Jupitermedia Corp. JUPM W
February 09, 2007 - 9:39am EST by
devo791
2007 2008
Price: 7.52 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 268 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Investment Thesis

The investment opportunity here is to purchase a company composed of two high quality businesses (30-40% margins, recurring revenues with no customer concentration, strong growth, and infinite returns on capital) for 10.3x after-tax FCF, or 7.4x EBITA.  Furthermore, I believe that profits are poised to grow at a rapid 20 – 40% annual rate over the next 5 years (near the upper end over the next couple years).  The company is managed by a long-term oriented, entrepreneurial CEO that is highly motivated with 35% ownership of the outstanding shares.
 
Overview
 
Jupitermedia operates two distinct businesses: Jupiterimages, the 3rd largest global stock photo agency, and JupiterWeb, an online media business that operates B2B websites primarily targeting IT and business professionals.  Jupiterimages generates around 80% of profits, with the remaining 20% coming from JupiterWeb.
 
A stock photo agency is essentially the primary middleman that sells photos to image buyers on behalf of 3rd party photographers.  In Jupiterimages case, they actually own 75% of the images they sell; however, the remaining 25% are sold on a more traditional agency basis, with royalties being paid to the 3rd party photographers.  Customers include: advertising agencies, book and magazine publishers, newspapers, in-house creatives, web publishers, etc.
 
Before proceeding, there are a few terms specific to the digital images business that should be explained.  First of all, there are two primary licensing models in the industry, rights-managed and royalty-free.  Images that are sold on a rights-managed basis are typically higher quality and have defined terms of use (e.g. the image can be used on billboards in the US for the next 2 months).  Images that are sold on a royalty-free basis are typically of lesser quality and grant the buyer unlimited usage of the image for a single fee.  Far less common in the industry, Jupiter also uses a third model, subscriptions, where they provide unlimited access to a defined collection of owned images for a monthly fee.  Technically, these images are royalty-free images, such that the buyer’s monthly fee grants unlimited access to all of the images in the collection.
 
Why is this an excellent company?
 
First and foremost, this is an excellent company because both of their businesses are high quality.  Both digital images and online media are reasonably stable businesses, possess 30-40% operating margins, generate essentially infinite returns on capital, and have attractive future growth profiles.  Digital imagery, which is 80% of the business, is particularly attractive due to its barriers to entry; having sufficient scale is crucial as a significant quantity of images are required to satisfy the needs of image buyers (buyers need to be able to find very specific images, as quickly as possible).
 
Secondly, these quality businesses are run by a motivated, entrepreneurial CEO – Alan Meckler – who has a history of creating significant value for shareholders.  He founded his first company, Mecklermedia, to create and operate a collection of niche magazines and tradeshows.  Started in 1971, the business did not really take off until 1994 when the company raised equity capital and began to focus on the potential of the Internet.  The business was sold only 4 years later in 1998 to PentonMedia for $300 M.
 
PentonMedia did not want Mecklermedia’s web assets, so Meckler purchased 80.1% of them for $18 M to launch what has evolved into Jupitermedia today.  Within Jupitermedia he purchased an IT market research business for $250k, which he built and sold for $11 M.  Capitalizing on the experience he gained running Mecklermedia, he also built an IT events business which he has also since sold for around $40 M.  His most significant investments within Jupitermedia have been the cumulative acquisitions of over $200 M in digital image collections.  Athough this business is still in its infancy, I believe that he has continued to create significant value in this business as well.
 
Alan Meckler is an ideal CEO to be partnered with.  He owns over 35% of Jupitermedia’s common stock.  He has a proven record of creating shareholder value in building media and trade show businesses.  Importantly, these are exactly the kinds of business that he expects to continue creating and developing within Jupitermedia.  Finally, he runs the company with a long-term focus and does not hesitate to make investments that lack immediate payoff.
 
Why is this an attractive price?
 
