CNET: Shares Oversold - Upgrading To Buy (CNET)

From Citigroup analyst Mark Mahaney's note to clients Friday: We are upgrading shares of CNET from a Hold to a Buy with a $13.50 price target. For perspective, we initiated on CNET on June 29, 2005 with a Buy rating and downgraded to a Hold rating on August 8, 2005.

CNET shares are off 36% year-to-date and off approximately 30% from when the company reported a disappointing in-line & lower March quarter. The March quarter results and outlook made us incrementally more cautious on the name – but not 30% more cautious. We lowered our estimates and price target at the time. With this upgrade we are changing neither our estimates nor our price target. For context, our 2006 estimates -$389MM in revenue, $90MM in EBITDA, and $0.21 GAAP EPS- are within management’s guidance, but modestly below the Street at $395MM, $91MM, and $0.22, respectively. Part of our call here is that the recent very sharp decline in the shares represent significant skepticism in management’s current guidance and in current Street estimates.

Below we address the four new concerns impacting CNET shares. Our overall stance is that these concerns are either overstated or misplaced.

1) Platform delays in the software & video game sectors : During its March quarter earnings call, CNET cited two reasons for lowering its 2006 guidance: 1) a delay in Microsoft’s Windows Vista launch and 2) a slowdown in video game publisher advertising as the sector anticipates major new platform launches by Sony and Nintendo later this year.

On the first reason, we’d note that Microsoft has consistently been one of CNET’s largest advertisers. And we’d point out that in March, Microsoft did announce a delay in the launch of the Windows Vista consumer version from late 2006 to January 2007. Brent Thill, Citigroup’s software analyst, thinks that there is some likelihood of Vista’s consumer launch slipping beyond January 2007, but still views a Q1:07 event as probable.

On the second reason, we note that the video game sector – thanks in part to CNET’s leading GameSpot property – has been a material (though undisclosed) revenue contributor for CNET. Elizabeth Osur, Citigroup’s video game analyst, believes that a Q4 launch by Sony and Nintendo of their new PS3 and Wii consoles is extremely likely. While she is skeptical that Q4 will see a material Y/Y increase in marketing spent by video game publishers, she does believe that advertising by the three major console makers (Sony, Nintendo, and Microsoft) will be significant.

The simple point for us is that material marketing dollars related to major software and video game platform launches are visible for Q4:06 and H1:07. And our channel checks have uncovered no reason why CNET shouldn’t be one of the beneficiaries of these dollars. So we don’t view the concerns over these platform delays as structural challenges.

2) Increased competition for CNET's Webshots segment : Webshots is an online photosharing service that CNET acquired in Q3:04. Although this information is undisclosed, we estimate that Webshots accounts for around 5% of CNET’s current total revenue. One of the new issues facing CNET is that the online photosharing segment has become increasingly competitive recently, with the very rapid rise of private companies like Facebook.com and Photobucket.com. We detail the online usage trends later in this report, but the simple point is that since the beginning of this year, both Facebook and Photobucket have surpassed Webshots in terms of total unique visitors.

We’re not making a call that Webshots can regain its lead over Facebook and Photobucket. We believe, instead, that after a year of back-end infrastructure improvements designed to support Webshot’s capacity, CNET is now focused on a series of product innovations that should stabilize growth for this property. Specifically, Webshots is adding social networking features (like College Live, for which 4,200 colleges have signed up), blogging tools, full Ajax deployment, broader video integration, and applications from its recent acquisition of Consumating.com. We expect a site redesign this summer.

And we believe our Webshots estimates are reasonably appropriate. We are modeling $21MM in 2006 Webshots revenue, up 16%Y/Y. For context, Webshots revenue grew 22% Y/Y in the March quarter.

Our takeaway point here is that we believe this concern with the ability of Webshots to compete in the tight photosharing market is legitimate. But we believe that this risk to what is 5% of CNET’s total revenue is likely captured correctly in estimates.

