151 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com Our View on Share Prices Despite Lower Trading Range, a Near-term Rebound Appears Less Likely Korea’s Internet sector has underperformed the KOSPI by 27.5% for the past year — NHN and Daum fell 56% and 65%, respectively. In particular, the shares fell sharply during August-September due to the emergence of regulatory risks. After such a sharp correction, NHN has been holding up better, outperforming the KOSPI by 12% since early October, while Daum has underperformed by 3%. We believe the weakness in Korea’s Internet sector largely stems from concerns about regulatory uncertainties and an economic slowdown. We expect these negatives to continue to dampen sentiment for the sector and its fundamentals for the next two to four quarters. Although current valuations are at historical lows, we believe the market is largely reluctant to offer premium on growth stocks and is more sensitive to near-term earnings. The trading range has significantly lowered to 14-16x FY08E EPS for NHN and 13-18x FY08E EPS for Daum, while the 12-month historical average trailing P/E range is 20-50x for NHN and 40-80x for Daum. Figure 92: Korean Internet Sector Relative to KOSPI Performance -40% -30% -20% -10% 0% 10% Dec-07 Feb-08 Apr-08 Jun-08 Aug-08 Oct-08 Internet sector to KOSPI NHN to KOSPI Daum to KOSPI Source: Datastream We believe both NHN and Daum lack near-term catalysts due to the weak economy and regulatory risks. We think NHN will hold up better than Daum, since investors will likely prefer the market leader, given that advertisers on tighter budgets tend to lean towards the market leader to reap more benefits from their dollar spending. We believe that although the downside for NHN should be limited at the current level, the stock is unlikely to rebound in the near term unless the market is convinced of an economic recovery. We believe Daum’s share price will be largely volatile and could carry more downside risk as the company has relatively less earnings visibility and is more sensitive to the economy. Our Price Targets Are Based on a 10-year DCF Valuation We derive our price targets using DCF, because the companies consistently generate recurring free cash flows from operations and there is no major change in the capital structure. We use a 10-year DCF model with a 5.8% risk-free rate, 0% terminal growth rate and 12.7% WACC for NHN and 14.3% for Daum. Our 10-year DCF model yields fair values of W130,000 for NHN and W33,000 for Daum. For Daum, we applied a 20% discount to our DCF-based fair value estimate to derive our price 152 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com target of W26,000, as Daum is a relatively small company in the market and its operations are more sensitive to the economy. Valuations for Korean Internet companies remained at a 20-30% discount to their global peers until 1H07, but the gap almost disappeared in late 2007 and early 2008 when Korean Internet share prices rallied due to unprecedented earnings growth. During the recent market weakness, however, the gap with the global peers widened again to the 10-20% level, which we believe will continue until regulatory uncertainties disappear and the next round of growth story begins in Korea. Figure 93: NHN-TTM Trailing P/E Bands Won 0 50,000 100,000 150,000 200,000 250,000 300,000 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 50x 40x 30x 20x 10x Source: Company data, J.P. Morgan estimates. Figure 94: Daum-TTM Trailing P/E Bands Won 0 20,000 40,000 60,000 80,000 100,000 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 70x 50x 30x 10x Source: Company data, J.P. Morgan estimates. Figure 95: Global Internet Companies’ EPS CAGR vs. 08E P/E NetEase NCSOFT Electronic Arts Ebay A mazon A libaba.com Yahoo Japan NHN Daum Comm Yahoo Google Baidu Tencent Sohu SINA 0.0 5.0 10.0 15.0 20.0 25.0 30.0 0.0 5.0 10.0 15.0 20.0 25.0 30.0 35.0 40.0 45.0 50.0 EPS CAGR(08E-10E), % FY08E P/E, x Source: Company data, J.P. Morgan estimates. Note: Price as of 28 Nov. 2008. Negative Share Price Drivers We believe the online ad market will contract by 4.6% due to the economic downturn. Korea’s domestic ad market has constituted about 1% of GDP, on average, for the past 15 years. Given the ad market has historically reacted more sharply to GDP growth and the ad market-to-GDP ratio tends