Digital Advertising Industry

The Henry Fund

Henry B. Tippie College of Business Cooper LaRue [cooper-larue@uiowa.edu]

Digital Advertising Industry

Communication Services Investment Thesis

February 12, 2020 Industry Rating Market Weight

Key Industry Statistics

The industry of digital advertising has drastically changed in the last five years to be dominated by a few main market holders. Alphabet, Amazon, Facebook, Alibaba and Microsoft capture 82% market share, and we predict they will continue to dominate. There is opportunity for these companies to become more profitable through developing more targeted and effective advertisements as they gain users around the world. However, we believe this progress will be slowed by data and privacy regulation from governments around the world and saturation in developed markets. We recommend a market weight position on the industry.

Drivers of Thesis Progression in artificial intelligence, data collection methods and

location-based advertising are making digital advertising cheaper and more effective

Digital advertising is expected to increase by 17% in 2020 driven by consumers spending more time on social media and less on T.V.

Digital advertisement is expected to be 54.4% of total advertising expenses by 2020, paving the way for the industry dominants such as Facebook, Google and Alibaba to capitalize

Geographic Revenue % North America Asia-Pacific European Latin America

Top Competitors Alphabet (GOOGL) Amazon (AMZN) Facebook (FB) Microsoft (MSFT) Alibaba (BABA)

Advertising % of Total Revenue Alphabet (GOOGL) Amazon (AMZN) Facebook (FB) Microsoft (MSFT) Alibaba (BABA)

39.7% 30.8% 25.3%

4.2%

$1.03T $1.07T $590B $1.40T $610B

83% 4%

98% 12% 53%

Risks to Thesis Changes in the regulatory environment could hinder companies'

ability to collect useful customer data, resulting in less effective advertisement targeting campaigns

The U.S. market is maturing and seeing slowing year over year growth. We predict 8% revenue growth in 2020 for the digital advertisement industry

60% 50% 40% 30% 20% 10%

0% -10%

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GOOG

12 Month Performance

FB

MSFT

AMZN

M

AM

J

J

A

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O

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S&P 500

D

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Yahoo Finance

Industry Description

Digital advertising targets consumers through online platforms to provide a quicker, cheaper and more targeted way at marketing content to potential consumers. It is predominantly done through social media, search engine optimization, email, video and banner advertisements. The industry is dominated by a handful of leading technology giants who compete for market share.

Yahoo Finance

Important disclosures appear on the last page of this report.

EXECUTIVE SUMMARY

The digital marketing industry has done very well over the past few years and continues to show strong growth in mobile, search and cross platform advertising. The industry is dominated by Google, Facebook and Alibaba, and to a lesser extent Amazon and Microsoft. These companies track users' demographic, behavioral and location-based data to effectively target ads through their platforms which has been very successful in years past and is expected to continue at a slowing growth rate. Much of the U.S. markets are saturated and we believe these companies will need to look abroad, specifically in the Asia-Pacific region for advertisement growth.

top three company's platforms. Google, Facebook and Amazon capture 70% of all digital ad spending in the U.S. which is a very high concentration for any industry. This oligopoly has been very beneficial for these three giants, but they are also facing continuous headwinds from regulators. Concerns of privacy and the data these platforms collect, which in turn makes their advertisement platforms so effective, is constantly under fire by the for violating privacy laws and we believe this will continue for the foreseeable future. Below is a graph showing the digital advertising forecast in the U.S. until 2023. This implies a 4-year CAGR of 11.7%.

Industry positives include the ever-increasing mobile screen time people worldwide are exposed to, strong political advertisement expected in 2020 and international growth. Companies are also getting better every day at monetizing user data to run more effective advertisement campaigns.

The headwinds for the industry include increasing risk of regulation, slowing U.S. growth year over year and potential data breaches that could cause a slowdown in user growth. Companies in digital advertising thrive on the ability to use data to pinpoint potential customers for their advertisers. We believe this will become increasingly more difficult as regulators catch up to the wild west of data sourcing and search for more transparency in the industry.

We believe these positives and negatives neutralize each other and therefore recommend a market weight rating on the industry.

INDUSTRY DESCRIPTION

As more of our daily lives are spent looking at screens, advertisers also adjust their marketing dollars accordingly. Spending in digital advertising grew to $129.34 billion in 2019 and is expected to grow by 17% in 20204. This is fueled by the transition of advertisers from traditional delivery methods such as T.V. and physical ads to digital. This switch is the fuel that can keep the digital advertising industry growing by 10%-15% CAGR for the next 3 years. We expect this growth to continue to be in the low double digits YOY which is a slowing rate from previous years.

