www.jpmorganmarkets.com
Asia Pacific Equity Research
09 January 2013
Nothing But Net - Asia
2013 Internet Investment Guide...
2
Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
Table of Contents
Key Inve...
3
Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
Companies
Baidu.com..........
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
Key Investment Themes
Ad M...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
Mobile Revenue Begins to T...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
offering (Baidu Map), (2) ...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
Games market stable with p...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
Sector multiples close to ...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
Table 2: Net Cash Level of...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
China: Top 10 Things to W...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
Key Reports and Recommend...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
Table 4: Valuation Compar...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
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Global Content Ecosystem
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Asia Pacific Equity Research
09 January 2013
Dick Wei
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Asian Content Ecosystem
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Asia Pacific Equity Research
09 January 2013
Dick Wei
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SectorOverview
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Asia Pacific Equity Research
09 January 2013
Dick Wei
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China Internet Market Ove...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
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dick.x.wei@jpmorgan.com
Internet population growt...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
Figure 8: Methods of Acce...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
Figure 10: Average Time S...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
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dick.x.wei@jpmorgan.com
Figure 11: Chat/IM Is the...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
Regulation: VIE, Accounti...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
Mobile Internet
As we men...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
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support. On Google Play, ...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
markets: CU Wo Store, CM ...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
Figure 17: China Handset ...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
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dick.x.wei@jpmorgan.com
Figure 19: Data revenue (...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
Figure 21: Internet Penet...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
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Geographic Presence
Figur...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
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Figure 26: % of smartphon...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
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dick.x.wei@jpmorgan.com
Online Advertising
Top-Do...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
Be Selective: Video, Soci...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
Figure 32: 2011: Search O...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
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dick.x.wei@jpmorgan.com
Table 9: Ad Vertical as %...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
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Table 10: Expected Launch...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
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Information Technology
Th...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
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in effect this year: only...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
Display Advertising (ex-V...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
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Tencent Substantiates the...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com
Online Video
We believe t...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
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Figure 39: Happening: Chi...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
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We think video still offe...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
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Users are increasingly ra...
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Asia Pacific Equity Research
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Dick Wei
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Tablet/Smartphone/Interne...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
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Consolidation Continues: ...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
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China Online Video Compet...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
(852) 2800-8535
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Figure 47: Total Monthly ...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
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Table 18: TV Stations Ad ...
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Asia Pacific Equity Research
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Dick Wei
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placement/embedded market...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
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Search
Mobile to Help Gro...
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Asia Pacific Equity Research
09 January 2013
Dick Wei
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years to estimate China s...
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Asia Pacific Equity Research
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Dick Wei
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Competitive Landscape
Key...
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Dick Wei
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Under a challenging macro...
JP Morgan eCommerce Research 2013
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JP Morgan eCommerce Research 2013

  1. 1. www.jpmorganmarkets.com Asia Pacific Equity Research 09 January 2013 Nothing But Net - Asia 2013 Internet Investment Guide Internet Dick Wei AC (852) 2800-8535 dick.x.wei@jpmorgan.com J.P. Morgan Securities (Asia Pacific) Limited Evan Zhou (852) 2800-8505 evan.z.zhou@jpmorgan.com J.P. Morgan Securities (Asia Pacific) Limited Korea Internet Sungmin Chang, CFA (82-2) 758-5719 sungmin.chang@jpmorgan.com J.P. Morgan Securities (Far East) Ltd, Seoul Branch Japan Internet Yusuke Maeda (81-3) 6736-8654 yusuke.x.maeda@jpmorgan.com JPMorgan Securities Japan Co., Ltd. Telecom, Internet and New Media Strategist James R. Sullivan, CFA (65) 6882-2374 james.r.sullivan@jpmorgan.com J.P. Morgan Securities Singapore Private Limited US Internet Doug Anmuth (1-212) 622-6571 douglas.anmuth@jpmorgan.com J.P. Morgan Securities LLC See page 137 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. After years of waiting, mobile internet usage finally reached a critical mass in 2012 and we think will further gain importance in 2013. The new mobile internet ecosystem built on eCommerce, local and social creates new opportunities for incumbents as well as entrepreneurs. On the other hand, the proliferation of mobile internet usage poses threats to some “PC Internet” companies. For 2013, we expect the better macro economic environment to foster new ideas in the highly dynamic and fast-changing internet sector. We expect this guide will provide internet enthusiasts and investors with useful research and investment ideas for 2013.
  2. 2. 2 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Table of Contents Key Investment Themes ..........................................................4 Ad Market to Benefit from Improvement in Macro Outlook.....................................4 Mobile Revenue Begins to Tap-in............................................................................5 Games market stable with pocket of opportunities....................................................7 eCommerce: competition among leading players .....................................................7 Sector multiples reached three-year low: re-rating likely with higher market risk appetite...................................................................................................................8 Our Top Picks for 2013...........................................................................................9 China: Top-10 Things to Watch in 2013................................10 Key Reports and Recommendations....................................11 China Internet Market Overview............................................16 Regulation: VIE, Accounting, “Real-name” Policy ................................................21 Mobile Internet........................................................................22 App Distribution – the Key Battlefield...................................................................22 Key Drivers - 3G and Smart Devices Penetration...................................................24 China Mobile Internet User Profiles.......................................................................26 Key Themes to Watch in 2013...............................................................................29 Stock Implications.................................................................................................29 Online Advertising..................................................................30 Display Advertising (ex-Video).............................................................................37 Online Video.........................................................................................................39 Search...................................................................................................................49 Social....................................................................................................................56 Online Gaming........................................................................62 2013: the rise of mobile games ..............................................................................63 Webgame to continue monetization momentum.....................................................63 MMOG/ACG - Robust growth from Key Title Releases ........................................65 eCommerce.............................................................................69 2013: The Big gets Bigger.....................................................................................69 Structural Growth Remains Stellar.........................................................................69 Gold Diggers vs. Shovel Sellers.............................................................................73 Category Winners: 3C, Appliance, Groceries and Daily Use ..................................75 C2C......................................................................................................................77 B2C ......................................................................................................................79 B2B ......................................................................................................................87 Logistics ...............................................................................................................88 Payment................................................................................................................90 Group Buying .......................................................................................................92
  3. 3. 3 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Companies Baidu.com...............................................................................96 Dangdang..............................................................................101 NetEase .................................................................................106 Shanda Games......................................................................111 Sina Corp ..............................................................................116 Sohu.Com .............................................................................121 Tencent..................................................................................127 Youku Tudou.........................................................................132
  4. 4. 4 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Key Investment Themes Ad Market to Benefit from Improvement in Macro Outlook While 2012 China ad spend was muted, we see potential earnings upside in 2013. In 2012, ad spend was overshadowed by a macro slowdown. Also, leadership transition made corporate and government more cautious in spending during 2012. Furthermore, the 2H12 China-Japan tension dragged down ad spends from Japan- related companies – including autos, cosmetics, and other consumer goods products. However, since November 2012, we have begun to see initial signs of macro improvements in China, from industrial productions and other economic indicators improving. In addition, Japan autos sales have seen sequential increase in December 2012. In prior cycles, we generally saw ad spending lag macro economic cycles by around six months. If history repeats again this time and no major disruption over the next few months, we expect some initial signs of ad spending pick up in May – June 2013. Downward earnings revision cycle already over, upside earnings revision in 2Q13 When companies gave out 4Q12 guidance during 3Q12 earnings releases, we already saw major downward revision on the Street numbers. We expect companies to report in line 4Q12 numbers and give in line 1Q13 numbers. Q1 are generally weaker quarters, however, we note that 1Q13 YoY revenue growth likely to re-accelerate from 4Q12 level (as we had a weak 1Q12 quarter with early Chinese New Year in 2012). We expect when ad companies release 1Q13 results in April/May, companies will give out positive full-year guidance, as the initial macro economic improvements in November 2012 finally triggers an improvement in ad spending six months later. Expect ad stocks to see re-rating over the next few months We think most ad stocks will re-rate over the next few months on the back of potential earnings revision. Our top-picks in China ad space are Baidu and Youku Tudou, as we believe these two names will see cyclical, as well as structural improvements in 2013.
  5. 5. 5 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Mobile Revenue Begins to Tap in Mobile devices adoption has finally reached a critical mass that advertisers have started to care about. We estimate that smartphone users will reach close to 400Mn by end-2013 from ~200Mn at end-2012. This exponential growth shall finally make advertisers invest and experiment in 2013. As a reference, 400Mn users would make mobile the largest reach media – after TV and internet. We expect 2013 to be a year that advertisers begin to pay serious attention to mobile advertising. Figure 1: Smartphone Penetration Source: J.P. Morgan estimates, Dec-11. *China Penetration is over total China population. Table 1: Mobile Traffic as a % of Total Traffic % 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 Baidu NA NA NA >15% ~20% NA 20%+ Naver 17% 23% 25% NA 38% NA NA Google NA NA NA 14% NA NA 20% Facebook* 42% 44% 47% 51% 54% 57% 60% Sina Weibo ** 40%+ 45% NA 50% 60% 69% 72% Source: Company Earnings Call, J.P. Morgan estimates. * Mobile Monthly Active Users (MAUs) as a % of total MAUs; ** % of DAU from Mobile. Video and Search: Swiper of Initial Mobile Spending We see mobile video and mobile search as low-hanging fruits in mobile internet ad, and as ready for large-scale monetization this year. These two services can easily be adopted on mobile devices, essentially without any changes in ad format. For online video, pre-roll video ad on mobile devices is similarly effective and can draw similar user attention compared with PC. Indeed, additional targeting can be done through different device types (e.g., targeting to higher-end iPhone/iPad users). We expect Youku Tudou to launch video on mobile devices this year, and shall be a net positive to the company. The amount of inventory on mobile devices can be similar to that on a PC in the long term, depending on what other competitors do. For mobile search, we see net additional amount on search queries to add to revenue upside to Baidu. The company has been making meaningful investments in mobile search since last year, and we expect mobile search to reach 10% of total revenue by Baidu end 2013. We believe Baidu will gain revenue share in mobile search in 2013, driven by: (1) Baidu as one of the default search engine on iOS device and has a strong mobile map 4% 9% 16% 25%21% 46% 73% 100% 42% 51% 56% 61% 34% 48% 62% 78% 0% 20% 40% 60% 80% 100% 120% 2010 2011 2012E 2013E China United Kingdom Japan United States
  6. 6. 6 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com offering (Baidu Map), (2) this year Baidu will likely run mobile Phoenix Nest monetization system, and (3) new ad formats such as cost-per-call, cost-per-action, and location based ad could add to new revenue. Other Mobile Ad Formats to Go Through Experimentation in 2013 We see other mobile ad formats such as display, in-apps, and social ads to need further experimentation in 2013. With limited screen size and available inventory on mobile devices, simply putting a traditional banner ad on mobile browser or mobile apps is not optimal – from both user experience and monetization perspectives. Furthermore, as advertisers and agencies in China had paid less attention in mobile advertising in prior years, we expect industry players to do more testing and optimization. One of the first things that many advertisers may need to do is to create mobile optimized websites for better user experience. We expect these mobile ad formats to see meaningful upside in 2014/2015. In the mean time, we think PC-based general-portal display advertising will see negative impacts by traffic shift to mobile – where monetization rate is still low. Larger Mobile Opportunities are Yet to Come We believe a larger mobile internet opportunities in China to begin in 2014, after the potential launch of 4G LTE in China. We argue that China Mobile has been reluctant to push for a wider mobile internet adoption in China, due to challenges in its current TD-SCDMA technology – lack of handset selection, inferior service quality, etc. As such, China Mobile - with the largest mobile user base in China - won’t focus on promoting mobile internet usage until they launch 4G LTE services. We expect after LTE launch, with the wider range of available handsets, a reliable and consistent mobile internet connection through Wi-Fi and mobile networks, China Mobile would push for a wider and true mobile internet adoption. Furthermore, low-cost mobile device penetration will be a tailwind for mobile internet usage in the longer term. Figure 2: Telecom Operator Share by PV - All Mobile Users Source: Baidu Mobile. Note: Page View data based on Baidu.com traffic. 12.6% 13.6% 13.7% 14.9% 16.5% 16.9% 20.0% 7.1% 8.0% 9.2% 13.6% 19.7% 20.7% 23.4% 80.4% 78.4% 77.1% 71.6% 63.8% 62.4% 56.6% 0% 20% 40% 60% 80% 100% 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 China Unicom China Telecom China Mobile
  7. 7. 7 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Games market stable with pocket of opportunities We expect the online games market to be stable this year, with ~20% growth in the overall market. MMORPG segment is likely to see only single-digit growth. We see larger titles to come in 2H13, with titles such as Blade and Soul, Call of Duty Online, Dragon Sword and Guild War 2. Without new large game launches, we expect the online game sector won’t see major earnings revisions until the later part of the year. We believe Tencent could outperform in 2H13 with earnings upside from major new game launches. We see mobile games to have the most significant growth in 2013, prompted by deepened proliferation of smartphone and tablets, improved development capability, and closer integration with mobile social network to help distribution and stickiness. We expect webgame to grow ~30% to Rmb9.7Bn in 2013, representing ~15% of China online game market. We think the sector could see a slight re-rating, if there is more clarity on recurring dividends. Investors are concerned that management could take risks and acquire high-risk game projects, and this could lead to higher earnings volatility for game companies. Regular dividends could help lower the chance of high-risk investments. eCommerce: competition among leading players In 2012, many of the smaller eCommerce companies were acquired or shut down, due to lack of funding after the 2011 investment boom and a slower economy. In particular, we note that many group-buying companies were consolidated, and some vertical eCommerce companies were also acquired by large platforms. We expect in 2013, competition in eCommerce to remain intense among the few leading B2C eCommerce platforms. These platforms would likely make further acquisitions of smaller players. We expect more pressure to smaller platforms like Dangdang. We also expect more capital market activities in the eCommerce sector in 2013. We think Tencent will outperform in 2H13 with earnings upside from major new game launches.