Valuing the digital images business at 10x next year’s EBITA and the online media business at 11x next year’s EBIT yields an overall enterprise that is worth $10 - $11, making the current price ~30% discount to this intrinsic value.  Here is a breakdown of this valuation:
 
Jupiterimages                           $265.7 M
JupiterWeb                              $139.2 M
Net debt                                   ($54.0 M)
Amortization tax shield                        $18.2 M
Total                                       $369.1 M         $10.35 / share
 
The company has a substantial amount of intangible assets that have been created through the acquisitions of numerous image libraries over the last few years.  These assets are amortizable for tax purposes, and because the aggregate value of these intangibles is so large relative to Jupiter’s enterprise value, the value of the effective tax shield is somewhat material to valuation.  The $18.2 M was calculated via present value analysis, similar to how one would value a net operating loss carryforward.
 
Also, note that I have loaded all of the corporate costs into the valuation of Jupiterimages.  Arguably some of these costs could be shifted to JupiterWeb, but it would have an inconsequential impact on the valuation.
 
While a 30% discount using these fairly conservative multiples is attractive, this valuation does not adequately account for the significant growth the company is likely to realize over the next 5 years.  I believe that Jupitermedia will ultimately prove to be even more valuable than this analysis indicates.  This is the case because I expect the company to grow profits over the next 5 years at a 20 – 40% annual rate, which is certainly a far greater rate than a 10x pre-tax multiple accounts for.
 
Over the next 5 years, I think that the company will be able to drive annualized revenue growth of 10 - 15%.  Due to the economic model of Jupiter’s images business which benefits from very high incremental margins, this revenue growth will translate into substantially greater EBITA growth.  More specifically, 10 – 15% revenue growth should translate into 20 – 40% EBITA growth across the company.  Even very modest top-line growth (4-5%) should be able to generate double digit EBITA growth from current levels.  If you apply 10x multiples to EBITA several years out assuming 20-40% growth, this would suggest that the company trades a discount to intrinsic value that is significantly greater than 30%.
 
How can this company drive 10%+ revenue growth?
 
The company should be able to grow revenues over the next 5 years at a double digit rate
due to the attractive outlook for the low-end of the images market and a number of company-specific initiatives.  Focusing on the images business first:
 
a)      Overall industry growth of 4-6% with Jupiter positioned in the highest growth areas
 
The market for stock imagery has historically grown at a 4-6% rate.  This growth has been driven by both price (stock image agencies with scale have developed at least modest pricing power) and volume (usage of imagery as compared to textual content has increased, and new platforms that require images have emerged, such as the web).  While growth in the high-end of the market may moderate somewhat going forward, the low-end of the market – which is Jupitermedia’s bread-and-butter and where they believe they have #1 market share – is likely to grow well in excess of the overall industry.  Considering that a substantial portion of the growth in the media business today is on the Internet, this should not be surprising.  Web publishers and advertisers do not want high-end imagery; they require images with relatively low detail to ensure fast page loading times.  With 85% of Jupiter’s images sold on a royalty-free basis, around 30% of which are sold through particularly value-priced subscriptions, Jupiter is essentially competing in the highest growth areas of an overall market that has grown around 5% annually.
 
b)      Addition of a direct sales force less than 2 years ago and its continued development
 
A significant source of growth will come from the fairly recent addition of a sales force and its continued expansion.  It is important to remember that Jupiter had not entered the digital images business until 2003.  As a result, until March 2005, they had absolutely no direct sales force; all of their sales were either transacted online without assistance or flowed through 3rd party distributors.  Getty, as an example, uses a sales force both to generate new customer accounts and to support existing client relationships.  Jupiter acquired a 50-60 person sales force from Creatas, and have since doubled the size of this team.  Furthermore, this doubling in size did not occur until the end of Q1 of this year.
 
