Internet Software & Services February 12, 2014 Information Technology Sector Industry Rating Market Weight Investment Thesis

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1 The Henry Fund Henry B. Tippie School of Management Adam Conzemius Internet Software & Services February 12, 2014 Information Technology Sector Industry Rating Market Weight Investment Thesis Internet Software and Services is seeing high valuations on the prospect of big internet growth. Companies that have come to dominate a sub-group within this industry are mature and may represent an above average growth prospect relative to the S&P 500, but do not capture the full growth potential of the industry. We recommend focusing on the infrastructure companies that play on the key drivers listed below as they have more room for upside. Drivers of Thesis User growth: We see estimates of 900 million new internet users by There is tremendous growth prospects for ISS companies with this many new users. M2M: machine to machine connections are expected to grow by 1.7 billion in the next four years. Infrastructure companies that can capitalize on this trend will be good picks. SaaS: software as a service is expected to grow at a 21.7% CAGR through With the potential to disrupt every industry, we see these companies as high growth opportunities. Companies delivering SaaS in business analytics, customer relationship management, and operations are top picks for growth this year. Risks to Thesis Cost per click decline: The core revenue driver for many marketing and advertising based firms continues to decline. Excess advertising capacity and a shift toward smartphone internet access drives this trend until prices settle at a lower point or a better value proposition is made to marketing departments. High valuation: this industry has strong growth prospects, but many companies appear to already have that growth priced into their stocks. Considering that, we recommend caution when picking a stock from this industry. 40% 30% 20% 10% 0% -10% Key Statistics Market Cap 1,020B Forward Price/Earnings 44.9 EPS Return on Investment (TTM) Return on Assets (TTM) % 3.7% Return on Equity (TTM) 9.4% Total Debt to Equity (TTM) 11.7 Dividend Yield Beta 1.77% 1.13 Top Companies by Market Cap (B) Google Facebook ebay 70.7 Baidu 60.4 Yahoo 37.8 Twitter 31.0 LinkedIn Qihoo Yandex Akamai Tech. Equinix Source: Fidelity Investments 12 Month Performance Industry Description Index S&P 500 F M A M J J A S O N D J S&P 500 Sector Industry P/E ROE ROA As defined by GICS, the ISS industry is comprised of companies developing and marketing internet software and/or providing internet services including online databases and interactive services, web address registration services, database construction and internet design services. The industry generates revenue by selling advertising platforms and marketing analytics or through transaction fees for use of infrastructure to other companies. Important disclosures appear on the last page of this report.

2 EXECUTIVE SUMMARY The ISS industry is poised for growth in key areas, but shows signs of full valuation. The next four years will have strong growth in internet users, 900 million new users, which is driving the high valuations. Infrastructure remains the only meaningfully sized subgroup that is unconsolidated; as such, it represents unique growth prospects within the industry. Industry Overview: By Market Cap SaaS (software as a service) will grow at a 21.7% CAGR through 2017 with many ISS companies taking full advantage of this trend. Companies delivering SaaS in business analytics, customer relationship management, and operations are top picks for growth this year. The SaaS business model offers added value to both ISS companies and customers, and increasing technical feasibility make us optimistic on these companies. 23% 7% 1% 13% 7% Auction Content Infrastructure Portal Internet advertising revenue will increase overall as growth in the number of users offsets the declining CPC rate. CPC is declining because of a large increase in advertising capacity on the internet and a shift toward smartphones, which are less profitable to advertisers. 49% Search Social Network Source: Fidelity Investments 1 One part optimism and two parts realistic valuation will go a long way in this industry. Growth through new internet users and rethinking outdated technology practices will breathe new life into ISS, but a number of companies are already at full valuation. INDUSTRY DESCRIPTION As defined by GICS, the ISS industry is comprised of companies developing and marketing internet software and/or providing internet services including online databases and interactive services, web address registration services, database construction and internet design services. Google and the largest 10 companies represent almost 40% and 82% of the entire industry, respectively. Many of the sub-groups within the industry are highly consolidated into a handful of very large firms. Sub-group Player % of sub-group Auction ebay 98.2% Content Shutterstock 48.9% Infrastructure Qihoo 10.0% Portal Yahoo 53.4% Search Google 81.4% Social Network Facebook 74.7% Source: Fidelity Investments 1 Business Model MARKETING: By market cap, most of the ISS industry is supported by providing advertising platforms and marketing analytics to other companies. The sub-groups using this model are B2C Infrastructure, Portal, Search, and content. ISS companies typically have a direct interaction with consumers, and will perform particularly strong in the early to mid-stages of an economic recovery when consumers begin to buy more and marketing budgets expand. Consumer discretionary spends the most money on marketing, which further suggests that the ISS companies with this model will perform particularly well in the early stage of economic recovery. 2 ISS is exposed to systematic risk in that overall economic health will affect customer spending. The ISS industry is also exposed to industry specific risk in the ISS industry and through a significant portion of advertising revenue being linked to consumer discretionary. Historically, the specific industry risks have been muted by strong industry growth. INFRASTRUCTURE SUPPORT: Auction and B2B Infrastructure companies can be thought of as providing infrastructure support. These companies are primarily supported through transaction fees they charge other businesses and to a lesser extent consumers. The companies in this model are also exposed to systematic risk the better the economy is doing the more their infrastructure is used and the more money they make. Page 2