to fall below 0.8% in a downturn, in FY09, the domestic ad market will contract 15% Y/Y, by our estimate. Contrary to the consensus view that the online ad market will continue to grow, backed by advertisers’ heavy-weight online ads, we estimate that the online ad market will 153 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com shrink by 3%, although the magnitude of the scale-down should be less than that of the total domestic ad market. We believe the biggest weakness will stem from display ads, which could result in a 12% drop in the combined revenue of NHN and Daum. We believe both the companies’ search ad revenue will still grow due to the market share shift towards performance-based advertising, although the growth could slow significantly to 12% in FY09, from 61% in FY07. We believe NHN will weather the economic slowdown better as advertisers are likely to opt for the portal with the largest market share, where the possibility of ads hitting target customers is higher. Stricter Regulations Likely to Dampen Sentiment Koreans are among the heaviest users of Internet portals for participating in various discussion boards. Since portals have played an influential role in forming public opinion in events such as the presidential election and the US beef case, some portals have been criticized for sorting and posting news reports that favor certain interest groups. In addition to the political bias, certain portals’ accountability for their users’ defamatory posts has been actively discussed. As a result, regulators and political parties are in favor of stricter controls on portals. We believe the implementation of regulations will dampen sentiment on the Internet sector as it reflects the government’s strong intent to apply stricter rules on portals and Internet users’ activities. More importantly, rigid control could hurt user traffic and portals’ revenues, in our view. Recovery in 4Q Likely to Be Weak after Disappointing 3Q Results NHN’s revenue and operating profit in 3Q declined Q/Q for the first time in the past four years. The weak economy and change in online game rules led to the 4% and 13% Q/Q drop in the portal’s revenue and operating profit, respectively. Daum’s revenue and operating profit fell 1.3% Q/Q and 4.7% Q/Q, respectively, mainly due to its higher dependence on display ads, advertisers’ preference for bigger portals, and management’s quality initiatives. We expect a recovery in 4Q to be weak despite seasonality, as companies are likely to reduce their ad budgets further, and Y/Y growth of the e-commerce market is unlikely to be exciting. Positive Share Price Drivers Development of Rich Media Ads Should Increase the Unit Price of Banner Ads Managements of NHN and Daum stated that their unit pricing for rich media banner ads—which use expansion ads, pop-up pictures or moving pictures—is about 20- 200% more expensive than for a static ad, depending on the ad type. According to NHN, rich media ad revenue accounts for about 25% of its banner ads (versus 8~15% for Daum) and this continues to grow. Such ads are mainly adopted by large- scale advertisers, which can afford a higher unit price. However, portals continue to develop new types of rich media ads, and we expect more advertisers to accommodate these new formats. Hence, we believe rich media will be a key driver for the Internet advertising market over the next few years. Diversification of Revenue Mix We expect portals’ revenue mix to continue to diversify as contributions from ecommerce and gaming businesses increase. For NHN, gaming accounted for 30% of sales as of 3Q08 versus 23% in FY06, while Daum’s e-commerce revenue accounted for 14% of total revenue as of 1Q08 versus 9.5% in FY06. Although gaming and ecommerce revenues account for smaller shares of total revenue than online ads, we 154 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com believe it is a meaningful development for them to have an additional strong growth driver, as in our opinion it creates a more balanced and diversified business model. 