JPM - e-Commerce 2011


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JPM - e-Commerce 2011

  1. 1. Global Equity Research 04 January 2010Nothing But Net2010 Internet Investment Guide Internet AC Imran Khan (1-212) 622-6693 J.P. Morgan Securities Inc. AC Bridget Weishaar (1-212) 622-5032 J.P. Morgan Securities Inc. Lev Polinsky, CFA (1-212) 622-8343 J.P. Morgan Securities Inc. AC Vasily Karasyov (1-212) 622-5401 J.P. Morgan Securities Inc. Shelby Taffer (212) 622-6518 J.P. Morgan Securities Inc. China Internet AC Dick Wei (852) 2800-8535 J.P. Morgan Securities (Asia Pacific) Limited Please also see two separate notes out today changing our rating for MercadoLibre and introducing 2011 estimates for our internet coverage. All data and valuation priced as of 30 December 2009.See page 326 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 mayhave a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making theirinvestment decision.
  2. 2. Imran Khan Global Equity Research(1-212) 622-6693 04 January Table of Contents Key Investment Themes ..........................................................5 Dot.Khan’s Top Ten Things to Watch for in 2010 ................15 U.S. Sector Outlooks.................................... 17 State of Advertising Overview...............................................19 Online Advertising Primers ...................................................23 Search Advertising.................................................................28 Display Advertising ................................................................32 Mobile Advertising .................................................................41 2010 eCommerce Outlook .....................................................50 2010 Online Payment Outlook ...............................................60 Online Travel Agencies..........................................................69 Social Networks Primer .........................................................75 2010 Cloud Computing Outlook ............................................82 eReader Market Outlook ........................................................89 International Sector Outlooks ..................... 97 China Internet Market Overview ............................................99 Online Advertising................................................................105 Branded Advertising ............................................................112 Online Search........................................................................114 Online Gaming ......................................................................121 eCommerce...........................................................................1322
  3. 3. Imran Khan Global Equity Research(1-212) 622-6693 04 January U.S. Company Previews............................. 139, Overweight, ($136.49) ..................................141 Blue Nile, Underweight, ($64.28) .........................................149 Dice Holdings, Neutral, ($6.62) ............................................156 eBay, Neutral, ($23.80) .........................................................164 Expedia, Neutral, ($26.46) ....................................................175 Google, Overweight, ($622.73) ............................................182 IAC, Neutral, ($20.82)............................................................189 Liberty Interactive, Overweight, ($10.93)............................196 MercadoLibre, Inc., Neutral, ($52.04) ..................................204 Netflix, Overweight, ($55.63)................................................212 Orbitz Worldwide, Neutral, ($7.04) ......................................220 Priceline, Overweight, ($223.61)..........................................227 RealNetworks, Inc., Neutral, ($3.76) ....................................234 Shutterfly, Inc., Overweight, ($17.84)..................................240 Yahoo!, Overweight, ($16.98) ..............................................248 International Company Outlooks .............. 257 Alibaba, Neutral, (HK$18.06)................................................259 Baidu, Overweight, ($416.23)...............................................267 China Finance Online, Neutral, ($7.28) ...............................274 NetEase, Overweight, ($37.01) ............................................280 Ninetowns, Neutral, ($1.78)..................................................287 Shanda Interactive, Overweight, ($52.10)...........................293 Shanda Games, Overweight, ($10.30).................................299 Sina, Neutral, ($45.22) ..........................................................305 Sohu, Overweight, ($57.51)..................................................312 The9, Neutral, ($7.15) ...........................................................319 The authors acknowledge the contribution of Jigar Vakharia and Ritesh Gupta of J.P. Morgan Services India Private Ltd., Mumbai, to this report. 3
  4. 4. Imran Khan Global Equity Research (1-212) 622-6693 04 January 2010 imran.t.khan@jpmchase.comFigure 1: J.P. Morgan Internet Technology Universe J.P. Morgan Internet Technology Universe Ticker Rating Dec10 Price Price Mkt Cap Ent .Val. EPS Y/Y EPS Growth Cal PE EBITDA ($M) Y/Y EBITDA Growth Ent. Val/EBITDA Rev ($M) Y/Y Revenue Growth Target 12/30 12/30 12/30 2008 2009E 2010E 2011E 09/08E 10/09E 11/10E 2008 2009E 2010E 2011E 2008 2009E 2010E 2011E 09/08E 10/09E 11/10E 2008 2009E 2010E 2011E 2008 2009E 2010E 2011E 09/08E 10/09E 11/10E Search/Advertising Google GOOG OW 622.73 $623 199,115 177,121 13.31 19.95 23.83 27.58 50% 19% 16% 46.8 31.2 26.1 22.6 9,347 10,868 12,725 14,579 16% 17% 15% 19.0 16.3 13.9 12.1 15,858 17,308 21,006 23,948 9% 21% 14% Yahoo* YHOO OW 16.98 $21 24,015 13,097 0.30 0.41 0.44 0.62 36% 6% 40% 56.0 41.2 38.7 27.5 1,813 1,603 1,772 2,194 -12% 11% 24% 7.2 8.2 7.4 6.0 5,399 4,634 4,779 5,112 -14% 3% 7% Group Average 51.4 36.2 32.4 25.1 2% 14% 19% 13.1 12.2 10.7 9.1 -3% 12% 10% Leading e-Commerce brands Amazon AMZN OW 136.49 $175 60,465 57,314 1.49 1.81 2.48 3.24 22% 37% 31% 91.6 75.2 55.0 42.1 1,450 1,729 2,252 2,709 19% 30% 20% 