s game division (Changyou) trades at 8.8x ‘11 and 8x ’12 PE. At our PT, we assume game segment to trade at 8.5x 11/12 P/E, or an implied value of US$1.6B (including Sohu’s claim on Changyou cash). We expect earnings upside could come from the launch of DMD (likely 1H’11), while multiples expansion could come from re-rating of sustained solid growth for leading game companies. Sogou value at US$200 M Based on Alibaba’s investment amount, post money valuation for Sogou is US$150M. We have assumed a higher value, as we believe Alibaba’s cooperation will create value to Sogou. Baidu has ~80% market search share in China with ~US$40B market cap. For Sogou, it currently has ~1% market share. Making a direct comparison, this implies Sogou value of US$500M. Baidu is currently trading at 40.3x P/E 2011E. If we assume Sogou were also profitable with similar margins, then Sogou probably can only trade at 20x (given high growth end market, but not a dominant player). From this calculation, we estimate Sogou’s valuation to be US$200M. In other words, we take a more optimistic view that with Alibaba's investment, Sogou can have a higher value in the future. The US$50M value difference causes ~US$1 share price impact in our SOTP analysis. Sohu has net cash of US$510M or net cash of US$13.2 per diluted share (excluding Changyou’s claim cash). On a consolidated basis, Sohu has cash of US$609.3M as of 3Q10, or US$15.9 per diluted share. 116 344
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Risks to Our Rating and Price Target Risks to our price target include a slowdown in the Chinese economy that could result in lower online advertising revenue growth, significant market share loss in online advertising to other websites, and volatility in wireless revenue due to policy change at mobile operators. For online games business, delays in upgrade and new game launches, and regulatory changes also add to downside risks. Sohu Sum-of-the-Parts Valuation 2011E Net profit Multiple (x) Value Multiple (x) Value (US$M) (US$M) (US$M) Branded ads 74.8 16 1197.0 20 1496.3 WVAS 8.8 8 70.6 10 88.3 Games profit (after 66% of MI) 168.1 7 1176.6 10 1680.9 Sogou (53% holdings) -10.6 nm 106.0 nm 106.0 Sohu.com net cash and other 317.3 317.3 Claim on Changyou cash (66.7% of Changyou cash) 192.1 192.1 Total equity value 3059.6 3880.8 Value per diluted share 78.0 99.0 Mean value per share (US$) 88.5 Source: Company data, J.P. Morgan estimates. Sohu DCF Model (base case scenario) 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E Sales growth 17.7% 21.4% 19.1% 15.5% 16.3% 15.6% 15.0% 13.0% 13.0% 13.0% 13.0% EBIT margin 31.5% 31.1% 30.3% 29.5% 28.7% 27.9% 27.7% 27.7% 27.7% 27.7% 27.7% NOPAT margin 26.8% 26.4% 25.7% 25.1% 24.4% 23.8% 23.5% 23.5% 23.5% 23.5% 23.5% Year end net fixed assets turns 3.2 3.2 3.2 3.2 3.2 3.2 3.2 3.2 3.2 3.2 3.2 Year end net working capital turns (8.0) (8.0) (8.0) (8.0) (8.0) (8.0) (8.0) (8.0) (8.0) (8.0) (8.0) Year end net other assets turns 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 Cash operating taxes as % of EBIT 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% Year end Invested Capital turns 1.9 1.9 1.9 1.9 1.9 1.9 1.9 1.9 1.9 1.9 1.9 Source: Company data, J.P. Morgan estimates. DCF Sensitivity Analysis Terminal Growth (%) 0% 1% 2% 3% 4% 5% 6% 7% 10.00% 107.6 113.4 120.5 129.7 142.0 159.2 185.0 228.0 11.00% 93.0 97.0 102.1 108.3 116.4 127.1 142.1 164.7 12.00% 81.1 84.1 87.6 92.0 97.5 104.5 113.9 127.0 WACC 13.00% 71.3 73.5 76.1 79.3 83.1 87.9 94.0 102.2 14.00% 63.2 64.9 66.8 69.1 71.8 75.1 79.3 84.7 15.00% 56.4 57.6 59.1 60.8 62.7 65.1 68.0 71.7 16.00% 50.6 51.6 52.6 53.9 55.4 57.1 59.2 61.7 Source: J.P. Morgan estimates. 117 345
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Sohu.com: Summary of financials US$ in millions, year-end December Income statement Ratio Analysis FY08A FY09A FY10E FY11E FY12E % FY08A FY09A FY10E FY11E FY12E Revenues 429 515 607 737 877 Gross Margin 75.3 76.3 74.0 73.1 73.4 Cost of Goods Sold 106 122 158 198 233 EBITDA margin 44.0 46.2 51.7 44.4 44.2 Gross Profit 323 393 449 539 644 Operating Margin 38.2 39.7 36.8 36.5 36.8 R&D Expenses 43 48 62 67 89 Net Margin 37.0 28.7 23.8 26.7 27.1 SG&A Expenses 115 140 164 203 233 R&D/sales 10.0 9.4 10.2 9.1 10.1 Operating Profit (EBIT) 164 204 223 269 323 SG&A/Sales 26.9 27.2 27.0 27.5 26.5 EBITDA 189 238 314 327 387 Interest Income 4.3 5.0 4.7 11.0 14.8 Sales growth 127.1 20.1 17.7 21.4 19.1 Interest Expense 0 0 0 0 0 Operating Profit Growth 400.9 24.7 9.1 20.4 20.2 Investment Income (Exp.) 0.0 0.0 0.0 0.0 0.0 Net profit growth 354.1 -6.8 -2.4 36.5 20.6 Non-Operating Income (Exp.) -0.5 0.8 -1.3 0.0 0.0 EPS (Reported) growth 345.6 -11.7 -2.3 32.9 18.6 Earnings before tax 168 210 226 280 337 Tax -9 -34 -34 -37 -45 Net Income (Reported) 159 148 144 197 238 Net debt to total capital -81.5 -92.5 -81.5 -84.8 -86.8 Net Income (Adjusted)* 169 162 160 216 256 Net debt to equity -81.5 -92.5 -81.5 -84.8 -86.8 USD EPS (Reported) 4.04 3.57 3.49 4.64 5.51 Asset Turnover 82.2 62.2 55.3 53.3 51.3 EPS (Adjusted)* 4.30 3.99 4.13 5.39 6.28 Working Capital Turns (X) 2.6 1.4 1.2 1.1 1.0 BPS 10.13 15.68 20.14 25.89 32.48 ROE 56.0 38.9 31.2 29.7 27.4 DPS 0.00 0.00 0.00 0.00 0.00 ROIC 54.8 38.1 30.7 28.8 26.4 Diluted Shares (Mn) 39 39 39 40 41 Balance sheet Cash flow statement FY08A FY09A FY10E FY11E FY12E FY08A FY09A FY10E FY11E FY12E Cash and cash equivalents 314 564 651 889 1,164 Net Income 159 148 144 197 238 Accounts receivable 37 47 51 61 71 Depr. & Amortisation 14 16 63 26 30 Inventories 0 0 0 0 0 Change in working capital 29 27 -4 18 17 Others 28 11 42 50 58 Other 11 46 76 78 90 Current assets 379 621 744 1,001 1,293 Cash flow from operations 213 237 280 318 375 LT investments 0 0 0 0 0 Capex -24 -80 -209 -55 -66 Net fixed assets 76 115 125 154 189 Disposal/ (purchase) 0 0 0 0 0 Others 67 92 228 228 228 Cash flow from investing -24 -80 -209 -55 -66 Total assets 522 828 1,097 1,382 1,710 Free cash flow 189 156 71 263 309 Liabilities Equity raised/ (repaid) -2 59 18 19 21 ST loans 0 0 0 0 0 Debt raised/ (repaid) 0 0 0 0 0 Payables 4 5 7 8 9 Other 5 34 -1 -45 -55 Others 126 146 176 211 245 Dividends paid 0 0 0 0 0 Total current liabilities 131 150 182 218 254 Cash flow from financing 3 93 17 -26 -34 Long term debt 0 0 0 0 0 Other liabilities 5 68 115 115 115 Net change in cash 192 249 87 238 275 Total liabilities 136 218 297 334 369 Beginning cash 123 314 564 651 889 Shareholders' equity 386 610 799 1,048 1,341 Ending cash 314 564 651 889 1,164 Source: Company data, J.P. Morgan estimates. * Adjustments: excluding stock based compensation expense 118 346
  • Global Equity Research 03 January 2011 Overweight Tencent 0700.HK, 700 HK Price: HK$178.00 To Maintain Its Leadership Position in China Internet Price Target: HK$205.00 Space We expect Tencent to continue maintaining its leadership position in China’s Internet internet space in 2011. New revenue from open platform applications, social AC Dick Wei eCommerce, mobile platform launch, and a new game pipeline could be some of (852) 2800-8535 the drivers for 2011. We remain Overweight with a Dec-11 PT of HK$205. dick.x.wei@jpmorgan.com Ritesh Gupta • Expect Tencent to Maintain its Leadership in China internet: Tencent has (91-22) 6157 3307 established itself as a leading internet platform in China with its leadership in ritesh.z.gupta@jpmorgan.com social networking, online gaming, instant messaging, and online and wireless J.P. Morgan Securities (Asia Pacific) Limited portal. We expect Tencent to further leverage and monetize its platform in 2011 through new ventures in eCommerce, mobile internet, third-party apps, and, to a P r ic e P e r fo r m a n c e certain extent, online search. As a well-executed leader in China’s internet 180 space, Tencent is likely to remain a key beneficiary of rising disposable HK$ 150 incomes and increasing internet penetration in China. 120 • Open Platform to Be a Key Focus: The company has already created open Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 platform interfaces for four key products: (1) social networks, (2) SoSo, (3) 0700.HK share price (HK$) Paipai, and (4) Tenpay. The strategy is to increase user loyalty to Tencent’s HSI (rebased) community and eventually increase monetization. Tencent plans to upgrade YTD 1m 3m 12m “Xiaoyou” to “PengYou” with better open-platform support. Abs 2.8% 0.5% 2.5% 7.4% Rel -2.5% 1.4% -0.1% 0.6% • Online games Should Continue to Be Strong: We expect game segment growth to continue to be driven by Cross Fire and Dungeon & Fighter upgrades and new unannounced titles launch (both in-house and licensed games). Mobile games and mobile social games will increase loyalty to Tencent’s platform and help Mobile VAS revenue. • 2011 earnings drivers to come from: (1) potential upside in gaming revenue, driven by the launch of multiple games in 2011; (2) better-than-expected ad growth with macro pick-up and improving brand image; and (3) new growth potential in SNS (third party apps, eCommerce and others), and (4) early signs of the success of mobile internet products. Reuters: 0700.HK, Bloomberg: 700 HK Rmb MM, YE December FY09 FY10E FY11E FY12E FY09 FY10E FY11E FY12E Net sales 12,440 19,540 25,018 31,429 ROE (%) 54 51 43 37 52-week range HK$120.4-193.0 Operating profit (EBIT) 6,020 9,803 12,094 15,246 ROIC (%) 56 47 37 33 Shares outstg 1,851MM EBITDA 6,801 10,840 13,489 16,839 Qtr GAAP EPS (Rmb) 1Q 2Q 3Q 4Q Avg daily value US$ 114MM Net Profit 5,156 8,130 10,589 13,479 EPS FY09 0.57 0.65 0.77 0.81 Avg dly volume 4.5MM Adj. Net Profit 5,477 8,601 11,069 13,950 EPS FY10E 0.96 1.03 1.16 1.22 Index (HSI) 22,969 Reported EPS (Rmb) 2.79 4.37 5.63 7.10 EPS FY11E 1.27 1.36 1.46 1.54 Free float ~50% P/E (x) 54.3 34.7 26.9 21.4 1M 3M 12M Dividend yld (%) 0.3% Adj. EPS (Rmb) * 2.97 4.62 5.88 7.34 Abs. Perf.(%) 0.5 2.5 7.7 Market cap US$41.2B Adj. P/E (x) 51.1 32.8 25.8 20.6 Rel. Perf.(%) 1.3 -0.1 0.8 Price target HK$205 EV/EBITDA 39.1 24.5 19.7 15.8 Cash 11,354 19,066 30,270 44,212 Date of price Dec 29, 2010 P/BV (x) 25.7 16.2 10.6 7.4 Equity 12,179 19,473 30,149 43,497 YE BPS (Rmb) 6.7 10.6 16.3 23.3 Source: Company data, Bloomberg, J.P. Morgan estimates. * Note: Excluding share-based compensation expenses.
