Archive for July, 2011

Disney, News Corp and Comcast have put their internet streaming venture Hulu on the block for sale.  At first glance, the service, which boasts 28 million users enjoying exclusive on-line access to the current programming line-ups from 264 content partners, including ABC, NBC, Fox and the Viacom family of channels, appears a hot property.  Revenues, driven by advertising and subscriptions to a premium ad-free service, are projected to nearly double YoY to $500 M for 2011.  Videos watched per user is up more than 10% year to date and paid Hulu Plus subscriptions are on track to top 1 million by year end.  The company claims that it is already profitable.  With recent streaming music IPO Pandora trading to a $2.7 B market cap while losing money on sales that are 30% lower, one would expect interest to be keen.  Nonetheless, would-be acquirers have been cautious in kicking Hulu’s tires.

The key issue?  How long and under what terms will network programming available to a Hulu buyer?  Already, Fox has announced its intent to lengthen the time between the initial broadcast of an episode to its availability on Hulu from 1 day to 8.  (NB the window would remain 1 day for Hulu Plus, and for confirmed subscribers to the Dish Network)  Will other networks follow Fox’s lead?  Currently, Hulu is the exclusive source for most of its programming, other than the content owners’ own sites.  How soon would a buyer expect to see the Hulu content sold in parallel to video streaming competitors?  Media reports suggest that the proposed window for future exclusivity is two years, a short head start given the ambitious plans of many deep pocketed players.   Reportedly, Yahoo has already asked that the window be extended as a condition of its bid.  When will a buyer have to return to the bargaining table?  Again, media reports suggest contractual access to programming with a 5 year expiration date.  Finally, will there be further conditions on the presentation of Hulu programming?  Disney, News Corp and NBC/Universal have demanded an ever greater advertising load.  Today, Hulu averages one minute of advertising for every 4.66 minutes of program viewing.  Clearly, the terms will determine the value to any buyer.

If Hulu’s owners are not willing to offer a measure of exclusivity and a reasonable term before programming terms must be renegotiated, these negotiations may go nowhere.  However, assuming that Disney, Fox and Comcast are serious about the process, these issues will be addressed and would expect either Amazon or Google to emerge as the services new owner.  Either would enjoy dramatic synergies with existing services and skill sets.  In the end, it will fall to the valuation each bidder makes of Hulu AND of the comfort the current owners have with the prospective buyers – it may not be a matter of highest bidder wins.  Given the pace of the proceedings, we would imagine that we would have an answer well before year end.

As the Internet economy has become an ever larger part of consumer transactions, the payments industry has slowly adapted to fill its needs.  Today, with the Internet accounting for roughly 5% of US retail transactions, and with new technology poised to add secure point-of-sale payments to basic capabilities of a smartphone, tension is rising between the traditional payments industry and the leading Internet players.  Given that payments represent a quarter of all banking revenue, the web-based interlopers will face stiff opposition from financial institutions already mobilized by a new regulatory regime.  Despite this, we believe Internet “meta-aggregators” like Google and Apple will be able to create attractive new businesses in facilitating payments

The traditional value chain for retail payments begins with a consumer who is issued a payment instrument – e.g. credit cards, debit cards, checks, etc. – by a bank.  Credit/Debit cards, the typical basis for non-cash retail payments, are associated with a payment network, such as Visa or MasterCard, which operates an infrastructure for merchant acceptance and consumer authorization.  Actual payments from the consumer bank to the merchant bank are facilitated by 3^rd party payment processors, such as Global Payments, Fidelity National Information Services, or Fiserv.  These roles are strictly regulated, with particularly strong scrutiny of banks, which must underwrite the credit and manage the customer account, including collections

Advances in technology are beginning to disrupt the traditional value chain.  On-line leaders have begun to establish non-bank payment accounts to facilitate e-commerce via services such as EBay’s PayPal, Google Checkout, and Amazon Payments. These intermediaries aggregate payments and manage authentication, allowing users to fund purchase via low or no fee automatic bank transfers, disintermediating high fees charged by issuers, payment processors and card networks.  While some accounts do tie back to credit and debit cards, the largest on-line players have established scale and consumer brand equity, putting them in position to squeeze payment networks and card issuers.  Clearly consumers trust the web – in addition to the 17.7% annual growth of e-tail, 30% of American consumers used non-bank payment accounts in 2009

