Online: Where The Growth Is
More than 220 years ago, when the British surrendered to the colonials at Yorktown, Va., legend says Lord Cornwallis marched out to a tune called The World Turned Upside Down. Today, a media investor knows just how the defeated commander must have felt. Media's collisions and revolutions are upending our notions about which companies and technologies matter in the $1.3 trillion industry. Downloads are transforming the music business, and pay-per-view is looming for movies and cable TV, while advertising is sprinting to the Internet. The media pie is growing faster than the economy, about 7% a year, according to PricewaterhouseCoopers' most recent forecast. But what we spend the money on, and who gets it, is changing enormously. And that means the media world will see plenty of winners and losers.
The market is betting hard on Internet companies such as Google (GOOG ) and Yahoo! (YHOO ) at the expense of big conglomerates because New Media are where all the growth is. Consulting firm Parks Associates forecasts that the Net will double its share of the U.S. advertising market, to 10%, by 2010. And that's a conservative estimate. It assumes Web advertising, now a $12 billion market, grows just 14% a year, about half the current pace. More aggressively, Piper Jaffray analyst Safa Rashtchy, one of the first to spot the potential of advertising tied to Internet search results, says the growth will be more like 20% a year in the U.S. and 40% abroad. If he's right, the global Web advertising market will hit $55 billion by 2010, up from $19 billion now.
The big losers are likely to be cable companies and others that distribute programs over expensive pipes. Pricing in that business is becoming cutthroat as phone companies such as Verizon Communications (VZ ) and SBC (SBC ) Communications follow satellite-TV outfits such as DirecTV into competing with cable. Legg Mason Value Trust (LMVTX ) manager William H. Miller III says he acted on this trend in 2004 by selling shares of Comcast and using the money to add to his Yahoo holdings. "Value is migrating to new media," Miller says. "We think content is getting more valuable and distribution is getting less valuable."
If you want to bet on the New Media age, the first place to look is Google. Granted, the search engine was an easier pick eight months ago, when it traded around $200. Google now trades at 48 times the earnings Wall Street analysts expect for 2006. Is that too much? Maybe, but not if you think influential Citigroup (C ) Smith Barney analyst Mark Mahaney is right. On Dec. 9 he sharply increased his estimates by nearly 60 cents a share. Now he says Google will earn $8.84 a share in 2006, in part because it gained 10 points of market share in 2005. That puts Google's price-earnings ratio at 48. "We are removing what was an overly conservative bias in our estimates," Mahaney says.
SLOW BUT SURE
For a broader play on Web advertising, try Seattle ad agency aQuantive (AQNT ). Its Avenue A/Razorfish unit is the largest agency buyer of ads tied to Web search. And aQuantive is a leader in pay-for-performance schemes that tie payments for online ads to the sales they actually generate. It is also in the forefront of bringing ways to measure and personalize ads to traditional media such as print and TV. aQuantive is a little expensive, trading at 45 times 2006 earnings estimates. But Merriman, Curhan & Ford (MEM ) analyst Richard Fetyko forecasts its profits will grow at 25% a year.
It seems counterintuitive to bet on change coming more slowly than expected, but it makes sense because some transformations take longer than others. Consider Netflix (NFLX ). The online video-rental company spent the past year fighting off an expensive challenge from rival Blockbuster (BBI ), but good times are starting to roll again. Analysts say Netflix will make 82 cents a share next year, putting its p-e ratio at a reasonable 31.
The threat to Netflix is that video-on-demand could kill the market for DVD rentals. But CEO Reed Hastings says VOD is materializing more slowly than expected because of wrangles over getting studios to license more movies for digital downloads. That makes next year's profits more secure -- and gives Netflix time to get big before VOD does. Someday a phone, cable, or Web media company will want to deliver movies online. And the 20 million subscribers Hastings believes Netflix will reach between 2010 and 2012 (it has 3.6 million now) -- all in the habit of paying for movie subscriptions -- will come in handy. Netflix could be an acquisition candidate for a company that wants to distribute movies online or stay independent and win attractive terms as a partner.
Even New Media devotees can hedge their risks with some judicious bets on Old Media companies that are making a decent transition to the new world. One of them is Walt Disney (DIS ), whose ESPN.com sports site is much larger than anything Viacom (VIA ) and Rupert Murdoch's News Corp. (NWS ) have at present. It's a leader in rich-media advertising, which offers video or animation that spiffs up brand advertising. Plus, sports-related businesses are expected to grow faster than most traditional media, according to PricewaterhouseCoopers. Another reason to like Disney: It partnered early with Apple Computer -- still the most innovative player in digital downloads -- to offer ABC programs via its iTunes site.
Believe it or not, among the hottest media bets is the $15 billion-a-year U.S. Yellow Pages market. Analysts at Kelsey Group forecast that $5 billion of locally targeted, small-business advertising will move online by 2009. But Yellow Pages companies have two things Web companies like: Internet-like margins of 40% or more and armies of local sales reps -- which portals don't have -- to sell advertising to small companies that lack tech savvy.
That makes companies such as R.H. Donnelley (RHD ), which publishes directories in 18 states, hot properties. Already, private equity types are sniffing around Verizon's Yellow Pages business, which is for sale. AT&T (T ) is taking its Yellow Pages business national through YellowPages.com. Even Barry Diller's IAC/InterActiveCorp, (IACI ) which has an elaborate local-advertising strategy and a cash-flow-conscious acquisition strategy, isn't out of the question. Since Donnelley is one of the few pure Yellow Pages plays, it's a good way to wager on the industry's strong cash flow and consolidation.
The media world can be baffling not just because of its size but also because of the number and speed of changes. But investors who bet on companies that have great content and Web advertising -- and are selling at reasonable multiples -- should do all right.
By Timothy J. Mullaney