155 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com U.S. Company Previews U.S. Company Previews 156 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com 157 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com Amazon.com, Overweight, ($50.76) We are upgrading Amazon.com to Overweight from Neutral. Although we believe a tough consumer environment may hamper spending in the near term, in the medium to longer term, we see Amazon continuing to take share within eCommerce even as eCommerce continues to outpace overall retail growth. Our 12-month price target for AMZN is $65. • Amazon is a net share gainer. eCommerce is gaining share – and Amazon is gaining share within eCommerce. Through the first 9M’08, US retail sales rose 2%, US eCommerce grew 8%, and Amazon North America retail revenue was up 31% Y/Y. We expect these relative trends to continue through F’09, with eCommerce growing faster than retail and Amazon outgrowing eCommerce. • Amazon is diversifying its business. The company has added more product lines (e.g., office products), continues to expand its geographic footprint, and is aggressively pursuing revenue streams not derived from physical sales from inventory: third-party sales, digital media sales and Web Services. We think Amazon is establishing itself as an unmatched online marketplace, and its higher- margin non-retail businesses could boost profitability in the medium to long term. • Low Cap-Ex model driving solid FCF generation. Since 2Q’07, Amazon’s TTM CapEx has been at or below 25% of operating cash flow, a trend we expect to continue. While we think operating margins are likely to stay in the 5% range in the medium term, we believe Amazon can continue to produce solid FCF growth, up 57% in F’09 and 42% in F’10. • 2009 drivers. In our view, the following factors will drive shares in 2009: (1) the impact of the economy on retail and eCommerce spending, both in the US and abroad, (2) Amazon’s ability to take share within eCommerce, (3) the impact of brick-and-mortar retail bankruptcies, and (4) customer uptake of digital download and web services businesses. • Adjusting 4Q’08 estimates. We are lowering our 4Q’08 revenue, EBITDA and EPS estimates, to $6.25B, $376M and $0.35 (from $6.65B, $407M and $0.40), as we expect the tough environment to result in slower revenue growth and add pricing pressure this quarter; we are also lowering our F’09 revenue, EBITDA and EPS forecasts due to our anticipation of a longer, deeper recession that we previously saw. Our F’08 – F’10 estimates are in the table below: Table 84: Amazon.com Financial Snapshot $ in millions, except per share data AMZN Y/Y 4Q’08E F’08E F’09E F’10E F’08E F’09E F’10E J.P. Morgan Revenue 6249.1 18711.1 21693.5 26165.1 63% 16% 21% EBITDA 376.0 1398.0 1419.2 1734.3 28% 2% 22% EPS $0.35 $1.32 $1.20 $1.54 18% -9% 28% Consensus Revenue 6563.6 19037.2 21700.5 25492 66% 14% 17% EBITDA 388.9 1280.7 1472 1847.2 18% 15% 25% EPS $0.43 $1.40 $1.57 $2.29 25% 12% 46% Source: J.P. Morgan estimates, Company data, and Bloomberg 158 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com Takeaways from the J.P. Morgan Internet Team’s 2008 Consumer Survey Amazon Emerging as the Clear Leader in US eCommerce In our November 2008 survey, we asked those who shop online which stores they expected to buy from this holiday season. Nearly 50% of online shoppers said they planned to shop at Amazon.com during the holiday season, and the expected reach for Amazon was 39% higher than that of its nearest competitor. Additionally, Amazon continues to do extremely well in terms of reach among those who earn $100K or more, with 59% of shoppers in that income category saying they had shopped there. No other online retailer in our survey had a penetration higher than 33% with the over-$100K income bracket. Figure 96: Amazon’s Reach with Higher-Income Users Is Unparalleled, above 50% % of online shoppers in each income group who made a holiday purchase from site in '07 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% Amazon eBay Walmart.com Target.com <$25K $25K-$49K $50K-$74K $75K-$99K $100K+ Source: J.P. Morgan Internet Team 2008 Consumer Survey Our Estimates and Outlook for 2009 Despite our long-term optimistic outlook for Amazon, we believe an unfavorable consumer spending environment is likely to depress revenue growth in the first half of the year. As such, we are reducing our F’09 revenue growth rate assumptions; we now expect North America revenue to grow 14% Y/Y (from 17% previously and 26% in F’08E), as we expect EGM revenue growth to slow to 20%, from 39% in F’08E. Internationally, we are now projecting 17% Y/Y growth, from 19% previously and 32% in F’08E. Our new revenue estimate is thus $22.0B, from $22.5B, implying a 15% Y/Y growth rate. Due to the difficult pricing environment, we see gross margin in F’09 at 21.4%, down ~70 bps Y/Y. We do not think Amazon will be able to significantly rationalize any of its operating expense lines, and thus think much of the gross margin contraction will flow through to the operating margin line: we expect a ~61 bps operating margin decline Y/Y to 4.8%. Our model now calls for EBITDA in F’09 of $1.43B, down from $1.56B previously and up 1% Y/Y. We are cutting our F’09 EPS estimate to $1.22, from $1.43. 