The following article is from Software Equity Group’s 2011 Q3 Software Equity Industry Report. A complimentary copy of the quarterly report can be downloaded here: http://www.softwareequity.com/research_reports.aspx
Segmenting the public Internet companies comprising our SEG Internet Index into discrete product categories can provide valuable insight about market trends, sector health, product lifecycles, Internet retail and advertising spending impacts and stock market biases. But perhaps most importantly, we track this data because the current median valuation of companies comprising a particular Internet category often weighs heavily when buyers value acquisition targets.
The SEG Software Index is comprised of eight Internet product categories:
- Ad Tech & Lead Generation – Companies that provide key elements in the Internet advertising arena such as search marketing services, software to host and manage ads and a network of websites that run ads. Representative companies include ValueClick and SINA.
- Infrastructure – Companies that provide key elements in hosting, communications, storage and content delivery. Representative companies include Akamai, Rackspace, Digital River and VeriSign.
- Media – Companies that provide or distribute content online. Representative companies include Yahoo, Netflix, Pandora Media, Demand Media and Youku (often referred to as China’s Youtube).
- Retail – Companies that facilitate retail transactions online. Representative companies include Amazon, eBay and Mercadolibre.
- Search – Companies that operate search engines. Representative companies include Google, Baidu and Yandex.
- Services – Companies that provide various services including, but not limited to, photo sharing, social networking and security over the Internet. Representative companies include Shutterfly, LinkedIn, Ancestory.com and Renren (often referred to as China’s Facebook).
- Travel – Companies that facilitate ticketing transactions for the travel industry. Representative companies include Priceline, Ctrip and Expedia.
- Video Games – Companies that primarily deliver video games through the Internet. Representative companies include Netease, ChangeYou and NCSoft.
Enterprise valuations of companies comprising the SEG Internet Index varied widely by Internet category in 3Q11 (Figure 19). Internet services companies, the only Internet category to experience QoQ growth in median EV/Revenue, led all of its counterparts in 3Q11, posting a median EV/Revenue multiple of 5.1x. The median EV/Revenue multiple was boosted by Qihoo (26.0x), a provider of online security based in China; by LinkedIn (22.5x), the well-known social media service for business professionals; and by Renren (21.3x), a Chinese social media provider known as the Facebook of China.
The Travel product category followed close behind, with a median EV/Revenue of 5.0x in Q3. The Travel product category had been the Internet leader in median EV/Revenue for the prior three quarters, but suffered a dramatic 31% drop in QoQ valuation from 2Q11 to 3Q11, the worst among all product categories. The selloff is most likely attributable to decelerating TTM revenue growth, which declined from 34.5% in 2Q11 to 25.7% in 3Q11. Despite the drop, the category still boasts two companies with median EV/Revenue multiples greater than 10.0x – HomeAway (17.6x) and Ctrip (10.4x).
The stark contrast in financial performance and market valuation of on-premise vs. online is especially poignant in the video game category. Video game developers that generate the majority of their revenue through on-line gaming are significantly outperforming those that generate the majority of their revenue through retail. In 3Q11 software companies distributing games through retail channels closed 3Q11 with 0.1% TTM revenue growth rate and a 8.7% EBITDA margin – the lowest among all SEG Software Index product categories. Predictably, these public software companies had a median EV/Revenue of 1.1x in 3Q11, the lowest, as well, of all SEG Software Index product categories.
Conversely, public Internet providers that host their games online posted median TTM revenue growth of 29.7%, and staggering EBITDA margins of 49.7%. In response, investors rewarded these Internet game purveyors with a median EV/Revenue multiple of 4.6x (Figure 19), led by Tencent Holdings (11.3x) and NCSoft (9.6x). We expect the disparity among retail vs online gaming developers to increase, given the growing popularity of more community focused games, smart phone gaming enablement and the wild successes of Zynga and a host of other players that have leveraged the Facebook platform and mobile app stores.
As the result of these favorable market dynamics, the Video Game segment led all other Internet product categories in TTM revenue growth (29.7%) and EBITDA margins (49.7%). While their revenue performance was not quite as impressive, most other Internet categories reported solid revenue growth, with seven of eight product categories generating Q3 top line improvement in excess of the SEG Software Index’ 14.7% median TTM growth rate.
Profitability varied widely among SEG Internet product categories. Video Game providers generated the highest EBITDA margins at 49.7% while the Retail product category generated the lowest EBITDA margins of 9.4%.
The stark contrast in profitability is in large part attributable to the high degree of profit sharing inherent in some Internet business models. Advertising and retail are two product categories heavily reliant on revenue sharing business models, and consequently posted the two lowest median gross profit margins among the eight product categories we track (Figure 20). Unsurprisingly, both categories also posted median EBITDA margins below the Internet median.