Excite Inc. Netscape Deal Not a Positive, According To Initial Analysis
CIBC Oppenheimer
May 5, 1998
Internet/New Media
Henry M. Blodget (212) 667-4509
Nils L. Erdmann (212) 667-6972
Investment Conclusion
On May 4, Excite and Netscape announced a broad, complex partnership to jointly develop search and channel content for Netscape's Netcenter. We can envision scenarios in which the agreement would ultimately prove highly beneficial for both parties, but our initial impression is that it is more favorable for Netscape than it is for Excite, even whenviewed in the context of the industry as a whole. As a result of 1998E ROE our uncertainty surrounding the long-term implications of the deal on Excite's franchise, we are not yet comfortable upgrading the stock.
Netscape is essentially outsourcing the development and management of a portion of its Netcenter property to Excite for two years. The partnership involves the co-branding of Netscape search and channel content, revenue sharing, traffic referrals, technology licensing, and a $70 million up-front payment from Excite to Netscape.
Based on a brief analysis (with much work still to do), we view the agreement as a net negative for Excite under most scenarios. We regard it as positive for Netscape, slightly negative for Yahoo! and Infoseek, and neutral for Lycos.
In our opinion, the benefits for Excite, which are, in some cases, hard to quantify (e.g., the value of co-branded pages and the boxing-out of competitors), do not justify the all-in costs--which include not only the cash payment but warrants, management focus, and ongoing operating expenses. In our view, Excite is bearing all of the risk in
the agreement in exchange for only part of the upside. providing free search, content, commerce, and community
Excite will fund the up-front payment through a loan with a strategic partner--a revenue through the sale of debt it will likely pay off by issuing new advertising and commerce equity soon. As a result of the additional sponsorships, expenses and programming teams, Excite will also likely postpone profitability into early 1999.
Key Terms of the Deal
Netscape and Excite announced a two-year agreement that begins in June, 1998.
Under the terms of the agreement:
Excite pays Netscape $70 million in cash--$50 million now, $20 million in
three months--and gives Netscape warrants to buy 2%-5% of its stock based on
two strike prices: one at approximately $65 per share, one at the stock price
a year from now. The majority of the cash payment is considered a prepayment
on future revenue-sharing royalties. The accounting treatment for the cash
payment, as it pertains to both Netscape revenues and Excite distribution
expenses has yet to be determined.
Excite agrees to program and host a Netscape search and directory service that
will be co-branded as follows--"Netscape Search, powered by Excite." This
search service will also be a premiere provider on the Netcenter site, and
will receive 25% rotation in the first year and 50% rotation in the second
year.
Netscape will continue its negotiations with other search providers, including
Lycos and Infoseek, to sell the remaining rotations on Netcenter, which amount
to 50% in the first year and 25% in the second year.
Excite agrees to program, host, and sell advertising on approximately half of
the Netscape content channels, including automotive, education, games,
auctions, classifieds, and shopping, which will also be co-branded as "powered
by Excite." Netscape maintains control over the other half of the channels,
including business, computing, finance, sports, news, and entertainment.
Excite bears all costs associated with developing and hosting the co-branded
service and sells all advertising on the co-branded pages, including
sponsorships and banners, for the full two years. This will require Excite to
hire an estimated 35-40 additional programmers and salespeople.
Excite still bears all the costs
nitial Analysis
In our opinion, Excite is paying a lot for the privilege of helping Netscape
build its media business--and is not getting that much in return. Up -front
payment aside ("fair value" in this sector is always a matter of great
debate), Excite will have to devote considerable management talent and focus
to making sure the Netscape programming and sales proceeds smoothly. If at
the end of the two years Netscape decides that it doesn't want to be in the
media business, Excite will be in a marvelous position--the up-front payment
and all the time and effort will have been worth it. If, however, Netscape
remains committed to becoming a major player in the Internet portal business,
we are not convinced it will have much more use for Excite. If so, Excite's
share of revenue and co-branded traffic will evaporate.
We do not believe that "powered by Excite" will generate either brand loyalty
or new users for the Excite franchise. We can't prove this and we have no
evidence to back it up, but our guess is that simply seeing the word "Excite"
all over the Web will not, in itself, build Excite brand loyalty. If it does,
our initial interpretation of the agreement is likely to be well off the
mark--as the co-branding could then prove a major home run for Excite.
We do not believe that Netscape's dependence on Excite will increase over the
terms of the deal--rather, we think it will decrease. If Netscape is serious
about building a media business, and we believe it is, we think that what it
is really looking for in this agreement is a way to ramp up its site without
having to immediately focus too many internal resources on advertising sales
and content programming. Over the next year, however, as the company becomes
more comfortable with its new identity (or the newer part of its overall
identity), we believe that Netscape will build its own sales force and devote
more effort to its own programming efforts.
Excite is taking all of the risk in exchange for limited upside. As we see
it, the main risks from Excite's point of view are that
1) Netscape will fail to deliver the requisite traffic, which would result in Excite having ramped
its salesforce and programming teams to create and sell inventory that doesn't
materialize in the time-frame that Excite expects it to (low probability, in
our opinion), or
2) Netscape will decide to part ways with Excite at the end
of the contract, taking its pageviews, reach, and sponsorship customers along
with it. Netscape's risk is that Excite will generate enough revenue from the
co-branded pageviews. Given that Excite has already given it a tidy guarantee
of $70 million, however, we don't regard this as a major risk. Excite's
revenue and profit upside, meanwhile, is limited (please see next point).
Revenue sharing agreement pays Excite first, but second year is split
50/50--and Excite pays all the expenses. The $70 million payment from Excite
to Netscape is essentially a pre-payment of future revenues the companies
expect to generate from the co-branded pages. In the first year of the
agreement, the sharing of the actual revenues will be heavily weighted in
Excite's favor: on an ongoing basis, it will likely book 80% or more of these
revenues. In the second year, however, the revenues will be split
50%/50%--with Excite continuing to bear all of the associated hosting and
sales costs. What this means is that, in 1999 and 2000, when the revenue
stream is presumably more meaningful than it will be in 1998 and 1999,
Netscape will receive $0.50 with no associated costs and Excite will receive
$0.50 with at least $0.20 in associated hosting, selling, and development
costs, leaving it with a net of $0.30. In our estimation, this means that
Excite will have to generate a minimum of $100 million in revenue from its
referral and co-branded pages to break even on the deal.
Excite is responsible for all expenses. Excite will sell the advertising for
the co-branded search and channels. As a result, Excite expects to expand
its sales force by 15-20 people. In addition, Excite will increase spending on programming
and development and add another 20 people. This will impact the
company's financial performance for the next 2-3 quarters, so we do not
expect the company to achieve profitability until late in 1998 or in
1999.
Excite licenses its search technology to Netscape at the end of the agreement,
presumably enabling Netscape to build its own search capability relatively
easily.
Netscape is maintaining control over its most valuable channels. Netscape is
maintaining complete control over the programming, branding, and ad sales on
the most valuable channels--including, business, finance, sports,
entertainment, and news--while programs and co-brands the less valuable ones
(with the exception of the shopping channel, which is obviously very
valuable).
Why our initial analysis will be followed by a deeper one: because Excite's
management team is smart.
In Short...
In our opinion, to consider the deal a net positive for Excite, one has to
believe:
that Netscape Search and Directory powered by Excite will generate positive
branding and additional customers for Excite. (We don't believe it will.)
that Netscape is not seriously interested in building and running its own
media business and/or is not capable of doing so. (We think it is both
interested and capable.)
that the risk of not winning the deal--or the competitive advantage gained by
winning it--was worth more than $100 million. (We don't think it was)
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