The Henry Fund Henry B. Tippie College of Business Cooper LaRue [[email protected]]

Digital February 12, 2020 Communication Services Industry Rating Market Weight Investment Thesis Key Industry Statistics

The industry of digital advertising has drastically changed in the last five years to Geographic Revenue % be dominated by a few main market holders. Alphabet, Amazon, Facebook, North America 39.7% Alibaba and Microsoft capture 82% market share, and we predict they will Asia-Pacific 30.8% continue to dominate. There is opportunity for these companies to become more European 25.3% profitable through developing more targeted and effective advertisements as Latin America 4.2% 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 Top Competitors the industry. Alphabet (GOOGL) $1.03T Amazon (AMZN) $1.07T Drivers of Thesis Facebook (FB) $590B  Progression in artificial intelligence, data collection methods and Microsoft (MSFT) $1.40T location-based advertising are making digital advertising cheaper and Alibaba (BABA) $610B more effective Advertising % of Total Revenue  Digital advertising is expected to increase by 17% in 2020 driven by Alphabet (GOOGL) 83% consumers spending more time on and less on T.V. Amazon (AMZN) 4% Facebook (FB) 98%  Digital advertisement is expected to be 54.4% of total advertising Microsoft (MSFT) 12% expenses by 2020, paving the way for the industry dominants such as Alibaba (BABA) 53% Facebook, Google and Alibaba to capitalize

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

Yahoo Finance 12 Month Performance Industry Description

GOOG FB MSFT AMZN S&P 500 60% Digital advertising targets consumers through online platforms to provide a 50% quicker, cheaper and more targeted way at 40% content to potential consumers. 30% It is predominantly done through social 20% media, search engine optimization, email, 10% video and banner advertisements. The 0% industry is dominated by a handful of leading giants who compete for -10% market share. F M A M J J A S O N D J

Yahoo Finance Important disclosures appear on the last page of this report.

EXECUTIVE SUMMARY top three company’s platforms. Google, Facebook and Amazon capture 70% of all digital ad spending in the U.S. The digital marketing industry has done very well over the which is a very high concentration for any industry. This past few years and continues to show strong growth in oligopoly has been very beneficial for these three giants, mobile, search and cross platform advertising. The but they are also facing continuous headwinds from industry is dominated by Google, Facebook and Alibaba, regulators. Concerns of privacy and the data these and to a lesser extent Amazon and Microsoft. These platforms collect, which in turn makes their advertisement companies track users’ demographic, behavioral and platforms so effective, is constantly under fire by the for location-based data to effectively target ads through their violating privacy laws and we believe this will continue for platforms which has been very successful in years past and the foreseeable future. Below is a graph showing the is expected to continue at a slowing growth rate. Much of digital advertising forecast in the U.S. until 2023. This the U.S. markets are saturated and we believe these implies a 4-year CAGR of 11.7%. companies will need to look abroad, specifically in the Asia-Pacific region for advertisement growth.

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 Source: Statista potential data breaches that could cause a slowdown in user growth. Companies in digital advertising thrive on the TARGETED SPENDING ability to use data to pinpoint potential customers for their advertisers. We believe this will become increasingly more Throughout the entirety of marketing history, companies difficult as regulators catch up to the wild west of data have tried to make advertisements more effective through sourcing and search for more transparency in the industry. personalization. The industry is continuing to make developments on targeting consumers through We believe these positives and negatives neutralize each demographic, behavioral and location-based other and therefore recommend a market weight rating on advertisements. As the industry matures in developed the industry. counties like the U.S., companies like Alphabet, Facebook, INDUSTRY DESCRIPTION Microsoft and Amazon have developed more effective methods to target consumers that are more personalized As more of our daily lives are spent looking at screens, than ever. advertisers also adjust their marketing dollars accordingly. Spending in digital advertising grew to $129.34 billion in Location Based Marketing 2019 and is expected to grow by 17% in 20204. This is One of the newest and still transforming advertising fueled by the transition of advertisers from traditional methods is using consumers’ locations to provide them delivery methods such as T.V. and physical ads to digital. with local deals or suggest items others in their area have This switch is the fuel that can keep the digital advertising used. As locational data has become easier for companies industry growing by 10%-15% CAGR for the next 3 years. to obtain it has allowed companies to more effectively We expect this growth to continue to be in the low double personalize ads to one’s preferences. For example, Coca- digits YOY which is a slowing rate from previous years. Cola uses artificial intelligence to understand how its Within the digital marketing industry, a majority of all brand and products are being interacted with on social advertisements are spent to place advertisements on the 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 their subset customer within that criteria using other platforms like Facebook, Twitter and Instagram and then methods. Today this tactic is most common among email uses those platforms to display advertisements1. advertisers which is part of digital advertisement segment, but not how the industry leaders produce revenue. Location based marketing is the fastest growing method of targeting consumers. Behavioral marketing has historically DIGITAL TRENDS been more common, but we are seeing that quickly change. Below is graph showing the estimated outlook of The most industry transforming aspect of digital spending towards location-based advertisements. This advertisements is how companies are targeting their forecast suggests a 3-year forward CAGR of 13.45%. 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