Several image buyers that I have spoken with have emphasized the importance of the regular contact that they receive from Getty.  While having a sales force is obviously more important for Getty’s higher-end mix of customers (such as high volume ad agencies), the development of Jupiter’s 20 month-old sales team should spur growth in both customers and image volume per customer.  In the most recent quarter, we can see the early results of this investment as direct sales were up 19%.
 
c)      Gradual conversion of 3rd party distribution to direct sales (~20-25% growth)
 
In addition to adding new customers and increasing volumes, growth in direct sales should allow Jupiter to gradually bring the business that they currently sell through 3rd party distributors in-house.  Jupiter sells through distributors, for the most part, in markets where they historically have not had scale.  As awareness of the Jupiterimages brand continues to grow globally, they are increasingly able to move into new markets on a direct sales basis.  This is still a sizeable portion of their images business, around 20-25%, whereas Getty obviously does not require any 3rd party distribution.  Converting this portion of their business to direct sales is significant to growth going forward due to the sizeable margins (~50%) that distributors earn.  The gradual elimination of 3rd party distribution should approximately double the revenues that Jupiter realizes in nearly a quarter of their images business, which represents a 20-25% revenue growth opportunity based on the current size of the business.
 
d)      Significant opportunities for international growth (~20-25% growth)
 
Images tend to have very broad geographic appeal, thus presenting the company with significant international growth opportunities.  International is approximately 35% of the images business today, whereas it is over 50% for Getty (48% of Getty’s business comes from the Americas, which includes Central and South America).  Building this business is a matter of continued advertising in international markets to build the Jupiterimages brand among potential customers, and increased direct sales efforts in international markets.  Getting international to 55% of image revenues represents a 45% revenue growth opportunity for the company.  It should be noted, however, that a portion of this growth should come simply from the aforementioned conversion of 3rd party distribution to direct sales.  Sparing you the math, getting the international business to 55% of revenues is around a 20-25% incremental revenue growth opportunity based on the current size of the images business (this excludes the growth from converting distribution to direct in international markets, which was accounted for earlier).
 
e)      Marketing investments today will yield revenue growth through increased market share
 
Over the last 3 years, Jupiter has assembled an image agency from the acquisition of numerous image collections, with a couple of the key pieces (such as Creatas and PictureArts) having been added to the company just last year.  Although the company will likely look to make additional image acquisitions where sensible, they feel that they finally have sufficient quantity and variety of content to satisfy the needs of most image buyers.  Being able to address the needs of most image buyers yet only having 4-5% market share is significant.  The principal reason why the company’s market share is this low is because the Jupiterimages brand is so new.  As the company continues to market the brand, and more image buyers learn about Jupiter, they will become increasingly likely to include Jupiterimages in their future searches for images.  Getty has commented that Jupiter has been advertising aggressively in trade publications, which is something that they haven’t really seen before from other competitors.
 
In particular, they have significant room to grow in the higher-end portions of the market.  They had some rights-managed images from the Comstock acquisition in April 2004, but it really wasn’t until last year that they added a decent quantity of rights-managed and higher-quality royalty-free content.  Being so new to the higher-end segment of the market, they are still developing the relationships with RM image buyers, particularly ad agencies.  Several of these acquired collections were previously distributed by Getty, and now Jupiter is obviously the only distributor.  Considering that image buyers tend to be loyal to large, high quality collections that they have used before, Jupiter should be able to: retain many of these customers, capture the margin that Getty was earning in the previously 2-tiered distribution, and introduce a lot of these new higher-end accounts to the Jupiterimages brand.  As a result, although the company has less than 1% of the high-end market presently, the CEO has stated that he believes they can grow this to 5% over the next 2-3 years.  While I would hesitate to make such a bold prediction, I think it is indicative of the types of opportunities that the company sees in this portion of the market.
 
f)       Growth from other media categories: video/film and music.
 
In addition to images, Jupiter has been building businesses in both royalty-free music and video.  Video, in particular, is presently losing money.  There is not any good data on market size for stock footage or music, but they are relatively small markets today, growing quickly, and Jupiter arguably has greater share in them than they do in images.  They are likely close to being #1 in royalty-free music, and are likely #2 in stock video footage to Getty.  Although the film business is too small for Jupiter to breakout, it has been growing at double-digit rates for Getty.  Similar to stock images, there is a significant value proposition to using stock footage; for example, advertisers can create TV commercials for hundreds of dollars (compared to $5 – 30k if a production firm is used to shoot original footage).  Although insignificant to the company today, I think both of these markets are likely to grow rapidly, well above the growth in digital images, and will eventually develop into highly profitable businesses.
 
g)      Revamped search engine should provide a catalyst for near-term revenue growth.
 