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Launch of Open Platforms to Be Next Growth Driver The company plans to expand Qzone and Tenpay into open platforms with the flexibility to host more third-party applications. By leveraging strong Qzone/QQ user base, the company creates a strong ecosystem with third-party content. By leveraging its strong The company is increasingly open to the idea of investing in small third-party Qzone/QQ user base, the developers focusing on developing applications for Qzone platform. In addition, company creates a strong ecosystem with third-party Tencent has been expanding its technology infrastructure to host more social content. applications to integrate Qzone with other content websites. For Tenpay, the company has been allowing other applications with payment needs to be integrated with its platform. The company has already been working with close to 100 applications. Tencent has been also working on developing a strategy to attract more applications with strong user interest on Tenpay. Our Estimates and Outlook for 2011 and 2012 We are maintaining our F’11 revenue and adjusted EPS estimates of Rmb25.0B and Rmb5.88, respectively. Our F’12 estimates call for revenue and adjusted EPS of Rmb31.4B and Rmb7.34, respectively. Valuation, Rating Analysis and Risks DCF valuation Our 10-year DCF-based valuation (assuming a WACC of 12% and a terminal growth rate of zero) yields a PT of HK$205. We expect Tencent to post a revenue CAGR of >20% from 2010 to 2015, and subsequently mid-teen growth from 2015 to 2021. We maintain our long-term growth forecast and DCF assumptions. We maintain our DCF-based Dec-11 PT of HK$205. Remain Overweight with a Dec-11 price target of HK$205 Our DCF-based Dec-11 price target of HK$205 implies 41.2x FY10E, 32.0x FY11E, and 25.3x FY12E reported EPS, or 38.9x FY10E, 30.6x FY11E, and 24.5x FY12E adjusted EPS, on the back of 41%/26% FY11E/12E EPS growth. The company has around HK$10.7 cash per share, after DST investments. We expect potential earnings upside to drive its share price further: (1) potential upside in gaming revenue, with new title and upgrade launches; (2) launch of new open-platform applications across QQ products, which also creates synergy in the QQ ecosystem, (3) better-than-expected ad growth with macro pick-up and improving brand image. Share price risks, in our view, include: tightened content censorship in China, revenue volatility of short-life cycle SNS applications, faster-than-expected decline in game revenue, and regulatory risks. 120 348
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Tencent: Summary of financials Rmb in millions, year-end December Income statement Ratio analysis FY08 FY09 FY10E FY11E FY12E %, year-end December FY08 FY09 FY10E FY11E FY12E Revenues 7,155 12,440 19,540 25,018 31,429 Gross Margin 69.7 68.7 68.2 68.5 68.6 Cost of goods sold 2,170 3,889 6,205 7,892 9,860 EBITDA margin 51.1 54.7 55.5 53.9 53.6 Gross profit 4,984 8,550 13,335 17,126 21,568 Operating Margin 43.8 47.8 49.2 48.3 48.5 R&D expenses 518 581 914 1,001 1,257 Net Margin 38.9 41.4 41.6 42.3 42.9 SG&A expenses 1,332 2,026 2,809 4,031 5,065 R&D/sales 7.2 4.7 4.7 4.0 4.0 Others 0 0 0 0 0 SG&A/Sales 18.6 16.3 14.4 16.1 16.1 Operating profit (EBIT) 3,134 5,943 9,612 12,094 15,246 EBITDA 3,654 6,801 10,840 13,489 16,839 Sales growth 87.2 73.9 57.1 28.0 25.6 Interest income 112 78 278 468 714 Operating Profit Growth 100.1 89.6 61.7 25.8 26.1 Investment income (exp.) 0.0 0.0 0.0 0.0 0.0 Net profit growth 77.8 85.2 57.7 30.3 27.3 Non-operating income (exp.) -140.7 -2.0 -1.1 0.0 0.0 EPS (Reported) growth 77.1 84.8 56.3 28.8 26.1 Earnings before tax 3,105 6,019 9,889 12,562 15,961 Tax -289 -819 -1,742 -1,956 -2,465 Net income (reported) 2,785 5,156 8,130 10,589 13,479 Net debt to total capital -73.0 -90.1 -65.3 -77.8 -85.3 Net income (adjusted) 2,945 5,477 8,601 11,069 13,950 Net debt to equity -73.0 -91.6 -78.2 -87.7 -92.8 Rmb EPS (Reported) 1.51 2.79 4.37 5.63 7.10 Asset Turnover 72.6 71.1 63.6 58.0 53.6 EPS (Adjusted) 1.60 2.97 4.62 5.88 7.34 Working Capital Turns (X) 1.9 1.9 1.9 1.5 1.1 BPS 3.88 6.73 10.65 16.30 23.27 ROE 45.6 53.7 51.4 42.7 36.6 DPS 0.14 0.35 0.45 0.58 0.73 ROIC 45.6 55.8 46.9 37.2 32.8 Diluted shares outstanding (MM) 1,841 1,845 1,861 1,882 1,900 Balance sheet Cash flow statement FY08 FY09 FY10E FY11E FY12E FY08 FY09 FY10E FY11E FY12E Total cash 5,129 11,354 19,066 30,270 44,212 Net income 2,785 5,156 8,130 10,589 13,479 Accounts receivable 983 1,229 1,910 2,401 3,001 Depr. & amortization 360 537 756 915 1,121 Inventories 5 0 0 0 0 Change in working capital 202 1,833 804 885 1,041 Others 378 574 1,465 1,817 2,274 Other 233 365 490 497 488 Current assets 6,496 13,157 22,440 34,488 49,486 Cash flow from operations 3,580 7,891 10,180 12,885 16,129 LT investments 389 972 3,246 3,246 3,246 Capex -1,705 -943 -2,437 -1,272 -1,568 Net fixed assets 2,041 2,623 3,480 3,837 4,283 Others -810 -584 -2,274 0 0 Others 930 753 1,577 1,577 1,577 Cash flow from investing -2,515 -1,526 -4,711 -1,272 -1,568 Total assets 9,856 17,506 30,744 43,148 58,593 Free cash flow 1,875 6,949 7,742 11,614 14,561 Equity raised/ (repaid) -301 255 124 666 746 Liabilities 0 202 3,838 3,838 3,838 Debt raised/ (repaid) -292 202 3,636 0 0 ST loans 245 697 1,318 1,652 2,048 Other -19 43 -704 -17 -17 Payables 1,847 3,664 5,418 6,813 8,514 Dividends paid -258 -639 -813 -1,059 -1,348 Others 2,092 4,563 10,574 12,303 14,400 Cash flow from financing -870 -140 2,243 -410 -619 Total current liabilities -76 0 0 0 0 Long term debt 0 0 0 0 0 Net change in cash 119 6,225 7,712 11,204 13,942 Other liabilities 743 764 697 697 697 F/X & term deposits change 1,190 0 0 0 0 Total liabilities 2,835 5,327 11,271 13,000 15,096 Beginning total cash 3,820 5,129 11,354 19,066 30,270 Shareholders' equity 7,021 12,179 19,473 30,149 43,497 Ending total cash 5,129 11,354 19,066 30,270 44,212 Source: Company data and J.P. Morgan estimates. *Note: Adjusted earnings exclude share-based compensation expense (non-cash) and one-time items. 121 349
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com 122 350
  • Global Equity Research 03 January 2011 Neutral The9 Limited NCTY, NCTY US Price: $5.05 New Three-legged Strategy But Still Lacks a Strong Price Target: $6.10 Game We expect weak operating performance for the company to continue in Internet 2011. Our Dec-11 PT of US$6.1 is at a 20% discount to year-end 2011 Dick Wei AC estimated cash per share. (852) 2800-8535 dick.x.wei@jpmorgan.com  Company has restructured into three divisions: (1) Global strategy: J.P. Morgan Securities (Asia Pacific) Limited Mainly based on R&D capability of Red 5 studio and other future Ritesh Gupta investments. Red 5 studio is led by an ex-World of Warcraft developer from (91-22) 6157 3307 Blizzard. (2) Domestic strategy: Maintain in-house and licensing strategy. ritesh.z.gupta@jpmorgan.com Currently, the company has an R&D staff of 300 for in-house development. J.P. Morgan India Private Limited (3) Alternative platform strategy: Mobile game/mobile game platform. Imran Khan The acquisition of minority stakes in Aurora Feint (an iPhone game (1-212) 622-6693 platform with 28M registered users and 2,220 games) to help jump-start imran.t.khan@jpmorgan.com The9’s mobile game business in China. J.P. Morgan Securities Inc.  Mobile gaming platform: The company has been trying to develop a Price Performance mobile gaming platform along with three telco carriers in China. The 9 company has tie-ups with Aurora Fient which runs the biggest game platform on iPhone in the US. The company also invested US$4 M in $ 6 Openfeint previously for a 13% stake. 3  Disclosed game pipeline includes: (1) 1Q11: Shen Xian Zhuan (in-house Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 game from Hang Zhou studio), (2) Free Realms (a cartoon-style MMORPG NCTY share price ($) licensed from Sony) to be launched in 2H11, and (3) Red 5, a subsidiary of NASDAQ Composite (rebased) The9 is also releasing a FPS game named Firefall in October 2011. The YTD 1m 3m 12m company terminated its online game FIFA Online from EA Sports recently. Abs -9.8% 1.1% 24.0% -7.7% The game was generating losses for the company. Rel -27.3% -5.7% 9.5% -25.1%  Expect losses to continue and the stock to trade below cash: With a small revenue base, while maintaining company headcount of 800 to support potential future growth, we forecast losses to continue in the medium term. The company currently has net cash of US$9.0 per share. We do not expect strong results from Shen Xian Zhuan launch by the end of 2010. As such, we believe the company still lacks share price drivers. Potential drivers could come from successes in handset games and Red 5 game. Reuters: NCTY; Bloomberg: NCTY US (US$ MM, Y/E-Dec) FY08 FY09 FY10E FY11E FY08 FY09 FY10E FY11E Sales 249.1 111.5 15.5 19.7 ROE (%) 6.3 -13.9 -12.9 -12.6 52-wk range (US$) 3.7-8.7 Operating profit 19.6 -70.8 -42.7 -37.9 ROIC (%) 4.5 -14.4 -13.0 -11.9 Shares outstg (MM) 25Mn EBITDA 60.7 -33.1 -27.4 -22.7 Qtr Diluted EPS (US$) 1Q 2Q 3Q 4Q Avg daily volume 0.1Mn Pre-tax profit 24.7 -57.6 -41.0 -35.5 EPS FY09 -0.26 -0.46 -0.43 -1.20 Avg daily value US$0.4Mn Reported Net Profit 14.1 -59.4 -38.8 -35.5 EPS FY10E -0.44 -0.38 -0.36 -0.35 Index (NASD) 2,667 GAAP EPS (US$) 0.51 -2.34 -1.53 -1.38 EPS FY11E -0.35 -0.35 -0.34 -0.34 Free float (%) 25% P/E (x) 13.5 nm nm nm 1M 3M 12M Dividend yld (%) 0% Adj. EPS (US$) 0.78 -1.99 -1.33 -1.21 Abs. Perf.(%) -1.7 35.5 -2.8 Market cap (US$) 0.17B Adj. P/E (x) 8.7 nm nm nm Rel. Perf.(%) -6.9 23.3 -20.3 Price target (US$) US$6.1 EV/EBITDA -1.2 2.3 2.7 3.3 Price Date Dec 29, 2010 P/B (x) 0.5 0.6 0.7 0.7 Cash (US$ MM) 323.2 245.5 215.4 192.8 Y/E BPS (US$) 14.3 11.8 10.4 9.2 Equity (US$ MM) 395.8 294.8 261.5 232.5 Source: Bloomberg, Company and J.P.Morgan estimates. Note: We have included share-based compensation adjustments starting 2006.
