Donaldson, Lufkin & Jenrette
Jamie Kiggen (jkiggen@dlj.com) 212.892.8985
Tim Albright (talbright@dlj.com) 212.892.6801
Hilary Frisch (hfrisch@dlj.com) 212.892.4374
Sender: jkiggen@dlj.com
The Internet Observer, 10.05.98
DLJ Internet Research
Global Warming
Many Americans have as little interest in the other side of the world as
they have in the other side of desire. After all, provincialism is one
birthright of the triumphant revolutionary. And certain segments of the
population just don't travel well, much like ripe fruit and bad wine.
But state-side investors, however traumatized these days, shouldn't be
blind to the fact that there is still a lot of money to be made in the
wider world.
Until this summer, it was a point of deep faith that globalization was a
primary engine of growth in almost every industry. Unfortunately, the
world is now a messier place than usual. The Pacific Rim woke up one
recent morning with a negative net worth, Brazil is wrestling with a
budget deficit as big as, well, Brazil, and Russia, still bitter about
the 1980 Summer Olympics, has executed a series of perfect high dives
into an empty pool. Consequently, dominant U.S.-based companies that
source most of their revenue from domestic customers have been a safer
haven for investors than almost anything except 30-year Treasuries.
Happily, the category-leading Internet companies are beginning to fit
this profile, and we are getting real pleasure (at least on up days)
from watching AOL and Yahoo! assume some of the characteristics of
flight-to-safety stocks (though we're still waiting for their betas to
fall a bit). But even as investors turn to these names partly because of
their limited exposure to emerging markets, it's important to track
their evolving international strategies. When growth in the U.S. market
slows (as it inevitably will), an even bigger opportunity will present
itself in distant lands.
The geographic mix shift is already happening: while in 1998 over 60% of
the estimated traffic and 90% of the estimated commerce activity (such
as advertising and transactions) will happen in the U.S., by 2002 we
expect under 50% of traffic and 60% of commerce activity to be
U.S.-based. The largest markets are also the earliest adopters, with
Germany, England, France, and Japan accounting for $3 billion of
Forrester's $15 billion ad spending estimate for the year 2003. And this
spending, in our view, should be seen as somewhat recession-proof, just
as it is in the U.S.; the dollars are so small relative to overall ad
budgets, and the ROI of online commerce is so compelling, that companies
are not likely to cut their Internet budgets to any meaningful extent.
So given the size of the overseas opportunity, it's worth identifying
those consumer Internet companies that have emerged with early leads in
their respective categories. As we have seen already in the short
history of business on the Internet, an early mover advantage often
presages long-term leadership, since early consumer usage is a leading
indicator of brand affinity. The nature of brand affinity is that once a
consumer preference is established, it requires an almost
physics-defying effort from competitors to replicate that market
position (or lousy execution by the market leaders). As you might
expect, among the larger-cap consumer Internet stocks, we believe that
AOL, Yahoo!, and Amazon are well-positioned to extend their brand
hegemony with a critical mass of international users, while DoubleClick
has shown admirable foresight and execution as an emerging global ad
network.
AOL is the poster-child for how to structure and execute an intelligent
international strategy, having been early to the game in several key
markets. It has been effectively addressing the international
opportunity in two ways: by partnering with key local media players to
build the AOL (not America Online) brand around a localized service, and
through the CompuServe acquisition. AOL has acquired approximately 2.5
million international subscribers (1.4 million AOL customers and 1.1
million from CompuServe), more than most of its competitors have in
total, and while Japan is proving to be a difficult market, Western
Europe (where AOL partners with Bertelsmann) has generated more than 1
million subscribers and is close to being profitable. Meanwhile, the
structure of these joint ventures is such that the partners bear the
expense burden, and AOL provides its brand and intellectual capital,
thereby allowing the ventures to remain off-income-statement until
profitability is achieved. If AOL's international revenue was being
reported, it would today be on an annual run-rate of around $600
million. Not bad, considering how many $600 million Internet companies
are out there.
Yahoo! is also knocking the cover off the ball around the world. Yahoo!
