JPM - e-Commerce 2011

Global Equity Research
04 January 2010

Nothing But Net
2010 Internet Investment Guide

Internet
AC
Imran Khan
(1-212) 622-6693
imran.t.khan@jpmchase.com
J.P. Morgan Securities Inc.
AC
Bridget Weishaar
(1-212) 622-5032
bridget.a.weishaar@jpmchase.com


Lev Polinsky, CFA
(1-212) 622-8343
lev.x.polinsky@jpmchase.com

AC
Vasily Karasyov
(1-212) 622-5401
vasily.d.karasyov@jpmorgan.com


Shelby Taffer
(212) 622-6518
shelby.x.taffer@jpmchase.com


China Internet
AC
Dick Wei
(852) 2800-8535
dick.x.wei@jpmorgan.com

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 may
have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their
investment decision.

Imran Khan Global Equity Research
(1-212) 622-6693 04 January 2010

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...........................................................................132

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U.S. Company Previews............................. 139
Amazon.com, 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.

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Figure 1: J.P. Morgan Internet Technology Universe
J.P. Morgan Internet Technology Universe
Ticker Rating Dec'10
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%
Priceline.com 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 10.2

Source: 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 MELI
Data in this table and this report is priced as of December 30, 2009 close

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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

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inventory sold via ad.com). 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.

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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:

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• 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.

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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
Boscov's 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 Men's 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

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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.

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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%
1H'02 2H'02 1H'03 2H'03 1H'04 2H'04 1H'05 2H'05 1H'06 2H'06 1H'07 2H'07 1H'08 2H'08 1H'09

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.

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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.

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Table 5: Selected M&A Activity in the Internet Space, 2009
Symbol Deal Type Date Annc’d Target Acquirer Seller Annc’d Tot Payment Status
IACI ACQ 3/26/2009 Sportspickle.Com IAC/Interactivecorp N/A Cash Complete
DIS DIV 4/1/2009 Multiple Targets Walt Disney Co Kab Distribution Inc 18.4 Cash Complete
EBAY DIV 4/13/2009 Stumbleupon Inc Multiple Acquirers eBay Inc N/A Cash Complete
DIS ACQ 4/30/2009 Hulu LLC Walt Disney Co N/A Undisclosed Complete
TWX SPIN 5/28/2009 Aol Inc Shareholders Time Warner Inc 2512.42 Complete
DHX ACQ 6/11/2009 Allhealthcarejobs.Com Dice Holdings Inc 3.73 Cash & Stock Complete
TWX ACQ 6/11/2009 Multiple Targets Time Warner Inc N/A Undisclosed Complete
IACI DIV 7/7/2009 People Media IAC/Interactivecorp American Capital Ltd 57 Cash Complete
TWX ACQ 7/15/2009 mmafighting.Com Time Warner Inc N/A Cash Complete
GOOG ACQ 8/5/2009 On2 Technologies Inc Google Inc 105.45 Stock Pending
EBAY DIV 9/1/2009 Skype Technologies SA Multiple Acquirers eBay Inc 2025 Cash and Debt Complete
NWSA DIV 9/24/2009 Pinnacor Inc Yellowbrix Inc News Corp N/A Undisclosed Complete
ADBE ACQ 10/23/2009 Omniture, Inc. Adobe Systems Inc. NA Cash Complete
GOOG ACQ 11/23/2009 Teracent Google Inc N/A Undisclosed Pending
GOOG ACQ 12/4/2009 Appjet Inc Google Inc N/A Undisclosed Complete
Source: 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

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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.

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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?

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U.S. Sector Outlooks

U.S. Sector Outlooks

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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 Spend

Source: 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.

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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: NAA.org, 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.

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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

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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.

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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.

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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)

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• 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.

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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:

• Query Volume (the total number of searches done in a given period)

• Coverage (the proportion of searches that had an ad)

• Click-through Rate (CTR) (the number of ads that were clicked as a
proportion of total ads)

• Average CPC (the average price advertisers paid for each click received)

Query
x Coverage x CTR x CPC = Revenue
Volume

26

JPM - e-Commerce 2011

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