31 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com Video Capabilities Google’s $1.65B acquisition of video sharing site YouTube gives insight into the value placed on video property. Traditional media companies have also moved onto the Internet by offering TV episodes online and with Internet designed webisodes. However, monetization of Internet videos has trailed its growth. Various companies have experimented with pre-roll, post-roll and in-video ads. Google has experimented with in-video ads on select YouTube videos in which the ad is overlaid on the bottom 20% of the video soon after it is launched. If the user does not click on it, it simply disappears. Additionally, Google has experimented with an e- commerce platform with the launch of a new service that allows viewers to buy music and games from selected partners featured on YouTube videos. With this service, YouTube viewers who want to buy, for example, a song featured in a music video can click on an icon that takes them to selected e-commerce partners, including Amazon.com and Apple's iTunes store. YouTube gets a share of the revenues from every transaction. We think this performance-based model is a good move for Google to help monetize YouTube. Mobile Ads An even younger industry is mobile phone advertising. The development of the iPhone and the advent of Google’s Project Android have placed a growing interest in the field. Performance-based Advertising While many graphical ads were originally used for branding purposes with less of a focus on conversion, the developments in behavioral and contextual advertising have put more pressure on ad networks to deliver conversions. Additionally, an abundance of inventory is making advertisers more focused on conversions. We expect this model to gain market share. Email Marketing Ad networks have entered the realm of email marketing by placing advertisements in emails sent by other companies to their customers. As in the other categories, ROI is enhanced by careful pairing of the ad with a related company or email content. Email marketing is a preferred method of advertising with its easy trackability and ROI calculation. Furthermore, unlike other advertisements, email is pushed to targeted customers rather than assuming that specific websites will pull these customers to the ad. Ultimately, we believe successful ad networks are going to need to be able to provide a diversity of advertising platforms to its marketers with clear targeting capabilities. Dominant Portals’ Role in the Growing Ad Network Market In 2007 we saw large portals make significant investments and acquisitions to strengthen their foothold in the ad network space. We believe large portals are naturally well positioned, as it is easier for both advertisers and publishers to fulfill all of their needs on fewer platforms, while a consolidated network yields greater leverage of technology and advertiser/publisher relationships. Looking forward, we think the market cannot sustain such a large number of ad networks. We expect larger players to gain share, and we think there may be further consolidation among private companies. We also see some companies likely closing their business. We believe the development of a non-intrusive video ad delivery system with contextual advertising capabilities will be valued by the ad network space. Success in mobile ads will be dependent on targeting, non- intrusiveness, and ability to load on slow-loading platforms. We see payment structures shifting with objectives to include CPA models in addition to CPMs. We believe marketers will turn to targeted email distribution given its high usage and push vs. pull ad model. 32 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com Creating Ad Networks Could Be the Answer to an Ever-Fragmenting Audience While portals were once the dominant source of news and information, Yahoo!, AOL and Microsoft only accounted for ~27% of total minutes spent online in October 2008 vs. 42% in 2002. We believe portals will become more significant players in ad networks as they turn to networks to grow their user reach, leverage user information through behavioral targeting, and leverage their existing capabilities to sell, place, and analyze display ads. Figure 15: Total Minutes Spent on Portals in October 2002 and 2008 millions 0 10,000 20,000 30,000 40,000 50,000 60,000 Yahoo! Sites AOL Media Netw ork Microsoft Sites Oct '02 Oct '08 58% Growth 56% Decline 19% Decline Source: ComScore data and J.P. Morgan estimates User Information Should Lead to Dominance Accurate and rich user information is among an Internet company’s most valuable assets. Additionally, the ability to leverage accurate user information to deliver relevant content to users is the key to increasing conversion rates. We think large cap companies are particularly well suited to running ad networks, as they can lever their user information with that of the publisher network to provide well targeted advertising. This should increase user conversion and monetization capabilities. A combination between any of the search players, a large publisher network, and a company with behavioral targeting capabilities would make sense, in our view. One Platform for Multiple Advertising Products=Higher Ad Dollar Allocation From the standpoint of an advertiser, advertising campaign management would be easier with a single ad firm offering multiple products (search, graphical, cost-per- lead, cost-per-action, in-game