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com Our Estimates and Outlook for 2011 and 2012 We are maintaining our F’11 revenue and adjusted EPS estimates of $15.5M and $(1.33), respectively. Our F’12 estimates call for revenue and adjusted EPS estimates of $19.7M and $1.21, respectively. Rating and Valuation Our Dec-11 price target is US$6.1 We recently rolled over our Dec-10 PT of US$6.1 to Dec-11. The company had total cash of US$226M at the end of 1H10 with zero debt. We expect 2011-end cash to fall to US$192.5M. At 2011-end, the company is expected to have US$7.7 per ADS in cash. We keep our 2011-end PT at a 20% discount to estimated 2011-end cash. We remain Neutral on The9 due to low revenue visibility and earnings decline from operating losses and R&D investments. However, we believe the share price will be supported by the current cash level of US$9.0 per ADS. The stock has been trading in the range of a 20%-30% discount to net cash over the past few quarters. We expect The9 to continue to trade within this range. The company could trade closer to a 20% discount to its net cash, given the potential success of some of its new game launches. Share price drivers We believe drivers will come from strong gamer response from newly launched games and alternative platform strategy. Risks to Our Price Target and Rating Downside risks to our price target and rating include: (1) larger-than-expected investments in game titles and studios, (2) new game launches that disappoint. We expect positive share price drivers/risks to be: (1) Better-than-expected performance of The9’s new game launches, and (2) the company being an acquisition target (due to its high cash). 124 352
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com The9: Summary of financials Income statement Ratio analysis Rmb in millions, year-end December %, year-end December FY07 FY08 FY09 FY10E FY11E FY07 FY08 FY09 FY10E FY11E Revenues Gross Margin 1,280 1,711 761 106 134 45.3 41.7 6.3 -1.6 10.2 Cost of Goods Sold EBITDA margin 700 998 712 108 120 35.0 21.3 -40.6 -209.2 -138.1 Gross Profit 580 714 48 -2 14 Operating Margin 18.4 7.9 -63.5 -274.5 -192.6 R&D Expenses 41 74 114 121 104 Net Margin 18.8 5.7 -53.3 -249.8 -180.6 SG&A Expenses 284 423 338 169 168 R&D/sales 3.2 4.3 15.0 113.6 77.5 Operating Profit (EBIT) 236 135 -483 -291 -258 SG&A/Sales 22.2 24.7 44.4 159.3 125.4 EBITDA 448 365 -308 -222 -185 Interest Income 50.7 56.7 30.5 24.7 23.8 Sales growth 29.8 33.8 -55.6 -86.1 26.5 Interest Expense 0.0 0.0 0.0 0.0 0.0 Operating Profit Growth -12.7 -43.0 -458.9 39.7 11.3 Investment Income (Exp.) -5.7 -2.2 -2.6 -8.2 -3.6 Net profit growth -22.9 -59.8 -518.4 34.6 8.6 Non-Operating Income (Exp.) -30.1 -19.0 61.8 -5.0 -4.0 EPS (Reported) growth -31.8 -60.2 -556.1 32.1 11.0 Earnings before tax 251 170 -393 -280 -242 Tax -9 -48 6 0 0 Net Income (Reported) 241 97 -405 -265 -242 Net debt to total capital -72.4 -73.4 -79.6 -60.0 -58.1 Adj. Net Income (ex-123R exp.) 289 149 -346 -230 -212 Net debt to equity -75.1 -76.9 -81.2 -68.4 -67.2 RMB: Diluted EPS (Reported) 8.71 3.50 -15.95 -10.45 -9.41 Asset Turnover 39.4 52.5 32.7 4.4 6.0 Adj. EPS (ex-123R exp.) 10.44 5.38 -13.61 -9.08 -8.22 Working Capital Turns (X) 0.9 0.9 0.4 0.1 0.1 BPS 97.56 98.42 80.33 71.01 62.95 ROE 14.0 6.3 -13.9 -12.9 -12.6 DPS 0.00 0.00 0.00 0.00 0.00 ROIC 11.6 4.5 -14.4 -13.0 -11.9 Shares outstanding (MM) 27 28 26 25 25 ROIC (net of cash) 44.0 19.4 -69.9 -54.9 -41.0 Balance sheet Cash flow statement Rmb in millions, year-end December Rmb in millions, year-end December FY07 FY08 FY09 FY10E FY11E FY07 FY08 FY09 FY10E FY11E Cash and cash equivalents 2,215 2,221 1,675 1,469 1,315 Net Income 241 97 -405 -265 -242 Accounts receivable 27 9 2 2 3 Depr. & Amortization 212 230 174 69 73 Inventories 101 126 126 182 208 Change in working capital 31 7 1 11 23 Others 72 139 0 0 0 Other 49 77 160 20 31 Current assets 2,415 2,494 1,803 1,653 1,526 Cash flow from operations 533 412 -69 -165 -116 LT investments 179 403 395 408 404 Capex / investment -362 -46 -71 -271 -56 Net fixed assets 344 200 76 60 35 Others -144 -122 60 -13 4 Others 307 166 52 269 277 Cash flow from investing -506 -168 -11 -284 -53 Total assets 3,246 3,263 2,325 2,390 2,242 Free cash flow 171 365 -140 -435 -172 Liabilities Equity raised/ (repaid) 1,229 -138 -115 3 14 ST loans 107 129 41 0 0 Debt raised/ (repaid) 70 23 -88 208 0 Payables 285 345 22 30 35 Other -49 -123 -262 32 0 Others 48 69 248 307 352 Dividends paid 0 0 0 0 0 Total current liabilities 440 544 312 337 387 Cash flow from financing 1,250 -238 -466 243 14 Long term debt 0 0 0 249 249 Other liabilities 0 0 2 20 20 Net change in cash 1,277 5 -546 -206 -154 Total liabilities 440 544 314 607 656 Beginning cash 938 2,215 2,221 1,675 1,469 Shareholders' equity 2,806 2,719 2,011 1,784 1,586 Ending cash 2,215 2,221 1,675 1,469 1,315 Source: Company data and J.P.Morgan estimates. 125 353
  • Dick Wei Global Equity Research (852) 2800-8535 03 January 2011 dick.x.wei@jpmorgan.com 126 354
  • Japan Equity Research 03 January 2011 Underweight DeNA (2432) 2432.T, 2432 JT Japan Price: ¥2,954 Domestic Growth Peaking, Competitive Pressures Price Target: ¥2,200 Overseas We are maintaining our Underweight rating on DeNA, with a target price of Internet ¥2,200 to November 2011. We believe domestic growth prospects have peaked, AC and consequently we expect returns to fall due to greater competition and pressure Hiroshi Kamide (81-3) 6736 8602 to spend on marketing to keep market share. We have low expectations for hiroshi.kamide@jpmorgan.com DeNA’s plans for overseas expansion and believe that these efforts will not offset the declining domestic growth profile. Yusuke Maeda (81-3) 6736-8654  We maintain our Underweight rating. We view DeNA as being in the 'early yusuke.x.maeda@jpmorgan.com glory' phase of the mobile social gaming market cycle, as it dominates the JPMorgan Securities Japan Co., Ltd. domestic market (we estimate a 40% share in CY’10). We believe Y/Y growth rates have peaked, and although short-term earnings visibility is high the Price Performance decelerating Y/Y growth profile looks unattractive. Overseas expansion via 2,800 M&A does position the company strongly versus domestic peers, but we Y believe competitive threats are also high as the market overcrowds. Overall, we 2,200 believe medium-term growth prospects are muted as domestic demand enters a 1,600 declining profile, with measured advances to be gained overseas. With the Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 business exiting a high-growth phase and entering a flattening growth profile in 2432.T share price (Y our view, we rate the shares Underweight. TOPIX (rebased) Company Data  Domestic prospects diminishing, overseas competitive threats. Mobile social Price ¥2,954 gaming is a new developing market, and the supply/demand balance is still in Price date Dec. 29, 2010 favor of early movers with hit content. Social gaming content has the advantage Market capitalization ¥420.7B of being able to be changed and adjusted 'on the go' in order to meet user needs Shares outstanding 142.4M 52-week range ¥3,105– 1,680 and can have a long shelf life compared with traditional package software. TOPIX 908.01 However, with more games on the market we think the business model will Dividend (F’10E) ¥46.5 become more reliant on winning new users and keeping them active—we Dividend yield (F’10E) 1.6% believe marketing costs will rise, resulting in lower returns. As we think the ROE (F’10E) 63.9% domestic market is unlikely to see a reacceleration of demand, positioning in the Source: Bloomberg, J.P. Morgan estimates. overseas markets becomes important for DeNA. However, competitive threats are significantly higher, and we envisage that replicating the success seen domestically will be very difficult to execute overseas. Despite acquiring US app maker ngmoco and having access to overseas resources and the virtual social gaming network 'Plus+', we believe it will become a niche service given the preference of overseas users to operate with real social graphs.  Valuation and risks. The shares are trading at 11.0x our F’11 EPS forecast, which is not a demanding valuation in our opinion. On our medium-term forecasts with decelerating earnings growth that turns negative, we believe the shares offer little upside, and hence our Underweight rating. Risks to our price target include a reaccelerating growth profile in the domestic market and speedy and pronounced earnings generation from overseas expansion. Consolidated Sales Y/Y OP Y/Y RP Y/Y NP Y/Y EPS P/E P/B EV/EBITDA Y/E Mar (¥B) (%) (¥B) (%) (¥B) (%) (¥B) (%) (¥) (x) (x) (x) 2009 37.6 26.5 15.8 25.1 16.1 25.6 8.0 17.4 55.1 53.7 17.5 22.5 2010 48.1 27.9 21.3 34.2 21.5 33.7 11.4 42.9 79.8 37.0 12.2 17.1 2011E 113.3 135.5 55.5 160.8 55.7 158.9 33.1 191.0 232.4 12.7 6.1 6.7 2012E 140.1 23.7 64.0 15.3 64.2 15.2 38.1 15.2 267.7 11.0 4.0 5.8 2013E 141.3 0.9 61.8 -3.3 62.1 -3.3 36.9 -3.3 258.9 11.4 3.0 6.0 Source: Company data and J.P. Morgan estimates. Note: The company had not disclosed its earnings forecasts as of Dec. 29, 2010.