3 Infrastructure support companies are exposed to specific risks in that many are supported by marketing departments of other companies, and the rest are supported by other companies using their infrastructure. SaaS offers a unique opportunity to some of these companies. Content companies sometimes use a business model similar to this one in that they will charge a subscription or usage fee for their content. The content model holds up well in the event that the content provided is truly of value to customers. RECENT DEVELOPMENTS October 17, 2013: Google shares jumped 13.8% upon releasing Q3 earnings. Total revenue increased 19% YoY with paid clicks up 26% and CPC down 8%. Since Google represents 40% of the entire industry, ISS is hyper sensitive to things that affect this particular stock. Cloud Computing INDUSTRY TRENDS Cloud computing is the ability to separate computing resources from a physical machine via shared computational power and data storage across the internet. A consumer can use infrastructure, software, or platforms that he or she does not own and is physically separate from. The advantages to be had from this trend are increased IT agility and better ROA on IT investments. We foresee cloud computing as being particularly important to IT in small and medium sized businesses as it removes large fixed costs and allows expenditures to be directly tied to sales. Key components of cloud computing: IaaS (Infrastructure as a Service): computing, data storage, networking, and operating systems that are the foundation of the cloud infrastructure and are delivered on demand as a service to consumers. PaaS (Platform as a Service): the foundation upon which custom software is created delivered via cloud infrastructure through a one-to-many model (e.g., database services, application platform, and business process management). SaaS (Software as a Service): software that is delivered via cloud infrastructure via standardized computer code through a one-to-many model. Cloud computing is a trend in the emerging stages of growth and will likely continue to grow for the next five years. 3 This year we expect to see considerable growth in this field as many Chief Information Officers (CIO) report that IT spending will increase 4.7% YoY with the primary growth being in business analytics, customer relationship management, and operations. 4 SaaS According to IDC, SaaS is expected to grow at a 21.7% CAGR through SaaS poses the possibility to disrupt every software category. 6 Customer use of SaaS will be based on a service model instead of a purchase/replacement cycle. SaaS offers the seller more opportunities to interact with customers, which means more opportunities to gather customer feedback and a likely shortening of renewal periods. SaaS will continue to grow this year as cloud capabilities improve. In particular, the IaaS and PaaS are now starting to gain more mainstream traction, so SaaS now has a better mechanism for delivery. Through SaaS, software manufactures will increasingly be forced to compete with internet software providers. Big Data and Analytics Gartner defines big data as follows: high-volume, highvelocity and high-variety information assets that demand cost-effective, innovative forms of information processing for enhanced insight and decision making. This means that a lot of data is being gathered in real or near realtime and it can be both structured and unstructured. Thus far, companies have had access to big data, but have not had the capability to use it. 5 Cloud computing is an infrastructural component that will drive big data analytics. Better access to analytical tools will provide companies with an opportunity to draw insightful conclusions from big data. This trend should see significant growth in the next year as it is the primary focus of most CIOs. 4 We cite big data and analytics as being a key driver for small and medium sized companies to rethink their IT departments and start relying more on cloud computing. Cost per Click Declines Cost per click (CPC) is an internet advertising model in which a company pays the advertisement platform each time a consumer clicks on its advertisement and is typically measured in thousands of clicks (CPM). This is Page 3