The dramatic rise of smartphone adoption raises an even more threatening prospect to the traditional payments industry.  The next generation of these devices will be equipped with Near Field Communications (NFC), a technology that provides fast, secure, two-way connections at very close range.  Using NFC, smartphones and tablets can act as electronic wallets, authorizing payments at retail via specialized terminals at the point of sale.  NFC transactions promise to be faster, more convenient, and less vulnerable to fraud/theft than card-based sales.  Gartner projects 349M global users and $429B in NFC transactions by 2015

The battle for NFC domination is underway and several platforms have already emerged. Isis, a joint venture backed by Verizon, AT&T, T-Mobile, Discover, and Barclays is pitting the carriers in one corner against payments incumbent Visa and it’s banking partners: US Bank, Bank of America, Wells Fargo, and JP Morgan Chase along with privately held startup DeviceFidelity which is providing the underlying NFC technology. Google has teamed with Citigroup, FirstData, MasterCard, and Sprint with it’s already announced open platform, Google Wallet. Apple is unlikely to sit idle considering its stake in mobile devices, and an announcement on NFC by year end would not be a surprise

Competition in NFC will be a race to critical mass on two separate tracks: consumer adoption and merchant penetration.  For consumers, adoption will be dependent on acquiring a device with NFC capability, activating an app, and opening a credit account, while merchant penetration will depend upon negotiations with merchants and the deployment of NFC readers to stores.  Carriers will look to push subscribers to their own networks, while smartphone platform architects will look to integrate NFC payments into an integrated user experience.  Banks and payment networks will look to leverage their existing credit relationships with consumers, and importantly, with merchants, to get a head start.  The disparate strengths of these categories of players, and the potential regulatory burden on non-banks, has driven the coalition approach by all serious players

We currently see the Google/MasterCard venture as best positioned given its head start and lead in  smartphone market share. Google Wallet NFC features come standard in several of the latest released Android devices. Visa’s solution is next best given backing from 4 of the top 6 credit card issuers and play with a technology that is compatible with most mobile devices including iPhone. Isis seems to be an attempt by the carriers, a distant fourth payments player, and the number 13 card issuer to get a foot into the marketplace. Neither Amazon or Apple have publicly yet announced an NFC strategy, but believe that the balance of power in the nascent NFC space could tip should they choose a side

Longer term, we believe Internet-based payments, both mobile and fixed, could grow to a large majority of non-cash payments.  While all of the first consortia for NFC platforms include both card issuers and networks, the balance of power will likely shift toward on-line players, allowing them to squeeze providers of credit underwriting and network services.  While it is conceivable that these companies could opt to cut out financial intermediaries entirely, the accompanying regulatory burden might be more than Google, Apple or Amazon would be willing to bear.   Nonetheless, returns for purely financial players in the NFC and on-line credit game will likely see significant pressure, while “meta-aggregators” earn fees for aggregating transactions, as well as providing added services to consumers and merchants

The success of the recent LinkedIn and Pandora offerings, the heady multiples for cloud services stocks like Open Table and Netflix, and the rumored valuations for innovators still private, like Facebook, Groupon, Zynga and Twitter, have prompted the media to raise the tech bubble alarm.  Given that tech stocks in aggregate trade at an all-time discount to the S&P500, that 20% of large cap tech stocks trade at single digit multiples on future earnings with double digit free cash flow yields, and that the companies leading the charge to the portable, cloud-based future, Apple and Google, trade at multiples below Proctor and Gamble with PEG ratios less than 0.35, the possibility of froth in amongst a small group of next-gen web stocks strikes us as a poorly fitting analogy with the indiscriminate and market ranging exuberance of the year 2000.

At first glance, some of the froth appears to be transference from investors thus far unable to buy a piece of Facebook and settling on the next best thing, resulting in valuations that presume very strong growth and profitability.  That said, history suggests that tech companies on the right side of a wave of change can deliver against even the most aggressive expectations, making it premature to dismiss nosebleed multiples out of hand.   Some of these companies will prove to be worth the money.  How, then, to distinguish contenders from pretenders?

Target Market. An obvious consideration in assessing the value of early stage companies is the potential market that they might address.  For example, Facebook addresses a larger market (all human beings) than does LinkedIn (all business professionals).  Of course, narrower ambitions may also suggest a greater likelihood of success and there is always the possibility of expanding scope down the line – Amazon has successfully expanded far beyond its origins as an on-line book purveyor.  Nonetheless, potential must be a consideration in valuing emerging internet businesses.