  8. 8. 8 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Sector multiples close to three-year low: re-rating likely with higher market risk appetite The sector has gradually experienced a de-rating over the past two years, currently tracking at below 20x forward P/E, close to its lowest level since early 2009. A few key issues led to a sector valuation decline: corporate governance concerns, de- registration of accountants leading to potential delisting concerns, and risks related to VIE structure. Figure 3: Sector Valuation at ~Three-Year Low - Fwd P/E Trend Source: J.P. Morgan estimates, Bloomberg. Note: market-cap weighted index includes BIDU, Tencent, SOHU, NTES, GAME, CTRP, QIHU, SFUN, People.cn, CYOU, JOBS, GA, LeTV, and PWRD. We expect sector multiples to likely pick up this year, with a recovery in earnings growth (or interests in China growth story to return) and many of the fraudulent corporate practices had been exposed. We also believe public accountants de- registration from PCAOB is an unlikely outcome. Furthermore, as we discussed in last year’s Nothing But Net 2012 report, we expected an increase in dividends in the sector. Most internet companies are cash flow positive and cash-rich. We see the trend of dividend payments to continue and more companies could make dividend policy regular in 2013. 40.9 11.6 0 5 10 15 20 25 30 35 40 45 50 Aug-05 Nov-05 Feb-06 May-06 Aug-06 Nov-06 Feb-07 May-07 Aug-07 Nov-07 Feb-08 May-08 Aug-08 Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10 Feb-11 May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Nov-12 22.3x 26.9x 31.6x 17.6x 12.9x
  9. 9. 9 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Table 2: Net Cash Level of China Internet Companies US$ millions Ticker FY2008 FY2009 FY2010 FY2011 3Q12 Dec-31 2012 Market Cap Cash as % of Mkt Cap NCTY US Equity 325 245 215 170 170 72 235.8% MCOX US Equity 17 26 116 61 43 32 134.6% JRJC US Equity 98 107 100 56 33 25 129.9% VISN US Equity 163 27 (54) 60 16 16 104.6% AMCN US Equity 162 124 107 113 108 127 85.4% RENN US Equity N.A. 127 198 1,041 892 1,297 68.8% DANG US Equity 17 24 256 197 196 333 58.8% PWRD US Equity 203 234 270 274 225 516 43.6% NTES US Equity 823 1,028 1,436 2,052 2,377 5,558 42.8% DATE US Equity 2 2 3 29 69 173 39.8% Sohu US Equity 314 564 733 794 672 1,800 37.3% 3888 HK Equity 164 186 236 255 270 823 32.8% JOBS US Equity 157 178 242 326 372 1,348 27.6% 777 HK Equity 187 184 185 207 185 720 25.7% GA US Equity 743 718 914 297 297 1,273 23.3% Sina US Equity 505 723 784 671 696 3,337 20.9% YOKU US Equity 6 39 269 584 595 2,983 19.9% FMCN US Equity 142 597 592 386 503 3,319 15.2% CTRP US Equity 183 237 505 761 322 3,259 9.9% QIHU US Equity N.A. 25 59 344 348 3,544 9.8% BIDU US Equity 390 671 1,225 1,854 3,005 35,060 8.6% CYOU US Equity 126 227 351 328 103 1,383 7.5% 700 HK Equity 751 1,633 2,555 2,317 2,371 59,324 4.0% Source: Bloomberg. Our Top Picks for 2013 We see overall improvements in macro outlook to lead to earnings upside in online advertising segment. Furthermore, we do not expect significant regulatory tightening in the internet space this year, as new Chinese leadership is positioned as more open and liberal than before. Early beneficiaries from structural change in mobile internet adoption are search and online video companies. On the other hand, PC-based general portals could see revenue risks, with their traffic moving to less monetized mobile devices. In light of cyclical and structure industry changes, our top picks for 2013 are: Baidu, Youku Tudou, and Tencent. We remain cautious on Shanda Games due to revenue risks in existing game titles. We expect Baidu and Youku Tudou to see earnings revision and re-rating over the next few months. Tencent could see earnings upside in 2H13, with new major game title launches. We expect Baidu and Youku Tudou to see earnings revisions and re-rating over the next few months. Tencent could see earnings upside in 2H13, with new major title launches.
  10. 10. 10 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com China: Top 10 Things to Watch in 2013 (1) Better macro economic outlook could lead to earnings upside in advertising and travel sectors. (2) Monetization of mobile search key to Baidu growth in the long term. (3) New mobile ad models to emerge – advertisers and agencies start looking at deeper integration at eCommerce / social / local ad strategy. This should lead to better monetization in 2014 and beyond. (4) Online video – Youku Tudou is expected to turn profitable. Online video continues to take share from TV ad spend. (5) eCommerce adoption to accelerate. Brick & Mortar retailers’ lose market share to online companies. Competition to intensify among leading B2C eCommerce platforms. (6) Weixin monetization – what new business models will Tencent come up with? We believe Weixin (WeChat) could become a payment platform that completes the purchase cycle from influencing the purchase decision to the transaction. (7) Mobile apps store and distribution platform consolidation – we expect larger platforms to win. (8) Can Sina Weibo grow outside of brand advertisers? And tap into SME and eCommerce? (9) Performance-based ads and social media to gain importance and to offset weakness in PC social networks. (10) More IPO activities, yet still more privatization and eventual re-listing in Hong Kong.
  11. 11. 11 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Key Reports and Recommendations Table 3: 2012 Top Franchise Reports - J.P. Morgan Asia Internet Team Research Date China Tencent: Weixin Part III – A Closer Look at Monetization, Public Account and International Aspiration 10-Nov-12 China eCommerce: Early Stage of Gold Rush – Where Does the Value Lie? 7-Nov-12 Dangdang: At the Crossroads: Initiate with Neutral, PT of $4.3 7-Nov-12 Baidu.com: Near-term Mobile Impact Much Less than Feared; Long-term Trends Look Promising 30-Oct-12 Baidu.com: Takeaways from Baidu World 2012 4-Sep-12 The Future of Chinese ADRs: PCAOB/SEC vs. China regulators/auditors 22-Jul-12 VIE storm: Deciphering VIE exposure of major companies 18-Jul-12 China Online Video: Paradigm Shift in Content Consumption 9-Jul-12 Youku Inc.: On the Path to Profitability 9-Jul-12 Tencent: Weixin Part II – Deep dive on mobile Open Platform and Social Graph 8-May-12 Sina Corp: Further Weibo monetization plan released – Notes from Weibo conference 3-May-12 Nothing But Net - Asia: 2012 Internet Investment Guide 12-Jan-12 Japan Pachinko/Pachislot Sector: Uncertainty About FY2012 Lineups Remains, but Reasons Differ for Each Company 19-Nov-12 Media Sector: Advertising Demand Improving; We Raise Our Forecasts for Ad Firms 20-Jun-12 Travels with Sully: Lessons from Tokyo: How to monetize wireless usage 28-May-12 START TODAY (3092): Upgrading to Neutral: Downside Risk Looks Limited 23-Mar-12 Gree (3632): We Welcome New Internal Controls; First iOS Game for US Market Released 16-Mar-12 Social Gaming: Aiming for a Balance - Monetization Versus Negative Press Coverage and Public Opinion 16-Mar-12 GOURMET NAVIGATOR (2440): Downgrading to Neutral: Recovery in Share Price - Expecting Steady Growth Going Forward 21-Feb-12 DeNA (2432): Maintain Overweight Rating, Sales Mix Improving 7-Feb-12 Korea Daum: Attractive once again 11-May-12 NHN: Expectations are still high 10-May-12 NHN: Reality check on Japan operation: Still too early to expect meaningful revenue generation 2-Apr-12 Korean portal sector update: Reality check on mobile Internet: Google leads NHN, while Baidu and Yahoo Japan are not far behind 22-Mar-12 Online game sector update: Multiple regulatory initiatives for teenagers again: stocks sold off but little impact on fundamentals 7-Feb-12 Source: J.P. Morgan. 2012 Top Picks Review Of our 2012 top picks in the internet sector, Baidu, Tencent, Youku, NetEase, and Tencent outperformed the Hang Seng by 37% in 2012. Youku performed on par with Nasdaq. Baidu and NetEase suffered from company-specific events and underperformed in 2H12. Figure 4: 2012 Sector Top Picks Performance - China Source: Bloomberg. 0.6 0.8 1.0 1.2 1.4 1.6 1.8 Baidu NetEase Tencent Youku Hangseng NASDAQ
  12. 12. 12 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Table 4: Valuation Comparison – China Internet Sector Ticker R'tg Price Mkt Cap EPS (Local Currency) P/E PEG EV/EBITDA 8 Jan (US$M) 2012E 2013E 2014E 2012E 2013E 2014E 12PE/13gth 2012E 2013E 2014E Online Platform Tencent 700 HK OW 255.6 61,070 9.36 12.52 15.65 27.3 20.4 16.3 0.8 19.6 14.8 11.9 Qihoo 360 QIHU US NC 32.5 3,876 0.60 0.89 1.41 54.1 36.3 23.0 1.1 44.1 27.2 17.0 YY YY US NC 13.6 737 0.51 0.75 1.34 26.4 18.0 10.2 NA 41.7 23.1 12.1 Median 27.3 20.4 16.3 0.9 41.7 23.1 12.1 Online Ad - Portal Bitauto BITA US NC 8.6 358 0.49 0.70 0.96 17.6 12.4 9.0 0.4 11.7 9.3 NM Sina SINA US OW 51.8 3,442 0.59 0.50 1.22 87.1 102.8 42.6 NM 134.1 36.2 18.9 Sofun SFUN US NC 27.1 2,162 1.86 2.21 2.65 14.6 12.3 10.2 0.8 11.3 9.6 8.3 People.cn 603000 CH NC 38.6 1,714 0.68 0.95 1.32 56.9 40.7 29.3 1.4 59.0 42.2 31.0 Sohu SOHU US OW 46.5 1,767 2.43 3.80 4.94 19.1 12.2 9.4 0.3 4.6 3.4 2.8 Phoenix New Media FENG US NC 3.5 273 0.23 0.25 0.32 15.1 14.1 11.1 2.1 12.0 9.7 6.7 Renren RENN US NC 3.6 1,361 -0.18 -0.14 -0.06 NM NM NM NA NM NM NM China Finance Online JRJC US NC 1.5 32 NA NA NA NM NM NM NA NM NM NM Median 18.3 13.2 10.7 0.8 11.9 9.7 8.3 Online Ad - Video Youku YOKU US OW 19.8 3,239 -0.61 -0.25 0.44 NM NM 45.0 NA 85.6 19.9 9.8 LeTV 300104 CH NC 18.5 1,244 0.49 0.71 0.99 37.8 26.1 18.7 0.8 14.7 10.6 8.0 Ku6 KUTV US NC 1.10 55 NA NA NA NM NM NM NA NM NM NM Median 37.8 26.1 31.8 0.8 50.2 15.3 8.9 Online Ad - Search Baidu BIDU US OW 101.1 35,340 4.81 6.20 8.19 21.0 16.3 12.3 0.7 15.9 11.9 9.0 eCommerce VIPShop VIPS US NC 18.0 912 -0.26 0.62 1.41 NM 28.9 12.8 NA NM 20.6 7.5 51jobs JOBS US NC 52.5 1,514 2.73 3.06 3.70 19.3 17.2 14.2 1.6 14.0 11.9 9.6 Ctrip CTRP US NC 23.4 3,359 1.14 1.27 1.54 20.5 18.4 15.1 1.8 19.2 16.9 14.4 eLong LONG US NC 15.4 526 0.18 0.44 NA 85.3 34.9 NM 0.6 NM NM NM Global Sources GSOL US NC 6.8 231 0.93 0.97 NA 7.4 7.1 NM 1.7 NM NM NM Mecox Lane MCOX US NC 0.62 36 NA NA NA NM NM NM NA NM NM NM Dangdang DANG US N 4.51 362 -0.94 -0.74 -0.25 NM NM NM NA NM NM 37.3 Median 19.9 18.4 14.2 1.6 16.6 16.9 12.0 Online Games Changyou CYOU US NC 28.5 1,496 5.33 5.84 6.31 5.3 4.9 4.5 0.6 3.2 2.9 2.6 Giant Interactive GA US NC 6.35 1,494 0.85 0.91 0.97 7.5 7.0 6.6 1.0 5.0 4.4 4.1 NetEase NTES US OW 42.5 5,554 4.26 4.48 4.72 10.0 9.5 9.0 1.9 4.9 4.3 3.9 Perfect World PWRD US NC 12.2 589 2.13 2.34 2.59 5.7 5.2 4.7 0.6 2.9 2.5 2.3 Shanda Games GAME US N 3.17 888 0.67 0.66 0.71 4.7 4.8 4.4 NM 2.4 2.4 2.2 The9 NCTY US NC 3.0 72 -2.82 -1.65 NA NM NM NM NA NM NM NM KongZhong KONG US NC 5.59 232 NA NA NA NM NM NM NA NM NM NM Median 5.7 5.2 4.7 0.8 3.2 2.9 2.6 Mobile Internet NetDragon 777 HK NC 10.4 675 0.62 0.83 1.05 16.8 12.4 9.9 0.5 7.2 5.5 4.4 Kingsoft 3888 HK NC 5.76 871 0.46 0.51 0.57 12.6 11.3 10.2 1.1 8.5 7.3 6.7 Median 14.7 11.9 10.0 0.8 7.9 6.4 5.5 Source: J.P. Morgan estimates, Bloomberg. Prices are in local currency.