3) New competition from Yahoo! Tech : On May 1st, Yahoo! re-launched its Yahoo! Tech property. Per our recent Yahoo! notes, we have been impressed by this property. The integration of video and multi-media graphics, the enhanced functionality, the ease of search, and the just plain intuitive feel of the site are impressive. In some ways, we viewed the relaunch as a very worthy competitor to CNET.

Our view is that this initiative by Yahoo! does create a legitimate new risk to CNET. But we believe it is likely overstated. Why? Because CNET remains a much more technology specific website than Yahoo! Tech, which seems relatively mass market. We don’t believe that marketers who have spent in the past to gain access to CNET’s highly specific demographic will change their minds because of Yahoo! Tech. Of the three main advertisers we have seen on Yahoo! Tech – Verizon, Panasonic, and HP – only the latter is a major advertiser on CNET. And we haven’t picked up any evidence from our industry checks that HP is cutting back its marketing commitment to CNET.

Finally, we note that CNET currently licenses some of its content to Yahoo! Tech. One potential sign that CNET was worried about competition from Yahoo! Tech would be if it were to stop licensing to Yahoo! This has not happened.

4) Perceptions of back-end-loaded risk to '06 numbers : The final new concern we have picked up from investors re: CNET is a concern that 2006 guidance and estimates are back-end-loaded and hence highly risky. This was one of our initial takeaways too from the March quarter results and guidance.

Since then, however, we have analyzed in detail CNET’s typical revenue and EBITDA seasonality. We then compared this seasonality with our own estimates for 2006. The results are detailed below. And the simple point is that our 2006 quarter revenue and EBITDA estimates are actually right in-line with the seasonal patterns of the prior two years. For example, we’re modeling 31% of CNET’s 2006 revenue to come from the December ’06 quarter, which is exactly the same contribution that the December quarters have had the last
two years.

With CNET shares off so sharply, we don’t think we need to go beyond the above analysis in terms of addressing this concern. But there are three intriguing ideas why 2006 might actually see a stronger than typical contribution from its September and December quarters.

First, marketing support related to the pending Windows Vista launch could tip up normal tech advertising spend in Q4:06. Second, marketing spending by the major video game console manufacturers will almost certainly be stronger than typical this holiday season because of the platform launches. And third, the emerging DVD format competition between BluRay (sponsored by a Sony-led consortium) and HD-DVD (lead by Toshiba) could also lead to an incremental increase in online marketing spend by two major marketers who are current
CNET advertisers.

The valid risk here may be that CNET experiences a fundamentals “hole” in Q2 We acknowledge this. But the concern over back-end loaded risk to ’06 numbers is, we believe, unfounded.

REVISITING THE CNET LONG THESIS

When we first launched coverage of CNET in June 2005, we laid out a series of investment positives. We update the key ones below.

1. Exposure to the secular growth in online advertising: We expect CNET to generate over 95% of its 2006 total revenue from online advertising. As such, CNET is a play off the secular growth in online advertising.

After double digit declines in 2001 and 2002, U.S. Internet advertising revenue grew 21% in 2003, 32% in 2004, and 30% in 2005. While the growth rate in 2005 did decelerate, we find impressive the very modest level of deceleration as well as the still intrinsically very high overall level. As is clear from the results of several Internet advertising companies, there is clearly strong interest in online advertising from Fortune 500 companies as well as from small- and medium-sized businesses.

[click to enlarge]

Two factors in particular give us confidence in the sustainability of U.S. Internet advertising’s growth rates and drive our likely conservative estimate of 23% compound growth through 2008. First, some of the largest Internet advertising segments – e.g. search and display advertising — are still developing significantly, with continued innovations in contextual, local, behavioral, and graphical solutions likely. Second, there still remains a wide gap between the percent of ad spending by media type vs. the percent of total media time households spend with each media type. Per Forrester, over 30% of U.S. media consumption (both at home and in the workplace) is done online, while we calculate that 5% or less of total U.S. media spend is currently on the Internet. As a rough contrast, less than 10% of media consumption is via newspapers, yet newspapers account for approximately 30% of total media spend. This gap is bullish for Internet advertising and for companies with broad exposure to the sector.