4 the standard fee model for advertising space on the internet. CPC has been on a downward trend because competition has increased and continues to increase dramatically in this space and because more consumers are coming online via smartphones, which are typically less profitable consumers for advertisers. 7 We look to see CPC to continue to decline this year for Google, and most advertisers, as more and more of its searches come from mobile devices, which represent an inferior value proposition to marketers. The company is currently attempting to find means to provide more meaningful customer data in its advertisement platform, but until that time the company will be faced with declining CPC. The graphic below clearly illustrates that the business model must transfer well to smartphones to survive in the future. Unique internet users are expected to grow by 900 million from 2.5 billion in 2013 to 3.6 billion in We believe that this fantastic growth prospect offers significant opportunities to ISS companies, but also causes investors grant a pass on the CPC problem in the short-term. Facebook will not face the same severity in declining CPC as it currently provides much richer customer data for better advertising results to its customers. M2M (machine to machine) growth is the other half of the internet growth story with 1.7 billion new M2M connections expected between 2013 and While this may not do much for companies with an advertisement based model, it does provide meaningful opportunity to those companies with online infrastructure. Internet Growth We note that internet enabled device shipments are expected to increase by 7.6% in 2014 as additional evidence of the number of users coming online. 11 All numbers in 1,000s Device E 2015E PC 341, , , ,491 Tablet 119, , , ,565 Phone 1,746,177 1,804,334 1,893,425 1,964,788 Other 9,344 17,195 39,636 63,835 Total 2,216,322 2,300,402 2,474,451 2,621,678 Source: Gartner 11 Page 4

5 MARKETS AND COMPETITION Auction Platform EBay dominates the auction platform category with 98.2% of the total market cap. EBay and Co. provide auction platforms for other companies and individuals to buy and sell goods through an auction. Typically the company will charge a transaction fee for providing this infrastructure when a sale is completed. Auction platforms are hugely subject to network effects, which explains why ebay completely dominates the category. We see this as a strong positive for ebay. EBay is a well-established company with a strong working business model and limited growth potential. Even though it is exposed to strong internet growth it is so big in the auction area that there is limited growth potential for this company. Infrastructure as of Dec '13 ebay Market Cap (B) $70.41 P/E (TTM) P/E (FY1) ROE 12.83% Div. Yield 0.00% Gross Profit M % SG&A % Sales 45.56% Profit Margin 17.79% Cash Ratio yr CAGR 12.70% D/E 17.44% Beta (52wk) 1.04 Qihoo (QIHU), Akamai (AKAM), and Equinix (EQIX), are among the largest players in this category at 10.04%, 8.49%, and 7.26% market cap, respectively. B2B companies sell a service to other businesses (e.g., online security for ecommerce transactions or a digital signature). This area has grown with the internet and continues to show room for new innovations with the way consumers use smartphones and digital devices. There is also significant opportunity in providing security for ecommerce. as of Dec '13 QIHU AKAM EQIX VRSN P Market Cap (B) $13.00 $11.00 $9.40 $7.40 $7.30 P/E (TTM) P/E (FY1) ROE 16.42% 11.80% 3.95% N/A -9.62% Div. Yield 0.00% 0.00% 0.00% 0.00% 0.00% Gross Profit M % 63.96% 50.45% 80.62% 40.57% SG&A % Sales 71.76% 38.06% 28.93% 25.89% 44.98% Profit Margin 14.85% 18.60% 4.41% 56.41% -4.50% Cash Ratio yr CAGR 62.10% 15.00% 24.90% 15.00% 80.80% D/E 81.60% 0.00% % N/A 0.00% Beta (52wk) The first thing we notice about this sub-industry is that growth potential is not spread universally across companies. This is because not everyone is exposed to internet growth in the same ways, so we recommend following a company that fits the industry growth drivers when picking an investment here. Some business models may not entirely make sense (e.g., Pandora (P)), but the growth potential is so high that the company can still find investors. The other thing to watch out for in high growth companies is the cash position because it is very easy to run out of cash quickly and be stuck in neutral during a high growth period these are companies to avoid. SQ&A should be examined closely to ensure that it is not growing due to an expanding sales force if it is, then the company will likely be unable to continue growing at some point until the problem is sorted out. We also note that some companies have high levels of debt despite being growth companies we suspect that if growth is less than expected that they could quickly run into liquidity problems. Overall, this area is a mixture of good and poor opportunities. This sub-group will be most affected by trends in SaaS and heavily affected by trends in internet growth, both people and M2M. Portals Yahoo (YHOO) market cap is 53.4% of the entire portal category. Companies in this category make content available to consumers, but do not create the content themselves. A portal should be a one stop shop for content consumed on a daily basis by an average internet user (e.g., news, weather, sports, photo sharing, etc.). The business model is to sell advertising space or marketing solutions to other companies. Yahoo is the Page 5