advertising, mobile advertising, video). Publishers could benefit from the scale of various advertisers across verticals and the higher CPMs accompanying better targeted ads. Minutes spent on portals has declined over the last 6 years, despite 30% growth in total minutes spent on the Internet. If a company had demographic, search query and web navigation data on a user, we believe it could provide advertising that is more user relevant and could tailor the ads to the user as he/she navigates the web. 33 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com Figure 16: Online Advertising Services by Company Service AOL GOOG MSN YHOO Search Ad Network Ad Serving*** Traffic Exchange*** Targeting Lead Generation Affiliate Marketing*** Rich Media Mobile Email ***Assumes DoubleClick/Performics acquisition Source: J.P. Morgan estimates, Company data Cost Synergies Entering the ad network space would allow large cap Internet companies to lever their existing sales force, technology, and publisher relationships in expanding their product offering. The sales team could expand its offering of graphical advertising to include properties on the ad network. Technology used to place graphical ads on owned and operated properties and for behavioral targeting could be extended for use on network sites. Finally, search network relationships could be leveraged in building the ad network. Scale Is Critical to Build a Market-Leading Product While we have established that the goal of ad networks should be to increase their exposure to an overlapping user base across a variety of properties for targeting, such an undertaking requires scale. ¾ Small companies must choose between generalization across a variety of publishers or going deep into a few verticals. Both options carry risk, as generalization limits targeting capabilities while focusing on limited verticals exposes companies to industry risk (for example, the current mortgage industry weakness). ¾ Large cap companies, however, have the resources to be both broad and deep, offering targeting capabilities while maintaining diversification of risk. Google Becoming More than Just a Search Engine and Search Network A latecomer to the display advertising field, Google has made recent strides to enter it and, in our view, would be a likely candidate for building its AdSense network to include display advertising. As the leader in search market share, Google has much information about user preferences for hosting behaviorally targeted ads. 34 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com Table 15: US Search Market Share, September 2008 millions Core Search Searches Search Market Sept-08 Share Google Sites 7,422 63% Yahoo! Sites 2,386 20% Microsoft Sites 998 9% Ask Network 510 4% Time Warner Network 481 4% Source: ComScore Strategic Acquisitions Provide Fast-Paced Industry Entrance Recent acquisitions have positioned it well to quickly gain market share. With the acquisition of DoubleClick, Google gains ownership of two key technologies: ¾ the DART suite: a comprehensive set of technologies that enable advertisers to effectively manage their online advertising campaigns while providing publishers with the ability to dynamically place ads on their sites. ¾ the DoubleClick Advertising Exchange: a platform for buyers to gain immediate access to inventory with goal-based bid rules, defined budgets, targeting, and frequency caps on inventory purchases, while sellers increase overall yield by reducing unsold and undervalued inventory DoubleClick has relationships with both publishers and advertisers that enable it to serve hundreds of billions of ad impressions per year. In 2004 (the most recent full- year data available), DoubleClick served over 800 billion online ad impressions (we expect it will serve ~2 trillion+ impressions in F’08). Beginning with display advertising tests within the AdSense for Content environment, Google has been exploring the serving of graphical advertisements for a couple of years. But we believe the acquisition of DoubleClick emphasizes the importance that Google places on entering the ad network market. Figure 17: Graphical Ad Market Will Represent an Estimated 36% of Total in 2010 % of industry revenues Graphical Advertising 36% Search Adv ertising 64% Source: J.P. Morgan estimates, Company Reports, ComScore, Nielsen//NetRatings, IDC, IWS, IAB 35 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com MSN Rich Targeting and Performance-based Advertising Capabilities With the acquisition of aQuantive, Microsoft obtained the DRIVE performance media platform, which provides premium advertising solutions to aQuantive advertisers and agencies. With selective inventory from only the top 250 publishers, DRIVEpm offers brand protection to its advertisers. The collection of visitor data over several years and CPA payment options allows for behavioral targeting and performance-based capabilities. While the selectivity of the publisher network will likely limit its scale, this premium network will offer a point of differentiation from competitive networks. Figure 18: DRIVEpm Ad Network DRIVEpm Network Top 250 Publishers Remnant Inventory Behavioral Targeting CPA Solution Advertiser and Agency Clients Source: aQuantive reports and J.P. Morgan estimates AdECN Should Improve Monetization Microsoft acquired AdECN, which serves as a hub for ad networks to buy and sell display advertising in a real-time auction marketplace. Advertisers will get more access to inventory to