39.5 33.1 25.4 21.2 19,166 23,871 30,343 36,790 25% 27% 21% Blue Nile NILE UW 64.28 $51 988 956 0.75 0.86 1.08 1.33 15% 25% 24% 85.7 74.5 59.7 48.3 25 30 35 41 20% 15% 17% 38.0 31.7 27.4 23.5 295 308 364 420 4% 18% 15% Dice DHX N 6.62 $7 437 448 0.23 0.19 0.13 0.17 -19% -30% 29% 28.6 35.2 50.1 39.0 68 48 43 49 -29% -11% 13% 6.6 9.3 10.4 9.2 155 109 105 119 -30% -3% 13% eBay EBAY N 23.80 $22.5 30,674 28,059 1.36 1.88 1.28 1.44 38% -32% 12% 17.4 12.7 18.6 16.6 3,149 2,942 3,060 3,248 -7% 4% 6% 8.9 9.5 9.2 8.6 8,541 8,595 8,798 9,740 1% 2% 11% Expedia EXPE N 26.46 $28 7,772 7,813 1.25 1.34 1.43 1.63 7% 7% 14% 21.2 19.8 18.5 16.3 775 854 906 1,005 10% 6% 11% 10.1 9.1 8.6 7.8 2,937 2,930 3,172 3,563 0% 8% 12% InterActive Corp IACI N 20.82 $24 3,128 1,257 1.79 0.55 0.86 1.03 -69% 56% 20% 11.6 37.7 24.1 20.1 171 160 218 242 -6% 36% 11% 7.3 7.8 5.8 5.2 1,445 1,352 1,437 1,552 -6% 6% 8% Mercadolibre MELI N 52.04 $51 2,304 2,257 0.43 0.74 0.97 1.18 74% 30% 22% 122.4 70.4 53.9 44.3 42 65 91 111 56% 39% 22% 54.0 34.5 24.8 20.3 137 182 252 303 33% 38% 20% Netflix NFLX OW 55.63 $63 3,319 3,064 1.33 1.86 2.09 2.68 41% 12% 28% 42.0 29.8 26.6 20.8 364 425 450 495 17% 6% 10% 8.4 7.2 6.8 6.2 1,365 1,668 2,126 2,454 22% 27% 15% Orbitz Worldwide OWW N 7.04 $9.5 609 1,122 (3.59) (3.89) 0.17 0.19 9% -104% 15% NM NM 42.1 36.6 133 147 149 149 10% 2% 0% 8.4 7.7 7.54 7.5 870 716 746 775 -18% 4% 4% PCLN OW 223.61 $260 11,234 10,564 5.92 8.19 10.41 12.27 38% 27% 18% 37.8 27.3 21.5 18.2 377 523 714 828 39% 37% 16% 28.0 20.2 14.8 12.8 1,885 2,315 2,724 3,032 23% 18% 11% Real Networks RNWK N 3.76 NA 508 101 (1.69) (1.53) (0.27) (0.30) -10% -82% 9% NM NM NM NM 6 (12) (24) (26) -285% 102% 11% 16.0 -8.6 -4.3 -3.8 605 562 555 548 -7% -1% -1% Shutterfly SFLY OW 17.84 $19 450 387 0.18 0.03 0.27 0.33 -84% 884% 22% 101.4 641.4 65.2 53.6 39 43 50 57 8% 19% 13% 9.9 9.1 7.7 6.8 213 231 261 298 8% 13% 14% Group Average 56.0 102.4 39.6 32.3 -12% 24% 13% 19.6 14.2 13.5 10.4 5% 13% 12% Average 55.2 91.4 38.5 31.2 18.7 13.9 11.8 10.2Source: Company reports and J.P. Morgan estimates.Note: EBITDA= Operating income+D&A+/- Extraordinary charges; Yahoo!’s Enterprise Value assumes its Asian assets are worth $8/share; All EPS estimates are GAAP, except EXPE, PCLN, and MELIData in this table and this report is priced as of December 30, 2009 close 4
  5. 5. Imran Khan Global Equity Research(1-212) 622-6693 04 January Key Investment Themes Display Advertising to Recover 2009 was a particularly difficult year for the display ad market (down approximately 5% in the US, vs. a low-single-digit decline for cable nets and flat for search), as CPMs were pressured from lower ad budgets reflective of macroeconomic weakness as well as an influx of non-premium inventory. We believe display advertising will still face challenges in attracting large brand advertisers and will likely underperform search market growth. However, we think an improvement in the display ad market will likely be driven by: • a macroeconomic rebound • premium publisher moves to focus on price integrity • better formats of display advertising (e.g., Apple ad campaign) • more rich media advertising • better integration with ad content and sponsor base Overall, we estimate display advertising should grow ~13% in 2010. Stabilization of Major Ad Categories According to IAB/PwC, roughly 46% of online spending in the first half of 2008 came from retail, finance, and automotive verticals. In the first half of 2009, that share fell to 43%, with most of the decline representing a drop in ad spend, reflective of the recession. As the economy improves in 2010, and major ad categories begin to stabilize, we believe display advertising will show signs of a recovery. Further, based on our industry checks, we think auto and finance (more than 20% of the total) advertisement trends are improving in 4Q’09. Table 1: US Online Ad Spend, by Major Industry Category: Auto and Finance Represents More than 20% of the Total % share 1H’08 1H’09 Retail 21% 20% Telecom (including ISPs) 15% 16% Financial Services 13% 12% Automotive 12% 11% Compuitng 10% 10% Consumer packaged goods 7% 6% Leisure travel 6% 6% Entertainment 4% 4% Media 3% 4% Pharmaceutical and healthcare 4% 4% Source: Interactive Advertising Bureau and PricewaterhouseCoopers “IAB Internet Advertising Revenue Report: 2009 Second-Quarter and First Six Months Results.” Reversal of Ad Trends − Pulling Back on Premium Inventory During the spin-off road show, AOL CEO Tim Armstrong mentioned that he will seek Super Bowl pricing for Super Bowl inventory (i.e., reduce the amount of 5
  6. 6. Imran Khan Global Equity Research(1-212) 622-6693 04 January inventory sold via Considering AOL has a high-single-digit market share, we think AOL’s decision to do so will have a positive impact on the market. Additionally, according to press reports, CBS will stop selling premium inventory via third-party ad networks. We believe these moves by larger publishers will improve price integrity for the display advertising market as a whole. New Forms of Display Advertising Should Increase the Attractiveness to Large Advertisers We have had several discussions with large advertisers who have indicated that display advertising is often ineffective because consumers do not pay attention to banners (banner blindness). We think many publishers are making a great strive to introduce ad formats beyond traditional ad banners, which we believe will increase effectiveness. As such, we expect the following new formats to emerge in 2010: • Sponsorships • Time-based • Purchase data integration • Better formatting, like Apple Search Advertising Growth Should Accelerate We think the search advertising market is poised to have a solid year in 2010. In addition to having more favorable ad budgets as a whole, we think this industry will benefit from an increased share of advertising dollars and a recovery in CPCs. Within the US, we expect the market to start to enter the maturation phase. Specifically, we think internet population and query growth will slow and market share shifts will stabilize. However, we think international markets will continue to benefit from increased search usage and broadband subscriber growth. US Market Share Shifts to Stabilize 2009 saw the introduction of Microsoft’s new search engine, Bing. As such, we conducted a survey in July to ascertain people’s perception of search engines. We surveyed over 750 people above 18 years of age nationwide to assess the impact of Bing on their search habits. We think the biggest impediment to Bing’s attempt to gain market share was that the majority of people are perfectly happy with their current search experience. 