JP Morgan’s “Nothing but Net”

If the title of JP Morgan’s 2008 report, “Nothing but Net”, is correct, it should be a banner year for the Internet. The 312 page report discusses several “Key Investment Themes”, asks a few questions for the upcoming year and then goes on to provide outlooks for the U.S. and China and offer in-depth analysis of over two dozen companies.

The free cash flow (FCF) of the top five Internet companies in JP Morgan’s universe totaled $8.8 billion in 2007; in the current year they predict that number to jump over 40 percent to $12.5 billion. While some of that cash may go to share repurchases, it is predicted that the large volumes of FCF generated in the past two years will fuel mergers and acquisitions activity in 2008. Of moves in this arena it is suggested that, “large companies will continue to seek out investments in social media, where sites often grow virally and the large-caps appear satisfied, for the most part, to let the public pick the winners out of a crowded field before making acquisitions.” In addition to the cash, the M&A activity will be pushed on by a few key drivers.

First off is 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.” The next driver noted is technology: “Companies that develop a technology that is difficult or uneconomical to replicate are often targets for acquisitions.” While companies bringing such technologies to the table may also generate traffic, in this case, “the technology is a motivator for the buyer.” Rounding out the three Ts is Transactional: “Companies with a proven track record of revenue and sales generation make attractive targets, as well.” Furthermore, JP Morgan believes there are, “synergies to be captured by a strategic partnership among large-cap Internet companies.” These synergies include increased scale, strengthened global footprint, broadened user insights and improved operational efficiencies. Google will also be a factor, “share gains and product introductions by Google may compel other large-cap Internet companies to explore strategic alliances.”

Global economic growth and the rise in Internet penetration worldwide will also aid the Internet’s momentum. Though the U.S. will factor into this growth, “the U.S., while remaining high, will continue to fade in relative terms in coming years.” The worldwide growth in GDP is creating, “ever-expanding consumer class.” When combined with, “the trend of rising Internet penetration, we believe an ever-growing market opportunity exists outside the U.S. for Internet companies, especially those with the scale to invest meaningfully in their international operations.” As far as the penetration rate is concerned, speed is also vital. The report states that, “rising broadband penetration across the world remains a key catalyst for the growth of the companies in our coverage universe.”

With all this momentum, and, “an ever-evolving marketplace,” which “gives rise to new opportunities,” JP Morgan predicts that the Internet IPO market will remain healthy in 2008. It is suggested that several types of companies will, “start achieving a level of scale and operational visibility where a public offering makes sense.” However, only one type of company is named outright: those involved in social networking. (Keep in mind this sector was also seen as in the sites of those with high FCF numbers.)

Of course with momentum comes resistance. In the scenario proposed in the report the resistance could come from the increased involvement of regulatory authorities. “As the industry grows and becomes entwined in more and more aspects of people’s lives, we think regulators are going to take more and more notice of Internet companies.” The areas which the regulatory authorities will be likely to notice should be of little surprise for those with an eye on the industry.

For one, it is predicted that mergers of large Internet-based companies will come under increased scrutiny. The report uses the Google-DoubleClick merger, which at this point is still being held up by European authorities worried that the, “merger will create a player in the online ad industry that is too dominant,” to illustrate that the seeds of 2008’s challenges have already been planted . The issue of privacy, an issue with the Google-DoubleClick merger, will also gain the attention of the authorities. As with large mergers, this challenge has already taken root, and some companies have already taken preparatory action. (Google makes user data anonymous after 18 months and Ask allows users to erase their search history immediately.) Privacy could be the one chink in the armor of social networking sites, their one blemish. (recall the Facebook Beacon fiasco.) Luckily for all those involved, search, social networking, and others, “we think history indicates that users are willing to sacrifice incremental erosions of their privacy in exchange for features they find useful, especially if sites do not over-reach.”

As with the other challenges to the “nothing but Net” year, the final one, Internet taxation, is seen as not much more than a challenge on paper. As for a tax on Internet access: this should not be an issue in the near future, as a, “bill renewing the ban on an Internet access tax for seven years passed the U.S. Congress in October 2007.” The second type of tax that has been thrown around is an Internet sales tax. However, JPMorgan’s Senior Vice President for Government Relations, Tom Block, sees this as a, “a non-starter, especially in an election year.”


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