  13. 13. 13 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Global Content Ecosystem
  14. 14. 14 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Asian Content Ecosystem
  15. 15. 15 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com SectorOverview
  16. 16. 16 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com China Internet Market Overview Internet Penetration Still Low at 39% China’s internet population grew at a steady pace in 2011, increasing 10.8% YoY to 537.6Mn by June 2012 or at a penetration rate of 39.1%, according to China Internet Network Information Center (CNNIC). Since late 2008, China has the world’s largest internet user base. We expect the stellar growth to slow down to 7-8% YoY in 2013, and gradually prompt internet penetration to reach 50% by end 2015. Figure 5: China Internet Users and Penetration Rate Mn Source: CNNIC, J.P. Morgan estimates. Furthermore, rural residents continued to adopt the internet in 1H12, with penetration up to ~20% of the total rural population. Figure 6: Rural Internet Penetration Reached 20% Source: CNNIC. Growth Moderated due to Demographic Bottlenecks In terms of depth, China's internet penetration rate of ~39% is still well below that of developed markets such as in the US, Japan, and Korea (over 70%). We expect internet users to grow by around 8% Y/Y in 2013 to reach ~606Mn, or the penetration rate to reach ~44% of the population by the end of 2013. 538 0% 10% 20% 30% 40% 50% 0 100 200 300 400 500 600 700 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12E Jun-13E Dec-13E Number of China Internet Users (Left, Mn) Penetration Rate as % of Total Population (Right) 35.2% 39.8% 44.6% 48.6% 52.4% 55.7% 59.1% 61.2% 11.7% 13.2% 15.0% 16.0% 17.2% 18.0% 18.6% 19.9% 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Penetration Rate (Urban Population) Penetration Rate (Rural Population)
  17. 17. 17 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Internet population growth slowed down in recent years, mainly due to relatively saturated penetration in the well-educated persons group. According to CNNIC survey, ‘Not skillful on PC/Internet’ remains the #1 reason for non-internet users to not go online, and this proportion is increasing. Figure 7: China Internet and Mobile Phone Users Growth Trajectory Source: CNNIC, Ministry of Industry and Information Technology (MIIT), J.P. Morgan estimates. As a comparison, 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. However, mobile phone has lower barriers to own and use, even in remote areas inhabited by people with less trained technical skills; hence, the sustained growth for the past 10+ years. Broadband Subs Continued Robust Growth According to the latest MIIT data, the number of broadband subscribers (by household) reached 172.5 million by Oct 2012. MIIT has set “Broadband China” as one of the key prioritized project s to implement in 2013 to further promote information consumption. Table 5: Broadband Subscriber Penetration by Number of Broadband Lines 2005 2006 2007 2008 2009 2010 2011 2012* Broadband subscribers (Mn) 37.5 51.9 66.5 83.4 103.2 126.3 150.0 172.5 Population Penetration (%) 2.9% 3.9% 5.0% 6.3% 7.7% 9.4% 11.1% 12.7% Households Penetration (%) 9.0% 12.5% 15.9% 19.9% 24.2% 29.3% 34.5% 39.1% Source: CNNIC, MIIT, J.P. Morgan estimates. Note: Data as of Oct 2012. Internet Access Device – Mobile Surpasses Desktop The number of mobile internet users accelerated by 22% Y/Y to 388Mn by Jun-12, as per CNNIC. The number of mobile internet users was 72.2% of all internet users. In 2013, we expect mobile internet usage to grow significantly as 3G and smart device penetration further deepen. 0 200 400 600 800 1,000 1,200 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 4.5years
  18. 18. 18 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Figure 8: Methods of Accessing by Device – 1H12 Source: CNNIC. Home Still the Preferred Location Home has been the preferred place for most users to access the internet, with more than nine out of 10 internet users accessing the internet from home, given the increase in internet-accessible computers, broadband penetration, and per capita wealth. We also see increasing usage of tablets as another factor for more information consumption at home. Figure 9: Main Access Locations by 2Q12 Source: CNNIC. Average Time Spent Online Remains Stable CNNIC’s Jun-12 survey showed users spent an average of 19.9 hours per week online. This was up from 18.7 hours per week six months earlier. We note that internet usage has more than doubled compared to the 9.8 hours per week spent online 10 years ago in Dec 2002. 70.7% 45.1% 72.2% 0% 10% 20% 30% 40% 50% 60% 70% 80% Desktop Laptop Mobile Phone 90.3% 30.9% 25.8% 12.6% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Home Internet Café Office Others
  19. 19. 19 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Figure 10: Average Time Spent Online Hours/week Source: CNNIC (Jun-12). IM, Search and Media are the Most Popular Internet Use According to the Jun-12 CNNIC survey, Instant Messaging is the most popular use of the internet (82.8% usage), closely followed by search engine (79.7%). Online Music is also popular, with 76.4% usage, while online news use was 73.0%. Microblog crossed the 50% mark, up from 40.2% usage in Jun-11. Table 6: Internet Usage by Category – 1H12 Service type % of surveyed use the service Users in millions Instant Messaging (chat room, QQ, ICQ) 82.8% 445.1 Search Engine 79.7% 428.5 Online Music/download 76.4% 410.7 News 73.0% 392.4 Blog 65.7% 353.2 Online Video (incl. download) 65.1% 350.0 Online Games 61.6% 331.2 Microblog 50.9% 273.6 Email 48.1% 258.6 Social Networking 46.6% 250.5 Online Shopping 39.0% 209.7 Online Literature 36.2% 194.6 Online Banking 35.5% 190.8 Online Payment 34.8% 187.1 BBS/forum 29.0% 155.9 Group Buying 11.5% 61.8 Online Travel reservation 7.9% 42.5 Online Stock trading 7.0% 37.6 Source: CNNIC (Jun-12). Chinese mobile users cite mobile chat/IM as the most used function while accessing the internet with their phones. Mobile search is chosen by 67% of mobile users while mobile news was the third most popular activity with 58% users. 13.4 12.3 13.2 14.0 15.9 16.5 16.9 18.6 16.2 19.0 16.6 18.0 18.7 19.8 18.3 18.7 18.7 19.9 0 5 10 15 20 25 Average Access Time Per Week
  20. 20. 20 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Figure 11: Chat/IM Is the Most Used Application on Mobile – 1H12 Source: CNNIC (Jun-12). 83% 67% 58% 49% 44% 42% 41% 30% 28% 27% 26% 11% 10% 10% 5% 4% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
  21. 21. 21 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Regulation: VIE, Accounting, “Real-name” Policy MIIT to promote information consumption in 2013 MIIT set the new 2013 targets at end-Dec: new add broadband subs 25Mn, new 3G subs 100Mn, Software and IT Service revenue to grow over 25% YoY. MIIT also plans to roll out 'Broadband China 2013' special project, aiming to eliminate the bottleneck for more information consumption. Before 2013, stimulative policies usually focus on promoting consumption on tangible goods. Starting from 2013, MIIT plans to promote content consumption on mobile internet, IPTV, mobile video, online shopping, mobile payment and device purchase on smart TV and smartphones. We are likely to see more pro-growth policies rolling out in 2013, especially in mobile content and the payment side. Concerns on VIE structure and joint-audit inspection still overhang In 2012, issues emerged from Variable Interest Entity (VIE) structure still dragged investor confidence on the entire sector. The SEC’s investigation on EDU and legal actions toward China accounting firms impacted sector performance. Negotiations on joint-audit inspection and working paper disclosure between PCAOB/SEC and China regulators are still ongoing. We expect a compromise to be reached by US and China regulators in early 2013. US capital markets remain critical for China early-stage companies to obtain capital and gain listed status. With more than US$100Bn of total market cap, Chinese companies are also an important component in the US capital markets to maintain its leading position worldwide. A showdown will do no one any good. As to issues on VIE structure, whatever the direction of new regulation will go to in the future, we believe it will only apply to new companies seeking listing, and do not see much impact to existing listed companies. “Real-name regulation” – A Roundtrip Implementation of “Real-name” regulation on social media had been the center topic in 1Q12 on Sina Weibo. It ended in a way similar to mobile phone real-name requirement, with rather loose enforcement and many workarounds to be in compliance. Toward the end-12, new laws on protecting personal information privacy was passed, igniting some uncertainties. The rules approved by the Standing Committee of NPC are the first major law to protect users’ personal information online via forceful legal tools. Compared with previous public expectations, the rules are quite moderate, as they mainly require internet users to use real names when signing web access agreements with service providers. We see the clauses of the new rules not meaningfully different from municipal-level industry regulations. Most sites including Sina Weibo are already working closely with government for compliance. The new rules have triggered debate over whether the policy can preserve users’ right to free speech or whether it will discourage them from freely voicing criticism out of fear of retaliation.