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Our Estimates and Outlook for F’11 We are maintaining our F’11 estimates for DeNA, with revenue of ¥140.1B and operating profit of ¥64.0B. Our key assumptions are as follows: • Average registered monthly users—We estimate the number of annual average registered users will grow 12.3% Y/Y to 24.3M in F’11, a marked slowdown from the estimated 38.9% Y/Y growth for F'10. • Monthly ARPU per registered user —We believe annualized monthly ARPU will peak at ¥406.6 in F’11. We expect operating margins to decline Y/Y, with marketing cost increases and margin dilution from the consolidation of overseas acquisitions. Our Estimates and Outlook for F’12 We are maintaining our F’12 estimates for DeNA, with revenue of ¥141.3B and operating profit of ¥61.8B. Our key assumptions are as follows: • Average registered monthly users—We estimate the number of annual average registered users will grow 3.1% Y/Y to 25.0M in F’12. • Monthly ARPU per registered user —We believe annualized monthly ARPU will decline 4.2% Y/Y to ¥389.4. We expect operating margins to continue declining Y/Y as the decline in earnings from the domestic social gaming business is not offset by overseas expansion. We Are Maintaining Our Nov. 2011 Price Target of ¥2,200 DeNA is the dominant player in mobile SNS social gaming services in Japan (40% share in CY’10 based on our estimates) and is conducting M&A for overseas market expansion. Despite the high earnings visibility in the short term, we believe the company faces the following challenges: Growth in domestic market has • We believe growth rates for their domestic SNS operation has peaked, and peaked unlikely to reaccelerate hereon in. Cost increases via marketing • Domestic ARPU levels are currently high, and we believe they are overreaching lowering margins, in order to realistic levels of sustainability. With registered user growth slowing Y/Y, there maintain sales volume is pressure on sales volume expansion and associated marketing costs (user acquisition costs) to maintain user activity on the site. Overseas expansion - limitations • Overseas expansion places the company in a relatively strong position compared via intense competition to domestic peers. Competitive threats are rising in a rapidly overcrowding market, and we believe DeNA will not be able to replicate the level of overseas success seen in Japan. With a reaccelerating growth profile unlikely to occur in the medium term, and with a domestic business that looks to have peaked, we rate the shares Underweight. Valuation and Rating Analysis Despite the volatility in growth rates at the company, free cash flow conversion is high and hence we have used DCF as our valuation method to derive a fair value for the stock. 128 356
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Our basic premise is that on a WACC of 10.5% and generating an average annual ¥33.9B of free cash flow into perpetuity (with a zero terminal growth rate), we derive a net present value of ¥273.3B. We then add back ¥46.5B net cash and equivalents, and the resultant fair value equity is ¥319.8B, producing a fair value of around ¥2,200 per share. For the number of shares outstanding, we have used 147.26M shares (includes the forthcoming third-party equity issuance for the acquisition of ngmoco—pending dilution from 1.0% warrants issued, and 1.0% dilution from the earn-out clause have been excluded). Investment Risks We view the risks to our investment thesis as follows: Upside risk • Growth reaccelerating in the domestic market • Overseas earnings growth more pronounced than expected into F’11 • Major M&A activity to raise market position and scale of operations Downside risk • Growth decelerating faster than expected in the domestic market • Overseas expansion failing to produce results in the expected timeframe • Major equity financing for M&A activity resulting in dilution 129 357
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Key Assumptions DeNA’s mainstay business is social media, which accounts for the vast majority (80- 90%) of its earnings. In the social media business, social gaming is the primary earnings source and is exhibiting dominant strength. We believe the current market share in terms of revenues generated by item sales including social gaming and advertising are as follows: DeNA 40%, GREE 25%, and Mixi 5%. We believe that in the short term this situation will not change dramatically. DeNA has been active in overseas M&A, most recently acquiring ngmoco in October 2010, which signaled a major expansion into overseas markets. We believe financing requirements are low for DeNA as it has completed a major deal with ngmoco. Business Lines Business Sales Description segment split Social Media 86.0% Comprises of the following service divisions Game related 68.8% Item sales, game ad sales, SAP ad sales, mixiAppli sales (ad and fee), affiliate ads Avatar 9.8% Avatar item sales and affiliate ad sales Ad sales 6.3% Display, tie-up, search, content matched and affiliate ad program sales Other 1.1% Overseas sales, 'Everystar' mobile portal, others ngmoco 0.0% 100% US subsidiary, specializing in smartphone apps Commerce 0.0% Mobile and PC auction and shopping sites Other NA Travel and insurance agency operations Source: J.P. Morgan based on company data Recent History—Impact of ‘Kaitou Royale’ DeNA experienced its turning point in terms of raising its market positioning in the mobile social gaming market in October 2009 (3Q F’09). The company up until then was in decelerating in growth, as its online avatar service was experiencing a slowdown. The company operated ‘MobageTown’, its mobile SNS gaming portal site and decided to follow GREE's success in social gaming content and developed its first breakthrough title called 'Kaitou Royale'. This title was initially exclusive to ‘MobageTown’, and had the following impact to user ARPU traffic, and earnings growth: Impact of Social Gaming Content Introduced in 3Q F’09 on ARPU, Pageviews and OP F’09 F’10 1Q 2Q 3Q 4Q 1Q 2Q Monthly ARPU ¥/user 124.8 111.3 166.3 292.3 356.9 371.8 Q/Q % -27.5 -10.8 49.4 75.8 22.1 4.2 Y/Y % -35.1 -33.2 1.8 69.9 186.1 234.1 User pageviews B 52.9 55.5 94.6 158.6 184.3 NA Q/Q % 3.3% 5.0% 70.5% 67.6% 16.2% NA Y/Y % 14.6% 14.1% 102.3% 209.6% 248.5% NA OP ¥B 3.1 3.1 5.2 9.8 12.0 13.6 Q/Q % -24.6% -1.7% 69.4% 87.9% 22.1% 13.6 Y/Y % -26.5% -10.6% 31.9% 136.0% 282.2% 341.8 OPM % 35.6 36.0 44.8 51.5 49.6 50.3 Source: J.P. Morgan based on company data ‘Kaitou Royale’ is a mafia/gang category game, with the objective to become a successful thief—a similar overseas equivalent title is 'Mafia Wars' from Zynga, 130 358
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com which is very popular on Facebook. Since 3Q F’09, the company has rolled out spin- off versions of the title, such as 'Sengoku Royale' (the same game in a samurai historical setting) in April 2010. DeNA also released ‘Kaitou Royale’ on the Mixi mobile platform in December 2009, and another PC browser game version ‘Kaitou Royale ZERO’ on Yahoo Japan’s ‘Yahoo! Mobage’ service in from September 2010. Other in-house social gaming titles are: • ‘Setururin’: A pet sim • ‘Nouen Hokorina’: A gardening sim • ‘Aqua Square': A fish/aquarium sim, similar to Zynga’s 'Fishville’ Quarterly Earnings Estimates ¥ billion F’10 F’11 F’12 F’10E F’11E F’12E Q1 Q2 Q3 E Q4 E Q1 E Q2 E Q3 E Q4 E Q1 E Q2 E Q3 E Q4 E Sales 24.2 27.1 29.7 32.3 33.6 34.0 35.4 37.1 35.7 33.8 35.5 36.4 113.3 140.1 141.3 Social media 20.4 23.2 25.5 27.9 28.7 28.8 29.6 31.3 29.9 27.8 28.9 30.3 97.0 118.3 116.8 ngmoco - - - - 1.1 1.3 1.6 1.8 2.0 2.2 2.4 2.5 - 5.8 9.0 eCommerce 3.4 3.4 3.7 3.6 3.4 3.4 3.7 3.3 3.4 3.4 3.7 3.0 14.1 13.9 13.6 Other - travel and 0.4 0.5 0.5 0.8 0.4 0.5 0.5 0.7 0.4 0.5 0.5 0.6 2.2 2.1 2.0 insurance agencies Operating profit 12.0 13.6 14.4 15.4 15.5 15.7 16.3 16.5 16.0 14.7 15.3 15.8 55.5 64.0 61.8 Social media 11.6 13.0 13.8 15.0 15.2 15.3 15.5 16.1 15.5 14.2 14.6 15.3 53.3 62.1 59.6 ngmoco - - - - -0.3 -0.1 0.2 0.4 0.1 0.3 0.5 0.6 - 0.2 1.5 eCommerce 1.1 1.1 1.2 1.1 1.2 1.2 1.3 0.9 1.2 1.2 1.3 1.0 4.6 4.4 4.6 Other - travel and -0.0 0.0 0.0 0.1 0.0 0.0 0.0 0.1 0.0 0.0 0.0 0.1 0.0 0.2 0.2 insurance agencies Eliminations -0.7 -0.4 -0.6 -0.8 -0.6 -0.7 -0.8 -0.9 -0.8 -0.9 -1.1 -1.2 -2.5 -3.0 -4.0 OPM % 49.6 50.3 48.6 47.8 46.1 46.1 46.0 44.6 44.9 43.6 43.1 43.4 57.2 45.7 43.8 Social media % 56.7 55.9 54.0 53.9 53.0 53.0 52.5 51.6 52.0 51.0 50.5 50.5 55.0 52.5 51.0 ngmoco % - - - - -29.2 -7.7 13.9 20.9 3.6 12.4 20.3 25.3 - 3.1 16.2 eCommerce % 33.4 31.8 33.0 31.8 34.0 34.0 34.0 25.7 34.0 34.0 34.0 34.0 32.5 32.0 34.0 Other - travel and % -7.6 0.4 5.0 6.3 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0 2.0 10.0 10.0 insurance agencies Sales growth Y/Y % 174.6 216.2 154.6 69.4 38.7 25.6 19.3 14.7 6.3 -0.6 0.1 -1.8 135.5 23.7 0.9 Social media % 289.9 369.9 230.4 87.5 40.6 24.2 16.1 12.1 4.3 -3.6 -2.4 -3.3 196.0 22.1 -1.3 ngmoco % - - - - - - - - 79.7 64.7 44.9 42.0 - - 55.0 eCommerce % 33.4 31.8 33.0 31.8 - - - -7.8 - - - -8.3 5.0 -2.0 -2.0 Other - travel and % -7.6 0.4 5.0 6.3 - - - -13.6 - - - -14.9 15.0 -5.0 -5.0 insurance agencies Social media Users (quarterly avg.) M 19.0 20.8 22.4 23.5 23.7 24.0 24.5 24.8 25.0 25.0 25.0 25.0 21.6 24.3 25.0 Q/Q % 12.0 9.5 7.7 4.9 0.9 1.3 2.1 1.2 0.8 - - - Y/Y % 36.1 40.6 44.9 38.5 24.7 15.4 9.4 5.5 5.5 4.2 2.0 0.8 38.9 12.3 3.1 Monthly ARPU ¥/user 356.9 371.8 379.2 395.8 403.0 400.3 402.6 420.4 398.5 370.4 385.2 403.4 373.1 406.6 389.4 Q/Q % 22.1 4.2 2.0 4.4 1.8 -0.7 0.6 4.4 -5.2 -7.1 4.0 4.7 Y/Y % 186.1 234.1 128.0 35.4 12.9 7.7 6.2 6.2 -1.1 -7.5 -4.3 -4.1 118.2 9.0 -4.2 Source: Company data, J.P. Morgan estimates Our earnings forecasts are based on the following key variable factors for the Social Media business: 131 359