62.6% of participants claimed that there were no factors that they would improve on their current search experience. However, our conversation with SEOs indicate that Microsoft’s Bing is gaining market share from other players, primarily Yahoo!. While we think cash back and Yahoo!’s discontinuation of toolbars and affiliate deals are helping Microsoft, we believe Bing is in fact gaining some share organically. comScore data confirms the stabilization of market share shifts, with monthly market share movements beginning to flatten out after this summer’s introduction of Bing.6
  7. 7. Imran Khan Global Equity Research (1-212) 622-6693 04 January 2010 Table 2: Domestic Core Search Market Share Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Google Sites 63.0% 63.3% 63.7% 64.2% 65.0% 65.0% 64.7% 64.6% 64.9% 65.4% Yahoo! Sites 21.0% 20.6% 20.5% 20.4% 20.1% 19.6% 19.3% 19.3% 18.8% 18.0% Microsoft Sites 8.5% 8.2% 8.3% 8.2% 8.0% 8.4% 8.9% 9.3% 9.4% 9.9% AOL LLC 3.9% 3.9% 3.7% 3.4% 3.1% 3.1% 3.1% 3.0% 3.0% 2.9% Ask Network 3.7% 4.1% 3.8% 3.8% 3.9% 3.9% 3.9% 3.9% 3.9% 3.9%Source: ComScore data and J.P. Morgan estimates. International Strong Growth Opportunity In the US, search players generate ~$65 per internet user, while we estimate the international market generates ~$15 per search internet user. We think this gap is due to the following two reasons: 1) digitalization of content, and 2) lack of broadband penetration. However, we estimate that advertising outside the US represents roughly 50% of global advertising revenues. As such, we believe there is significant growth potential in the international search markets. We think increased mobile penetration and faster broadband will help drive growth in 2010. We Think eCommerce Will Continue to Capture Share in the Retail Market According to the US Department of Commerce, in the first nine months of 2009, US Retail sales were down 10% Y/Y, while US eCommerce sales were down just half of that (-5%). We think US growth in eCommerce (including eBay GMV) will experience a recovery in Y/Y growth rates as economic conditions improve. At the same time, we expect a greater proportion of retail sales to continue to shift online, driven by (1) increases in product selection, (2) continued Y/Y improvements online for brick-and-mortar retailers, (3) volatility and uncertainty in the offline retail space, and (4) further improved efficiencies from site optimization. We see two trends that affect offline retail in a way we think should be a positive for online retailers: Low Inventories Could Drive Consumers Online We think traditional retailers have been very conservative with merchandising during the 2009 holiday season. We expect online retailers to benefit from this defensive posture, as consumers who show up to brick-and-mortar stores and find that the items they are looking for are not available. In this regard, eCommerce companies benefit from their less complicated supply chain: instead of needing to maintain appropriate stock levels at several hundred stores, web retailers only need to worry about inventory levels at one warehouse (or, at most, a handful of warehouses). Brick-and-Mortar Bankruptcies A variety of brick-and-mortar retailers have gone through bankruptcy since the start of the economic downturn. We think offline bankruptcies can have the following effects on eCommerce: 7
  8. 8. Imran Khan Global Equity Research(1-212) 622-6693 04 January • Near-term pricing pressure. As stores enter bankruptcy and close, the push to liquidate inventory could result in margin pressure on the survivors, both online and offline. • Upheaval changes consumer behavior. We believe some consumers establish shopping habits and relationships with retailers that can be difficult to break. A bankruptcy can drive these customers, who would have otherwise been difficult to acquire, to examine alternative options and form new shopping habits. For some such shoppers, changes in the offline world could result in lower convenience (e.g., the store nearby closes and now the closest store is too far away), which would drive greater adoption of eCommerce. • In the medium to long term, we think thinning the B&M herd could prove to be a positive for online retailers, which could find it easier to win and maintain wallet share in a marketplace with fewer competitors. We think one significant winner is likely to continue to be Amazon, which stands to gain from the decline of players in both its core media arena (given the difficulties for Borders) and in its growing electronics business (Circuit City et al.) Similarly, we think Blue Nile could see its market share increase as traditional jewelers struggle.8