An effective search engine is a particularly important feature for stock photo agencies.  Jupiter, for example, has over 7 M images from which image buyers must search through to find one or two images that match their very particular requirements.  Furthermore, the non-textual nature of images prevents the indexing of this content from being fully automated.  As a result, people are needed to manually “keyword” images: keywords are assigned to each image in the library from a standardized list.
 
The importance of a quality search engine is somewhat obvious.  If potential buyers are unable to find what they are looking for quickly, they leave.  As Jupiter has cobbled together their image business through a series of acquisitions over the last 3.5 years, they have historically had a very bad search engine.  Search result pages would take 7-9 seconds to load, images were not ‘keyworded’ effectively, and there were poor options for filtering the search results.
 
In July, the company finally implemented a new and improved search engine.  The company believes their search engine is now on par with Getty, and customers that I have spoken with that have used the site recently have noticed the significant improvement and agree with this view.  Management still sees an opportunity to improve the existing search engine through better keywording.  Given the recency of the launch of the new search engine, I don’t think the company has fully benefited from its impact.  In the long run I would not expect any of the major image agencies to benefit from having superior search technology; however, replacing a terrible search engine with one that is on par with competitors should provide, at least, a catalyst for near-term growth.
 
h)      Market fragmentation positions image agencies with scale well for growth
 
Although Getty (revenues of $800 M) and Corbis ($250 M) are both much larger than Jupiterimages ($105 M), the rest of the market is very fragmented.  In fact, Jupiter’s next closest competitor is less than a quarter their size.  All of these tiny, fragmented companies combined account for approximately 54% of the ~$2.5 B stock image market.  This is important because Jupiter’s market share gains do not have to come at the expense of their much larger competitors in Getty and Corbis; it is more likely that they come from the rest of the market, which lacks the scale that the top 3 players have. 
 
As for why the market is still so fragmented considering the advantages that agencies with scale have, it is important to remember how relatively recently the industry had started consolidating.  Getty, the market leader by a wide margin, did not begin rolling-up image agencies until 11 years ago.  Furthermore, the market has evolved significantly.  Image agencies didn’t go digital until 5-6 years ago; prior to that, image buyers flipped through catalogs of printed photos that the agencies mailed out (in addition to the sale of image CDs).  While I’m sure that certain niche collections will be able to maintain their share of the market, I doubt that that share in aggregate is anywhere near the current 54%.  While some of these collections will be acquired by the top 3 players, I expect that a number of them will simply lose share over the coming years.
 
Lots of growth drivers, but how can this company drive 10%+ revenue growth?
 
As detailed above, Jupiter has a number of growth opportunities, some of which are easier to quantify than others.  As a baseline, the industry has historically grown at around 5% annually.  Considering that Jupiter is particularly focused on the low-end of the market, which has the greatest growth prospects, using a 5% organic rate of growth for Jupiter’s existing business is conservative and provides for some pricing deflation in the industry.
 
Furthermore, the conversion of business from 3rd party distribution to direct sales is expected to provide a 20-25% growth opportunity and increased penetration of international markets is expected to provide an additional 20-25% growth opportunity.  Combined, this represents around 40-50% cumulative revenue growth from new business in largely international markets (70% of the 3rd party distribution revenues are in international markets).  Both of these targets are achievable within a 5 year timeframe, which thus yields around an additional 8 – 10% growth annually.
 
Organic growth in existing business of 5% with 8 – 10% annual growth from new international business yields around 13 – 15% annual revenue growth.  This doesn’t take into consideration, however, the new business that I expect them to win domestically – which is arguably the largest growth opportunity for the company.  Although it is difficult to put a precise number on it, the combination of: finally having a direct sales force to market Jupiterimages, the growing brand awareness that has been achieved through significant marketing investments, and key search technology that has been dramatically improved in the last 6 months is likely to generate a significant amount of new domestic business.  Furthermore, the 40 – 50% international growth opportunity was derived assuming a mature level of international penetration based on the current size of the domestic business.  If the company is able to take market share domestically for the reasons I have articulated, the size of this international growth opportunity would similarly increase in proportion, and would thus represent a much larger revenue growth opportunity than the 40 – 50% that I have specified.
 