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com • Average registered monthly users—we expect a gradual slowdown trend to continue into F’12, with the ceiling of around 25M users • Monthly ARPU per registered users —we believe that ARPU is nearing its ceiling limit as well, despite the tendency for the over 30s demographic to be high spenders. Corporate History and Basic Information DeNA – Corporate History Year Summary 1999 Established in Tokyo, as an online PC auction site “Bidders” 2004 Open's "Mobaoku" mobile auction site 2005 Tie-up with KDDI as their official auction service Lists on TSE Mothers 2006 Open's "Mobage Town" mobile game portal and social network service with avatar content 2007 Lists on TSE 1st section 2009 Launches social gaming on "Mobage Town" 2010 Launches "Mobile Game" open platform Launches "Game Community" globally to iPhone and iPod touch Acquires US iPhone app company ngmoco Launches "Yahoo! Mobage" with Yahoo Japan Source: J.P. Morgan based on company report. DeNA – Shareholder Structure Tomoko Namba 15% Sonet Others Entertainment 48% 14% Trustee Accounts 23% Source: J.P. Morgan based on company data Note: Data as March 2010 DeNA’s shareholder structure shows management (CEO Namba) and So-net Entertainment as core shareholders. The free float is estimated to be 6.4% as of March 2010. Acquisition of ngmoco DeNA announced the 100% acquisition of US based smartphone game application developer ngmoco on October 12, 2010. The key details are as follows: 132 360
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com ngmoco—Basic Financial Outline and Transaction Details Purchase price ($M) Final price 303.0 Equity finance 146.0 Options 27.0 Cash 128.0 Earn-out phase 100.0 Equity finance 31.0 Options 12.0 Cash 56.0 Completion dates Closing phase Nov-10 Earn-out phase Dec-11 Consolidation date From F’11 Company location San Francisco CEO Neil Young* Incorporated June 25 2008 Financials Sales ($M) F’08* 0.5 F’09 3.2 OP ($M) F’08* -2.5 F’09 -10.9 Total assets ($M) F’08 3.3 F’09 28.3 Estimate goodwill ($M) Closing phase 274.7 Earn-out phase 100.0 Estimate goodwill (¥B) Closing phase 23.3 Earn-out phase 8.5 DeNA equity dilution (%) Closing phase 3.4 Stock options exercised from closing phase 1.0 Earn-out phase 1.0 Source: J.P. Morgan based on company data Note: ngmoco’s F’08 was a seven month reporting period. * The founder and CEO of ngmoco, not the Canadian singer/songwriter. Forex rate is $1=¥85. CEO Namba commented at the 2Q F’10 analyst meeting that ngmoco is growing so that its profits will offset any annual goodwill amortization charge arising in F’11. We have asked the company about the amortization schedule and was told it was over around a 10-year period. Company Disclosure DeNA has ceased to release monthly data regarding user registration numbers and pageview traffic for its ‘MobageTown’ service, as well as data from its mobile ecommerce operations (shopping transaction volume and subscription customers) from August 2010. The reason given by the company was that, given the major shift in business model, the company felt that disclosure was no longer required as these monthly data was not related to actual recent trading. Although we agree that mobile ecommerce operations have little bearing on earnings visibility now, the data supplied for ‘MobageTown' are useful indicators of user activity. The company now releases registered user numbers at quarter end at quarterly financial reporting, but nothing on pageview statistics. 133 361
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Financial Statement – DeNA (2432) ¥ billion Income Statement - Annual F’08A F’09A F’10E F’11E F’12E Segment Statement - Quarterly 4Q 1Q 2Q 3Q 4Q F'09A F’10A F’10A F’10E F'10E Revenues 37.6 48.1 113.3 140.1 141.3 Revenues 19.1 24.2 27.1 29.7 32.3 Social media 24.1 32.8 97.0 118.3 116.8 Social media 14.9 20.4 23.2 25.5 27.9 ngmoco 0.0 0.0 0.0 5.8 9.0 eCommerce 3.5 3.4 3.4 3.7 3.6 eCommerce 11.9 13.5 14.1 13.9 13.6 Others 0.7 0.4 0.5 0.5 0.8 Others 1.6 1.9 2.2 2.1 2.0 Operating profit 9.8 12.0 13.6 14.4 15.4 Operating profit 15.8 21.3 55.5 64.0 61.8 Social media 9.1 11.6 13.0 13.8 15.0 Social media 0.0 18.5 53.3 62.1 62.1 eCommerce 1.1 1.1 1.1 1.2 1.1 ngmoco 0.0 0.0 0.0 0.2 0.2 Others 0.1 0.0 0.0 0.0 0.1 eCommerce 3.1 4.4 4.6 4.4 4.4 Eliminations -0.4 -0.7 -0.5 -0.6 -0.8 Others -0.8 -0.3 0.0 0.2 0.2 Eliminations 13.6 -1.4 -2.5 -3.0 -5.1 OPM % 51.5 49.6 50.3 48.6 47.8 Non operating income 0.3 0.3 0.3 0.3 0.3 Social media % 60.9 56.7 55.9 54.0 53.9 Non operating expense 0.0 0.0 0.0 0.0 0.0 eCommerce % 31.8 33.4 31.8 33.0 31.8 Recurring profit 16.1 21.5 55.7 64.2 62.1 Others % 7.5 -7.6 0.4 5.0 6.3 Extraordinary income 0.0 0.2 0.0 0.0 0.0 Revenue growth Y/Y % 81.5 174.6 216.2 154.6 69.4 Extraordinary expense -1.0 -1.0 0.0 0.0 0.0 Social media % 123.7 289.9 369.9 230.4 87.5 Pre-tax profit 15.1 20.7 55.7 64.2 62.1 eCommerce % 5.3 4.1 6.8 6.0 3.2 Tax -6.7 -8.7 -22.7 -26.1 -25.3 Others % 67.0 27.2 8.6 10.0 14.9 Minority interests -0.5 -0.6 0.1 0.1 0.1 Net profit 8.0 11.4 33.1 38.1 36.9 EPS ¥ 55.1 79.8 232.4 267.7 258.9 BPS ¥ 169.2 243.0 484.0 743.0 971.3 DPS ¥ 6.0 12.0 46.5 53.5 51.8 Payout ratio % 10.9 15.0 20.0 20.0 20.0 Ratio Analysis F’08A F’09A F’10E F’11E F’12E Balance Sheet and Cash Flow F’08A F’09A F’10E F’11E F’12E <Balance sheet> <Y/Y growth> Current assets 32.4 49.1 84.7 127.5 156.1 Sales % 26.5 27.9 135.5 23.7 0.9 Cash and cash equivalents 24.5 33.5 55.6 95.9 124.3 Operating profit % 25.1 34.2 160.8 15.3 -3.3 Accounts receivable 5.3 10.2 18.1 22.4 22.6 Recurring profit % 25.6 33.7 158.9 15.2 -3.3 Other current assets 2.7 5.5 11.0 9.2 9.2 Net profit % 17.4 42.9 191.0 15.2 -3.3 Tangible fixed assets 0.9 1.1 1.2 1.2 1.3 Intangible fixed assets 1.4 1.7 24.6 28.3 32.6 <Margins> Investments and other assets 2.7 3.4 3.4 3.4 3.4 GPM % 76.6 77.8 80.0 80.0 80.0 Total assets 37.3 55.3 114.0 160.5 193.4 OPM % 42.1 44.2 57.2 45.7 43.8 Current liabilities 11.5 18.6 42.1 51.8 52.3 RPM % 42.8 44.7 49.2 45.8 43.9 Long term liabilities 0.2 0.0 0.0 0.0 0.0 Effective tax rate % 44.1 42.1 40.7 40.7 40.7 Total liabilities 11.7 18.6 42.2 51.9 52.3 Shareholders' equity 24.1 34.6 68.9 105.8 138.3 <Valuations> Minority interest 1.6 2.0 2.8 2.8 2.8 P/E x 53.7 37.0 12.7 11.0 11.4 Total net assets 25.7 36.7 71.7 108.6 141.1 P/B x 17.5 12.2 6.1 4.0 3.0 Total liabilities and net assets 37.3 55.3 114.0 160.5 193.4 Dividend yield % 0.2 0.4 1.6 1.8 1.8 EV/EBITDA x 22.5 17.1 6.7 5.8 6.0 <Cash Flow> EV/EBIT x 24.5 18.3 7.0 6.1 6.3 Cash flow from operating activities 9.5 13.5 23.1 22.1 14.9 EV/Sales x 10.3 8.1 3.4 2.8 2.7 Cash flow from investing activities -3.8 -2.5 -4.0 -4.0 -4.0 Cash flow from financial activities -4.0 -1.0 5.8 -7.6 -7.4 Gross change in cash/cash <Profitability> 1.7 10.0 24.9 10.5 3.5 equivalents Cash and cash equivalents at the ROCE % 68.1 68.5 102.5 71.0 49.6 21.8 23.4 33.4 58.3 68.8 beginning of the year Effect of change in consolidated ROE % 35.1 38.7 63.9 43.6 30.2 0.0 0.0 0.0 0.0 0.0 companies ROA % 21.3 20.6 29.0 23.8 19.1 Cash/ cash equivalents at FY end 23.4 33.4 58.3 68.8 72.4 Free cash flow 7.2 10.1 43.4 45.9 37.8 Free cash flow conversion % 45.5 47.4 78.2 71.7 61.1 Free cash flow yield % 1.7 2.4 10.3 10.9 9.0 Source: Company data, earning results and J.P. Morgan estimates. Note: Fiscal year ends March. Stock price as of Dec. 29, 2010. 134 362