Critical Mass.  For internet-based competitors, most barriers to competition kick in with scale.  From a crowded field, one player emerges with sufficient size to begin pressing its advantage.  Google beats Yahoo and Altavista to the mark and takes off.  Same for Facebook overtaking MySpace.  In contrast, Groupon is fending off competition from LivingSocial and Yelp, with Google and Facebook gearing up – arguably, none has reached the level of critical mass.  Companies with clear dominance in a market are obviously more valuable than those in the midst of a fight for survival.

Barriers to Competition. How easy is it to displace an early market leader?  History says it can be very difficult – Microsoft’s dominance of PC software is an obvious example.  One factor in a company’s permanence at the top is the existence of network effects – business advantages that geometrically expand with market share.  Facebook users are unlikely to switch loyalties, unless a rival could easily replicate one’s circle of friends.  A competitor to OpenTable would need to gain the cooperation of a critical mass of restauranteurs in a city to displace it.  Another key issue is control of proprietary technology or content.  Apple used its proprietary audio file format as major barrier as it built its dominant iTunes music franchise.  Netflix has begun to finance the production of proprietary content to augment the non-exclusive licensed programming that is still the basis of its streaming service.   Cumulative investment – e.g. in infrastructure, in R&D, in brand-building, in distribution, etc. – is also a considerable obstacle for rivals.  Google’s massive network of data centers give its various services – e.g. search, YouTube, etc. – substantial speed advantages.

Sizing Up the Next Generation. We evaluated a range of public and private companies that are vying for leadership in the socially connected, media streaming future along these criteria.  In reverse order of valuation:

1. Facebook – With an expected IPO valuation exceeding $100B, projected 2011 revenues of $4B+ and profits of $1B+, THE social network is the 2000lb gorilla in this category.  Its target market is the more than 2 billion current Internet users and the $1.5 Trillion market for global advertising, so it is ambitious.  Given that it is believed to have more than 700M users, it would seem that it has exceeded the necessary critical mass.  Finally, the barriers to switching are high.  Facebook’s value to users is largely contingent on the participation of their friends – switching would entail leaving friends behind and re-establishing connections elsewhere.  With less than 2% of the global advertising market currently captured by the Internet, we believe Facebook is extraordinarily well positioned to sustain exceptional revenue growth from its huge base of users.
2. Groupon – Groupon is rumored to be seeking a valuation of up to $30B in its planned IPO with sales growing rapidly from the $2.5B run rate delivered in 1Q11, but on-going losses at the bottom line.  The company’s business model addresses the $200B spent on non-measured advertising in the US, and it has established a 50% share of the still nascent local discount deals market.  However, the recent dramatic market share growth of rival Living Social, boosted by big deal with Amazon, suggests that critical mass has not been established.  Against that, the looming entry of web giants Facebook and Google to the space and the potential for price competition to draw disgruntled merchants to a competitive offer, suggest that the switching barriers are less than substantial.
3. Zynga – This pending IPO is expected to be filed this week, with a forecast valuation of $15-20B.  Projecting revenues of $1.8B and profits of $630M for 2011, Zynga has successfully piggybacked on Facebook’s user base, showing at least one way that social networking can be monetized.  While video games are a $52B global market, Zynga’s games address a different demographic that is likely incremental to the more fast-twitch console oriented experience at the core of the market.  Critical mass is also a difficult call, as games are inherently hit driven.  Certainly Zynga has established a content model that it has replicated through multiple iterations and monetized admirably.  Nonetheless, it would seem that the door is still open for future rivals to offer compelling alternatives that stop Zynga’s momentum in its tracks.
4. Netflix – Unlike others on this list, Netflix has been public for nearly a decade.  However, its status as a Web2.0 darling began with its introduction of video streaming in early 2007 and the geometric rise in its share price which began in earnest from the start of 2009.  Netflix is now valued at nearly $14B on trailing sales of $2.4B and a YoY growth rate of 45%.  Its primary target market is the $100B US Cable industry, although it also targets international markets.  While Netflix dominates the current streaming movie subscription business, the target is much broader and largely undeveloped.  Without proprietary access to content or a differentiated delivery infrastructure, we believe barriers to switching are modest and that competition from the likes of Apple, Google, Amazon and even Facebook could be formidable.
5. Living Social – Living Social inhabits much the same space as Groupon, offering deals on behalf of local merchants in a growing roster of cities, addressing the same $200B target market for local advertisning.  Its 2011 sales are estimated at $1B, with a projected IPO valuation of more than $10B.  A well publicized deal with Amazon at the beginning of 2011 accelerated the company’s growth, allowing it to gain ground on market pioneer Groupon.  Ultimately, Living Social’s rapid growth is a bit of an indictment, demonstrating that neither company has reached critical mass and that switching costs are far from insurmountable.  Combined, the projected Groupon and Living Social valuations would be the 20^th largest technology stock capitalization, despite the likelihood of aggressive competition and the absence of profits for either company.
6. Twitter – Twitter is on pace to reach 200 million users by year end 2011 and is serving more than 1 billion tweets per week.  Growth in users and usage is prodigious, with particular emphasis on the 182% annual growth in users from mobile platforms.  While it has been stoking adoption, Twitter has not been focused on revenues, as total sales for 2011 are expected to be well below $200M.  Despite the lack of monetization to date, we believe Twitter is well positioned to pick up a slice of the global advertising market – 25% of its subscribers follow product brands on the service, with two thirds of those intending to purchase.  The user base is also much better educated and higher income than Facebook, significantly valuable to advertisers once management focuses on driving sales.  We also see Twitter as having very significant switching barriers in its amassed audience and content, and its technical platform.  While current valuation estimates of ~$10B are modest relative to more developed monetization platforms, we believe the uniqueness of the platform and its potential as a vehicle for advertising are poorly appreciated by investors.
7. LinkedIn – LinkedIn’s May IPO was a big success, and although the stock pulled back some 30% from its opening price, it has retraced most of that drop with the recent positive initiations from analysts at the firms in the underwriting group and is valued at about $8B.  Thus far, LinkedIn has not been able to monetize its services very easily and total 2010 revenues were just $243M with $15.4M in net income. LinkedIn has 100 million largely well-off, well educated and professionally employed users and is adding about 1 million users per week.  The target market – global business professionals – probably numbers well less than 1 billion worldwide, even if the definition is stretched to its limits but is very attractive to advertisers.  LinkedIn is likely past critical mass vs. its current peers, but is potentially vulnerable to market entry from Facebook or to a lesser extent, Google, which is also able to reach LinkedIn’s target market.
8. Pandora – Pandora’s share price has boomeranged from its offering at $17, down to $13 and back over the course of two weeks, returning to a valuation of just over $3B.  Revenues in 2010 were $137M, up 160% YoY.  US radio industry revenues were $20B in 2010, including satellite, with another $4B in industry revenues from the sale of digital music files.  Pandora has 90 million registered users and 30+ million regular users, but likely has not reached critical mass.  Switching barriers are an issue for Pandora, as Apple, Google and Amazon are all launching cloud-based streaming media services that will compete directly with Pandora, while favorable royalty rates to recording companies will need to be renegotiated over time.  The key will be whether or not Pandora’s “music genome” process, which purports to deliver music selection unusually well suited to listener tastes offers a truly sustainably differentiated service.  If not, it is difficult to imagine the company holding off its much larger rivals.
9. Open Table – Open Table was the first of the social networking IPOs to hit the market, and has performed admirably since, up nearly three-fold since the May 2009 offering to a $2B market cap.  The addressable market – restaurant reservations around the world – is likely well above $1B per year, with 2011 sales estimated at nearly $150M on nearly 50% annual growth.  With 37% of North American reservation taking restaurants on board and 9% of all reservations placed through its system, Open Table appears to have established critical mass, with no significant competitors.  Switching costs are fairly high, as Open Table supports its partner restaurants with proprietary software and a well conditioned base of diners.  The platform appears to have expansion opportunity outside of North America and could be expanded to support a range of other reservation driven businesses.

Summary.  Looking at the business models of these “Web2.0” stocks, we are most comfortable that Facebook, Twitter and OpenTable will be able to sustain their leadership in their pursuit of their target markets.  Each of these companies is pursuing an attractive target market opportunity, and each has established critical mass that strengthens the natural barriers to competitors.  While investors may be concerned about the ability to monetize these strong competitive positions, we believe that this is a strategic choice, critical to establishing critical mass, and that new sources of revenues can be easily tapped.  We are more skeptical about the other companies in this note, as we believe each is likely to see vigorous rivalry from strong competitors that will erode market share and pressure margins