Taking all of this into consideration, it is hopefully clear why I think that 10%+ revenue growth is a very achievable goal for the company over the next 5 years.  Obviously if management execution is smooth, pricing in the industry is robust, and my expectations pan out, there is significant upside to this number and revenue growth can realistically be much greater (i.e. 15% - 20%).  That said, I think that 10%+ revenue growth is a conservative growth target and accounts for the unavoidable hiccups along the way.
 
Significant operating leverage magnifies the impact of 10%+ revenue growth
 
While 10%+ revenue growth is certainly attractive, what makes this particular investment opportunity so compelling is the operating leverage, which should lead to substantially greater growth in profits and cash flow.
 
Similar to Getty Images, there is meaningful operating leverage in the sale of incremental rights-managed images.  Because additional image sales require only a royalty to be paid to photographers plus minor amounts of sales support, incremental margins on rights-managed images are 50%+.  Unlike Getty Images, however, Jupiter actually owns 75% of the images that they sell.  As a result, these images don’t have royalties attached to them and thus possess 85%+ incremental margins.  While the sale of an additional owned image through the website is technically pure profit, an 85% incremental margin provisions for both sales support and an allocation for overhead.  Although digital images is already a fairly high margin business – $37 M in EBITDA at around a 35% EBITDA margin – the margin expansion will be further leveraged by around $20 M in corporate overhead.
 
Put another way, the overall company currently has an EBITA margin of around 24% and both businesses have very high incremental margins.  Incremental margins in the images business, which is 80% of profitability, should be at least 75%.  That 75% is loosely calculated as: they own 75% of their images and earn 85%+ incremental margins on them, and they pay royalties on 25% of the images, and earn at least 50% incremental margins on these.
 
From these incremental margins, it is hopefully clear how 10-15% revenue growth will translate into 20-40% EBITA growth across the company for several years into the future.
 
What about the online media business?
 
Although I have focused on the images business as it generates the majority of cash flow, the online media business is also a very attractive asset that should see meaningful revenue growth over the next 5 years, with similarly high operating leverage.
 
There are several factors that should drive growth in this business over the next few years.  First of all, management admits to having underinvested in the business.  This is not surprising as the company has been obviously distracted over the last 3.5 years as they raised and deployed a significant amount of capital to build the Jupiterimages business.  Over the last few years, the online media business has seemingly been run on auto-pilot.  Management has announced that this is about to change.  While it is impossible to quantify the impact of management investing more time and money in this business, there are a number of things that they can and will be doing to grow the business.  Among them, they will be implementing various improvements to some of the existing sites that have become stale, creating a few new sites, and potentially making a few small dollar amount acquisitions. 
 
Secondly, given the IT focus of their web sites, the launch of Microsoft’s Vista should be a tailwind for CPMs.  The new Vista OS will launch during the first half of 2007, and is expected to trigger a PC upgrade cycle.  Jupiter’s key advertising customers are largely IT companies that will need to be advertising their new products during this important time.
 
The final growth lever is that management intends to grow their online media segment through the creation of an events business.  While the ultimate success of an events business is obviously an unknown, as mentioned previously, the CEO has had great success in the past building precisely these businesses.  Importantly, it is a low risk investment due to the low capital intensity of the business (no physical capital and negative working capital) and the skewed risk/reward proposition.  An event that is a failure could lose $100-150k and would potentially be scrapped if there was no potential.  A successful event, however, has the potential to do several million in revenues with 50%+ operating margins, and could be held on an on-going basis.  Given the significant success that Meckler has had in the past creating events and trade shows, this represents a significant growth opportunity for the company with minimal risk.
 