  • Global Equity Research 03 January 2011 Neutral Gree (3632) 3632.T, 3632 JT Price: ¥1,069 ARPU Growth Slowing, User Acquisition Costs Rising Price Target: ¥1,000 We are maintaining our Neutral rating on GREE, with a target price of ¥1,000 Internet through November 2011. We believe the shares have corrected to reflect the AC Hiroshi Kamide competitive pressures and structural issues regarding peaked demand in the (81-3) 6736 8602 domestic market. However, we think that GREE will struggle to surprise on the hiroshi.kamide@jpmorgan.com upside with limited resources. Yusuke Maeda (81-3) 6736-8654  We maintain our Neutral rating. The company pioneered mobile social yusuke.x.maeda@jpmorgan.com gaming in Japan with “Tsuri-Sta!”, a casual fishing game in May 2007. The JPMorgan Securities Japan Co., Ltd. situation today is in stark contrast, as DeNA has become the market leader and GREE is struggling to compete in terms of content offering, marketing spend, Price Performance and user monetization. We believe much of these negatives have been priced into the stock, but with sluggish earnings growth and no positive catalysts in 1,400 sight we rate the shares Neutral. Y 1,100  Marketing cost increases heighten our concern. We think recent performance 800 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 metrics have given rise to concern. Average monthly ARPU growth has visibly slowed, with 1Q’10 showing 2.5% growth Q/Q (ARPU ¥192 per month) 3632.T share price (Y TOPIX (rebased) despite the launch of the platform business in June 2010 and the release of two Company Data new in-house game titles (“Columbus” and “Monster Planet”). At the same time, marketing spend has increased 22.3% Q/Q (monthly ¥549 spend per user). We Price ¥1,069 Price date Dec. 29, 2010 conclude that users activity is waning as the games on offer are entering the Market capitalization ¥243.1B latter stages of their product cycle and replacements have yet to construct a Shares outstanding 227.4M recovery. With more social gaming content available compared to three years 52-week range ¥1,580– 875 TOPIX 908.01 ago, we believe GREE is finding it difficult to construct winning titles as the Dividend (F’10E) ¥5.0 SNS platform becomes more competitive and hit driven. Dividend yield (F’10E) 0.5% ROE (F’10E) 55.9%  Valuation and risks. As of December 29, the shares have fallen 32% from their Source: Bloomberg, J.P. Morgan estimates. 52-week high in June 2010, and we believe the structural negatives (increasing competition, rising costs) have been priced in. Short-term earnings visibility is fair but not one denoting a reacceleration of growth. The shares are currently trading on a P/E of 12.7x our F’11 EPS forecast, which we do not think is demanding considering our 45% Y/Y OP growth forecast, but as this is in line with expectations we believe the shares are fairly valued. Upside risk factors include ARPU growth via strong title releases. Downside risk factors include declining profitability through increasing marketing expenditure. Parent Revenue Y/Y OP Y/Y RP Y/Y NP Y/Y EPS P/E P/B EV/EBITDA Y/E June (¥B) (%) (¥B) (%) (¥B) (%) (¥B) (%) (¥) (x) (x) (x) 2010 35.2 152.6 19.6 134.1 19.6 135.3 11.5 157.6 50.7 21.1 11.8 11.3 2011E 56.0 58.8 28.4 44.9 28.4 44.9 16.8 46.3 74.0 14.4 6.1 7.5 2011Co.E 54.0 ~ 53.3 ~ 27.0 ~ 37.9 ~ 27.0 ~ 37.8 ~ 15.9 ~ 38.2 ~ 70.0 ~ - - - 60.0 70.3 30.0 53.2 30.0 53.1 17.7 53.8 77.9 2012E 65.2 16.5 32.3 13.7 32.3 13.7 19.1 13.7 84.2 12.7 4.0 6.6 2013E 73.0 12.0 35.8 10.9 35.8 10.9 21.2 10.9 93.3 11.5 3.0 6.0 Source: Company data and J.P. Morgan estimates.
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Our Estimates and Outlook for 2011 We are maintaining our F’11 estimates for GREE, with revenue of ¥65.2B and operating profit of ¥32.3B. Our key assumptions are as follows: • Average registered monthly users—We expect a gradual slowdown in user growth into F’11, reaching 27M users in 4Q’11. This is slightly higher than DeNA (25M) given the more casual nature of the platform. • Monthly ARPU per registered user —We believe ARPU will remain in the ¥190-210 zone. Y/Y we expect monthly ARPU to grow by 5% on an annualized basis to ¥206.1. We expect operating margins to decline slightly Y/Y, with marketing costs growing faster than topline growth. Our Estimates and Outlook for 2012 We are maintaining our F’12 estimates for GREE, with revenue of ¥73.0 and operating profit of ¥35.8B. Our key assumptions are as follows: • Average registered monthly users—We expect registered user numbers to reach 29M. • Monthly ARPU per registered user —Y/Y we expect monthly ARPU to grow by 4% on an annualized basis to ¥213.3. We believe that operating margins will stabilize, but with no major improvement as the business needs to invest in order to maintain its growth profile. We Are Maintaining Our Nov. 2011 Price Target of ¥1,000 The challenges faced by DeNA are not dissimilar to GREE—slowing domestic growth prospects and execution risks over expansion into the heavily contested overseas market. We believe these issues are more pronounced at GREE, as it has a more mature growth profile compared to DeNA in social gaming. GREE’s most successful fishing game was released in May 2007—DeNA's core game “Kaitou Royale” was released in October 2009. The key points to make are: • We believe growth rates for their domestic SNS operations has peaked and unlikely to reaccelerate hereon in. GREE has a more mature growth profile compared to its peer group. • We think operating costs are likely to increase in order for the company to remain competitive—new game developments, proactive marketing and staff increases. • We believe much of these negative factors have been priced into the stock. Although we think a reaccelerating growth profile is unlikely in the medium term, we believe the company will perform in line with our expectations. We rate the shares Neutral. Valuation and Rating Analysis Despite the volatility in growth rates at the company, free cash flow conversion is high and hence we have used DCF as our valuation method to derive a fair value. 136 364
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Our basic premise is that on a WACC of 10.5% and generating an average annual ¥18.8B in free cash flow into perpetuity (with a zero terminal growth rate), we derive a net present value of ¥209.6B. We then add back ¥21.4B in net cash and equivalents, and the resultant fair value equity is ¥231.0B, producing a fair value of around ¥1,000 per share. Investment Risks We view the risks to our investment thesis as follows: Upside risks • New game releases that reignite user activity, resulting in ARPU increases • Major influx of advertising demand on the SNS site • Inactive users are recaptured Downside risks • Faster-than-expected decline in user activity, leading to drops in ARPU • Major hikes in marketing spend to compete with peers • Increasing development costs of new games, as more resources are required to create competitive titles 137 365
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Key Assumptions GREE’s mainstay business is item sales through the sales of social games and avatars and accounts for 80-90% of total revenues. With an estimated market share of 25% in CY’10, GREE holds the No. 2 spot in sales among domestic SNS companies, behind DeNA. We believe that in the short term this situation will not change dramatically. GREE is taking a longer-term view on overseas expansion, completing a small transaction to acquire a minority stake in countries such as South Africa and Indonesia. We believe GREE is not prioritizing M&A strategy, and hence its financing requirements are low. Business Lines Business Sales Description segment split Item sales 82% Premium service subscriptions (¥300 per month) Monthly user defined virtual currency purchases (¥300 to ¥5,000 per purchase) Discretionary user spend on virtual currency (¥300 to ¥5,000 per purchase) Discretionary user spend on avatar items (¥1,000 to ¥10,000 per purchase) Advertising 18% Banner and listings ads, primarily for mobile content providers, internet services, finance Source: J.P. Morgan based on company data Quarterly Earnings Estimates ¥ billion F’10 F’11 F’12 F’10E F’11E F’12E Q1 Q2 E Q3 E Q4 E Q1 E Q2 E Q3 E Q4 E Q1 E Q2 E Q3 E Q4 E Revenue 12.4 13.8 14.6 15.1 15.5 16.0 16.5 17.1 17.4 17.8 18.8 18.9 56.0 65.2 73.0 Item sales 10.1 11.0 11.9 12.2 11.9 11.6 12.4 12.7 11.7 10.6 12.7 12.3 45.2 48.5 47.3 Advertising 2.3 2.8 2.7 3.0 3.6 4.5 4.1 4.4 5.8 7.2 6.1 6.7 10.7 16.6 25.7 Operating profit 6.2 6.9 7.4 7.8 7.7 8.0 8.3 8.2 8.7 8.9 9.4 8.7 28.4 32.3 35.8 OPM % 50.1 50.0 51.0 51.5 50.0 50.0 50.0 48.1 50.0 50.0 50.0 46.1 50.7 49.5 49.0 Sales growth Y/Y % 81.5 69.0 57.5 38.2 24.9 16.0 13.2 13.1 8.7 7.7 10.2 8.6 58.8 16.5 12.0 Item sales % 91.5 71.5 59.3 35.6 17.1 4.9 4.7 4.1 0.8 -14.7 0.5 5.5 60.6 7.4 -2.6 Advertising % 47.3 60.0 50.0 50.0 60.0 60.0 50.0 50.0 29.2 76.0 37.6 15.1 51.9 54.7 54.9 Sales assumptions Average registered M 21.5 23.6 24.6 25.1 25.6 26.1 26.6 27.1 27.7 28.2 28.8 29.4 23.8 26.4 28.5 monthly users Q/Q % 10.3 9.8 4.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 Y/Y % 55.3 48.4 40.6 28.7 19.1 10.4 8.2 8.2 2.0 8.2 8.2 8.2 Monthly total ¥/user 192.2 195.0 198.0 201.0 202.0 205.0 207.0 210.0 210.0 210.0 218.0 215.0 196.0 206.1 213.3 ARPU per user Q/Q % 2.8 1.5 1.5 1.5 0.5 2.0 2.0 2.0 0.0 0.0 3.8 -1.4 Y/Y % 16.9 13.9 12.6 7.5 5.1 5.1 4.5 4.5 4.0 2.4 5.3 2.4 13.8 5.1 3.5 Source: Company data, J.P. Morgan estimates. 138 366