  22. 22. 22 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Mobile Internet As we mentioned in last year’s ‘Nothing But Net’, 2012 is the fledging year for mobile internet usage. Ubiquitous access of internet through various mobile devices has made mobile traffic grow significantly over the past several quarters, for all major players around the world. Mobile has become a significant part of the business that no one can ignore. Table 7: Mobile Traffic as a % of Total Traffic % 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 Baidu NA NA NA >15% ~20% NA 20%+ Naver 17% 23% 25% NA 38% NA NA Google NA NA NA 14% NA NA 20% Facebook* 42% 44% 47% 51% 54% 57% 60% Sina Weibo ** 40%+ 45% NA 50% 60% 69% 72% Source: Company Earnings Call, J.P. Morgan estimates. * Mobile Monthly Active Users (MAUs) as a % of total MAUs; ** % of DAU from Mobile Nevertheless, from a revenue contribution perspective, monetization still largely lies in MVAS through telecom subscription. Contribution from other channels in ad, games and eCommerce ramped up fast but still not the majority. Figure 12: China Mobile Internet Market Size and Segments Rmb million Source: iResearch. *MVAS refers to SP/CP MVAS revenue including SMS, MMS, WAP, IVR, Ringtone, Novel, Video, IM, etc, not including MVAS revenue from telecom operators. App Distribution – the Key Battlefield Because of smaller screen size and a more constrained user activity scope, content distribution/delivery channels have become crucial to developers to influence user choice and promote their products. We categorize distribution channels into the following five types:  OS Default: namely Apple App Store, Google Play and Windows Phone Store. iOS and Android have together taken ~ 45% of the total smartphone traffic in China, Windows still only ~1-2%. Economics and competition on these channels are regulated relatively well, with stable revenue-sharing policies and payment 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 Mobile eCommerce Mobile Ads Mobile Games MVAS Others
  23. 23. 23 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com support. On Google Play, payment is still an issue in China, as Google has disallowed third-party payment and could not locate a local partner to enable Rmb-denominated payments. Figure 13: Mobile OS Platform market share by PV Source: Baidu Mobile. * PV is page views from Baidu mobile search  Device OEMs: Major smartphone OEMs almost all have their own, customized app stores shipped along with the devices, such as Samsung Apps, LePhone MM, Nokia Ovi Store, Huawei Hispace Store, etc. They also sign contracts with vendors to “pre-install” these vendors’ apps/games onto their devices for users’ convenience. Figure 14: Smartphone brands market share by PV Source: Baidu Mobile. * PV is page views from Baidu mobile search  Telecom operators: Although not as dominant in the smartphone era, telecom operators still control many effective channels to users. Operator-run app 2.2% 3.2% 6.4% 12.2% 14.4% 21.4% 33.9% 1.5% 1.8% 3.2% 4.4% 5.8% 7.9% 10.7% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 Android iOS Symbian S60 MTK-based OS Feature Phone Symbian S40 Windows Others Unidentified 40.4% 38.9% 28.5% 27.8% 22.0% 20.8% 16.8% 5.1% 6.3% 7.1% 8.7% 10.4% 11.6% 12.1% 1.5% 1.8% 3.2% 4.4% 5.9% 8.0% 10.7% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 Nokia Samsung Apple Knockoff HTC Huawei Lenevo ZTE Moto Coopad Sony LG Unidentified Others
  24. 24. 24 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com markets: CU Wo Store, CM Mobile Market and CT eStore are default download sources for many mobile users. Sales persons in branches can easily influence customers. Operators also pre-install lots of apps in their operator-specific customized handset models. In terms of presence among the three China operators, market shares have shifted from CM to CU and CT over the past quarters. Figure 15: Telecom Operator Share by PV - All Mobile Users Source: Baidu Mobile. * PV is page views from Baidu mobile search Figure 16: Telecom Carrier Share by PV - iOS/Android Users Source: Baidu Mobile. * PV is page views from Baidu mobile search  Third-party app markets: With better user experience, more flexibility and professional daily operations, 3P app markets became the main source of app/service distribution on Android system. Leading players include 91 Assistant, HiMarket, AppChina, gfan, Anzhi, 360 Mobile Assistant, Baidu Apps, Tencent Apps Center, SnapPea (Wandoujia, 豌豆荚) etc. Developers publish their apps through these markets free of charge, but will need to pay for ad slots if they need to be highlighted by the app markets.  Killer apps: As we discussed in our first Weixin Note back in November 2011, we believe killer apps, such as Weixin could also serve as an effective channel to distribute apps with its high user traffic and stickiness. Popular apps with high installation base and user activities such as Sina Weibo, UCWeb Browser, 360 Mobile Safe and Mobile QQ all have their own sections of ‘App Centers’ within the app to promote and help distribute other apps. Developers also pay for ad service or in very few cases share revenues with publishers. Key Drivers - 3G and Smart Devices Penetration We estimate the current smartphone installed base to be around 200Mn in China, and expect this number to reach 400-450Mn by end of 2013. This would be a large enough user size to generate meaningful revenue to internet companies. A variety of tablet offerings and upgrades from Apple, Amazon and Samsung should also prompt more mobile usage. 12.6% 13.6% 13.7% 14.9% 16.5% 16.9% 20.0% 7.1% 8.0% 9.2% 13.6% 19.7% 20.7% 23.4% 80.4% 78.4% 77.1% 71.6% 63.8% 62.4% 56.6% 0% 20% 40% 60% 80% 100% 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 China Unicom China Telecom China Mobile 26.6% 27.4% 26.9% 26.7% 29.7% 33.5% 32.1% 32.0% 43.6% 39.1% 41.0% 41.3% 0% 20% 40% 60% 80% 100% 4Q11 1Q12 2Q12 3Q12 China Unicom China Telecom China Mobile
  25. 25. 25 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Figure 17: China Handset and Smartphone Subs estimates 2009 2010 2011 2012E 2013E Total China mobile subs 747,384 859,003 986,253 1,123,289 1,238,915 YoY % 16.6% 14.9% 14.8% 13.9% 10.3% Mobile penetration rate % 56.0% 64.1% 73.0% 82.4% 89.8% China Mobile 522,283 584,017 649,568 716,323 773,805 China Unicom 147,587 167,426 199,660 241,910 287,965 China Telecom 56,090 90,520 126,470 162,718 201,396 Others (MII announced - listed operators announced) 21,424 17,040 10,555 2,338 (24,252) Total subs 747,384 859,003 986,253 1,123,289 1,238,915 Smartphone % China Mobile 28.0% 32.0% 35.0% China Unicom 23.0% 30.0% 35.0% China Telecom 26.0% 32.0% 35.0% China Mobile 181,879 229,223 270,832 China Unicom 45,922 72,573 100,788 China Telecom 32,882 52,070 70,489 Smartphone Total 260,683 353,866 442,108 Smartphone Penetration 26.4% 31.5% 35.7% Source: Company reports and J.P. Morgan estimates. * Smartphone Penetration is % over total telecom subs. Figure 18: Network Connection Method Breakdown - iOS/Android Users Source: Baidu Mobile. Telecom Operators. Operators are increasingly becoming data pipes of SP/CPs, as users are less relying on operators to pay for services and apps. We noted increasing cooperating activities involving internet service providers, telecom operators and device OEMs. The motive for telecom operators is to cultivate the habit of using mobile data and earn the data fee elsewhere over a longer term. 47.4% 41.2% 32.2% 26.3% 22.3% 26.2% 28.7% 36.8% 39.6% 40.6% 26.4% 30.1% 31.0% 34.1% 37.1% 0% 20% 40% 60% 80% 100% 3Q11 4Q11 1Q12 2Q12 3Q12 2G 3G Wi-Fi
  26. 26. 26 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Figure 19: Data revenue (excl. SMS) as % of total mobile service revenue % Source: Company reports and J.P. Morgan estimates. China Mobile Internet User Profiles We reference surveys from CNNIC, data from Baidu, the largest mobile search provider, and Ipsos to portray a comprehensive view of China mobile internet users. User Base Size A number of mobile internet users in China has been growing at a steady pace in the last few years. Mobile internet penetration (as a percentage of total internet users) has increased from 6% in Jun-08 to 28% in Jun-12, with an average increase of 6% every year. This is almost equal to internet penetration on desktop. Figure 20: China Mobile Internet Users / Penetration Source: CNNIC. *Penetration is over total internet users. 5% 10% 15% 20% 25% 30% 35% 40% 2005 2006 2007 2008 2009 2010 2011 2012E 2013E China Mobile China Telecom China Unicom 73 118 155 233 277 303 318 355 388 6% 9% 12% 17% 21% 22% 23% 26% 28% 0% 5% 10% 15% 20% 25% 30% 0 50 100 150 200 250 300 350 400 450 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Mobile Internet Users (Mn) Mobile Internet Penetration
  27. 27. 27 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Figure 21: Internet Penetration by Access Device Source: CNNIC. Figure 22: Smartphone Penetration Source: J.P. Morgan estimates, Dec-11. *China Penetration is over total China population. Age Figure 23: Mobile Internet User Age Group % Source: CNNIC, Sep.12. 17% 20% 20% 21% 23% 26% 26% 28% 28% 6% 6% 7% 9% 11% 15% 16% 18% 18% 6% 9% 12% 17% 21% 22% 23% 26% 28%19% 22% 25% 29% 31% 34% 36% 37% 39% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Desktop Laptop Handset Total Internet Penetration 4% 9% 16% 25%21% 46% 73% 100% 42% 51% 56% 61% 34% 48% 62% 78% 0% 20% 40% 60% 80% 100% 120% 2010 2011 2012E 2013E China United Kingdom Japan United States 1.2% 25.4% 30.2% 25.5% 12.0% 4.3% 1.4%0.7% 28.5% 35.7% 24.2% 8.3% 2.1% 0.5% 0% 5% 10% 15% 20% 25% 30% 35% 40% Below 10 Age 10-19 Age 20-29 Age 30-39 Age 40-49 Age 50-59 Above 60 Overall Internet Mobile
  28. 28. 28 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Geographic Presence Figure 24: Geographic Breakdown - iOS/Android Users % Source: Baidu Mobile. Apps Preference Figure 25: Mobile App Preference % Source: CNNIC. Time & Location In a survey conducted by Ipsos, 64% of people in China said they use their smartphones 7 days a week. This compares with 77% in Japan, 62% in the US, 59% in UK and 58% in Australia. 13.9% 7.4% 5.5% 4.0% 0% 2% 4% 6% 8% 10% 12% 14% 16% 4Q11 1Q12 2Q12 3Q12 Guangdong Jiangsu Beijing Shandong Shanghai 83.0% 58.3% 66.7% 49.2% 41.9%41.2%43.8% 26.8%30.0%25.9%27.7% 11.4% 9.9% 9.7% 4.8% 3.9% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