enable better matching to their requirements and increasing ROI. Publishers should be able to increase their yield through increased volume of available inventory. With both parties benefiting, AdECN should provide better monetization through higher CPMs for Microsoft remnant and non-premium inventory. Partnerships Are Growing MSN’s Display Reach Outside Its O&O Properties Agreements to provide advertising on Facebook and Digg have expanded MSN's advertising network beyond its owned and operated properties and have allowed MSN to capitalize on the growing social networking trend. Facebook and Digg are two fast growing social networks. The challenge that we believe Microsoft will face will be providing targeting capabilities sufficient to monetize such a diverse user and content base. Table 16: Partner Page View Growth, August 2008 millions Aug-2007 Aug-2008 Y/Y Growth Total Internet 474,003 468,006 -1.3% FACEBOOK.COM 15,260 15,551 1.9% DIGG.COM 24 27 16.6% Source: comScore data and J.P. Morgan estimates 36 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com Yahoo! A Clear Fit in the Ad Network Space Yahoo! is particularly well positioned to provide targeted advertising to a network, in our view. As one of the top-ranked websites by unique visitors (according to comScore), Yahoo! has a wealth of information about visitor habits and preferences. Figure 19: Top Sites by Unique Visitors and % Reach, October 2008 thousands 0 20,000 40,000 60,000 80,000 100,000 120,000 140,000 160,000 Google Sites Yahoo! Sites Microsoft Sites AOL Media Network Fox Interactiv e Media 77% 76% 65% 58% 48% Source: ComScore data Yahoo! has made strategic acquisitions to build off of its existing assets and to gain dominance in this space. ¾ Its acquisition of Right Media, in addition to its owned and operated pages, has made it a destination for the buying and selling of inventory. ¾ The acquisition of Blue Lithium has provided Yahoo! with behavioral targeting technology, visitor information off its owned and operated sites, advanced analytic reporting, and a sales force more accustomed to direct response sales. These additions should have a smooth integration, as Yahoo! already possesses a sales force accustomed to selling display and contextual advertising, has experience with behavioral targeting with SmartAds, and has entered the ad network arena with newspaper partnerships and agreements with eBay and Comcast. The acquisition of Blue Lithium builds on these earlier efforts and has now made it a significant player in the ad network space. 37 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com Ad Exchanges: A New Marketplace Ad Exchanges: A Response to Audience Fragmentation One of the largest deterrents to the graphical advertising market has been the increase in the difficult to monetize non-premium inventory. Social networking, blogs, photo sharing, and email have all increased inventory levels but are difficult to monetize given their non-targeted user base and lack of focus on ads. Ad exchanges focus on better monetizing this portion of inventory through aggregation and an open market. While portals were once dominant, Yahoo!, AOL, and Microsoft only accounted for ~27% of minutes spent online in August 2008, down from 42% in August 2002. Much of this decline can be attributed to audience fragmentation, a result of increases in non-premium inventory. Meanwhile online gaming and social networking websites have experienced double-digit Y/Y growth rates in minutes spent online. Figure 3: Non-Premium Inventory Growth Billions Facebook 6.8B minutes, Aug 13% Y/Y Growth Facebook 6.8B minutes, Aug 13% Y/Y Growth MySpace 18.2B minutes, Aug 28% Y/Y Growth MySpace 18.2B minutes, Aug 28% Y/Y Growth YouTube 8.5B minutes, Aug 78% Y/Y Growth YouTube 8.5B minutes, Aug 78% Y/Y Growth Online Gaming 16.1B minutes, Aug 44% Y/Y Growth Online Gaming 16.1B minutes, Aug 44% Y/Y Growth Source: comScore and J.P. Morgan estimates We believe this audience fragmentation hampered the development of the graphical advertising market, as it resulted in the following challenges: • Audience fragmentation makes it difficult for advertisers to reach their target audience through only a few publishers; • Small publishers have difficulty attracting advertisers due to limited scale; and • Monetization is limited due to the difficulty of attracting sufficient advertisers to cover available inventory (purchasing power). Ad exchanges have emerged as an efficient solution to these new challenges and are gaining traction to alter the landscape for selling and purchasing display advertising inventory. 38 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com The Rise of the Ad Exchange The ad exchange is a real time marketplace with an auction-based system where the participants – advertisers and publishers – transact on a common platform to purchase and sell online graphical advertising. The publishers place remnant inventory on the exchange for the advertisers to purchase through bidding on a user- friendly interface. Network barriers are lowered and all participants interact on a common platform, while the outside relationships are not disturbed. Ad exchanges do not compete with ad networks, targeting technologies, or publishers, but rather serve as another way for the exchange of inventory within these groups. Figure 4: Ad Exchange Linkages Ad Exchange Bid Optimization Rich Media VendorsContextual Networks Other Ad Exchanges Targeting Technologies Display