6 dominant company in this category. Portals have no enduring economic forces in their favor, and have struggled to remain a one-stop shop as social networks have developed. as of Dec '13 YHOO NTES SFUN SINA ATHM Market Cap (B) $37.80 $9.20 $6.50 $4.90 $3.70 P/E (TTM) P/E (FY1) ROE 9.89% 24.69% 94.90% 3.88% 24.14% Div. Yield 0.00% 1.30% 1.20% 0.00% 0.00% Gross Profit M % 73.05% 83.92% 59.15% 79.27% SG&A % Sales 57.91% 25.72% 29.08% 55.76% 33.65% Profit Margin 29.21% 54.11% 46.85% 6.79% 37.50% Cash Ratio yr CAGR 11.90% 13.50% 38.70% 36.80% 38.00% D/E 0.34% 4.82% % 67.16% 0.00% Beta (52wk) Portals have demonstrated their business models and offer exposure to the ISS industry at less risk than some other sub-groups. However, we do not believe portals offer high value because they rely heavily on advertising revenue, which is mostly going to social networks and search services. Social Networks Facebook (FB), Twitter (TWTR), and LinkedIn (LNKD) dominate this category at 74.68%, 13.24%, and 9.91% market cap of sub-group, respectively. A social network is an online community where people and entities interact with one another directly. Often people will share personal and professional details via a social network, which presents excellent consumer data. These companies are supported by selling advertising space and analytics capabilities to other companies. Social networks have become very popular in the last ten years and look to have reached a mature level. The subgroup exhibits strong tendencies toward network effects (no surprise when it is called social network), and we believe this creates strong preference for the large established players. We believe that these companies offer excellent exposure to key internet growth trends and will play well with the mobile internet trend. However, the valuation of these companies is already quite high. The three listed in the table are the only ones to consider investing in if one would like exposure to this sub-group. as of Dec '13 FB TWTR LNKD Market Cap (B) $ $31.00 $23.20 P/E (TTM) N/A P/E (FY1) , ROE 10.95% % 1.51% Div. Yield 0.00% 0.00% 0.00% Gross Profit M % 59.89% 77.93% SG&A % Sales 38.72% % 74.80% Profit Margin 18.94% % 1.75% Cash Ratio yr CAGR 32.20% 76.00% 45.30% D/E 3.08% 6.70% 0.00% Beta (52wk) Search Services Google (GOOG) and Baidu (BIDU) comprise most of the market cap value in this sub-group with 81.43% and 12.16%, respectively. These companies make it possible for consumers to find content on the internet by maintaining an index of said content on each website. Advertising space and marketing analytics are sold to other businesses as the dominant business model in this category. The outlook is good as this is a necessary component of the internet, and over one billion consumers will be coming online in the next decade. There is no powerful economic force allowing established competitors to maintain dominance, but for the time being they do the job better than anyone else can, so they go unchallenged. as of Dec '13 GOOG BIDU Market Cap (B) $ $60.40 P/E (TTM) P/E (FY1) ROE 15.36% 32.03% Div. Yield 0.00% 0.00% Gross Profit M % 63.36% SG&A % Sales 33.34% 28.32% Profit Margin 20.45% 32.93% Cash Ratio yr CAGR 17.60% 27.70% D/E 6.01% 45.96% Beta (52wk) Search is where the bulk of the entire industry value is located. Baidu offers better exposure to the Chinese market than Google, and so we believe that it has strong Page 6

7 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 growth prospects in the search business. Google has begun to diversify its product offering, so some of those diversifications are driving down the profit margin as they are less profitable than the core business, search. Both companies would be a good investment in the ISS industry. ECONOMIC OUTLOOK Technology Sector Business Cycle Better Unemployment Outlook Unemployment numbers have steadily improved this last year from 7.9% down to 6.7%. We believe that the numbers can improve slightly or remain flat for the remainder of the year. If unemployment stays steady then it will be because the labor force participation rate slightly increases from a fairly low current rate of 63%. As the labor market improves the US should see wages grow this year Unemployment Rate J F M A M J J A S O N D J F Source: FRED database 8 Inflation to Remain Low Source: Fidelity Investments 1 We believe the above chart well represents the current economic situation for major economies around the world and how the technology sector fairs in each one. Federal Reserve Taper Inflation will remain low throughout the year as the Federal Reserve continues to formally target a 2% inflation rate. Inflation can be expected to increase by from the 1.5 level of this year with the Federal Reserve tapering and better unemployment outlook. Inflation % Change YoY In December the Federal Reserve announced that it would tapper its $85B bond buying program by $10B per month, which will result in unwinding QE3 by late We believe that the Federal Reserve will decrease the bond buying program down to zero Fed Taper Core CPI Core PPI Fed Target INVESTMENT POSITIVES Source: FRED database 8 0 Dec Jan Feb Mar Apr May Jun Jul Aug Sep Source: analysts forecast SaaS growth: as cloud computing expands this year there will be a significant shift toward SaaS for solutions that have traditionally been delivered Page 7

8 through software. Internet Software and Service companies will have an opportunity to expand their product lines. Internet growth: as 900 billion new internet users come online in the next four years there will be significant opportunities for ISS companies to provide a new level of advertising reach for their customers. As 1.7 billion new M2M connections develop in the next four years there is huge opportunity for any ISS company that provides infrastructure used by these devices. Technology Business Cycle: IT companies traditionally do well during this stage of the business cycle, which we see as a basic supporting reason to maintain investments in IT companies. INVESTMENT NEGATIVES Declining CPC: Increasing supply of advertising space and a shift toward smartphones to access the internet are causing CPC to decline for many companies supported by this business model. High Valuation: high valuations indicate that investors have already priced in growth opportunities for many companies in the industry. VALUATION P/E ratio of 44.9x for this industry is very high compared to the sector ratio of 20.2x, which supports the sub-group analysis that showed some companies being fully valued or overvalued. Last year the ISS industry increased by 44.8% significantly outperforming the S&P 500 which only managed a 19.9% return. We see that this valuation reflects awareness that huge growth potential exists, but it is not spread evenly across companies. In addition, some companies have weak business models or means to make money, so investments there should be carefully examined before deciding to pull the trigger. ISS has the potential to post solid gains again this year with strong economic and industry trends. Overall, the US is poised for growth this year with low inflation and low unemployment. The Federal Reserve is winding down QE3 because it is confident of increased economic stability. The ISS industry should see significant growth related to increased internet users, growth of M2M connections, and SaaS growth. We like the search sub-industry as it will capitalize on the internet user growth and has a well-built business model. Where the model has problems, CPC declining, investors are granting a pass in the short-term. If it starts to look like these companies will not make a strong transition to mobile internet access, then their stock prices will decline despite other trends. We also like infrastructure companies as they pose the best exposure to internet growth, in terms of users and M2M growth, and SaaS. There are some companies with poor business models and valuations, but there are also some with a strong outlook for growth. All of the companies we reviewed in this area have existed as a public company for less than five years, and cannot be recommended for this fund. For a group with different requirements, we recommend watching Demandware (DMWR) and Intralinks (IL). REFERENCES 1. Fidelity Investments: Information Technology Sector, ctors/sectors/sectors_in_market.jhtml?tab=sdbusine ss&sector=45, February Nielsen: Ad Spend by Sector. January Fidelity Investments: 2014 Outlook: Information Technology, December WSJ: CIO Network, February Bain: The value of Big Data: How analytics differentiates the winners, Bain: The cloud reshapes the business of software, Google: 10-K, September Federal Reserve: FRED database, February Cisco, Visual Networking Index: Global Mobile Data Traffic Forecast Update, , February S&P Capital IQ: Industry Surveys - Computers: Consumer Services & the Internet, October Gartner: Newsroom January 2014 IMPORTANT DISCLAIMER Henry Fund reports are created by student enrolled in the Applied Securities Management (Henry Fund) program at the University of Iowa s Tippie School of Management. These reports are intended to provide potential employers and other interested parties an example of the analytical skills, investment knowledge, and communication abilities of Henry Fund students. Henry Page 8

9 Fund analysts are not registered investment advisors, brokers or officially licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any of the aforementioned securities. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold a financial interest in the companies mentioned in this report. Page 9