  29. 29. 29 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Figure 26: % of smartphone users that don’t leave the house without their device Source: Google, Ipsos, 1Q12. Figure 27: % of smartphone users that use their device 7 days a week Source: Google, Ipsos, 1Q12. 43% of people in China said they never leave home without their smartphone. This compares with 80% in the US, 78% in Japan & UK, and 74% in Australia. Key Themes to Watch in 2013 1) Mobile Ad: We think disruptive innovation is needed for mobile ads to gain momentum in the next few years. We already see early success of Sina Weibo’s Promoted Feeds ad and Facebook’s Sponsored Stories/News Feed ads to gain good traction to advertisers on mobile. Mobile search could see improved economics with better presentation, wider distribution and innovative application with LBS features. 2) Mobile Games: We see mobile games to benefit most from a growing smartphone installed base in 2013, as developers grow more adept in releasing high-quality hits, and distribution platforms with social relationships (such as Weixin) to help boost reach and user engagement. 3) Mobile eCommerce should see further significant growth, along with the booming eCommerce market, but mobile payment remains one of the key issues to be further streamlined. 4) App Distribution. Competition among 3P app markets on Android will intensify, along with the emergence of some killer apps as another powerful distribution channel. Stock Implications Tencent is our top pick for investors to gain mobile exposure in 2013, with its constantly evolving Weixin platform and meaningful market shares in mobile games, browsers, app distribution, and a complete suite of mobile offerings. We also see Youku, Sina and Baidu benefitting with their innovative mobile ad solutions as advertisers further allocate budget to mobile. Netdragon (777.HK, not covered) has become a leading player in 3P app market distribution. AutoNavi (AMAP US, not covered), and Qihoo may also benefit from increasing mobile user activities in their respective segments. 43% 78% 80% 78% 74% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% China Japan USA UK Australia 64% 77% 62% 59% 58% 81% 79% 70% 61% 71% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% China Japan USA UK Australia Mobile PC
  30. 30. 30 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Online Advertising Top-Down: 2013 Online Ad Market to Register 26% Growth With decent YoY growth of ~29% in 2012, we estimate online ad to account for ~20% of China total ad market by now. Advertisers continue to allocate a higher proportion of their budget online, mainly from traditional newspapers and TV segments. With this level of penetration and advertisers’ conservative stands toward early next year, we expect a slower growth for both online and traditional ad in 2013, especially in the first half. Overall, we forecast the online ad market to witness 29% YoY growth in 2012, to reach Rmb68Bn (or US$10.8Bn) and 26% YoY growth in 2013 to reach Rmb86.4Bn (US$13.7Bn). Table 8: China Online Advertising Market Forecast 2007 2008 2009 2010 2011 2012E 2013E Brand (RMB M) 4,871 8,411 8,997 13,518 17,715 19,486 21,825 Search (RMB M) 2,880 5,331 6,991 11,038 18,880 28,028 38,782 Video (RMB M) 250 570 1,360 2,150 4,250 7,013 10,168 Others (RMB M) 2,771 3,770 4,742 6,513 12,372 13,980 15,658 Total Online Ad market (RMB M): 10,771 18,082 22,089 33,219 53,217 68,507 86,433 Total Online Ad market (US$M) 1,062 2,632 3,235 4,940 8,288 10,865 13,753 Growth Rate (Rmb, %) 75.2% 67.9% 22.2% 50.4% 60.2% 28.7% 26.2% Total China Ad market (Rmb M) 161,903 181,375 197,564 247,593 303,030 339,394 373,333 Growth Rate (Rmb, %) 14.1% 12.0% 8.9% 25.3% 22.4% 12.0% 10.0% Ad market as % of GDP 0.62% 0.60% 0.58% 0.63% 0.71% 0.73% 0.75% Online Ad as % of Total Ad market 4.9% 10.0% 11.2% 13.4% 17.6% 20.2% 23.2% Source: iResearch, CNNIC, J.P. Morgan estimates. Note: Growth rates are in Rmb terms. Top-down structural drivers in 2013 are: 1) Wider adoption of new online ad formats in video, social, mobile ads. 2) Rising number of users and increasing time spent on the internet will continue to drive online ad allocation. 3) Lower smart device price, declining unit broadband fees, higher influence of online/social media. 4) deeper penetration of online advertisers in to lower-tier cities and SMEs. 5) an increasingly ROI-driven mindset from advertisers enabled by tracking and performance evaluation technology. Time spent on internet per users would accelerate from the increased penetration of smartphones and tablets. Figure 28: Time Spent on Internet Has Steadily Increased Source: CNNIC, Jun-12. 16.9 18.6 16.2 19 16.6 18 18.7 19.8 18.3 18.7 18.7 19.9 0 5 10 15 20 25 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Average Time Spent Online(hrs/week)
  31. 31. 31 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Be Selective: Video, Social, Mobile We recommend investors focus on growth segments within online advertising, i.e., video, performance-based social ad and mobile ad. These segments are better ROI and targeted reach therefore less subject to budget slow-down in 2013. Figure 29: Online Ad Segments Growth – Video Still Stands Out % Source: iResearch and J.P. Morgan estimates. Figure 30: Mobile Ad Market Growth Source: iResearch. In 2012, we saw pure-play online ad names underperformed the market and other segments. In 2013, we expect the overall online ad segment to outperform, with growth segments of video, social and search pure-plays to be the leading performers. Figure 31: 2012 China Online Ad Stock Performance Source: Bloomberg. 150% 128% 139% 58% 98% 65% 45% 40% 0% 20% 40% 60% 80% 100% 120% 140% 160% 2007 2008 2009 2010 2011 2012E 2013E 2014E Display Search Video Other Format Total Online Ad 107.6% 121.5% 155.8% 184.3% 153.4% 134.6% 116.2% 0% 50% 100% 150% 200% 0 500 1000 1500 2000 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 Mobile Ad Market Size (RMB M) YoY Growth (13.9%) (5.3%) (3.4%) (5.2%) 59.5% 16.4% 89.2% 22.9% 15.9% -50% 0% 50% 100% Baidu Sohu Sina NetEase Tencent Youku Qihoo Hangseng NASDAQ
  32. 32. 32 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Figure 32: 2011: Search Outperformed Display Source: Bloomberg. Figure 33: 2012: Market Share Grabber Outperformed; Video Better than Banner Display Source: Bloomberg. Bottom-Up: Consumer Behavior Drives Growth From a bottom-up perspective, we expect online ad market drivers to be: 1) increasing user adoption of internet and buying behavior online, 2) higher SME advertisers’ adoption of online ad and pay-for-performance ad, 3) eCommerce migration in certain product categories such as travel, 3C (Computer, Consumer Electronics, Communication) and apparels. Verticals that we believe are likely to see decent growth in 2013 are: FMCG (Fast Moving Consumer Goods), IT and eCommerce. 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 Baidu Sohu Sina NetEase Tencent Youku Tudou Hangseng NASDAQ 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0 Baidu Sohu Sina NetEase Tencent Youku Qihoo Hangseng NASDAQ
  33. 33. 33 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Table 9: Ad Vertical as % of Total Ad Rev SINA SOHU NTES Tencent RENN QIHU FMCN AMCN VISN YOKU BIDU FENG Auto Top-4 25-30% (Brand Ad) Top-3 Top-5 33% 28% IT Top-4 Largest Telco Top-4 14% FMCG Top-4 13-15% (Brand Ad) Top-3 Top-5 2nd Largest 32% 9% 30% 55-60% 12% Internet Top-5 11% 6% 15% eCommerce Top-3 (Search Ad) 10% (Brand Ad) ~40% 12% Group-Buying ~10% Financial Services Top-3 4th Largest 3-4% 15% 15% 11% Consumer Electronics 2-3% 12% 15% Real Estate 13-15% (Brand Ad) 4-5% 5% Apparel Top-5 3rd Largest Healthcare Top-3 (Search Ad) 6% Top 5 5% Fashion / Luxury Top-5 2% Daily-care 5th Largest Education Top 5 Machinery Top 5 Travel Top-2 (Brand Ad), Top-3 (Search Ad) 20% Top 5 2% Games 13% (Brand Ad) ~9% Others 23% (Brand Ad) Top 5 Period 3Q12 2Q12 3Q12 3Q12 3Q12 2Q12 3Q12 3Q12 2Q12 2Q12 3Q12 3Q12 Source: Company Filings, Earnings Call Scripts. Automobiles In 2013, we are mildly constructive on auto sector advertising dollar growth. Our China Autos Analyst Nick Lai suggests that specific segments in passenger vehicles such as SUV and Luxury will see sales volume growth of 20%+. The inventory level has improved in late 2012, showing robust demand from SUV and luxury segments. We expect ad dollars to register growth from rising demand and the comeback of the Japan auto OEM spend.
  34. 34. 34 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Table 10: Expected Launch of Auto Models in China Rmb in '000 Producer New model expected launch time estimated price (Rmb K) DongFeng Nissan New Teana Jul-13 N/A Juke 1H13 N/A New Livina 4Q12 N/A DongFeng PSA C4L 4Q12 120 - 160 Citroen Cross 4Q12 N/A Peugeot 3008 4Q12 180 ~ Great Wall Voleex C70 4Q12 60 - 80 CH012 4Q12 N/A Halva H7 around end-13 N/A Halva H2 2Q/3Q 12 BYD I3 4Q12 50 - 80 Geely SC5 4Q12 N/A SC6-RV 4Q12 45.8 - 62.8 GC515 4Q12 45 - 60 EX8 4Q12 120 - 150 SX5 4Q12/1Q13 N/A GX313 4Q12/1Q13 40 - 50 EV8 4Q12/1Q13 N/A GV5 4Q12/1Q13 60 - 120 GAC Trumpchi 1H13 60 - 80 GAC Mitsubishi ASX mid-13 170 - 230 Source: J.P. Morgan estimates, Company data. Fast -moving Consumer Goods FMCG vertical continued to gain more weight for most online ads companies in 2012. Historically, FMCG advertisers used to allocate less spending online. As consumption becomes more important in China, marketing campaign that integrates online and offline is required to differentiate a brand. Formats such as video and social can provide enough reach as well as segmentation for targeting to address need from advertisers in FMCG. We see 2013 ad dollars from FMCG to be continually robust. Real Estate We saw real-estate ad spending pick up a bit toward the end of 2012, helped by higher transaction volume and inventory de-stocking. That said, we think it is reasonable to assume a 'back-to-average' scenario for Real Estate ad spending, rather than predicting an accelerating market. Government-led affordable housing programs would still constitute sizable amount of supply, requiring less ad spend. eCommerce eCommerce ad spend has come down from the peak in 2011 and normalized in 2012 as the companies continue to spend online to convert traffic into buying behavior. We note that after the fade of capital inflows to the entire sector, most eCommerce companies cut their marketing spend meaningfully to improve cash flow and profitability. Only a few entrants and large comprehensive retailers spend regularly. That said, we think eCommerce ad spend shall be one of the key segments that would enjoy sustainable structural growth in the next 5-10 years. Video, vertical search and social ad placement were proportionally higher with their better ROI and favorable user demographics. Search on vertical and general engines are still popular with trackable performance and good ROI.