  9. 9. Imran Khan Global Equity Research(1-212) 622-6693 04 January Table 3: Notable Retail Bankruptcies, F’07–F’09 units as indicated Company name Product line(s) # stores # stores closing Bankruptcy filing date A&M Carpet Home Furnishing 4 2 2-Oct-09 Active Ride Shop Sporting Goods 29 8 23-Mar-09 Advantage Rent-A-Car Inc Car Rental 86 35 8-Dec-08 Appco Convenience Stores 55 8 9-Feb-09 Better Bedding Shops Home Furnishing 21 11 4-Mar-09 BI-Lo Grocery 230 23-Mar-09 Boscovs Department Stores Departmental Store 50 10 4-Aug-08 Bruno’s Super Market 66 ~25 5-Feb-09 Chernin’s Shoe Shoes 19 2-Feb-09 Circuit City Electronics 775 155 10-Nov-08 Crabtree & Evelyn Personal Care 126 30 1-Jul-09 Drug Fair Medical 32 18-Mar-09 Eddie Bauer Departmental Store 371 17-Jun-09 EJ’s Shoes Inc Shoes 15 12 5-Jun-09 Friedman’s Inc Jewelry 473 455 4-Apr-08 Goody’s Apparel 355 69 9-Jun-08 Gottschalks Departmental Store 21 13 14-Jan-09 Hudson’s Furniture Furniture 19 4 21-Oct-09 Joe’s Sports and Outdoor Sporting Goods 31 31 4-Mar-09 KB Toys Toys 460 120 11-Dec-08 Levitz Furniture Furniture 76 27-Oct-08 Lillian Vernon Direct Retailer 20-Feb-08 Linens ‘N Things Housewares 500 120 2-May-08 Lopez Supermarkets Grocery 2 12-Aug-09 Max & Erma’s Restaurant 106 23-Oct-09 Mervyn’s Departmental Store 150 177 29-Jul-08 Movie Gallery Movie Rental 4600 520 17-Oct-07 Mrs. Fields Cookies Store 1200 15-Aug-08 Ritz Camera Centers, Inc. Camera Equipments 800 400 20-Feb-09 S&K Menswear Mens Tailors 135 30 9-Feb-09 Samsonite Luggage Maker 173 84 2-Sep-09 Saratoga Shoe Depot Shoes 27-Aug-09 Sharper Image Electronics 96 19-Feb-08 Shoe Pavilion Shoes 115 16-Jul-08 Sportsman’s Warehouse Sporting Goods 67 38 21-Mar-09 Steve & Barry’s Apparel 175 9-Jul-08 Super 88 Grocery 3 26-Oct-09 The Bombay Co. Furniture 388 15-Oct-07 Ultra Stores Jewelry 181 12 9-Apr-09 Value City Furniture Furniture 100 27-Oct-08 Walking Company Shoes 210 90 8-Dec-09 Whitehall Jewelers Jewelry 375 23-Jun-08 Wickes Furniture Furniture 43 43 3-Feb-08 Source: Company reports, press reports, J.P. Morgan estimates. Note: # of stores closing as of the date of announcement of bankruptcy filing; more stores may have closed subsequently. Online Travel Agencies Poised for Growth In 2009, online travel agency companies in the US performed relatively well compared to offline agencies and suppliers, primarily due to some counter-cyclical effects of the weak macroeconomic environment. We think that, as suppliers were faced with excess inventory, they effectively used both OTAs and promotional activity to clear some of their levels. As such, we think 2009 was one of the first years where shifts between online travel agencies to online supplier sites stabilized. In 2010, we expect to see the improved macroeconomic environment, easing ADR comps, and improved FX rates have a large impact on gross bookings growth. Overall, we think OTAs will benefit from increasing ADRs and increased 9
  10. 10. Imran Khan Global Equity Research(1-212) 622-6693 04 January international online penetration. However, increased business travel may potentially hurt volume growth rates. Priceline Dominates Domestic Market Share Gains In 2009, Priceline significantly outperformed the competition, with domestic gross bookings growth of 17.6% in the first 3 quarters of 2009, vs. a 2.7% decline at Expedia and a 9.2% decline at Orbitz during the same period. We think strength can be attributed both to its opaque business model and lowest price/discount brand positioning. In 2010, we think some of the tailwinds will start to ease, as suppliers will likely pull back opaque inventory as the economy recovers. However, we do think Priceline will maintain much of its price-disclosed market share gains. Figure 2: US Market Share 2008 Figure 3: US Market Share 1H09 Priceline, Priceline, 9% 11% Trav eloc Ex pedia, Trav eloc Ex pedia, ity , 22% 42% ity , 21% 43% Orbitz, Orbitz, 27% 25% Source: PhoCusWright’s US Online Travel Overview Ninth Edition. Source: PhoCusWright’s US Online Travel Overview Ninth Edition. International Markets Benefit from Online Penetration We expect online under-penetration to remain a significant tailwind to OTAs in 2010. However, despite the overall low online penetration of the European travel market as a whole, we do note that there is much variance on a country-by-country basis. Countries including the U.K., France, and Scandinavia sit well above the 2008 penetration level at 40%, 30%, and 45%, respectively, while countries such as Spain and Italy have very low penetration at 19% and 14%, respectively. Thus, we think OTAs with a higher exposure to under-penetrated markets (such as Priceline) will outperform their competition in 2010. Long-term Secular Trends Continue to Remain Positive Although the economic news cycle was largely negative in 2009, we believe the longer-term secular trends that are driving the growth of online activity remain quite positive, and we expect these trends to help internet companies continue growing despite the macroeconomic slowdown. In particular, we see growing broadband penetration as a catalyst for more robust commercial internet activity. As such, we believe the continuing increase in broadband uptake, as well as an increase in connection speeds, provide a tailwind for growth at internet companies.10
  11. 11. Imran Khan Global Equity Research(1-212) 622-6693 04 January Figure 4: Broadband Penetration in the US Continues to Increase Broadband subs in millions 100 100% 80 100% 80% 55% 81.2 60 45% 77.4 60% 35% 69.9 58.1 40 48.0 20% 40% 37.4 11% 20 5% 20% 6.2 12.4 19.2 27.7 29% 21% 0 0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009E US Broadband Subs Y/Y Grow th Source: OECD, J.P. Morgan estimates. More specifically to eCommerce, we believe the growth of online retail is closely related to increasing broadband penetration; the growth trajectories have closely paralleled each other over the past several years. However, we note that the macroeconomic environment has hindered eCommerce growth over the past year. As the economy recovers, though, we believe the growth of online retail will recommence its historical parallel trajectory with the rate of increasing broadband penetration. Figure 5: eCommerce Growth Parallels Increased Broadband Penetration Units as indicated 30% 60000 25% 20% 40000 15% 10% 20000 5% 0 0% 1H02 2H02 1H03 2H03 1H04 2H04 1H05 2H05 1H06 2H06 1H07 2H07 1H08 2H08 1H09 eCommerce, $M (seasonally adj.) Broadband Penetration, % Source: Department of Commerce, OECD, J.P. Morgan estimates. Note: OECD data defines penetration as Broadband subscriptions per 100 people. As such, we think continued increases in broadband penetration will be a catalyst for eCommerce continuing to take share away from overall retail sales going forward, providing opportunities for growth even if retail sales as a whole stagnate. We Expect Healthy M&A Activity As expected, M&A activity remained somewhat slow in the first half of 2009 likely due to 1) fears of how long the economic downturn would last, 2) sellers resistant to sales at reduced valuations, 3) companies exercising caution in spending excess cash, and 4) the inability to borrow enough money. 11