Within the digital marketing industry, a majority of all advertisements are spent to place advertisements on the

Source: Statista

TARGETED SPENDING

Throughout the entirety of marketing history, companies have tried to make advertisements more effective through personalization. The industry is continuing to make developments on targeting consumers through demographic, behavioral and location-based advertisements. As the industry matures in developed counties like the U.S., companies like Alphabet, Facebook, Microsoft and Amazon have developed more effective methods to target consumers that are more personalized than ever.

Location Based Marketing

One of the newest and still transforming advertising methods is using consumers' locations to provide them with local deals or suggest items others in their area have used. As locational data has become easier for companies to obtain it has allowed companies to more effectively personalize ads to one's preferences. For example, CocaCola uses artificial intelligence to understand how its brand and products are being interacted with on social media. It then uses this data target customers in those areas. It uses this data to advertise different drinks and

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flavors based on the interactions through communication platforms like Facebook, Twitter and Instagram and then uses those platforms to display advertisements1.

Location based marketing is the fastest growing method of targeting consumers. Behavioral marketing has historically been more common, but we are seeing that quickly change. Below is graph showing the estimated outlook of spending towards location-based advertisements. This forecast suggests a 3-year forward CAGR of 13.45%.

their subset customer within that criteria using other methods. Today this tactic is most common among email advertisers which is part of digital advertisement segment, but not how the industry leaders produce revenue.

DIGITAL TRENDS

The most industry transforming aspect of digital advertisements is how companies are targeting their customers using multiple platforms. Advertisers want their content to be seen multiple times among different platforms and devices. We believe this cross-channel coordination is where companies like Facebook and Google are posed to create growth and add value for their advertisers. In the U.S., 76% of all advertising revenue is spent through either search or social media. This puts these communication companies in a leading position to dominate. The trend of users spending more time on mobile and less on desktop also plays to these companies favor.

Mobile vs. Desktop

Source: eMarketer

Behavioral Marketing

Behavioral marketing tracks consumers' interests and preferences through how they interact with the internet. Most commonly this information is collected through social media and internet searches. It recognizes what users like and then recommends similar products or services. This method of targeting has become most common because companies have gotten better at collect and analyzing users' habits online often without them knowing. It has been shown to produce effective results than basic demographic marketing but not as effective as location based.

In 2019, the average US adult spent nearly three hours a day on their smartphone. This is up 9% from 2018 and is expected to steadily increase for the next few years3. As consumers spend more time on their mobile devices the advertising spending also shifts. In 2021 advertisers are expected to spend 50% of all advertisement budgets through digital mobile mediums5. Below is a graph showing the change in advertisement dollars to be spent on mobile vs. desktop.

Demographic Marketing

Historically demographic marketing has been the most common. It is becoming less and less popular due to its "one size fits all" mentality. Today companies are able to easily retrieve behavioral and locational data on their consumers and use that data to pinpoint its most noteworthy prospects. Demographics are a good place for many advertisers to start but then they need to identify

Source: Statista

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Social Media Spending

Companies are becoming more active on social media every year. It is a great way for them to continuously connect with their current customers and a way to reach out to potential ones. Advertisement spending on social media platforms reflects this. In 2019, advertisement spending was up 26.5% YOY to $35.67 billion. Within this social media spending, 94% of it was through mobile5. Below is a graph shows Blomberg's outlook pertaining social media spending. The implied 4-year CAGR for mobile spending is 11.6%.

Social Media Spending Outlook (In Millions)

$70,000 $60,000 $50,000 $40,000 $30,000 $20,000 $10,000

$0 2016 2017 2018 2019 2020 2021 2022 2023 2024

Desktop

Mobile

Source: Bloomberg

As desktop spending declines, mobile is expected to grow by double digits YOY. Spending on social media represented 27.8% of all digital advertisement spending which is the second largest category behind search5.

Search Advertisement

Search advertising is when companies pay to have their brand promoted through a search engine, so it gets more visibility to users. It is considered a pull method of marketing in that it tries to make the user feel like it is not a paid advertisement. Instead, just a helpful link regarding their search. This has become more popular as the old ways of banner ads and pop-up windows have become less effective. Search advertisement represents 48.3% of all digital advertising and is expected to slowly increase its market share. This way of advertisement targeting is dominated by Google as 92% of global searches are done through Google's search engine6.

Spending on search targeted advertisements is declining YOY with 2019 down 4%. However, it is still expected to grow by 11.7% in 20205. We believe this slow in growth is due to the maturing market of search and companies will need to come up with more effective ways to get users attention in order to drive this advertisement revenue back up.

Cross-Channel Coordination

Where we believe the competition is separated in the industry is dependent on who will best be able to integrate cross - channel coordination among their different platforms and across devices. Social platforms are getting better at recognizing what users are looking at on one platform and then able to target advertisements for similar products/services on other platforms. We believe a company like Facebook who owns multiple social platforms is positioned to do well in this advertisement dimension. Facebook can see what users are viewing on Facebook and then use that data to target them with advertisements on Instagram. Similarly, Google can do this with YouTube. We believe this gives these companies an advantage in the space over other social platforms like Twitter or Microsoft who just have one main social platform.

CUSTOMER GROWTH

As companies do better in a growing economy, we expect them to continue to spend a large amount of their marketing budgets on digital advertising. Especially running advertisements through Facebook, Google, Amazon and other traffic heavy platforms.

The main cyclical event which impacts the industry in 2020 is the U.S. presidential election. In election years billions of dollars are spent through a wide range of mediums and digital platforms will account for a large percentage of that. While companies like Facebook and Google do not break out political revenue data for us, it is estimated that $1.6 billion dollars will be spent on digital video alone11.

To a more fundamental point, we continue to see average daily screen time increase around the world which in turn leads to more opportunity for digital advertisers to run ads. We see daily average screen time increase in the U.S. and around the world where 52% of global advertising dollars are spent5. This international growth is where we

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think digital advertisers can do a better job at monetizing user data to make each user more valuable.

Political Advertisement

Political advertisers are expected to spend about $10 billion on their campaigns in 2020. This is a 57% increase over the last primary election in 20167. We believe much of that will be used through digital mediums to target as many potential supporters as possible. It is also an effective strategy to connect with young voters.

Historically a lot of political advertisements are broadcasted through television. We believe this year a larger percentage than expected will be used on social media and other digital platforms. According to Facebook, 85% of US presidential campaign advertisements have targets to reach at least 250,000 Americans8. We believe Facebook is the best platform for campaigns to use and that they will gravitate towards it with their campaign dollars. Facebook has recently come under social pressure for refusing to fact check political ads which does have social repercussions, but it should help them grow political advertising revenue.

Other platforms have taken a tougher stance on the issue with Twitter banning all individual campaigning advertisements and Google deciding to restrict some content as well. In a cut and dry political system we do think these platforms should do their best to stop the spread of political misinformation, but it's not that easy. Mark Zuckerberg says they do not feel comfortable being responsible for interpreting the first amendment and therefore they are leaving it up to users to decide if content is credible on their own. Facebook has taken this stance as it does not want to open itself up to potential lawsuits.

Increasing User Screen Time

In recent years we have seen a dramatic transition of user's eyes from the T.V. to their phones. This is a proponent of growth within the digital advertising space. Online platforms are in a competitive battle with T.V. content for views, and as far as time spent is concerned, mobile platforms are winning. We believe this transition is especially noteworthy as most of non-digital advertising is spent through television.

Source: eMarketer

As expected, advertising dollars are transitioning with the users to be spent more on mobile, rather than traditional mediums, such as T.V. This is another positive for digital advertisers who can keep the attention of their users longer. Even as companies like Apple and Google have introduced tools to help users become more aware of their time spent on mobile, with aim of helping users limit their own usage. No real change has been seen in the user population.

International Growth

While the North American and European markets have become saturated, growth will need to stem from emerging markets. In 2019 digital advertisement accounted for 51.45% of global ad spending and it is expected to increase to 54.4% in 2020. After 2020 it is expected to increase at 2% each year5.This is a driver for sustainable growth, but this prediction is not exponential as we would like to see in a fast-growing industry. We expect most of this international growth to occur in the Asia-Pacific region in the next five years.

RISKS FOR GROWTH

We believe there are two main risks for growth in the industry. One is tightening regulation from governments around the world on privacy laws and data collection practices. The other is potential hacks of the top company's social networks that could damage their reputation and eliminate users.

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