  35. 35. 35 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Information Technology This is an area we believe will see sustained ~20% YoY growth in 2013, as hardware companies continue to roll-out latest models of smartphone, tablets, ultrabooks, and appliances manufactures update their product with more smart features. Windows 8-related products shall be a major driver in this category from 4Q12 onward. Financial Services Finance ad spend is sustained by decent profit from commercial banks and their continued efforts in promoting wealth management products, credit card, and brand building. Security and investment industry suffered in market weakness. Budgets from mutual funds, insurance and brokerage houses would still be limited in 2013. We expect overall ad demand from this sector to be mediocre in 2013. Telecom Telecom operators, especially China Unicom and China Telecom, spent aggressively in 2012 to promote their broadband packages, 3G plans and subsidized handset models. We see this driving force to moderate in 2013. China Mobile's effort in pushing out TD-LTE in '13/'14 may spur some additional spend. Telecom operators' initiatives in promoting their own internet value-add services such as mobile apps and app store would be another factor for demand growth. CCTV 2013 Auctions Results: Better than Feared CCTV reports 2013 prime time ad revenue of Rmb15.88Bn, up 11.4% YoY. This is better than previous CCTV-internal forecasts of high-single-digit growth. Leading verticals are Food & Beverage, Home Appliance and Finance. Other verticals such as Auto, Alcohol and Travel also saw decent growth. Most slots are bid by domestic companies, as we believe multinationals continue to view CCTV as a less effective media in terms of ROI and reaching targeted audience. We believe multinationals to further allocate their budget onto internet and new media in 2013. Table 11: CCTV Auction Results vs. Online Brand Ad Growth Year CCTV Prime time Auction Revenue (Rmb Bn) YoY Growth Online Banner Ad Growth Online Video Ad Growth Number of times (X): Online Brand Ad Growth / CCTV Auction Growth 2000 1.92 2001 2.16 12.5% 2002 2.63 21.6% 26% 1.2 2003 3.31 26.2% 102% 3.9 2004 4.41 33.1% 72% 2.2 2005 5.25 19.0% 23% 1.1 2006 5.87 11.8% 49% 4.3 2007 6.80 15.8% 72% 163% 4.2 2008 8.03 18.1% 89% 150% 4.2 2009 9.26 15.3% 8% 140% 1.0 2010 10.97 18.5% 53% 61% 2.8 2011 12.67 15.5% 37% 107% 2.6 2012 14.26 12.5% 10% 65% 1.6 2013E 15.88 11.4% 12% 45% 1.8 Average 18.2% 48% 104% 2.6 Source: CCTV, Zenith Optimedia. J. P. Morgan current estimates. Top ad spend grossing is still coming from the Alcohol segment. The industry bid for total ~Rmb4.2Bn, or 26 % of total auction value. As the CCTV ‘Alcohol Ban’ is still
  36. 36. 36 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com in effect this year: only 4 items are eligible for bidding from alcohol manufacturers; overall alcohol appearance counts are also limited during different time frame. This intensifies competition among deep-pocket Chinese alcohol brands. Table 12: By Vertical Bidding Results* - ex-Alcohol growth is muted Rmb in Mn Industry 2011 2012 2013 % Growth Wine & Spirits 2,262.5 3,347.9 4,388.8 31% Finance 1,306.7 1,437.6 798.4 -44% Home Appliances 1,161.6 1,082.3 1,131.0 5% Food 957.9 1,245.2 1,118.2 -10% Transportation 822.2 461.8 883.4 91% Dairy Products 752.2 140.2 114.5 -18% Drinks 700.8 1,151.5 1,666.6 45% Cosmetics 614.1 301.1 412.9 37% Pharmaceutical 341.1 403.6 309.1 -23% IT 288.5 949.0 623.1 -34% Telecommunication 277.4 438.0 263.5 -40% Health Products 238.9 144.9 65.0 -55% Apparels 180.4 200.9 165.6 -18% Manufacturing 173.0 266.0 200.9 -24% Home products 63.9 108.3 72.4 -33% Others 17.4 222.1 117.1 -47% Travel 10.1 92.3 41.04 -56% Business / Commercials 229.2 610.1 166% Agriculture 36.0 133.2 270% Media 175.2 Petro Chemicals 92.4 Total 10168.7 12,257.57 13,382.34 YoY Growth 20.5% 9.2% ex-Wine + Spirits Total 7,906.2 8,909.7 8,993.5 YoY Growth 12.7% 0.9% Source: Charm Communications. * This is the results from CCTV ad live auctions, not including close-auction portion. Excluding the Alcohol segment, we saw some muted growth on TV ad spend, especially from IT, Communications and Financial Services sectors. We believe as eCommerce is becoming increasingly meaningful for 3C product selling, it makes perfect sense to directly advertise online to prompt purchase behavior, compared to spending much brand dollars on offline mass media. We saw a significant rate increase in top-tier TV ad inventories, which could push mid-size advertisers to the internet. On a comparable basis, the ‘CCTV News Countdown Combo’ items, which include 15 seconds of ad and 5 seconds of countdown ad right before the 7PM CCTV News everyday, were auctioned to a total of Rmb1.06Bn, up 62.5% from Rmb656Mn in 2011 and Rmb550Mn in 2010. We believe this kind of pricing pushes ROI-conscious and mid-size advertisers to internet and online video. With the CCTV auction setting a stable tone, we think the online portals and online video ad rates are highly likely to achieve ~15-20% YoY hike. We expect online ad companies to see benign growth into 2013, mainly from continued budget migration to online segments.
  37. 37. 37 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Display Advertising (ex-Video) We Expect ex-Video Display Ad Spend to Grow ~12% in ‘13E In 2012, we estimate ex-video display ad segment growth softened to 10%, suffering from overall online ad slowdown and partial substitution from video, social and search. For 2013, we expect ex-video display ad growth to be under pressure, as advertisers move dollars away from traditional banner and text ad into video, search and mobile. We think Social will be a bright spot amid the softening with better targeting capability and ROI. Table 13: China Display Ad (ex-Video) Segment Forecast 2007 to 2013E 2007 2008 2009 2010 2011 2012E 2013E Display Ad sub-total (Rmb Mn) 4,871 8,411 8,997 13,518 17,715 19,486 21,825 Display Ad sub-total (US$Mn) 647 1,224 1,318 2,010 2,759 3,091 3,473 Growth 72% 89% 8% 53% 37% 10% 12% % of Display as Total Ad Mkt 3.0% 4.6% 4.6% 5.5% 5.8% 5.7% 5.8% Source: J.P. Morgan estimates. Positive factors driving 2013 display ad spending include: 1) continuation of budget dollar shift from offline to online driven by wider adoption in Weibo and targeted social ads, 2) increasing user reach into lower tier cities and 3) improving ad delivery technology, inventory management and performance measurement. On the negative side: 1) soft macro sentiment on total ad budget, 2) a preference of sales-generation and promotional ad budget allocation from brand ad, 3) increasing advertiser awareness on ROI and preference on non-CPM based ad, and 3) fierce competition among leading players. Traditional Banner Display to Lag Overall Online Ad Growth Traditional banner is less of a feature but more of a standard product. To offer better comprehensive products and differentiate with vertical websites to brand advertisers, leading portals are all packaging various resources to offer more precise and effective branding campaigns. In 2013, we expect comprehensive ad offerings combining different features such as social, video, sponsorship, banner, text, etc. from leading portals to sustain leading positions for major portal sites. Figure 34: Leading Players Display Ad Growth Source: J.P. Morgan estimates, Company data. 95% 84% 17% 45% 52% 76% 32% (20%) 0% 20% 40% 60% 80% 100% 2007 2008 2009 2010 2011 2012E 2013E Total Display Sina Sohu Tencent NetEase
  38. 38. 38 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Tencent Substantiates the Lead With the release of Guang Dian Tong and a revamp of portal front page to integrate more social elements, Tencent's display ad segment surpassed Sina in 3Q12 as the largest online ad company in China. Up until 3Q12, Tencent’s online advertising revenue was Rmb1Bn (including ~10% of search), compared with Sina’s level (US$123Mn by 3Q12). Video and performance-based social ad should help Tencent to substantiate the lead in display ad market in 2013. Table 14: Leading Display Ad Players Revenue Comparison US$ in millions (US$Mn) 2004 2005 2006 2007 2008 2009 2010 2011 2012E 2013E Total Display Ad Market Size 647 1,224 1,318 2,010 2,759 3,091 3,473 647 1,224 1,318 Sina 169 258 228 290 369 413 460 169 258 228 Sohu 112 169 177 212 279 289 318 112 169 177 Tencent 59 108 127 184 279 492 650 59 108 127 NetEase 37 54 51 85 112 120 126 37 54 51 Others 270 634 735 1,240 1,720 1,776 1,919 270 634 735 Source: J.P. Morgan estimates, Company data. Figure 35: Tencent to Grab More Share and Size in Display Ad Source: J.P. Morgan estimates, Company data. The Return of Alimama In 2013, Taobao Alliance, the affiliate advertising program of Taobao, will be merged into Alimama, the online ad-trading platform of Alibaba, shifting its focus from Taobao merchants to comprehensive online advertising. Taobao Alliance will only become one component of the larger platform. The Alimama platform will have three main components: Taobaoke, the affiliate advertising service that was Taobao Alliance's primary product; display advertising available via eTao's TANX (Taobao Ad Network & eXchange) ad exchange; and a newly-established Taobao mobile ad union service. The Taobao Alliance currently boasts over 500,000 website partners, several million merchant members, and daily average page views exceeding 4.5Bn., Alimama will be part of the eTao division in the group structure. 26% 21% 17% 14% 13% 13% 13% 17% 14% 13% 11% 10% 9% 9% 9% 9% 10% 9% 10% 16% 19% 6% 4% 4% 4% 4% 4% 4% 42% 52% 56% 62% 62% 57% 55% 0% 20% 40% 60% 80% 100% 2007 2008 2009 2010 2011 2012E 2013E Sina Sohu Tencent NetEase Others
  39. 39. 39 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Online Video We believe the structural change in how users consume content has prompted significant marketing dollar shift from traditional TV to online video, thereby fundamentally changing the cash flow picture for leading online video players. We expect the China online video market to grow at a CAGR of 40% from 2012 to 2015 to US$3.1Bn, accounting for 15% of the online ad market and 4% of the total ad market in China. Better visibility on profitability with deepened monetization and cost normalization. We are likely start to see quarterly profitability in leading players towards 2H13. This would provide clearer visibility to the end of the money-burning tunnel and be the major catalyst for sector re-rating. Secular Growth from Structural Ad Dollar Shift Online video has seen strong growth in China with the number of users growing to ~350Mn by the Jun 2012, representing ~65% of the total internet users, according to CNNIC. Figure 37: Growing Online Video Users in China Source: CNNIC Online video ad market size is still only a fraction of traditional TV ad size, similar to the early stage of banner ad adoption. Eventually video ad will grow to become a major format of display ad to well serve the purpose of advertiser branding campaigns. We estimate the online video market size in China to grow to US$1,112Mn in 2012, ~7% of the size of the TV ad market. Table 15: China Online Video Ad Market Size Forecast US$ in millions 2007 2008 2009 2010 2011 2012E 2013E 2014E 2015E Video Ad Market size 33 83 199 320 662 1,112 1,618 2,265 3,058 Growth 163% 150% 140% 61% 107% 65% 45% 40% 35% Video as % of Total Online Ad Mkt 2.3% 3.2% 6.2% 6.5% 8.0% 10.2% 11.8% 13.5% 15.2% Video as % of Total Ad Mkt 0.2% 0.3% 0.7% 0.9% 1.4% 2.1% 2.7% 3.3% 4.0% Source: iResearch, J.P. Morgan estimates. 161 180 202 222 240 265 284 301 325 350 0% 2% 4% 6% 8% 10% 12% 14% 0 50 100 150 200 250 300 350 400 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Online Video Users (Mn) Sequential Growth (%) Figure 36: Online Video Performance Source: Bloomberg. Figure 38: Sector Performance ‘12 Source: Bloomberg. 60% 110% 160% 210% Dec-11 Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12 Youku LeTV Ku6 NASDAQ 16% (12%) 26% 16% (50%) 0% 50% Youku LeTV Ku6 NASDAQ
  40. 40. 40 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Figure 39: Happening: China Online Video Growth at Early Stage, Similar to Early Years of Banner Ads US$ in millions Source: Zenith Optimedia China, J.P. Morgan estimates. Table 16: J.P. Morgan Online Ad Market Forecast – China US$ in millions 2007 2008 2009 2010 2011 2012E 2013E 2014E Display (ex-Video) 647 1,224 1,318 2,010 2,759 3,091 3,473 4,098 Video 33 83 199 320 662 1,112 1,618 2,265 Search 382 776 1,024 1,641 2,940 4,445 6,171 7,653 Other Online 368 549 694 969 1,927 2,217 2,491 2,790 Total Online Ad market 1,062 2,632 3,235 4,940 8,288 10,865 13,753 16,806 Growth Rate 87.5% 147.7% 22.9% 52.7% 67.8% 31.1% 26.6% 22.2% Total China Ad market 21,499 26,398 28,935 36,820 47,194 53,829 59,403 67,719 Growth Rate 20.1% 22.8% 9.6% 27.2% 28.2% 14.1% 10.4% 14.0% Video Ad as % of Total Online Ad 2.3% 3.2% 6.2% 6.5% 8.0% 10.2% 11.8% 13.5% Video Ad as % of Total China Ad 0.2% 0.3% 0.7% 0.9% 1.4% 2.1% 2.7% 3.3% Source: Zenith Optimedia China, J.P. Morgan estimates. Ecosystem Dynamics – Video ROI still Favorable We categorize video business into the following segments in the entire value chain: 1) Production, 2) Distribution, 3) Media Channels, 4) Enablers, 5) Users/Audience, and 6) Advertisers. Figure 40: Maturity of Online Video Value Chain Creates Virtuous Circle Source: J.P. Morgan. 5,499 6,253 6,577 7,761 8,298 10,521 13,152 14,730 16,203 18,194 13 33 83 199 320 662 1,112 1,618 0% 30% 60% 90% 120% 150% 180% 0 3,000 6,000 9,000 12,000 15,000 18,000 2005 2006 2007 2008 2009 2010 2011 2012E 2013E 2014E TV Online Video Online Video Growth (RHS) Content Selection Production User Behavior Advertiser Targeting Budget Allocation Ad Media Selection