  12. 12. Imran Khan Global Equity Research(1-212) 622-6693 04 January However, in the second half of 2009, we saw a modest pick-up as management teams began to feel more comfortable with the economic outlook. For example, in October 2009, Adobe’s acquisition of Omniture was completed, a transaction worth approximately $1.8B on a fully-diluted equity value basis. In 2010, as market fundamentals continue to improve, we expect M&A activity to increase. To the extent acquirers are willing to part with cash, we expect them to have the resources: large internet and media companies continue to generate significant cash flows. At the large-cap internet companies, we expect 36% FCF growth in F’09, and 12% growth in F’10. Including the Media universe, the respective expectations are for 2% growth in ’09 and 17% in ’10. Including Microsoft, J.P. Morgan estimates call for nearly $50B in FCF generated in the broader internet space in F’10. As such, we expect to see more cash deals. Additionally, the loosening of the credit markets should make financing more accessible to companies seeking to borrow funds. Table 4: We Project $17B+ in FCF at Large Internet Companies $ in millions 2008 2009E 2010E GOOG 5,494 8,559 9,303 YHOO 1,312 1,219 1,392 AMZN 1,364 2,386 2,737 EBAY 2,316 2,095 2,476 PCLN 288 487 600 EXPE 361 439 499 TWX 4,177 3,175 3,099 DIS 3,868 3,311 4,239 NWS 2,482 1,147 2,258 VIA 1,748 1,980 1,995 CBS 1,672 750 1,178 MSFT 16,375 17,070 16,768 Total 41,458 42,619 46,545 Y/Y Growth 3% 9% All excluding MSFT 25,083 25,549 29,777 Y/Y Growth 2% 17% Large-Cap Internet 11,135 15,186 17,007 Y/Y Growth 36% 12% Source: Company reports and J.P. Morgan estimates. Note: For Disney and News Corp., fiscal year data used rather than calendar year.12
  13. 13. Imran Khan Global Equity Research(1-212) 622-6693 04 January 2010imran.t.khan@jpmchase.comTable 5: Selected M&A Activity in the Internet Space, 2009 Symbol Deal Type Date Annc’d Target Acquirer Seller Annc’d Tot Payment StatusIACI ACQ 3/26/2009 Sportspickle.Com IAC/Interactivecorp N/A Cash CompleteDIS DIV 4/1/2009 Multiple Targets Walt Disney Co Kab Distribution Inc 18.4 Cash CompleteEBAY DIV 4/13/2009 Stumbleupon Inc Multiple Acquirers eBay Inc N/A Cash CompleteDIS ACQ 4/30/2009 Hulu LLC Walt Disney Co N/A Undisclosed CompleteTWX SPIN 5/28/2009 Aol Inc Shareholders Time Warner Inc 2512.42 CompleteDHX ACQ 6/11/2009 Allhealthcarejobs.Com Dice Holdings Inc 3.73 Cash & Stock CompleteTWX ACQ 6/11/2009 Multiple Targets Time Warner Inc N/A Undisclosed CompleteIACI DIV 7/7/2009 People Media IAC/Interactivecorp American Capital Ltd 57 Cash CompleteTWX ACQ 7/15/2009 mmafighting.Com Time Warner Inc N/A Cash CompleteGOOG ACQ 8/5/2009 On2 Technologies Inc Google Inc 105.45 Stock PendingEBAY DIV 9/1/2009 Skype Technologies SA Multiple Acquirers eBay Inc 2025 Cash and Debt CompleteNWSA DIV 9/24/2009 Pinnacor Inc Yellowbrix Inc News Corp N/A Undisclosed CompleteADBE ACQ 10/23/2009 Omniture, Inc. Adobe Systems Inc. NA Cash CompleteGOOG ACQ 11/23/2009 Teracent Google Inc N/A Undisclosed PendingGOOG ACQ 12/4/2009 Appjet Inc Google Inc N/A Undisclosed CompleteSource: Bloomberg, company reports, news reports. We continue to see three key factors as motivating drivers for M&A activity in the internet space: • Traffic. Developing high-traffic sites is difficult, and larger companies are often willing to pay for sites that have proven an ability to generate traffic. • Technology. Companies that develop a technology that is difficult or uneconomical to replicate are often targets for acquisitions; such companies may also generate traffic but the technology is often a motivator for the buyer. • Transactional. Companies with a proven track record of revenue and sales generation can make attractive targets, as well; an example of a transactional- focused acquisition is the 2007 purchase of Mezimedia by ValueClick. Key Attributes of Acquisition Targets We believe the attributes that potential acquirers will seek in a target include: • Brand strength. Acquirers will likely seek a company that garners recognition and respect from both its customers and its partners. • Product leadership. We think acquirers hold the power in this weak M&A environment and, as such, will seek out companies that have the best product as viewed by customers, partners, and competitors. • Ease of integration. With an increasing focus on profitability in this weak economy, we think companies will attach more importance to the level of challenge in integrating the company and the time required to recognize synergies. • Barriers to entry. This will likely be a key determining factor in the build vs. buy decision making process. Within our universe, we believe the two independent companies that best embody these attributes are MercadoLibre and Netflix. IPO Market Should Pick Up in 2010 As predicted in our Nothing but Net 2009 report, the IPO market remained fairly difficult in 2009. However, as market conditions improve and we see an increase in 13
  14. 14. Imran Khan Global Equity Research (1-212) 622-6693 04 January 2010 cash flow, we think the IPO market will show signs of a recovery in 2010 with the internet sector as a leading driver of growth. Table 6: Internet and Related IPOs, F’09 Units as indicated Pricing Date Issuer Name Symbol Amt ($M) Mkt cap ($M) % mcap Offering Price Price, 12/15 Performance 04/01/09 Changyou.Com Ltd CYOU 138 1,664 8% 16.00 32.40 103% 05/13/09 Digitalglobe Inc DGI 279 1,058 26% 19.00 23.54 24% 05/19/09 Solarwinds Inc SWI 174 1,373 13% 12.50 21.09 69% 05/20/09 Opentable Inc OPEN 69 592 12% 20.00 26.48 32% 06/24/09 Medidata Solutions Inc MDSO 101 356 28% 14.00 15.72 12% 06/30/09 Logmein Inc LOGM 123 468 26% 16.00 20.97 31% 09/23/09 Vitacost.Com Inc VITC 132 251 53% 12.00 9.12 -24% 09/24/09 Shanda Games Ltd GAME 1,044 2,947 35% 12.50 10.23 -18% 11/04/09 Ancestry.Com Inc ACOM 100 594 17% 13.50 14.00 4% 11/19/09 Archipelago Learning Inc ARCL 119 477 25% 16.50 19.00 15%Source: Company reports, Bloomberg, J.P. Morgan estimates. Our Top Picks In our coverage universe, we think Amazon (Price Target $175), Yahoo! (Price Target $21), Priceline (Price Target $260), and Netflix (Price Target $63) are the best positioned global internet companies and offer the best risk/reward return for investors. Please see the appropriate company sections for a detailed analysis of our thesis. 14