159 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com Our Estimates and Outlook for 2010 We think a recovery in consumer spending is not likely until 2H’09 and believe that a rebound in F’10, as well as easier comps from the depressed levels of 1H’09 could set up accelerating revenue growth at Amazon in F’10. We are modeling 19% Y/Y revenue growth in F’10 to $26.2B; we think both North America and International revenue growth could be faster in F’10 than F’09. Our model calls for EBITDA of $1.73B, slight Y/Y operating margin expansion to 5.0%, and EPS of $1.54. We Are Introducing a Price Target of $65 In introducing price targets for our coverage, we have derived multiples based on 5-year forward EBIT CAGRs. We believe the historical record does not provide a meaningful guide to valuation as (a) the majority of the companies in our coverage did not have a track record as public companies through the previous recession; and (b) even the public companies were still in their early-growth (and, for some, rapid growth) stage during the last economic downturn. As such, given our projection for Amazon of a ~38% F’09-F’14 EBIT CAGR, and our view of the beginning of a possible economic turnaround in 2H’09, we believe the stock can achieve a 38x EV/EBIT multiple to our F’09 EBIT estimate (reflecting better forward visibility than the current valuation of 29x our F’09 estimate) and thus arrive at our December 2009 price target of $65. The parameters of our EV/EBIT multiple analysis are in the table below: Table 85: Key Valuation Assumptions 5 yr forward EBIT CAGR 38% 1x EBIT Growth 38 2009 EBIT $ 704 Implied Enterprise Value $ 26,416 + Cash $ 2,602 - Debt $ 895 Market Value $ 28,123 Share count 436 2009 Price Target $ 65 Source: Company reports and J.P. Morgan estimates. Our EV/EBIT valuation is based on the following projections for revenue and operating income growth Table 86: Growth Profile $ in millions 2009E 2010E 2011E 2012E 2013E 2014E Revenues 21,693.5 26,165.1 31,528.7 37,676.5 44,646.3 52,146.9 Y/Y change 20.6% 20% 19% 18% 17% Less: Operating Expenses 20,989.3 25,239.8 30,299.1 35,905.7 42,146.1 48,684.3 As % of total revenues 96.8% 96.5% 96.1% 95.3% 94.4% 93.4% Operating Income (Loss) 704.2 925.3 1,229.6 1,770.8 2,500.2 3,462.6 Operating margin 3.2% 3.5% 3.9% 4.7% 5.6% 6.6% Source: Company reports and J.P. Morgan estimates. 160 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com Valuation and Rating Analysis AMZN trades at a premium to its peers. Our updated F’09 assumptions yield a 2009 EV/EBITDA multiple of 14.5x our F’09 EBITDA estimate of $1.42B, versus the ecommerce group at 6.5x and its large-cap peers at 7.8x. Given the rapid revenue growth and superior industry position, we believe the stock has capacity to see further multiple expansion and thus rate AMZN Overweight. Risks to Our Rating AMZN could underperform if it encounters difficulties in its international expansion, including regulatory hurdles that make the business climate less hospitable and potentially less profitable than the markets where it currently operates. Amazon may have difficulty growing revenues while maintaining its current operating margins. Amazon could suffer if consumer spending continues weakening or remains depressed longer than we expect. Amazon faces competition from a variety of online and offline retailers, and improved offerings from these competitors could hamper Amazon’s growth. . Figure 92: Korean Internet Sector Relative to KOSPI Performance -40% -30% -20% -10% 0% 10% Dec-07 Feb-08 Apr-08 Jun-08 Aug-08 Oct-08 Internet sector to KOSPI. dampen sentiment on the Internet sector as it reflects the government’s strong intent to apply stricter rules on portals and Internet users’ activities.