Networks Large Publishers Agency Side Ad Servers Source: www.clickz.com (Article: Ad exchanges are the future) Key features of ad exchanges: • Transparent and dynamic pricing landscape due to open bidding process; • Reduced operational friction due to improved clarity of placement of ad serving on a website; • Enhanced efficiency due to simplification and standardization of business processes; • Improved liquidity of ad inventory; • Interests of smaller niche players safeguarded, as existing relationships and budget sizes exert no influence, and each bidder has equal access to the media; • Increased role of technology to automate and provide a common platform; and • Elimination of intermediaries and their margins. The Value of an Ad Exchange For Advertisers: An advertising exchange establishes a transparent and automated clearinghouse, easing pricing concerns. The advertiser can place different bids for each ad 39 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com impression after evaluation of the perceived value against the buy criteria. Thus, the advertisers gain from: • Smarter spending; • Better ROI; and • Access for inventory for targeting purposes. For Publishers: The ad exchange model should usher in more competition and enhanced technologies for targeting. This should drive the demand for inventory upwards, resulting in higher CPMs. The publisher can set a floor price for the impressions to be accepted by the exchange and will gain as yields optimize when highest bids win in a real-time auction. The benefits for the publishers are: • Better targeting; • More valuable inventory; • Higher prices; and • Better yield. Key Takeaways • Exchanges should increase CPMs for publishers, as they provide an open auction market to a large population of advertisers. • Advertisers should gain easier access to a broad range of inventory, which can be used for targeted advertising. • The major Internet players should become ad exchange operators as they strive to provide a one-stop solution to all of an advertiser’s needs. 40 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com 2009 eCommerce Outlook 2008 saw Amazon, the standard-bearer of eCommerce, continuing to consolidate market share, as the company demonstrated that it remains a formidable competitor, driven by a combination of a broad product selection, low prices and a focus on customer service. Macroeconomic weakness proved a significant headwind to growth in eCommerce, especially in the second half of the year, and we expect that much of 2009 could see significantly reduced growth as a result of the slowdown in the economy and in consumer spending. At the same time, we think it is likely that online shopping will continue to take market share away from offline retail channels in the coming year, especially as the retail landscape experiences upheaval and the dislocation of several incumbent players. Additionally, we think broadband penetration will continue to rise, and we see broadband penetration as a key catalyst for the growth of eCommerce. 2009 eCommerce Forecast We think US growth in eCommerce (including eBay GMV) will experience weaker Y/Y growth rates as economic conditions worsen. At the same time, we expect a greater proportion of retail sales to continue to shift online, driven by (1) increases in product selection, (2) continued Y/Y improvements online for brick-and-mortar retailers, (3) volatility and uncertainty in the offline retail space, and (4) further improved efficiencies from site optimization. Table 17: US eCommerce Forecast units as indicated US eCommerce Forecast 2004 2005 2006 2007 2008E 2009E 2010E 2011E '08-'11E CAGR Internet population (M) 186 195 203 211 217 222 227 231 2.2% Online shoppers 104 117 130 143 153 160 170 176 4.8% Shopping sessions / shopper / month 2.00 2.03 2.11 2.10 2.11 2.09 2.12 2.24 1.9% Total shopping sessions / year (M) 2,497 2,847 3,289 3,618 3,878 4,020 4,324 4,724 6.8% Average price / session $39.50 $41.25 $43.00 $45.50 $45.00 $45.50 $47.25 $47.75 2.0% Total eCommerce revenue (US $M)) 98,644 117,419 141,437 164,612 174,525 182,902 204,302 225,549 8.9% Product return rate 10.0% 9.0% 9.0% 8.0% 8.0% 8.0% 8.0% 8.0% 0.0% Net Revenue 88,780 106,851 128,708 151,443 160,563 168,270 187,958 207,505 8.9% Y/Y Growth 20.4% 20.5% 17.7% 6.0% 4.8% 11.7% 10.4% Source: Department of Commerce, Internet World Stats, company reports, J.P. Morgan estimates Note: includes eBay US GMV Given the unprecedented global scale of the current slowdown, we are projecting significant slowdowns in eCommerce growth across the world’s regions. Further, the Y/Y growth in dollar-denominated volume of eCommerce is likely to suffer due to the stronger dollar; whereas much of F’07 and F’08 benefited from an FX tailwind, the conversion will hurt dollar volume growth rates in F’09. In some places, the impact of the FX tailwind is quite dramatic: e.g., our projection for Korean eCommerce is to post a mid-teens Y/Y rise in local currency terms in F’09, but, assuming current exchange rate levels are maintained through the coming year, the dollar-denominated volume would decline at a low-double-digit rate. . 3,878 4, 020 4, 3 24 4,7 24 6.8% Average price / session $39.50 $41 .25 $43 .00 $45 .50 $45 .00 $45 .50 $47 .25 $47 .75 2.0% Total eCommerce revenue (US $M)) 98, 644 117 ,41 9. $M)) 98, 644 117 ,41 9 141 ,43 7 1 64, 612 1 74, 525 182,902 2 04, 302 225, 549 8.9% Product return rate 10.0% 9.0% 9.0% 8.0% 8.0% 8.0% 8.0% 8.0% 0.0% Net Revenue 88,780