  15. 15. Imran Khan Global Equity Research(1-212) 622-6693 04 January Dot.Khan’s Top Ten Things to Watch for in 2010 1. Is display advertising secular or cyclical? 2. Can Yahoo! turn around its business? 3. Increased M&A activity 4. Continued growth of casual and social gaming and its impact on console gaming 5. Rapid growth of mobile search and increased monetization in international markets 6. Improved monetization of social networking; is social networking a new gateway? 7. More innovation for online payments 8. App economy on social networking and mobile platforms and its impact on the broader market 9. Can we see further margins improvement? 10. Rapid growth of the eCommerce market at the expense of brick-and-mortar stores; is Amazon on its way to become the new Wal-Mart? 15
  16. 16. Imran Khan Global Equity Research(1-212) 622-6693 04 January 2010imran.t.khan@jpmchase.com16
  17. 17. Imran Khan Global Equity Research(1-212) 622-6693 04 January 2010imran.t.khan@jpmchase.comU.S. Sector Outlooks U.S. Sector Outlooks 17
  18. 18. Imran Khan Global Equity Research(1-212) 622-6693 04 January 2010imran.t.khan@jpmchase.com18
  19. 19. Imran Khan Global Equity Research(1-212) 622-6693 04 January State of Advertising Overview We think the online advertising market is at an interesting inflection point. On the one hand, time spent online continues to grow, DVR usage is on the rise, and newspaper advertising revenues are consistently declining. However, advertisers and content providers still seem to be struggling with targeting, successful brand advertising campaigns, copyright issues, and the massive amounts of inventory. Below we will look at drivers of the total advertising market and then in the following sections, we will study the issues relating specifically to search, display, video, and mobile advertising. Consumers Get Content Through Many More Avenues In 1980, the average US household received 10.2 channels, but, by 2007, this number had increased to 107.4 channels. In addition to increasing options on TV, US consumers have also embraced the internet, and we estimate that in 2009 US consumers watched ~240M YouTube videos a day, spent over 10B minutes on Facebook every month, and wrote over a trillion text messages (roughly 12/person daily). We believe there is currently a large disconnect between ad spend vs. time spent on each medium and that the rectification of this will help drive internet ad spend in 2010. Additionally performance-based advertising should continue to gain traction as advertisers are looking for more ROI-driven ads.Figure 6: Internet Now Ranks Second in Time Consumption but Trails Significantly in Ad Spend Time Spent Time Spent Time Spent Vs Ad Spend Time Spent Vs Ad Spend 40% 40% 37% 38% 35% Youth Adults 35% 32% 9% & Teens Largest Upside Largest Do wnside 30% 30% 25% 25% 19% 20% 20% 20% 37% 15% 15% 29% 8% 9% 8% 10% 7% 6% 10% 19% 5% 5% 8% 7% 0% 0% TV Internet Magazine Radio New spaper TV Internet Magazine Radio New spaper Time Spent Ad SpendSource: After TV: Nielsen Media Research Custom Survey 2008 and Samir Arora Glam Media Presentation. Newspaper Market Share Losses Could Accelerate We estimate that newspaper ad spend declined 18% in 2008, an acceleration in declines from 2007’s 8% Y/Y drop. Newspaper circulation is also falling, with average daily circulation down 10.6% Y/Y in September 2009. In our opinion, people are becoming increasingly dependent on the internet for breaking news. Furthermore, blogs are becoming more accepted as a trusted news source and opinion provider. Given the declines in both circulation and ad spend, we think the existing cost structure will make this business model unsustainable in the future. 19
  20. 20. Imran Khan Global Equity Research(1-212) 622-6693 04 January Figure 7: Newspaper Ad Spend Continues to Decline $ in billions 60.0 10% 5% 5% 50.0 5% 2% 40.0 0% 0% 30.0 -5% 49.4 49.3 45.4 -8% 46.2 48.2 20.0 -10% 37.2 10.0 -15% -18% 0.0 -20% 2003 2004 2005 2006 2007 2008 Newspaper Ad Spend Y/Y Growth Source:, J.P. Morgan estimates. Figure 8: Newspaper Circulation Declines Are Accelerating 0% -0.9% -4% -1.8% -2.1% -2.6% -2.5% -2.8% -2.6% -3.6% -4.6% -8% -7.1% -12% -10.6% Sep-04 Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Y/Y change in av erage daily circulation Source: Audit Bureau of Circulation, J.P. Morgan estimates. It Is Increasingly Difficult to Reach TV Viewers Overall TV viewership continues to rise, with total day up 4% Y/Y in 2008 among those aged 2+ and a 1% rise through the first three quarters of 2009. The rise in total viewership is despite declines at the broadcast networks, which are more than offset by rising cable audiences. Even among younger demographics, overall TV viewing is rising. In the 18-34 age group, TV viewership was up ~3% in 2008 and flat through 1H’09. However, it is increasingly difficult to reach these TV viewers. By the end of 2010, nearly 35% of households are expected to have a DVR.20