UK, Yahoo! Germany, Yahoo! France and Yahoo! Japan lead all Internet
gateway companies in traffic and reach. Yahoo! Japan, a joint venture
with SoftBank launched shortly after Yahoo!'s 1996 IPO, generates around
15 million page views per day, an amazing number in any nascent market,
but especially impressive in a geography that every other Internet
company has had trouble solving. Yahoo!'s international traffic, which
exceeds the total traffic reported by Lycos or InfoSeek last quarter,
enables it to cut substantial commerce deals encompassing only the
international sites. A month ago, Amazon and CDNow announced
international deals with Yahoo! that, combined, total in excess of $3
million per year. Ultimately, we think it's reasonable to expect at
least 25%-30% of Yahoo!'s revenue to be achieved on foreign soil.
Amazon has understood the international opportunity since the company's
inception. Two thirds of the $80+ billion book market is non-US based,
with Japan, Germany and the UK together equaling book sales in the
United States. Germany, among others, has a higher per capita book
spending number than the U.S., and Jupiter expects online shoppers who
purchase books to spend $102 on average in the year 2002, versus $72 in
the U.S in the same time period. Early in its history, a sizable chunk
of Amazon's sales, approximately 30%, came from overseas, and Amazon's 1
millionth customer was an IT worker in Japan purchasing a technical
manual on Windows NT (speaking of global juggernauts). Over the past
year, international purchases have fallen to 22% of total sales, which
is a reflection of Amazon's aggressive domestic marketing efforts. In
the meantime, Amazon has acquired a leading online German bookseller,
Tele-Book, and the # 2 UK online bookseller, BookPages, providing strong
local footholds and like-minded management teams. While we don't expect
Amazon to necessarily buy its way into every significant market, we also
don't expect Amazon to dally in going after any substantial opportunity
to grow its business, and if that means getting there first by
acquiring, then acquire (and amortize) away. Of course, it's not limited
to books either. The $40 billion music market, of which 70% is non-U.S.,
will be among the many vibrant international opportunities for Amazon.
DoubleClick, the leading Internet advertising network, is another one of
the earliest and most visible international success stories, with 25+%
of its traffic coming from overseas. DoubleClick's ad serving technology
(DART) is able to identify users from international domains and to then
"geo-target" those users with ads from international advertisers. And
the cycle perpetuates itself as greater and greater critical mass is
achieved. Having successfully captured a number of international
advertisers (such as Heineken, Israel's Golden Pages or Korea's SK
Telecom), DoubleClick is able to then sell its advertiser penetration to
add top name international sites, such as MTV Europe, Fashion Europe or
SegaZone. DoubleClick believes that 50% of its revenue will be
eventually be derived from outside the US, up from 10% today. Now that's
a growth engine.
A final name worth mentioning is StarMedia, a private company that is
positioned to become the dominant consumer Internet franchise in Latin
America. StarMedia has already has developed a vibrant service in the
manner of AOL and Yahoo!, is pursuing OEM relationships with local ISPs,
and, through highly effective marketing, has created a very visible
pan-Latin America brand. With its well-executed first mover advantage,
StarMedia could be poised to capture a disproportionate amount of the
estimated $600+ million in Latin American Internet ad spending expected
to occur by the year 2003. Not to mention the economic value that could
flow from the handful of Spanish-speaking people outside Latin America.
One final point to conclude today's globetrotting. The Internet has
inspired over-usage of all sorts of metaphors, especially those that
attempt to express the magnitude of the opportunity still in front of
us: we're in the first inning, we're in diapers, we're in the petri dish
(just made that one up). These sentiments are rapidly becoming cliched,
but are no less true for being so. The international version of the same
habit of speaking is a little more colorful (we're through the first
wicket, etc. etc.), but it also should suggest how much vaster the
Internet ultimately is than a merely parochial view can assess. In 19th
century novels, one went abroad to flee a ruined reputation. For 21st
century Internet investors, we'd suggest going abroad precisely to avoid
such an outcome.
With this issue, the DLJ Internet Observer is back on a bi-weekly
publishing schedule, and its authors are happy to announce a product
upgrade with the addition of the worldly Hilary Frisch to the team.
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