  41. 41. 41 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com We think video still offers better ROI for advertisers comparing to other display ad formats and traditional TV ad, especially in Tier-1 cities where inventories are limited and highly sought after. Input cost on bandwidth and content side is rationalizing, as economies of scale play a larger role and video sites grew their leverage on the bargaining table. Video sites have been picky on premium content selection, while investing aggressively in building up in-house productions for better cost control and flexibility. Proliferation of smartphone and tablets further promoted consumption and time spent on video. Ad pricing on tablets is already marked similar or higher than on desktop. Figure 41: Video Business Ecosystem Source: J.P. Morgan. Production Distribution TV Stations Audience Advertisers Online Video Websites / Apps Service Channels Pay for Device/Service Content Copy Delivery Marketing Peripherals Content Delivery Other Channels: DVD, airline, oversea, etc User Behavior Content Selection Budget Allocation Telecom Carriers Cable Operators PC/Smartphone/ Tablet TV Enable Infrastructure Help Sell Device/Service IPTV / OTT Vendors Media Enablers
  42. 42. 42 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Users are increasingly ranking online video as one of their key activities online. According to the latest CNNIC survey, online video ranked # 5 in the most frequently used online services covering 65% of all internet users. Figure 42: Most Often Used Services / Tools, Jun ’12 Source: CNNIC. Advertisers, especially MNC/FMCG companies started to use online video extensively to address specific demographics or market brand image. We think online video advertiser penetration is yet to reach saturation in the coming two years. Figure 43: Youku # of Advertisers Growth vs. Sina Source: Company reports. Further Monetization Potential in 2013 Online video companies still have many levers to pull including: 1) increasing ad duration or more rolls before/after hot content, 2) mid-rolls which have only been mildly used to maintain user experience, 3) mobile usage which have only been ramping up (mobile contributes ~20% of traffic on Youku and Tudou at peak level in 3Q12) but only mildly monetized, 4) ad rate hike of 15-20% following TV annual ad rate increase. 65.1% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Instant Messaging (chat room, QQ, ICQ) Search Engine Online Music/download News Online Video (incl. download) Online Games Blog Microblogs Email Social Networking Online Literature Online Shopping Online Payment Online Banking BBS/forum Group Buying Online Travel reservation Online Stock trading 141 303 423 505503 582 760 790 980 1080 1220 1300 840 860 0 100 200 300 400 500 0 200 400 600 800 1,000 1,200 1,400 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Youku # of advertiser (LHS) Sina # of advertiser(LHS) YOKU Rev per advertiser (RHS, US$ '000) SINA Rev per advertiser (US$ '000)
  43. 43. 43 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Tablet/Smartphone/Internet TV penetration to disrupt the ways of content consumption. Although still the mainstream channel right now, PC/laptop are not the ultimate appropriate channel for content consumption. We see upcoming game changer devices like new iPad/iPad mini, new Kindle, whitebox tablets, and Apple’s future TV products to disrupt video experience on long-format content, and proliferation of smartphones for fragmented, on-the-go content. Bandwidth Unit Price to Gradually Decline We see declining unit bandwidth price for both consumers and corporates coming in 2012 and 2013, fueled by last-mile bandwidth upgrades and gradual introduction of competition on telecom operators’ bandwidth pricing for corporates. Figure 44: Bandwidth Cost Burden of Online Video Sites Rmb ‘000 Source: Company reports and J.P. Morgan estimates. * LeTV is 9M12 number; Tudou is 2Q12; Youku is 3Q12. In the long run, we expect bandwidth cost to normalize to around 15-20% of revenue for leading online video sites, meaning gross margin could be lifted by 15-20 pct points on average through moderation of this cost item into steady state. Content Price to Polarize; Content Spend to Rationalize After burning millions in content purchasing in 2011, online video companies have pulled back a lot in spending in 2012 and become more careful in picking specific productions and diversifying into other genres such as animation, sports events and variety shows. Purchase alliances such as ‘Video Content Cooperation (VCC)’ are also formed to buy in bulk in stead of chasing exclusive. We expect content price to polarize in 2013 as: 1) leading players finish their initial inventory build-up and get more experienced at choosing and pricing content, only willing to pay premium for the real premium contents, 2) proliferation of mediocre content supply stimulated by high market price after 2011 to drag on overall price level at the lower end, 3) self-produced content at lower cost to help control costs and build brand, and 4) less funding available to be burned overall. On content spending, we expect cash content spending in 2013 to be 20-25% higher than 2012 for leading online video companies, driven by follow-on installments of payments for previous purchase and continued content library expansion to drive more traffic and ad inventories. 22% 38% 17% 0% 5% 10% 15% 20% 25% 30% 35% 40% 0 20,000 40,000 60,000 80,000 100,000 120,000 140,000 160,000 Youku Tudo LeTV Bandwidth Cost As % of revenue
  44. 44. 44 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Consolidation Continues: 4-5 leading players will survive Industry consolidation and horizontal cooperation are still on their way. Following a series of transactions in 2011, in 2012, we saw Youku and Tudou merged together, IPTV player BesTV (600637 CH) entering into online video space, and Baidu fully acquired iQiyi. Table 17: Investment and Transactions in Online Video sector Company Action Type Target Deal Date Investment Amt (US$MM) Deal Term % of Ownership Notes (Deal Rationale) Shanda Acquisition Ku6 6/18/2009 Stock 51% Baidu Divestiture Qiyi.com 3/23/2010 50 Cash Sold part of iQiyi to PE Sina Acquisition Tudou 8/30/2011 66.4 Cash 9.05% Financial investment RenRen Acquisition 56.com 9/26/2011 80 Cash 100% Tudou Joint Venture LeTV 10/18/2011 0.49 Cash 49% Formed JV for content purchasing cooperation Youku Merger Tudou 3/14/2012 Stock Merged with Tudou to form combined entity BesTV Acquisition Funshion 3/29/2012 30 Cash 35% BesTV expanding into online video Baidu Acquisition iQiyi 11/1/2012 200 Cash 100% Acquisition of remaining stakes in iQiyi Source: Company reports, Bloomberg. In February 2012, NetEase cooperated with LeTV on content with a revenue-sharing agreement to offer video service to its users. In the agreement: 1) LeTV is responsible for setting up a platform (163.letv.com) for NTES, provide CDN, content and broadcasting technology. LeTV needs to make sure all content available have required rights. 2) NTES needs to use LeTV’s content on this URL and provide marketing for this platform on NTES’s portal. 3) NTES is responsible for attracting advertisers on this platform. Revenues from this platform are shared by LeTV and NTES based on VV. 4) As a guarantee for minimum revenue to LeTV, NTES needs to pay LeTV Rmb30Mn, 50Mn, and 20Mn in 2012, 2013 and 2014 respectively. On March 12, 2012, Youku announced that Tudou will combine with Youku in a 100% stock-for-stock transaction. The relative value of this stock transaction for Youku is 71.5%, and for Tudou is 28.5%. The deal closed in August. The combined company expects to have more pricing power. Revenue synergies may mainly from: (1) expanded content library, (2) Youku’s better monetization capabilities, and (3) stronger bargaining power over ad agencies. On November1, 2012, Baidu announced plans to fully acquire online video site iQiyi in an all-cash transaction from Providence. Baidu will increase its stake in iQiyi from 60% to close to 100%. The company did not disclose financial details of the transaction, but we believe iQiyi is valued at ~US$500Mn in this deal, around 25% of Youku standalone valuation of ~US$2Bn before the merger with Tudou. We expect negative earnings impact in 13E to be ~ US$0.02 per ADS, less than 0.3% of 13E EPS from our published estimates. We maintain our long-term view that Youku Tudou, Tencent, iQiyi and Sohu will be the leading online video sites in China. Smaller video sites would likely be further consolidated in the next two to three years. With high barriers to entry, we expect consolidation and cooperation in the industry to continue, bringing strength in balance sheets, easing competition and ultimately improving profitability.
  45. 45. 45 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com China Online Video Competitive Landscape After two years of investments, IPOs and acquisitions, China online video landscape changed significantly. Leading players substantiated their positions. Market share became more concentrated among the Top 10 players, who comprise 85% of the entire market. Figure 45: China Online Video Market Share by Revenue – 3Q12 Source: Analysys. Figure 46: Competitive Landscape - China Online Video Industry Analysys iResearch comScore Company Category Market Share Reach (MM) PV (MM) Avg. UTS (m) UV (MM) Sponsor/Alliance Youku All-in-one 21.0% 227 2,737 127 123 Merged with Tudou Tudou All-in-one 7.9% 167 1,268 70 121 Merged with Youku; Sina investment for 9%; JV w/ LeTV on content purchase Sohu Video Long Format 10.2% 162 1,904 67 111 Sohu.com; VCC iQiyi Long Format 10.3% 109 925 133 56 Baidu supports funding and traffic; VCC Tencent Long Format 6.5% 145 671 36 103 Tencent; VCC Leshi (LeTV) Long Format 6.5% 123 910 101 JV w/ Tudou on content purchase; Content cooperation with CNTV; Content provider for NetEase video CNTV Long Format Content cooperation with LeTV, PPTV, Tencent Ku6 UGC 0.5% 83 327 13 Shanda Interactive 56.com UGC 2.1% 0 277 16 Renren.com PPTV Client-base 6.4% 95 726 53 62 Content cooperation with CNTV PPS Client-base 6.6% 10 Content cooperation with TVB Xunlei Client-base 4.8% 86 876 85 28 Sohu invested for US$10MM in 2011; Content cooperation w/ AirMedia Funshion Client-base 5.0% 14 BesTV invested US$30MM for 35% Storm Client-base Content cooperation with CNTV Source: J.P. Morgan estimates, Analysys (3Q12), iResearch (May,’12), comScore (Jan, ‘12); UTS=User Time Spent; PPTV, PPS and Xunlei # are website only. Youku 21.1% iQiyi 10.4% Sohu Video 10.3% Tudou 8.0% PPS 6.6% Tencent 6.6% LeTV 6.5% PPLive 6.5% Funshion 5.0% Xunlei 4.8% iFeng 3.3% Sina 2.5% Others 8.4%
  46. 46. 46 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Figure 47: Total Monthly Unique Viewers in '000 Source: comScore. Regulation – Still tight, with incremental flexibility out of government transition year During the political transition year of 2012, SARFT firmly stands on its "control" mode to ensure the stable media environment of the year. Most of the restrictions on advertising and on broadcasting TV content are still here to stay, while the progress of Triple-Play moved little, especially on the OTT front. SARFT has been paying more attention to content regulation in 2012. In late November 2012, Jiangsu Education TV station was suspended from broadcasting for allowing guest speakers commenting in an inappropriate way. Earlier in Aug.12, SARFT also commented to satellite TV stations that certain genres of TV drama would be broadcasted in a controlled manner. After 1Q13, when most central government agencies complete a re-shuffle after the NPC in March/April, some new policies could likely be rolled-out to give new directions on the regulation front. Major regulations that remain effective in 2013 include: In-drama Ads (“限广令”) SARFT issued a ban on in-drama ads both in prime and non-prime time beginning December 2011. The policy is still in effect. 0 20,000 40,000 60,000 80,000 100,000 120,000 140,000 YOUKU.COM Tudou Sites KU6.COM SOHU.COMTV SINA Video QQ.COM Video 56.COM QIYI.COM CNTV.CN We expect new policies likely to be rolled out after 1Q13, when most central government agencies complete a re-shuffle after the NPC in March/April.
  47. 47. 47 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Table 18: TV Stations Ad Bidding Result – Nov.’12 Rmb in millions TV Station Ad Bidding Nov.11 Nov.12 In-drama Ad Total TV Station Ad % In-drama Ad Total TV Station Ad % Comments CCTV-1 'Golden Theater' 740 14,260 5% N.A. 15,880 'Golden Theater' not sold in Nov bidding Hunan TV 'Golden Eagle Theater' 940 2,541 37% N.A. 1,160 Only 15% of total available resources for 2012 Zhejiang TV 'China Blue Theater' 550 932 59% 387 1,670 23 % Voice of China takes over Rmb1,040Mn out of total Anhui TV 'First Theater' 410 466 88% 700 766 91 % Jiangsu TV 'Happiness Theater' 320 2,133 15% N.A. N.A. Did not disclose bidding results Source: J.P. Morgan. Note: YoY bidding amount not comparable as TV stations releases different ad resource for bid each year. Entertainment Restriction (“限娱令”)  No less than 2 hours of news between 6:00 and 24:00 every day.  No less than 2 self-produced news program between 18:00-23:30, each no less than 30 minutes.  Each comprehensive channel need to have at least one program dedicated to moral and ethics education  No more than 9 entertainment programs nationwide between 19:30 to 22:00  No more than 90 mins of entertainment program for each comprehensive channel between 19:30 to 22:00 As a result, starting from Jan 1, 2012, news-related TV programs increased 33% YoY, while entertainment shows went down 70% during prime time. Oversea Production Restriction (eff. in Feb, 12)  Imported overseas dramas should be less than 50 episodes, and mainly of HD format  No overseas production to be broadcast during prime time  Total oversea production broadcasting time should not exceed 25% of total air time every day  Limited trailer length for overseas productions broadcast in drama preview TV programs Alcohol Ad Restriction (“限酒令”)  No more than two ads for alcohol products between 19:00 to 21:00 on CCTV-1  No more than 12 ads for alcohol on each CCTV channel Medicine Ad Restriction  No healthcare ads before 18:00 on CCTV-1  No healthcare ads on CCTV-2, CCTV-9, CCTV-4 Traditional TV stations continued other alternative methods to mitigate the impact from this policy, including: 1) move the mid-roll ad portion to pre-rolls and post- rolls, 2) increase the price for other ads and title sponsorship, 3) product
  48. 48. 48 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com placement/embedded marketing in dramas, more self-made dramas, and 4) more trailer broadcasting for more ads inserts. OTT - Huge Opportunity Bottlenecked by Regulation There are numerous branded and white-box OTT set-top-boxes proliferating in China during 2012, to address the surging demand for watching online video over TV screens. Chinese consumers have grown their habits in using tablets and smartphones to watch online video sites’ offerings anywhere anytime. The need for extending the experience to bigger screens is natural. This demand gives growth room for OTT solutions. We've seen Xiaomi announced the Xiaomi Box solution but then shelved the plan for potential policy infringements. Also low- key players like Qvod carefully positioned its solution “Dapingmu (Big Screen)” as PC peripherals and 'substitutes for HDMI cords', so that conflicts with SARFT Document No.181 could be avoided. In our view, OTT video consumption still remains an interesting long-term trend to keep an eye on. As the technology of larger screens evolves, and with the emergence of many real internet-capable TV sets/ set-top boxes, the content end of the entire value chain is facing enormous opportunities to extend its service onto larger screens and broader audiences. If contents and ads from online video sites could be played via OTT STBs, this could further help viewership growth and boost CPM of online video ads to be on par with TV level. Apart from regulations and licensing issues, copyright and broadcasting rights remain a key issue for online video sites to participate in the OTT camp. Currently most of the major online video websites have been mainly purchasing ‘internet broadcasting rights’ for major hit dramas, movies and TV shows. This right may not include the scope of ‘Internet TV/Smart TV’ in many cases. If SARFT is strict on right requirement for eligible content in OTT, current eligible content library from online video sites to be played on OTT may be fairly limited.
  49. 49. 49 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Search Mobile to Help Growth in 2013 We believe search still provides better and more definite growth than display ad despite uncertainty due to increasing mobile traffic. The search advertising market in China is expected to grow 48% YoY in 2012, as per our estimates, to reach Rmb28Bn (US$4.45Bn). We believe search advertising is still in the early growth stage in China, driven by: 1) increased mobile search monetization, 2) rising internet penetration, 3) significant growth in websites and pages including mobile optimized versions, 4) higher search usage due to greater mass of web content, and 5) large number of SMEs turning to search advertising due to the higher ROI. Table 19: China Search Market Forecast 2007 2008 2009 2010 2011 2012E 2013E 2014E Total Search Market (Rmb M) 2,880 5,331 6,991 11,038 18,880 28,028 38,782 48,096 Total Search Market (US$ M) 382 776 1,024 1,641 2,940 4,445 6,171 7,653 Growth rate (Rmb, %) 104% 85% 31% 58% 71% 48% 38% 24% Search ad as % of total ad market 1.8% 2.9% 3.5% 4.5% 6.2% 8.3% 10.4% 11.3% Source: CNNIC, iResearch, J.P. Morgan estimates. Note: Excluding distributor discount. Figure 48: YoY Revenue Growth through Cycles - Search Outperform Display Source: Company reports and J.P. Morgan estimates. Where Are We on the Growth Curve of Search? In ‘Nothing But Net 2012’, we used a five-scenario growth analysis in order to triangulate the potential market size of online search in China. This year, we revisit our model and update our estimates. Using various references to US and Korea search market, we estimate China search market size could reach US$6.0Bn-US$8.7Bn by 2015 in our base case. This compares to US search market 2011 size of US$13.6Bn. Search Market Size Analysis - 2013 We use Korea and US as proxies for online search market growth rate and growth potential, based on the market significance, user behavior and economy profile. We present five different scenarios in our forecast: Scenario 1: We compared search market size as percentage of nominal GDP in China and US. We shifted US search market size as percentage of nominal GDP six (20.0%) 30.0% 80.0% 130.0% 180.0% 2005 2006 2007 2008 2009 2010 2011 2012E 2013E Baidu Sina Sohu NetEase
  50. 50. 50 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com years to estimate China search market size in 2013-2017. The market will reach US$5.0Bn and US$6.3Bn in 2013 and 2014, respectively. Scenario 2: We compared search market size as percentage of nominal GDP in China and Korea. We shifted Korea search market size as percentage of nominal GDP five years to estimate China search market size in 2013-2017. The market is expected to reach US$5.8Bn and US$6.7Bn in 2013 and 2014, respectively. Scenario 3: We compared search market growth rate in China and US. We shifted US search market growth rate seven years to estimate China search market size in 2013-2017, and the market is expected to reach US$5.6Bn and US$7.3Bn in 2013 and 2014, respectively. Scenario 4: We compared search market growth rate in China and Korea. We shifted Korea search market growth rate five years to estimate China search market size in 2013-17, and the market should reach US$5.5Bn and US$6.0Bn in 2013 and 2014, respectively. Scenario 5: We compared search market size as percentage of personal consumption in China and US. We shifted US search market size as percentage of personal consumption five years to estimate China search market size in 2013-17. The market could reach US$4.2Bn and US$5.1Bn in 2013 and 2014, respectively. Figure 49: Five Scenarios for China Search Market Size Estimate US$Mn Source: iResearch, World Bank, J.P. Morgan estimates. 0 2,000 4,000 6,000 8,000 10,000 12,000 2008 2009 2010 2011 2012E 2013E 2014E 2015E 2016E 2017E 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)
  51. 51. 51 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Competitive Landscape Key trend in 2013 in search is the launch of Qihu search with ~10% traffic share. Qihu has a leading browser and anti-virus software in China. Qihu had been driving traffic to Google but in mid-August it switched default search engine from Google to an in-house search engine. Although this has reduced search traffic share Baidu has increased its revenue share to 80.3% in 3Q12 vs. 77.7% in 3Q11. As Qihu starts to monetize its search in 2013 we could see some decline in Baidu revenue market share. Table 20: Baidu Continued to Gain Market Share (by Revenues) 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 Baidu 67.8% 71.0% 72.7% 73.4% 74.4% 77.0% 77.7% 77.3% 77.6% 79.5% 80.3% Google 29.5% 26.8% 24.8% 24.0% 22.9% 20.1% 18.3% 18.3% 17.8% 16.2% 14.6% Sogou 1.0% 1.0% 1.2% 1.3% 1.3% 1.6% 2.1% 2.5% 2.7% 2.9% 3.3% SoSo 0.8% 0.6% 0.9% 0.9% 0.9% 0.7% 1.4% 1.5% 1.5% 1.1% 1.2% Others 0.9% 0.6% 0.4% 0.4% 0.4% 0.4% 0.4% 0.4% 0.4% 0.3% 0.6% Source: iResearch. We expect the Baidu revenue market share decline to be less than the decline in traffic share. Our base case is that Baidu would be able to maintain market share at ~75-80% in 2013, with some of the other search engines, especially Google, loosing revenue market share to Qihu. Figure 50: Baidu traffic share loss after Qihu search launch % Source: CNZZ. Baidu vs. Qihoo After a good start in 2012, investor concerns regarding Qihoo and increasing mobile traffic resulted in a steep decline in Baidu’s share price. We estimate Qihoo search to have ~10% search traffic market share. Impact on Baidu's top line does exist (we estimate ~5%), but shall already be priced in the share price drop. 0% 10% 20% 30% 40% 50% 60% 70% 80% Aug-16 Aug-23 Aug-30 Sep-06 Sep-13 Sep-20 Sep-27 Oct-04 Oct-11 Oct-18 Oct-25 Nov-01 Nov-08 Nov-15 Nov-22 Nov-29 Dec-06 Dec-13 Dec-20 Dec-27 Baidu Qihoo Sogou Google Soso
  52. 52. 52 Asia Pacific Equity Research 09 January 2013 Dick Wei (852) 2800-8535 dick.x.wei@jpmorgan.com Under a challenging macro environment and fundamental shift in search traffic growth to mobile, key issues to look at for Baidu in 2013 are: 1) successful mobile monetization, and 2) how does the competition with Qihoo pan out? Quality of search vs. convenience. We believe Baidu has better search technology and a broader search product offering (such as travel, Q&A, Post Bar, maps, document database). We expect users, particularly more high-end users, to be gradually attracted to these features. Qihoo management believes search technology is not differentiated (if it is good enough), and that users will follow the convenience of the browser default setting (as evident by Sohu search, where 70% of Sohu searches are from its own browser/toolbars). We estimate Baidu to see a 5% revenue impact over time, as some of Qihoo users will not set Baidu as the default search. In Baidu World 2012, Baidu officially unveiled a full suite of Baidu Cloud services, with 7 major tools and support of over 100G of free storage, several hundred thousand servers of computing power and big data intelligence/predictions based on search queries. Investment in Content. Baidu has been recruiting experienced people from portals to further build up content management in News, Knows, Wenku and Baike. It was reported that Chief Editor of NetEase news joined Baidu News in late ‘12. If Baidu owns high-quality content, other search engines have to direct traffic to Baidu sites in order to provide precise, high-quality search results. Users are likely to stay with Baidu after being directed to Baidu sites. Baidu may find it easier to use this content strategy to compete in downstream contents to increase user stickiness than to compete in upstream channels for traffic sources. Seven Tools on Baidu Cloud  Engine: new high-performance mobile browser core (Webkit-based) receives full score 500 in HTML5 test and support latest WebGL in 3D web apps.  LBS: supports indoor navigation. Baidu map API coupled with cloud storage and cloud indexing could be used by various location-focused apps.  ScreenX: real-time multi-device collaboration. For example, to record melodies on 4 instruments at the same time.  PCS: personal cloud storage, to provide free private cloud to developer. Support code converting etc to lower developing cost.  Site App: help convert PC webpage site to mobile sites suitable for smartphone browsing.  BAE: Baidu apps engine, provide basic web app developing platform with free server resources and various cloud-based services.  MTC: mobile testing center. Real-time testing on environments of different models. Baidu’s traffic from mobile devices increased to around 20% of its total traffic, up from around 10-15% last year. We estimate mobile revenue only accounts for 10- 15%. If we look at Google’s mobile growth, with dominant share of 90%+ in US mobile search, mobile has become the biggest contributor to its paid click growth especially in holiday eCommerce, and now represent ~12.0% of the Google’s gross ad revenue in 2012and ~18% in 2013. In 2012 mobile search revenue growth is

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