  21. 21. Imran Khan Global Equity Research(1-212) 622-6693 04 January Figure 9: DVR Usage Is Becoming Mainstream 35% 31% 30% 27% 25% 22% 20% 17% 15% 11% 10% 5% 0% 2005 2006 2007 2008 2009E DVR Subscribers as a % of Households Source: MAGNA and J.P. Morgan estimates. Cable and Internet Advertising Are Gaining Market Share In October, we surveyed 20 media buyers and planners who jointly manage $1.6B in annual advertising spend to assess current trends in the advertising market. When respondents were asked to report trends in the percent of ad budgets spent on each type of advertising, participants indicated that the greatest gains in market share of total ad dollars are in cable TV and internet advertising. Internet ad spend (including search, display, email, and other forms) in 2010 is expected to account for 29.0% of budgets vs. a 25.8% share in 2009E. Cable ad spend is also expected to see upside, with ad buyers/planners expecting to spend 26.2% of their budget there in 2010 vs. 24.5% in 2009E. Many respondents noted in comments that TV remains the dominant media but print spend continues to decline with the difference going to digital and some cable TV. Figure 10: Trends in Ad Dollar Market Share by Platform % of total ad dollars Other Radio Adv ertising Magazines New spapers Outdoor Cable TV Broadcast Internet Adv ertising 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 2008 2009 2010 Source: J.P. Morgan proprietary survey. Our Survey Shows Participants Seem Encouraged by 2010 Ad Spend Estimates In October, we surveyed 20 media buyers and planners who jointly manage $1.6B in annual advertising spend to assess current trends in the advertising market. Based on current ad spend trends and preliminary talks with marketers, 40% of our survey respondents estimated 2010 ad spend would be roughly flat with that of 2009, while 25% thought ad spend would be up 5-9% Y/Y in 2010 and another 25% thought it 21
  22. 22. Imran Khan Global Equity Research(1-212) 622-6693 04 January would be up 10-14% Y/Y. Only 10% of respondents thought ad spend would further decline in 2010 on a Y/Y basis. Figure 11: Preliminary Expectations for 2010 Ad Spend vs. 2009 # of participants 10 8 6 4 2 0 Up better Up 10-14% Up 5-9% Roughly Flat Dow n 5-9% Dow n 10- Dow n more than 15% 14% than 15% Source: J.P. Morgan proprietary survey.22
  23. 23. Imran Khan Global Equity Research(1-212) 622-6693 04 January Online Advertising Primers Graphical Advertising 101 Graphical advertising, also known as display advertising, includes all forms of advertising excluding search. Thus a range of advertisements from traditional banner ads to video and lead generation are included in this category. Because of the range included in this category, it is more difficult to make generalizations about graphical ad characteristics. However, the following factors should be evaluated when looking at the graphical advertisement space. We Expect More Innovation in the Display Advertising Market We think display advertising companies will aggressively tackle challenges including 1) unlimited inventory, 2) lack of marketer confidence with ROI, and 3) declining RPMs. Some key developments that we expect to see are: • Sponsorship Advertising. We think content providers are misusing page views by creating excessive content and ads. As a result, we think sponsored ads, which allow the advertiser to control the entire user experience, will become more widespread, particularly with brand advertisers. • Time-based Advertising. We think advertisers will begin to use time spent on a page as a measure of user engagement. This could then give guidance to what ads are shown and how much of an impact they had on a user. • New Ad Formats. We think many users are beginning to tune out the standard banner ads on a page. As a result, we think new ad formats beyond those of the IAB need to be introduced to grab user attention. • More Optimization. We think display ads need to be better targeted through use of behavioral targeting and interest-based ads. Content Quality Probably one of the most important factors in ad placement is the content near where the ad will be placed. In general, graphical ads are less targeted than search ads since search ads are dictated by the interest of the user whereas graphical ads are generally determined by the content of the host website. Typically, webpages are grouped into two categories: premium inventory and non-premium inventory. Premium inventory is more focused on a specific vertical of content or demographic. An example of premium inventory would be the Yahoo! Finance page. Non-premium inventory includes very general untargeted pages. Examples of non-premium inventory include social networking sites and email. Revenue Model Revenue for graphical advertising can be cost-per-thousand (CPM), cost-per-click (CPC), or cost-per-action (CPA). CPM-based advertising is the traditional TV model employed in graphical advertising. In this model, advertisers negotiate a rate that will be paid for every thousand times the ad is displayed. Because the likelihood of a target market user seeing the ad is much higher on premium inventory than on non- premium inventory (where advertisers likely pay for many non-target users to see the ad), the range of CPMs is wide. Premium inventory can carry CPMs north of $30, while non-premium CPMs can be below $1.00. 23
  24. 24. Imran Khan Global Equity Research(1-212) 622-6693 04 January CPC and CPA models fall into the category of performance-based advertising, since an action by the user is required before the advertiser is charged for the advertisement. In CPC advertisements, the advertiser is charged per click on the ad. In CPA models, the advertiser is charged when a pre-defined action is taken by the user (such as providing contact information on a form). Ad Characteristics A final consideration in graphical advertising is the specifics of the advertisement. Banner ads can be found in a variety of size and shapes, can be in video form, and can be incorporated into pop-ups. Positioning on the web page is also a key concern. These factors are all important in the consideration of setting a price for the advertisement. Why Use Graphical Advertising? Since no action is required on the part of the user, this form of advertising is very attractive to brand advertisers, which are hoping to cultivate name recognition and brand identification rather than just driving immediate sales. However, there has been some evidence that graphical advertisements can directly increase sales, when mixed with a search advertising campaign. In a study conducted by Atlas Solutions, participants were split into three groups: those who clicked only on search advertisements, those who clicked only on display advertisements, and those who clicked on a search advertisement and also viewed or clicked a display advertisement. Using the display click only group’s conversion rate as a