2. Leadership in key online verticals : CNET has consistently been one of the leading U.S. Internet properties in terms of monthly unique visitors. In April, it ranked as the 14th most visited site, well behind sites like Yahoo!, Google, and eBay, but ahead of others like MonsterWorldwide, Viacom, and Adobe.

More key, CNET has consistently ranked as the leading Internet property for technology related news and information. In part, this was due to its acquisition of the #2 technology news site (ZDNet) several years ago. But CNET’s relative strength in this niche is still impressive.

Finally, through both organic growth and acquisitions, CNET has established category leadership in two newer verticals – gaming information through its GameSpot division and online photo services through its Webshots division. Recently, each of these divisions was ranked within the top 4 in its category (GameSpot #2 and Webshots #4) in terms of U.S. monthly unique visitors. The GameSpot positioning has been very consistent. The Webshots positioning has not. Until as recently as January 2006, Webshots was the #2 property in this segment. As discussed above, this segment has experienced significant competition from private companies Photobucket.com and Facebook.com. Still, our view is that this #4 positioning, which can be improved upon, is a valuable asset for CNET.

3. Business model leverage translates into one of the strongest EPS growth outlooks in the Internet sector: This was a key investment positive in our initiation report. Over the course of the past year, we believe this positive has become stronger. As one important update, we’d point out that CNET’s international segment – 19% of its total revenue – reached profitability on a full-year basis for the first time in 2005. What was initially an investment risk for us – unprofitable international exposure – has now turned into a positive, as the profitability ramp of this material segment should serve as a major source of EPS leverage over the next few years. Somewhat akin to MonsterWorldwide.

Below we detail the current and outlook fundamentals for many of leading Internet stocks we cover. What’s helpful about this comparison is that it highlights CNET as having one of the largest leverage opportunities – read margin expansion – in our sector in 2006. And that, combined with only modestly decelerating revenue growth, generates one of the strongest EPS growth outlooks in the Internet sector (30% in ’06). We’d note that Google and Netflix both have materially higher ’06 EPS growth outlooks by this screen, but neither stock has suffered the YTD correction that CNET has and both trade at higher multiples – (GOOG) and (NFLX) at 25X and 19X ‘06 EBITDA vs. CNET at 15X.

[click to enlarge]


We’d also point out another positive development in CNET’s business model over the past year. As an investment negative in our initiation report, we highlighted CNET’s relatively low FCF conversion or the % of its EBITDA that it converted into FCF. Since that point, however, CNET’s FCF conversion rate has steadily improved. And in the March 2006 quarter, that conversion rate reached a record high 50% on a trailing twelve month basis.

4. The ongoing potential for an M&A takeout : The Internet sector has experienced significant consolidation – the most recent example being the acquisition of iVillage by NBC. Our view is that there is a scarcity value in online content plays. And traditional media (print, television, cable, radio) are facing some secular growth challenges that make an online content acquisition a logical possibility. We present below a list of the most relevant recent acquisitions in this sector.

[click to enlarge]


We don’t have a specific acquirer in mind. Nor do we have a specific timetable in mind. We’re just reviewing the M&A landscape, thinking of CNET as one of the leading stand alone vertical content plays, and stating that a sale at some point isn’t out of the question. In terms of what recent M&A multiples imply about CNET’s valuation, we note that the low end of the range of recent multiples (17X to 23X) provides valuation support for CNET at current levels. On our ’06 EBITDA estimate (which is generally in-line with the Street), a 17X multiple for CNET would imply a $10.29 take-out. And at the high end, a 23X multiple would imply a $13.59 take-out, which would be a considerable premium to CNET’s current share price.