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Corporate History and Basic Information GREE – Corporate History Year Summary 2004 Establishes GREE PC social networking site 2006 Business and capital tie-up with KDDI, leading to mobile "EZ GREE" site 2007 Launches social games on GREE SNS 2008 Lists on Mothers 2010 Lists on TSE 1st Section 2010 Starts GREE Platform – third party application developers selected to bolt on gaming content 2010 Announces capital tie-up with Project Goth Inc., operator of SNS platform ‘Mig33” Source: J.P. Morgan based on company report. We make no earnings assumptions for overseas expansion plans, given that the tie-up with Project Goth Inc. involves little capital (less than ¥0.5B) and planned to be a long-term relationship aimed at emerging market opportunities. GREE – Shareholder Structure Others 25% Trustee Yoshikazu Accounts Tanaka 18% 50% KDDI 7% Source: J.P. Morgan based on company report. Note: Data as of June 2010. 139 367
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Key Game Titles GREE’s in-house social gaming titles are as follows: In-house Social Gaming Titles Title Service start Category Tsuri-Sta! May-07 Fishing game Clinoppe Jul-07 Pet sim Dorirando Aug-09 Excavation game Hakoniwa Sep-08 Gardening sim Monster Planet Jun-10 Monster sim/battle game Columbus Aug-10 Pirate game Source: J.P. Morgan based on company report GREE’s core title “Tsuri Sta!” has been active since May 2007. While this is a testament to the longevity of social gaming applications, recent title releases have performed poorly. We believe that increasing competition from DeNA and other social application providers are giving GREE a run for their money, and that GREE’s client base may be shifting between titles thereby not creating incremental growth via item sales. 140 368
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Financial Statement – GREE (3632) ¥ billion Income Statement - 4Q 1Q 2Q 3Q 4Q F’08A F’09A F’10E F’11E F’12E Segment Statement - Quarterly Annual F’09A F’10A F’10E F’10E F’10E Revenues 13.9 35.2 56.0 65.2 73.0 Revenues 10.9 12.4 13.8 14.6 15.1 Item sales 10.5 28.2 45.2 48.5 47.3 Item sales 9.0 10.1 11.0 11.9 12.2 Advertising 3.5 7.1 10.7 16.6 25.7 Advertising 2.0 2.3 2.8 2.7 3.0 Operating profit 8.4 19.6 28.4 32.3 35.8 Operating profit 5.3 6.2 6.9 7.4 7.8 Non operating income 0.0 0.0 0.0 0.0 0.0 Non operating expense 0.0 0.0 0.0 0.0 0.0 OPM % 48.4 50.1 50.0 51.0 51.5 Recurring profit 8.3 19.6 28.4 32.3 35.8 Extraordinary income 0.0 0.0 0.0 0.0 0.0 Revenue growth Y/Y % 112.7 81.5 69.0 57.5 38.2 Extraordinary expense 0.0 -0.2 0.0 0.0 0.0 Item sales % 126.2 91.5 71.5 59.3 35.6 Pre-tax profit 8.3 19.4 28.4 32.3 35.8 Advertising % 67.3 47.3 60.0 50.0 50.0 Tax charge -3.9 -7.9 -11.6 -13.1 -14.6 Minority interests 0.0 0.0 0.0 0.0 0.0 Net profit 4.5 11.5 16.8 19.1 21.2 EPS ¥ 20.0 50.7 74.0 84.2 93.3 BPS ¥ 40.8 90.5 174.6 267.9 359.2 DPS ¥ 5.0 5.0 5.0 5.0 5.0 Payout ratio % 25.1 9.9 6.8 5.9 5.4 Ratio Analysis F’08A F’09A F’10E F’11E F’12E Balance Sheet and Cash Flow F’08A F’09A F’10E F’11E F’12E <Y/Y growth> <Balance sheet> Sales % 374.7 152.6 58.8 16.5 12.0 Current assets 15.3 30.9 51.6 75.1 96.9 Operating profit % 696.4 134.1 44.9 13.7 10.9 Cash and cash equivalents 10.6 21.4 37.4 54.9 74.4 Recurring profit % 692.3 135.3 44.9 13.7 10.9 Accounts receivable 3.8 7.7 11.8 17.6 19.7 Net profit % 667.1 157.6 46.3 13.7 10.9 Other current assets 0.9 1.9 2.5 2.5 2.7 Tangible fixed assets 0.1 0.2 0.2 0.2 0.3 <Margins> Intangible fixed assets 0.0 0.2 0.3 0.4 0.5 GPM % 92.2 92.1 92.0 91.9 91.5 Investments and other assets 0.2 1.0 1.0 1.1 1.1 OPM % 60.0 55.6 50.7 49.5 49.0 Total assets 15.6 32.2 53.1 76.8 98.7 RPM % 59.7 55.6 50.7 49.5 49.0 Current liabilities 6.5 11.6 13.4 15.8 17.1 Effective tax rate % -46.4 -40.7 -40.7 -40.7 -40.7 Long term liabilities 0.0 0.0 0.0 0.0 0.0 Total liabilities 6.5 11.6 13.4 15.8 17.1 <Valuations> Shareholders' equity 9.1 20.6 39.7 60.9 81.7 P/E x 53.6 21.1 14.4 12.7 11.5 Minority interest 0.0 0.0 0.0 0.0 0.0 P/B x 26.2 11.8 6.1 4.0 3.0 Total net assets 9.1 20.6 39.7 60.9 81.7 Dividend yield % 0.5 0.5 0.5 0.5 0.5 Total liabilities and net assets 15.6 32.2 53.1 76.8 98.7 EV/EBITDA x 26.4 11.3 7.5 6.6 6.0 EV/EBIT x 26.5 11.3 7.8 6.9 6.2 <Cash Flow> EV/Sales x 15.9 6.3 4.0 3.4 3.0 Cash flow from operating activities 5.7 11.6 5.3 5.4 8.7 Cash flow from investing activities -0.1 -10.8 -2.2 -2.2 -2.2 <Profitability> Cash flow from financial activities 3.7 -0.1 -1.1 -1.1 -1.1 Gross change in cash/cash ROCE % 166.0 132.0 94.2 64.1 50.2 9.3 0.8 2.0 2.0 5.3 equivalents Cash and cash equivalents at the ROE % 88.7 77.5 55.9 38.0 29.8 1.3 10.6 11.4 13.3 15.4 beginning of the year Effect of change in consolidated ROA % 28.6 35.8 31.7 24.9 21.5 0.0 0.0 0.0 0.0 0.0 companies Cash and cash equivalents at FY 10.6 11.4 13.3 15.4 20.6 end Free cash flow 4.5 9.6 14.7 16.3 21.0 Free cash flow conversion % 0.5 0.5 0.5 0.5 0.6 Free cash flow yield % 1.9 3.9 6.0 6.7 8.6 Source: Company data, earning results and J.P. Morgan estimates Note: Fiscal year ends June. Stock price as of Dec. 29, 2010. 141 369
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com 142 370
  • Global Equity Research 03 January 2011 Neutral Mixi (2121) 2121.T, 2121 JT Price: ¥441,500 Obstacles Remain on the Road to Monetization Price Target: ¥425,000 We are maintaining our Neutral rating on Mixi, with a target price of ¥425,000 to Internet November 2011. We believe management is taking a long-term view of the AC Hiroshi Kamide business, focusing on developing new services and improving user experience. (81-3) 6736 8602 The focus on advertising as the key revenue driver should see improving prospects hiroshi.kamide@jpmorgan.com with smartphone penetration, but this will still take over a year to materialize in Yusuke Maeda our opinion. While valuations are not inexpensive, we believe Mixi has interesting (81-3) 6736-8654 prospects longer term. yusuke.x.maeda@jpmorgan.com JPMorgan Securities Japan Co., Ltd.  We maintain our Neutral rating. Mixi continues to roll out new services and functions to improve the site, and a current TV advertising campaign is under Price Performance way aimed at raising brand awareness. Online advertising demand continues to 900,000 grow albeit at a relatively modest pace, as we think ‘feature phone’ mobile media remains high maintenance and unwieldy for most advertisers. Item sales Y 600,000 from the various applications available on Mixi’s platform are beginning to gain 300,000 traction, but management's emphasis on providing useful utility-type services Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 cannot compete in terms of generating user ARPU available from social gaming 2121.T share price (Y in our opinion. TOPIX (rebased) Company Data  Keeping users satisfied, thinking long term. The release of functions such as ‘Mixi Check’ (a sharing function similar to Twitter and Facebook share/like Price ¥441,500 Price date Dec. 29, 2010 icons) and ‘Mixi Voice’ (an updated version of their microblogging service) Market capitalization ¥68.3B continue to keep the user community involved. We believe this is the core Shares outstanding 0.155M strength of Mixi’s management, with their focus on providing well thought out 52-week range ¥777,000– 383,000 TOPIX 908.01 services and a deep user experience. Monetizing user traffic is a core activity, Dividend (F’10E) ¥0.0 but as we understand management takes user satisfaction as its key objective. Dividend yield (F’10E) 0.0% ROE (F’10E) 11.9%  Valuation and risks. The shares are currently trading at 28.6x our F’11 EPS Source: Bloomberg, J.P. Morgan estimates. forecast, which is a high valuation multiple. However, the shares have consistently traded at high levels, and hence we do not see this as being a major mispricing. We think advertising demand should benefit from smartphone penetration. More applications are available on the platform now (around 1,000 for mobile SNS, 1,300 for PC), which will likely grow as users adapt to new services. Upside risks include major application hit services resulting in major item sales. Downside risks include unplanned investment into new services and further marketing activities to boost user activity. Consolidated Sales Y/Y OP Y/Y RP Y/Y NP Y/Y EPS P/E P/B EV/EBITDA Y/E Mar (¥B) (%) (¥B) (%) (¥B) (%) (¥B) (%) (¥) (x) (x) (x) 2010 13.6 12.8 2.8 -27.0 2.7 -29.4 1.3 -33.0 8,476 52.1 4.7 17.7 2011E 16.8 23.4 3.6 29.5 3.6 32.8 1.8 40.6 11,911 37.1 4.2 11.1 2011Co.E 17.4 27.6 2.8 0.6 2.8 3.2 1.4 6.2 8,985 49.1 - - 2012E 20.7 23.6 4.4 24.6 4.4 24.7 2.4 29.8 15,457 28.6 3.6 9.5 2013E 25.0 20.5 5.8 30.2 5.8 30.3 3.1 30.3 20,143 21.9 3.1 7.7 Source: Company data and J.P. Morgan estimates.
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Our Estimates and Outlook for 2011 We are maintaining our F'11 revenue forecast of ¥20.7B and operating profit forecast of ¥4.4B, representing Y/Y growth of 24% and 25%, respectively. We estimate that top-line growth will remain stable and high as the company improves its media power and makes more inroads into winning new customer accounts. However, opportunities for margin improvement are likely to be limited as the company invests in new service development as well as marketing costs. Our Estimates and Outlook for 2012 We are maintaining our F'11 revenue forecast of ¥25.0B and operating profit forecast of ¥5.8B, representing Y/Y growth of 21% and 30%, respectively. In F'12 we believe that demand for mobile advertising will benefit from smartphone penetration, greater adoption by major advertisers, a greater range of advertising products, and Mixi's ability to raise pricing. We Are Maintaining Our Nov. 2011 Price Target of ¥425,000 Mixi is the leading SNS operating with a real user community, as opposed to a virtual one. The company has no direct domestic competitor and is hence strongly positioned as an internet media company with potential for longevity and a loyal user base. However, we believe it faces the following challenges: Mobile advertising demand still • The dominance of mobile advertising revenue (63% of total ad revenue in 1Q hampered by technology F’11) limits short-term growth potential, as the media itself remains high maintenance and cumbersome for the majority of advertisers. User monetization with social • The focus on social utility applications being made available on the Mixi applications limited platform delivers some potential for user monetization by item sales, but compared to social gaming applications its impact is limited. • We believe the site is yet to clearly show its monetization potential, but in the medium term we expect steady progress as opposed to a major ramp up in earnings growth. Valuation and Rating Analysis Despite the volatility in growth rates at the company, free cash flow conversion is high and hence we have used DCF as our valuation method to derive a fair value for the stock. Our basic premise is that on a WACC of 10.5% and generating an average annual ¥4.6B free cash flow into perpetuity (with a zero terminal growth rate), we derive a net present value of ¥53.1B. We then add back ¥12.6B in net cash and equivalents, and the resultant fair value equity is ¥65.7B, producing a fair value of around ¥425,000 per share. Investment Risks We view the risks to our investment thesis as follows: 144 372
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Upside risk • Major hit services on the Mixi platform, resulting in strong reacceleration of item sales • Major adoption of smartphones, leading to more mobile advertising clients and greater demand for advertising Downside risk • Ineffective but expensive marketing campaigns that deteriorate margins • Major upfront investment costs for new developments, e.g. contractor fees 145 373
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Key Assumptions Mixi’s mainstay business is internet media, and advertising revenue accounts for 80- 90% of its earnings. We believe current market share in terms of revenues generated by item sales including social gaming and advertising are as follows: DeNA 40%, Gree 25%, and Mixi 5%. We think that this situation will not change dramatically in the short term, although driven by mobile advertising demand increasing with smartphone adoption, we think Mixi will increase its market share over the medium term. Mixi has operations in China, but we believe management is prioritizing organic growth. We do not think Mixi is prioritizing M&A strategy, hence financing requirements are low. Business Lines Business Sales Description segment split Internet media Advertising 80% Sales of banners, tie-ups, listings and search ads on PC and mobile sites Item sales 16% Sale of virtual currency to use application services, provided by third parties Recruitment 4% Job listings site for IT specialists Other - Includes China star-up operations Source: J.P. Morgan based on company data. Mixi - Quarterly Earnings Estimates ¥ billion F’10 F’11 F’12 F’10E F’11E F’12E Q1 Q2 Q3 E Q4 E Q1 E Q2 E Q3 E Q4 E Q1 E Q2 E Q3 E Q4 E Sales 4.0 3.9 4.2 4.7 5.1 4.9 5.1 5.6 6.3 5.9 6.2 6.6 16.8 20.7 25.0 Internet media 3.8 3.7 4.0 4.5 5.0 4.7 5.0 5.3 6.1 5.7 6.0 6.3 16.0 19.9 24.1 Recruitment listings 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.3 0.7 0.8 0.9 Other - - - - - - - - - - - - - - - Operating profit 1.1 0.6 0.9 1.0 1.1 1.0 1.0 1.3 1.4 1.3 1.4 1.7 3.6 4.4 5.8 Internet media 1.4 0.9 1.2 1.3 1.5 1.5 1.5 1.7 1.8 1.8 2.0 2.3 4.8 6.2 8.0 Recruitment listings 0.1 0.2 0.1 0.2 0.1 0.2 0.1 0.2 0.2 0.2 0.2 0.2 0.6 0.6 0.7 Other 0.0 0.0 0.0 0.0 0.0 -0.1 -0.1 0.0 0.0 -0.1 -0.1 0.0 -0.1 -0.2 -0.2 Eliminations -0.4 -0.4 -0.5 -0.4 -0.5 -0.6 -0.6 -0.6 -0.6 -0.7 -0.7 -0.8 -1.7 -2.2 -2.7 OPM % 26.8 15.8 20.7 21.6 21.3 20.7 20.1 23.3 21.5 22.0 23.2 25.7 21.2 21.4 23.1 Internet media % 35.6 24.6 30.0 29.6 30.0 31.0 31.0 31.9 30.0 32.0 33.0 36.8 30.0 31.0 33.0 Recruitment listings % 80.6 84.6 85.0 75.0 80.0 80.0 80.0 80.0 80.0 80.0 80.0 80.0 81.0 80.0 80.0 Other % - - - - - - - - - - - - - - - Sales growth Y/Y % 31.2 22.0 21.6 20.0 28.3 25.7 23.7 17.7 23.0 21.4 19.9 18.2 23.4 23.6 20.5 Internet media % 31.3 21.5 21.1 19.5 29.1 26.5 24.3 18.0 23.4 21.9 20.2 18.5 23.0 24.2 21.0 Recruitment listings % 30.8 34.8 35.0 31.7 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0 33.0 10.0 10.0 Other % - - - - - - - - - - - - - - - Sales assumptions Average registered M 20.3 21.3 22.5 23.7 24.3 24.9 25.5 26.1 26.6 26.9 27.2 27.4 22.0 25.2 27.0 monthly users Q/Q % 5.6 4.9 5.8 5.0 2.5 2.5 2.5 2.5 2.0 1.0 1.0 1.0 - - - Y/Y % 18.6 20.5 23.5 23.1 19.5 16.7 13.1 10.4 2.0 8.2 6.7 5.1 21.4 14.3 7.4 Monthly total ARPU ¥/user 63.1 58.0 61.4 66.5 70.7 65.6 67.2 70.9 79.2 73.6 75.6 79.7 63.5 68.6 77.0 per user Q/Q % -3.7 -8.1 5.9 8.2 6.4 -7.3 2.5 5.5 11.7 -7.1 2.7 5.5 - - - Y/Y % 10.7 0.7 2.2 1.5 12.1 13.1 9.4 6.6 11.9 12.2 12.4 12.4 1.7 8.1 12.2 Source: Company data, J.P. Morgan estimates. Our earnings forecasts are based on the following assumptions: 146 374
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com • Average registered monthly users—We believe a steady increase of 2.5% Q/Q for the medium term is realistic for Mixi, as it continues to attract users with real identities that want to use it as a communication tool. Hence, the market Mixi caters to is broader than that of social gaming sites. • Monthly ARPU—We believe monthly ARPU trends will see a slow but steady climb, primarily driven by item sales demand. However, it will remain considerably low compared to social gaming peers. Corporate History and Basic Information Mixi – Corporate History Year Summary 1997 Commences "Find Job!" job listings site 2004 Launches "Mixi" SNS 2006 Lists on TSE Mothers 2007 Releases the mobile service 2009 Launches "Mixi Appli" – the open platform service based on Google’s OpenSocial API standard 2010 Membership policy changes from invitation only to an open registration Announce business alliance with China's Renren and Korea's Cyworld SNS sites Facebook offers export tool to Mixi users Source: J.P. Morgan based on company report. Mixi – Shareholder Structure Others 28% ngi group 1% Kenji Kasahara 58% Trustee Accounts 13% Source: J.P. Morgan based on company report. Note: Data as March 2010. CEO Kasahara is the largest shareholder, with legacy investor ngi group as a minority shareholder with about 1%. The free float is estimated to be 14.8%. 147 375
  • Hiroshi Kamide Global Equity Research (81-3) 6736 8602 03 January 2011 hiroshi.kamide@jpmorgan.com Financial Statement – Mixi (2121) ¥ billion Income Statement - F’08A F’09A F’10E F’11E F’12E Segment Statement - Quarterly 4Q 1Q 2Q 3Q 4Q Annual F'09A F’10A F’10A F’10E F'10E Revenues 12.1 13.6 16.8 20.7 25.0 Revenues 3.9 4.0 3.9 4.2 4.7 Internet media 11.2 13.0 16.0 19.9 24.1 Internet media 3.8 3.8 3.7 4.0 4.5 Recruitment listings 0.9 0.5 0.7 0.8 0.9 Recruitment listings 0.2 0.2 0.2 0.2 0.2 Others 0.0 0.0 0.0 0.0 0.0 Others 0.0 0.0 0.0 0.0 0.0 Operating profit 3.8 2.8 3.6 4.4 5.8 Operating profit 0.3 1.1 0.6 0.9 1.0 Internet media 4.3