As mentioned earlier, I valued this business at 11x the current EBIT run-rate.  It should be noted that in a sale to a strategic buyer, I believe the company would likely be able to fetch a higher price than this.  Online media is highly sought after, and this has been reflected in the multiples that acquirers have paid.  Somewhat recent examples include:
-          IGN, acquired by News Corp for $650 M, which was 80x EBITDA and 11x revenues
-          iVillage, acquired by NBC for $619 M, which 38x EBITDA and 6.5x revenues
The closest comparable public competitor would be CNET, which trades for around 33x EBIT, 16x EBITDA, and 3.8x revenues.  CNET has grown at a decent rate, however, they also have more of a consumer focus (which is arguably a more competitive market than B2B) and have had their valuation impacted by some company-specific issues, which includes option backdating.  Given the valuations that acquirers have paid and the substantial opportunities for improvement, if Jupiter put their media business up for sale, I would be surprised if it didn’t sell for at least 15 – 20x the current EBIT run-rate.  As a result, I think that the 11x multiple that I have valued this business at is very conservative.
 
What is the market missing?
 
I think that the market has failed to understand several aspects of the business.
 
Starting with the most recently reported quarter, the stock declined around 35% after results were reported.  The quarter itself was not that bad, however, their sales to international distributors missed management estimates significantly.  This miss caused sell-side analysts to downgrade the stock and significantly reduce estimates, due to a lack of “visibility” in sales to distributors.
 
This reaction seems peculiar considering that:
-          Sales to international distributors are only approximately 13% of revenues and are a lower margin business due to the ~45-50% revenue share with distributors.
-          Selling to distributors is an undesirable, non-strategic business, which the company is likely to replace over time with direct sales.
-          This was only the first quarter that distribution revenues have missed management’s estimates.
-          Management had no explanation for this miss, which suggests that the quarterly performance may just be a temporary anomaly.   I think that one logical explanation is that international distributors might simply be cutting their business with Jupiter now that they see them gearing up to sell direct internationally.
-          The 14% sequential revenue decline in distribution revenues was on top of an unusually strong quarter.  Distribution revenues were actually flat on a year-over-year basis.
-          They went so far as to say that international sales (a significant chunk of which are sales to distributors) have been strong so far in October and November on the quarterly conference call.
 
I think that a number of other factors have conspired to drive shares down to these very attractive levels.  First of all, after missing estimates last quarter, management stopped giving earnings guidance.  Previously, management had been providing rolling 12 months forward guidance, which was 46 – 50 M in EBITDA when they last gave their guidance on the previous quarterly call.  For comparison, the comparable run-rate EBITDA figure that I have valued this business using is only 36 M, so clearly management would seem to agree that there is considerable near-term upside to the current run-rate earnings power.  Upon having guidance pulled, rather than think for themselves, sell-side analysts have essentially thrown their hands in the air and assumed that sales to distributors will continue declining sharply, thus preventing the company from achieving any meaningful revenue growth.  Even odder is that sell-side models that I have seen have simultaneously slashed the operating leverage in the business, which for some reason will be far more muted going forward.  Compounding the declines in expected EBITDA is that analysts now view the company as being more risky and thus value the company at a lower multiple.  The notion that the company has become more risky due to a lack of near-term “visibility” in sales to distributors is downright silly and obviously only presents more risk for sell-analysts whose job it is to precisely guess next quarter’s earnings.
 
Furthermore, the true profitability of the business is obscured by a number of accounting charges that serve to make GAAP income appear low.  The most significant of these charges, amortization of intangibles from prior acquisitions, should amount to around 11 M next year, which is ~30% of the company’s 36 M in adjusted EBITDA.  These amortization charges are largely taken to reflect the diminution in value of acquired images.  Like most other intangibles acquired through acquisition, including these charges in the analysis of on-going profitability is double-counting.  The company already expenses through the income statement the cost of creating new photos to refresh the image library. 
 