baseline, Atlas found that search click only users convert at a rate over 3 times higher. Users exposed to both search and display convert at an even higher rate – 22 percent better than search alone and 400 percent better than display only. Placing and Measuring a Graphical Advertisement The graphical ad placement process is a little more intensive than the search ad placement process. First, the banner ad or video needs to be created according to the specifications of the host website. As different websites might have different requirements, the format may have to be altered to meet various content website demands. A price and budget is then negotiated with the content website. Larger websites typically have their own sales force, with which advertisers deal directly. However, smaller websites often outsource the process of finding advertisers and hosting ads to ad networks that standardize the process across multiple host websites. The ad is then provided to each website or to the ad network for placement and performance tracking. New technologies have made the measurement of display advertisements more difficult. For example, AJAX technology now allows users to preview the contents of a page without actually clicking over to the page itself. These technologies have begun to render page views as a less important metric of performance (time spent at a site is becoming more important) and performance measurement and content monetization are currently hotly debated topics. How Graphical Ad Revenue Is Determined The total revenue of a publishing site is determined by 3 factors: • Page Views (the total number of pages viewed in a given period) • Coverage (the proportion of pages that had an ad)24
  25. 25. Imran Khan Global Equity Research(1-212) 622-6693 04 January • Average CPM (the average price advertisers paid for 1000 ad views) Page x Coverage x CPM x 1/1000 = Revenue Views The Role of TAC Rates Because of the relatively high costs associated with developing and maintaining the graphical advertising platform and with attracting and servicing advertisers, some content providers have chosen to outsource the placement of display ads with larger content providers or ad networks. An example of this is the Newspaper Consortium developed by Yahoo!. In these cases, the revenue is split between the parties. The traffic acquisition cost (TAC) rate is established in negotiations and is in force for the length of the partnership. The TAC rate is the percentage of revenue that is paid to the content owner for obtaining the traffic. Typically, this rate is lower than the TAC rate for search, as the graphical advertising process is more complex and less automated. For the content providers that provide the outsourced display advertisements (such as Yahoo!), the company usually reports a gross revenue and a net revenue, which excludes TAC payments. Search Advertising 101 Search advertising has become the leading form of online advertising due to multiple characteristics. • Advertisements are very targeted, since the searcher enters a key word or phrase describing the information he would like to receive. • The searcher is very receptive to looking at advertisements since information gathering is the focus of his activity (this contrasts television ads or radio ads, where the main focus of the viewer is on being entertained). • Search advertisements have significant reach given the large volume of searches conducted. • Given the automated nature of search advertising, advertisers of all sizes and with all ad budgets can easily take advantage of this marketing method. • Finally, advertisers do not pay to have the ad appear, but only pay when a searcher clicks on their advertisement and is transferred to the website. Because an action is required on the part of the searcher (clicking on the ad) and advertisers do not pay unless this action occurs, search advertising is considered a form of performance-based advertising. 25
  26. 26. Imran Khan Global Equity Research(1-212) 622-6693 04 January Efforts Are Being Made to Innovate in Search After years of the same format for search results, we have seen most of the key players start to innovate in the space. Some key developments that we expect to see are: • Multimedia Search Results. We think search companies will embrace the diversity of data media and incorporate more video, image, and audio results into searches. • Increased Personalization. We think a greater focus will be made to target results based on geographic location and other factors. • Dynamic Results. With data constantly being added to the web through blogs, twitter, and social networks, we think real-time results will become more the standard. The Auction Process Advertisers or search engine marketers (SEMs are advertising agencies that manage the search ad campaigns of larger companies) first create a text ad, which is a very short (~70 characters in length), text-only, advertisement or description of the website. Advertisers then select the key search words or phrases that they would like their ads to appear alongside. Advertisers also select their monthly budget and their maximum cost-per-click (CPC), which is the amount an advertiser is willing to spend to have one searcher click on the ad and be transferred to the advertising website. When a searcher uses the keyword in a search, a search algorithm compares all of the maximum bids for the keyword and the quality of the advertising site. Both factors are usually used in the formula for selecting an advertisement and determining the order in which advertisements appear, since search engines are concerned with providing the most relevant ads to users to maximize the user experience. Thus, there are occasions when ads with lower maximum CPC bids appear above ads with higher bids. The ads then appear in the order determined by the algorithm. If the searcher clicks on an ad, that advertiser is charged a CPC based on other bids in the auction and the quality determination of the advertiser. How Search Revenue Is Determined The total revenue of an owned and operated search engine is determined by 4 factors: