11 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com • Sales of virtual goods, which can further the depth of the user experience on a social site; • A model that exposes a site to the classifieds or eCommerce markets, both of which are gaining market share from their offline counterparts; and • Paid premium memberships or selling a la carte paid features (such as the ability to post more or higher-quality photos). Several sites are already pursuing a variety of these approaches (both LinkedIn and Classmates, e.g., sell premium memberships). We expect much more experimentation as the market continues to mature. Mobile Is Long-term Interesting, but Near-term Challenging With 84% of Americans using mobile phones (CTIA), we firmly believe the mobile market is a promising opportunity. Given this level of reach and better mobile Internet technologies and hardware, we think this medium is becoming attractive to advertisers. As a result, Google, Yahoo!, and MSN are strategically focusing on establishing market share in this industry. Figure 6: Technology Penetration in the US (2008) as labeled 0.00% 20.00% 40.00% 60.00% 80.00% 100.00% PC Mobile Mobile Web Subscribers Mobile Internet Users 0 50 100 150 200 250 300 Usage (M) Penetration Source: CIA Government Stats (http://www.cia.gov/cia/publications/factbook/index.html) (Feb 2008); International Telecommunications Union (http://www.itu.int/ITU-D/ict/statistics); CIA Government Stats (http://www.cia.gov/cia/publications/factbook/index.html) (Mar 2008) for Vietnam and Hong Kong mobile phone data, "OECD Broadband Statistics to June 2007", OECD; www.point-topic.com; mybroadband.co.za; Hong Kong and India government statistics; European Travel Commission; www.bezeq.co.il; Santiago Times newspaper; Nielsen Mobile data, JPMorgan Estimates However, although mobile phone penetration is high, the mobile search market is in the early adoption stage. In 1Q’08, only 15.6% of wireless subscribers were using mobile Internet services, according to Nielsen Mobile data. Even within this small subset of mobile Internet users, usage drastically trails that on PCs. Nielsen Online reports that the PC Internet user visits more than 100 domains per month, whereas mobile Internet users visit 6.4 individual websites per month, on average. We think mobile Internet adoption will not accelerate until the introduction of better phones and technologies. 3G networks perform up to 6x faster than prior mobile Internet networks (Nielsen), which we think will greatly improve the user experience and make it more comparable to that on a PC. Additionally, new phones such as the iPhone have improved the size and resolution of the screens. However, we note that 12 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com smart phone technology has not yet become the norm and uptake of mobile Internet likely has a ways to go. Additionally, we find it unlikely that advertisers will quickly be adopting mobile advertising. In addition to not having the scale and reach of the Internet, mobile advertising is difficult, as it involves dealing with multiple ad networks and mobile service providers and creating ads that can be viewed on small screens. Furthermore, we think advertisers will cut back on experimental models of ad spend in the face of this economic recession. M&A: Slow in 1H’09, but Could Pick Up in 2H We believe M&A activity is likely to remain quite slow in the first half of the year as companies and management teams try to understand the scope and length of the economic downturn. Further, we think sellers are likely to be resistant to sales at reduced valuations, and may prefer stock transactions that expose them to upside in the event of an eventual turnaround. Additionally, we think companies are likely going to exercise caution in parting with any cash on their balance sheets – whether for acquisitions or for share buybacks. We have already seen some of this caution manifest itself this year, when the ten largest companies in the Internet/media space (see table below) spent 66% of their TTM Free Cash Flow on share buybacks (compared to the equivalent figure of 126% a year ago.) The companies remained relatively acquisitive, although two of the largest acquisitions were originally announced in 1H’07 (News Corp.’s $5.1B cash payout for Dow Jones and Google’s $3.2B cash payout for DoubleClick). Excluding those deals, cash acquisitions would have been relatively flat Y/Y, at 28% of free cash flow, in line with the equivalent figure a year ago. Table 2: At Largest Internet and Media Companies, Buybacks Less Popular $ in millions FCF Cash Acquisitions Cash Buybacks GOOG 4,707 72% 0% YHOO 1,386 60% 22% AMZN 970 45% 0% EBAY 2,456 29% 102% TWX 5,946 52% 14% DIS 4,767 14% 93% NWS 2,049 263% 40% VIA 969 24% 175% CBS 1,487 137% 3% MSFT 15,654 19% 103% Total (3Q’08 TTM) 40,390 49% 66% Total - year ago (3Q’07 TTM) 38,853 28% 126% Source: Company reports, J.P. Morgan estimates We believe some deal activity is likely to recover by the second half of ’09, assuming the environment stabilizes somewhat, and management teams feel more comfortable with the outlook. For CBS and MSFT, estimates used in this section are from J.P. Morgan analysts Michael Meltz, CFA and John DiFucci, respectively. 13 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com 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 four large-cap Internet companies, we are modeling a significant deceleration in Y/Y FCF growth for F’09: from 36% in F’08E, we expect only 12% Y/Y FCF growth at the four largest Internet firms in our coverage. Including the Media universe, the respective expectations are for 13% growth in ’08 and 5% in ’09. Including Microsoft, J.P. Morgan estimates call for nearly $40B in FCF generated in the broader Internet space. Table 3: We Project $10B+ in FCF at Large Internet Companies $ in millions 2007 2008E 2009E GOOG 2,272 4,825 6,086 YHOO 1,352 1,699 1,056 AMZN 1,184 661 1038 EBAY 2,187 2,351 2,472 TWX 4,045 5,135 6,017 DIS* 3,832 3,868 3,588 NWS* 2,802 2,482 1,951 VIA 1,539 1,608 1,705 CBS 1,983 1,324 1,257 MSFT 19,652 15,528 14,831 Total 40,848 39,482 40,002 Y/Y Growth -3% 1% All excluding MSFT 21,196 23,954 25,171 Y/Y Growth 13% 5% Large-Cap Internet 6,994 9,537 10,652 Y/Y Growth 36% 12% Source: Company reports and J.P. Morgan estimates. Note: For Disney, News Corp., fiscal year data used rather than calendar year; MSFT CY’08 FCF impacted by a $3.1B cash tax payment. We continue to see three key factors as motivating factors for M&A activity: • Traffic. Developing high-traffic sites is difficult, and larger companies are often willing to pay for sites that have proven an ability to generate traffic. • Technology. Companies that develop a technology that is difficult or uneconomical to replicate are often targets for acquisitions; such companies may also generate traffic but the technology is often a motivator for the buyer. • Transactional. Companies with a proven track record of revenue and sales generation can make attractive targets, as well; an example of a transactional- focused acquisition is the 2007 purchase of Mezimedia by ValueClick. We Think an IPO Market Recovery Is More Likely in 2010 The IPO market was virtually nonexistent through most of F’08, with Rackspace as the lone significant deal in the Internet and Internet-related sector; compared to 13 such deals in F’07 (see chart below). 14 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com Table 4: Internet and Related IPOs, F’07 and F’08 Units as indicated Pricing Date Issuer Name Symbol Amt ($M) Mkt cap ($M) % mcap Offering Price Price, 12/30 Performance 06/26/07 Comscore Inc SCOR 101 457 22% 16.50 12.19 -26% 10/02/07 Constant Contact CTCT 123 433 28% 16.00 12.84 -20% 07/17/07 Dice Holdings Inc DHX 221 805 27% 13.00 4.11 -68% 03/21/07 Glu Mobile Inc GLUU 86 327 26% 11.50 0.39 -97% 11/16/07 Internet Brands Inc INET 48 334 14% 8.00 5.51 -31% 06/07/07 Limelight Networks Inc LLNW 276 1,192 23% 15.00 2.29 -85% 08/09/07 MercadoLibre Inc MELI 333 752 44% 18.00 15.69 -13% 07/19/07 Orbitz Worldwide Inc OWW 510 1,244 41% 15.00 3.65 -76% 07/25/07 Perfect World Co Ltd PWRD 217 894 24% 16.00 16.68 4% 02/15/07 Salary.com Inc SLRY 69 158 44% 10.50 2.11 -80% 05/16/07 TechTarget Inc TTGT 115 508 23% 13.00 3.90 -70% 02/08/07 U.S. Auto Parts Network Inc PRTS 115 298 39% 10.00 1.37 -86% 03/08/07 Xinhua Finance Media Ltd XFML 300 883 34% 13.00 0.55 -96% 08/07/08 Rackspace Hosting RAX 188 1,460 13% 12.50 5.59 -55% Source: Company reports, FactSet, J.P. Morgan estimates We think the market climate is unlikely to moderate significantly in the near term in order for the IPO window to reopen soon. Given the lead time involved in most deal activity, we think it is therefore more likely that it will not be until 2010 that the IPO market starts to show signs of a recovery. Our Top Picks We think the significant declines in share prices in the stock market create opportunities to buy the best positioned companies at a reasonable valuation. In our coverage universe, we think Google (Price Target $430), Amazon (Price Target $65), Priceline (Price Target $86), Baidu (lead analyst Dick Wei; Price Target $300), and MercadoLibre (Price Target $24) 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. 15 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com Dot.Khan’s Top Ten Things to Watch for in 2009 1. Potential search deal likely between Yahoo! and Microsoft 2. Net Neutrality should become an important mainstream issue 3. Performance-driven advertising should continue to rise 4. Challenges in monetizing video advertising should persist 5. Mobile usage should continue its strong growth momentum, but mobile advertising will likely be challenging this year 6. Amazon’s low pricing strategy should continue to bring value seeking customers 7. Possible bankruptcies in brick-and-mortar retail should create opportunities for eCommerce companies 8. CPMs should remain under pressure 9. Consolidation activities could potentially resume during 2H’09 10. Promotional activity in the OTA space should increase 16 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com 17 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com U.S. Sector Outloooks U.S. Sector Outlooks 18 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com 19 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com 2009 Search Advertising Outlook As macroeconomic weakness bled into the advertising market, we reduced our Search Advertising Market Forecast twice in 2008. We are now further revising our most recently updated estimates (published 11/3/2008). We believe global paid search revenues will reach $33.2B in 2009, down from the $39.6B expected in Nothing but Net 2008. We think the search market growth rate will decelerate given the following factors: • Overall ad budget weakness; • Moderation in keyword price inflation; and • Possible decrease in the volume of highly monetizable searches. However, in the long term, we think the search market industry will benefit from the changes that result from this recession. We think the rate of adoption of performance- based advertising over more traditional forms, especially newspapers, has recently increased and that these shifts will be sticky. Furthermore, we think Internet users will use search more for comparison shopping and that they will become more comfortable responding to ads. Global Search Expected to Grow 12% in F’09 On the back of 34% Y/Y growth in F’08, we forecast that global paid search revenues will grow 12% in 2009. From a metrics standpoint, we believe query volumes will grow 24% in F’09, while RPS will decline 9%. We anticipate a climb in search usage as consumers become more price-conscious and engage in comparison shopping; however, we think monetization will be pressured, as decreased ad budgets will likely result in less bidding for keywords. We continue to see personalized search and vertical search as hot topics. Beyond 2008, we expect the global paid search market to grow at a 19% CAGR through 2011. Table 5: J.P. Morgan’s Global Search Advertising Revenue Forecast units as indicated Global 2003 2004 2005 2006 2007 2008E 2009E 2010E 2011E ’08-’11E CAGR Internet Population (M) 710 820 924 1,020 1,113 1,205 1,295 1,380 1,471 6.9% Queries / Month / User 17 22 29 36 44 53 60 68 74 12.1% Number of Queries (M) 142,017 220,128 323,827 441,796 585,395 760,474 939,917 1,119,430 1,308,646 19.8% RPS (per 1,000 searches) $19.04 $23.42 $28.17 $33.58 $37.58 $38.81 $35.28 $37.00 $37.65 -1.0% % Coverage 35.3% 38.7% 41.7% 43.9% 44.5% 44.0% 43.8% 43.7% 43.8% -0.1% % Clickthrough Rate 16.3% 17.3% 18.8% 20.6% 21.5% 22.0% 22.1% 22.2% 22.8% 1.1% $ Revenue / Click $0.33 $0.35 $0.36 $0.37 $0.39 $0.40 $0.36 $0.38 $0.38 -2.0% Global Search Forecast ($M) 2,704 5,156 9,121 14,835 21,999 29,511 33,158 41,417 49,277 18.6% Y/Y Growth 123.4% 90.7% 76.9% 62.6% 48.3% 34.1% 12.4% 24.9% 19.0% Source: J.P. Morgan estimates, company reports, comScore, Nielsen//NetRatings, IDC, IWS US Search Expected to Grow 10% in F’09 We are now modeling 10% Y/Y growth in F’09, down significantly from 2008’s 23% growth rate. Broken down by metrics, we are modeling US query volume growth of 19% Y/Y in 2009 (a minor deceleration from the 24% we observed in 20 Global Equity Research 05 Januar y 2009 Imran Khan (1-212) 622-6693 imran.t.khan@jpmorgan.com 2008), driven by an increase in the number of searches conducted per user and a slight increase of 2.5% in the domestic Internet population. On the monetization front, we expect the domestic RPS to reach only $75.33 per 1000 searches in 2009, down from $81.59 in 2008 (a 7.7% decline). We expect this RPS decline to be driven by decreases in advertisers’ budgets, which should lead to lower keyword bids. Table 6: J.P. Morgan’s US Search Advertising Revenue Forecast Units as indicated United States 2006 2007 2008E 2009E 2010E 2011E 08-'11E CAGR Internet Population (M) 203 211 217 222 227 231 2.2% Queries / Month / User 47 57 68 79 90 100 13.5% Number of Queries (M) 114,896 144,080 177,938 211,746 245,626 277,557 16.0% RPS (per 1,000 searches) $74.86 $81.65 $81.59 $75.33 $81.84 $84.94 1.3% % Coverage 62.8% 63.5% 62.0% 62.0% 62.0% 63.2% 0.6% % Clickthrough Rate 26.2% 27.3% 28.0% 27.0% 27.5% 28.0% 0.0% $ Revenue / Click $0.46 $0.47 $0.47 $0.45 $0.48 $0.48 0.7% US Search Forecast ($M) 8,602 11,764 14,518 15,951 20,102 23,576 17.5% Y/Y Growth 47.2% 36.8% 23.4% 9.9% 26.0% 17.3% Source: J.P. Morgan estimates, Company reports, comScore, Nielsen//NetRatings, IDC, and IWS Our Proprietary Research Shows… Market Share Shifts Are Likely to Continue In November, the J.P. Morgan Internet Team surveyed 766 US residents to determine Internet usage behavior. Our market research confirmed the trends reported by comScore. Among survey participants, Google was the dominant search engine, with 59.0% of participants listing it as their most frequently used search engine, up from 54.6% in last year’s survey. Yahoo! remained second among participants, with 20.0% of participants using it most frequently, down from last year’s 21.8% market share among our survey participants. MSN, Ask, and AOL trailed with 7.7%, 6.6%, and 2.0% of participants using them most frequently, respectively. Figure 7: Most Frequently Used Search Engine % of participants AOL, 6.6% Ask, 2.0% Google, 59.0% MSN, 7.7% Yahoo, 20.0% Other, 3% Don't Use / Don't Know, 2% Source: J.P. Morgan research . indicated United States 20 06 20 07 20 08E 20 09E 20 10E 20 11E 08-'11E CAGR Internet Population (M) 20 3 21 1 21 7 22 2 22 7 23 1 2. 2% Queries / Month / User. indicated Global 20 03 20 04 20 05 20 06 20 07 20 08E 20 09E 20 10E 20 11E ’08-’11E CAGR Internet Population (M) 710 820 924 1, 020 1,113 1 ,20 5 1 ,29 5 1,380 1,471