The second of these charges, stock-based compensation expense, is significant larger than the actual economic option expense due to the nature of the accounting standards for recording stock-based compensation.  More specifically, sell-side models have generally extrapolated the current quarterly accounting charges to arrive at around 4 to 4.5 M next year.  This is a surprisingly large number when one considers that the company has permanently reduced their option granting, which is currently only around 2.0% - 2.5% of the outstanding shares annually.  These are fairly modest option grants for any company, let alone a company that is growing as rapidly as Jupiter is.  The reason why the accounting charge is so much greater than the economic expense is because the current accounting charges are severely skewed by options that were previously granted at strike prices that are now significantly above the current share price.  The grant for this year, for example, was struck at $15.50, which is more than 2.5x the current share price.  I will spare you the details of my Black-Scholes model assumptions, but I calculate that the on-going economic option expense is only around 1.5 M, which is quite a bit lower than the 4 – 4.5 M that the company will be taking for accounting purposes.  Furthermore, because the share price has declined so significantly, the company has relatively little over hang from stock options that are currently outstanding.
 
The final charges that are currently distorting current earnings are the numerous investments that the company has been making, such as those in royalty-free video.  While it is not possible to precisely quantify the magnitude of the losses generated by these ventures, based on management’s comments on the most recent quarterly call, I believe they amount to around $3 M, which is close to 10% of EBITA.
 
The last aspect of the business that I think the market may not fully understand is the degree of operating leverage in the business.  When management was spoon-feeding sell-side analysts guidance it was easy, but now that guidance has been pulled, expectations for operating leverage have been muted, as I mentioned previously.  I think the problem here is that there really isn’t a truly comparable company in the public markets.  There is only one other stock photo agency that is public, Getty Images, but the reality is that Getty has a much different business.  In terms of operating leverage, the most important difference between the two companies is that Jupiter owns 75% of their images, compared to Getty who pays royalties on almost all of the images that they sell (excluding their relatively small editorial business, which is an entirely different animal and isn’t as scalable).  Furthermore, because Getty’s images are relatively high quality, they have a significant mix of rights-managed content, which have the highest royalty rates (i.e. variable cost).  As a result, although Getty certainly has a scalable business such that they can grow profits at 1.5x the rate of revenues, Jupiter’s business is significantly more scalable and should allow for profits to grow at 2 – 3x the rate of revenue growth.
 
Risks
 
While I do not think that there is any one significant risk to the company, there are several smaller ones that should be considered.
 
a)      A deflationary price environment in royalty-free images, due to the micropayment model
 
I think that one of the biggest risks to the company is a deflationary price environment in the royalty-free market.  For the industry to have historically achieved 4 - 6% annual growth, pricing growth has clearly been reasonably robust at around 2 - 3%.  While 2 – 3% pricing is hardly gouging customers, there is the potential for some disruption in the royalty-free market as a new licensing model known as “micropayments” continues to grow rapidly.  Images sold through micropayment sites are essentially very cheap royalty-free images ($1 - $5 per image) that have been contributed by amateur photographers.  With royalty-free images averaging around $200 / image, a concern is that a mix shift will erode pricing in the industry.  I do not believe that this disruption is a significant concern.
 
First of all, although micropayment pricing is obviously very low today, I believe that it is inevitable that the quality images that are posted on micropayment sites today will increase in price significantly over time.  Not surprisingly, photographers are wealth-maximizers, and so a photographer is not going to sell a photo for $2 that he can license through a traditional RF model for $200; because photographers are paid a percentage of the revenues, their interests are aligned with the stock agency they partner with to receive the highest possible dollar amount per image. 
 
Secondly, this is very much analogous to what happened to the industry when the royalty-free licensing model was born.  Getty, for example, started selling royalty-free images in 1998, when pricing was much lower.  At that time people worried that royalty-free would erode their rights-managed business, but with the benefit the benefit of hindsight we know that this did not happen and that royalty-free images increased in price over time and carved out their own niche in the market.
 
Additionally, the reality is that this will likely end up being only 10 – 20% of the industry.  It is difficult for photographers to address the needs of image buyers without having a budget.  Photographic equipment, access to models, and other costs associated with conducting a photo shoot all require money.  Perhaps more importantly, genuine photographic talent is needed, and apparently this is largely lacking on micropayment sites today.  The common theme that I have heard from image buyers is that while the quality of the photos is good relative to the cost of the images, the quality on the sites is very uneven and so it can take a lot of time to find an image that is worth buying.  Being able to find suitable images quickly is probably the most important criteria that I have heard from numerous image buyers.
 
Furthermore, although the micropayment model is currently booming and doing very impressive volumes (Getty’s iStockPhoto sold 2.5 M images last quarter), this hasn’t led to any pricing deflation in the royalty-free market yet.  In fact, it is quite the opposite; in a relatively soft imagery market, royalty-free pricing has actually been strong.  Given their significant market share, Getty’s results provide the best view of pricing in the industry, and over the last few quarters while rights-managed pricing has declined (6% in Q4, 3% in Q3), royalty-free pricing has increased (small growth in Q4, 6% growth in Q3).  Furthermore, the pricing growth has been supplemented by strong volume growth in RF (double digit volume growth at Getty in Q4).
 
Finally, I should note that Jupiter already owns a 49% stake in a micropayment site (which they are increasing to 95%) as well, so that whatever market niche this licensing model eventually reaches, they will be participating in it.
 
While I’ve argued that the new micropayment model will not have a significant impact on the RF market, I do believe that anytime you have this much disruption in an industry it warrants being cautious.  If you run through my numbers again on how the company can grow revenues at a double-digit rate over the next 5 years, you will notice that I’ve left a sizeable buffer to account for these sorts of risks, and so this target should be achievable even in the face of significant pricing headwinds.
 
b)      Getty taking market share in the subscription business
 
Jupiter’s subscription products comprise around 25% of their images business.  It is a good niche for the company as they have an estimated 50-70% of the subscription market.  Getty finally launched a subscription product last year called Creative Express.  That said, Getty has thus far not had any impact on Jupiter’s subscription business.  In fact, the subscription business continues to set record revenues each quarter, and year-to-date it has grown by 28% over last year.  The risk here is Getty eventually launching a more competitive product and taking market share.  There are a few reasons why this should not be a significant issue.
 
First of all, to achieve the price points that are offered in a subscription product, you need to have ownership of the images; having to pay a royalty on each image for every subscription would destroy the economics.  Because Jupiter has such a large collection of owned low-end images, this has given them a huge advantage and allowed them to offer subscription products with vastly more images in them.  Secondly, Getty is not pushing this product as hard as they can because given the lower ASPs in subscriptions, Getty is hardly eager to cannibalize their higher-priced, highly profitable royalty-free business.  Furthermore, the market is likely only 50 - 60 M today, so the reality is that it is probably not a big enough market yet to justify an investment above what Getty is already spending here.  Nonetheless, Getty obviously has a dominant position in the industry and they continue to create content (i.e. own more images) which will allow them to improve their subscription offering over time.
 
c)      Leverage
 
Although the company has some debt, I believe there is limited-to-no financial risk here.  First and foremost, leverage levels are very modest relative to cash flow.  Debt to EBITDA is only 1.6x, and this falls to 1.3x if you use forward EBITDA.  Furthermore, this ratio actually understates the free cash flow that Jupiter has available to service and retire debt since a large portion of their EBITDA is shielded by tax-deductible amortization.
 
Secondly, the business itself is stable with fairly recurring revenues, high margin, and not capital intensive.
 
Finally, the business is reasonably divisible and several pieces could be sold to raise cash without affecting the rest of the company.  The entire JupiterWeb division, for example, could be sold, or even just individual sites.  In the images division, they could also sell individual collections without impairing the rest of the business.  I would not expect any such asset sales, but the company certainly could if they ever needed to raise capital.
 
The flip side of this risk is that the business is arguably under-leveraged.  The modest amount of debt that they currently have could potentially be retired over the next couple years if they chose to.  The business can arguably support debt that is 4-5x EBITDA, which thus presents the company with yet another potential lever that can be pulled to increase shareholder returns.

Catalyst

When the company reports earnings next quarter, shows analysts that the sky isn’t falling, and resumes providing guidance, I would expect the stock to react favorably.

Continued solid growth in the images business should also propel the stock, and a few successful events/trade shows would get investors excited about this new avenue of growth for the company.
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