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 Source: eMarketer consumers spend more time on their mobile devices the Behavioral Marketing advertising spending also shifts. In 2021 advertisers are expected to spend 50% of all advertisement budgets 5 Behavioral marketing tracks consumers’ interests and through digital mobile mediums . Below is a graph preferences through how they interact with the . showing the change in advertisement dollars to be spent Most commonly this information is collected through on mobile vs. desktop. 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. 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 Source: Statista noteworthy prospects. Demographics are a good place for many advertisers to start but then they need to identify

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Social Media Spending Spending on search targeted advertisements is declining YOY with 2019 down 4%. However, it is still expected to Companies are becoming more active on social media grow by 11.7% in 20205. We believe this slow in growth is every year. It is a great way for them to continuously due to the maturing market of search and companies will connect with their current customers and a way to reach need to come up with more effective ways to get users out to potential ones. Advertisement spending on social attention in order to drive this advertisement revenue media platforms reflects this. In 2019, advertisement back up. spending was up 26.5% YOY to $35.67 billion. Within this social media spending, 94% of it was through mobile5. Cross-Channel Coordination Below is a graph shows Blomberg’s outlook pertaining social media spending. The implied 4-year CAGR for mobile Where we believe the competition is separated in the spending is 11.6%. 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 Social Media Spending Outlook (In Millions) better at recognizing what users are looking at on one $70,000 platform and then able to target advertisements for $60,000 similar products/services on other platforms. We believe a $50,000 company like Facebook who owns multiple social platforms is positioned to do well in this advertisement $40,000 dimension. Facebook can see what users are viewing on $30,000 Facebook and then use that data to target them with $20,000 advertisements on Instagram. Similarly, Google can do this $10,000 with YouTube. We believe this gives these companies an $0 advantage in the space over other social platforms like 2016 2017 2018 2019 2020 2021 2022 2023 2024 Twitter or Microsoft who just have one main social platform. Desktop Mobile CUSTOMER GROWTH Source: Bloomberg As companies do better in a growing economy, we expect As desktop spending declines, mobile is expected to grow them to continue to spend a large amount of their by double digits YOY. Spending on social media marketing budgets on digital advertising. Especially represented 27.8% of all digital advertisement spending running advertisements through Facebook, Google, which is the second largest category behind search5. Amazon and other traffic heavy platforms. Search Advertisement The main cyclical event which impacts the industry in 2020 is the U.S. presidential election. In election years billions of Search advertising is when companies pay to have their dollars are spent through a wide range of mediums and brand promoted through a search engine, so it gets more digital platforms will account for a large percentage of visibility to users. It is considered a pull method of that. While companies like Facebook and Google do not marketing in that it tries to make the user feel like it is not break out political revenue data for us, it is estimated that a paid advertisement. Instead, just a helpful link regarding $1.6 billion dollars will be spent on digital video alone11. their search. This has become more popular as the old To a more fundamental point, we continue to see average ways of banner ads and pop-up windows have become less daily screen time increase around the world which in turn effective. Search advertisement represents 48.3% of all leads to more opportunity for digital advertisers to run digital advertising and is expected to slowly increase its ads. We see daily average screen time increase in the U.S. market share. This way of advertisement targeting is and around the world where 52% of global advertising dominated by Google as 92% of global searches are done 5 through Google’s search engine6. dollars are spent . 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 . 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 Source: eMarketer targets to reach at least 250,000 Americans8. We believe Facebook is the best platform for campaigns to use and As expected, advertising dollars are transitioning with the that they will gravitate towards it with their campaign users to be spent more on mobile, rather than traditional dollars. Facebook has recently come under social pressure mediums, such as T.V. This is another positive for digital for refusing to fact check political ads which does have advertisers who can keep the attention of their users social repercussions, but it should help them grow political longer. Even as companies like Apple and Google have advertising revenue. introduced tools to help users become more aware of their time spent on mobile, with aim of helping users limit their Other platforms have taken a tougher stance on the issue own usage. No real change has been seen in the user with Twitter banning all individual campaigning population. advertisements and Google deciding to restrict some content as well. In a cut and dry political system we do International Growth think these platforms should do their best to stop the spread of political misinformation, but it’s not that easy. While the North American and European markets have Mark Zuckerberg says they do not feel comfortable being become saturated, growth will need to stem from responsible for interpreting the first amendment and emerging markets. In 2019 digital advertisement therefore they are leaving it up to users to decide if accounted for 51.45% of global ad spending and it is content is credible on their own. Facebook has taken this expected to increase to 54.4% in 2020. After 2020 it is stance as it does not want to open itself up to potential expected to increase at 2% each year5.This is a driver for lawsuits. sustainable growth, but this prediction is not exponential as we would like to see in a fast-growing industry. We Increasing User Screen Time expect most of this international growth to occur in the Asia-Pacific region in the next five years. In recent years we have seen a dramatic transition of user’s eyes from the T.V. to their phones. This is a RISKS FOR GROWTH proponent of growth within the digital advertising space. Online platforms are in a competitive battle with T.V. We believe there are two main risks for growth in the content for views, and as far as time spent is concerned, industry. One is tightening regulation from governments mobile platforms are winning. We believe this transition is around the world on privacy laws and data collection especially noteworthy as most of non-digital advertising is practices. The other is potential hacks of the top spent through television. company’s social networks that could damage their reputation and eliminate users.

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Regulation Regulation in the digital advertising industry is currently Cyber Hacking fairly limited as governments for one, don’t fully understand how companies like Facebook, Google, Any company that is collecting and storing private user Amazon and others collect and use personal data. Also, the data will have hackers attempting to obtain that data. industry is changing so fast it is hard for the government While this is most common among medical networks, to keep up with these companies. Companies are moving companies who create revenue through digital advertising forward with projects and methods that have not been are also susceptible. We fear that a large-scale theft of brought to the attention of regulators yet and therefore information to a platform like Amazon, Facebook or are not illegal but are a concern for many users. In the U.S. Google will damage their reputation and stunt growth. We federal government there has not been a major change in think this is unlikely though, as we think most people have digital legislation since the Children’s Online Privacy Act in become desensitized to data breaches. Many people 2012 which protects children’s data who are under 13. assume these companies such as Facebook, Google, and However, there have been some state restrictions on Amazon already know everything about them anyway and social media companies pertaining to collecting user do not worry much about it. data. States such as California and Illinois have passed state regulation to protect their residents. MARKETS AND COMPETITION

The digital advertising industry faces heavy competition The California Consumer Privacy Act which went into from its main players which are Facebook, Google, effect January 1, 2020 hopes to create more transparency Amazon, Microsoft and Alibaba. These companies account between users and the platforms they interact with. It for 82.4% of global digital advertisement revenue and requires platforms to ask users permission to use their those top companies are expected to gain an even higher data and requires that companies immediately report any percentage of market share going forward. In this industry data breach of their system, no matter how small12. This the network effect is these companies’ biggest asset. It is California law effectively also applies to all states as these very difficult for a new competitor to get enough users and companies have adjusted their platforms to comply with collect enough data to make their internal digital California, therefore they are the same in all states. advertising business better than the current dominators.

Facebook for example has recently been in the hot seat for Below is an infographic showing the relative breakdown of selling private information to Cambridge Analytica revenue across the top ten companies. Other global digital resulting in a $5 billion fine to Facebook. This was by far advertisers include Baidu and Tencent but I have decided the largest fine ever imposed on a company by the Federal not to include them as direct competitors because those Trade Commission. Facebook may still not be out of the two companies derive most their revenue from China. woods when it comes to its knowledge of private Facebook does not compete in China because Facebook information. In January, Facebook also settled to pay $550 and Instagram are illegal there. Alibaba also derives most million dollars to the state of Illinois for breaching of its revenue from China but we believe Alibaba is best biometric privacy laws. Lawsuits have become somewhat positioned to pose a threat to U.S. companies as they have normalized as most social media companies are frequently some U.S. customers and they are much larger than Baidu involved in them. We think this will push legislators to and more diversified than Tencent. make more radical policies in the future to protect user data.

Internationally, the European Union has much stricter laws which makes it harder for digital advertisement companies to collect and make money off user data. The EU has somewhat been ahead of the U.S. in this sense and we expect the U.S. to follow suit soon.

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dependent on advertising revenue compared to their peers.

Percentage of Company Revenue from Advertiseing 98% 100% 83% 80% 60% 53% 40% 20% 12% 4% 0% FB GOOGL AMZN MSFT BABA

Sources: 18-21 in references

While we do believe Amazon and Microsoft will perform well in the future, it will not be due to taking advertising revenue from Facebook and Google. Advertising revenue is a relatively very small part of both Amazon’s and Source: eMarketer Microsoft’s revenue and they do not have the social platforms to be able to reach as many people on a In U.S. markets we predict the big four; Google, Facebook, consistent basis as Facebook. Microsoft owns LinkedIn, Amazon and Microsoft will continue to slowly eat away at which is becoming increasingly popular, but we believe their smaller competition slowly. Advertisement revenue they will continue to keep that platform as more of a as a whole is slowly transitioning towards online and we professional medium. Cluttering it with advertisements will see these additional dollars predominately go to these would change the feel of it drastically. Microsoft also owns four companies. Within those four we believe Google and the search engine Bing which executes a very small Facebook will continue to grow at a faster rate than percentage of global searches but was up 16% in 201913. Amazon and Microsoft. Below you can see the regional breakdown for each of the peers in this industry. We see Facebook as the market dominator in social media as they are able to use both Facebook and Instagram to market cross platform to consumers. This is very attractive Revenue by Region for companies looking to advertise on social platforms. 100% Facebook is also well position to collect substantial 80% amount of data on its users and monetize what brands users are interacting with the most. 60% 40% Peer Comparisons 20% We have identified the four main competitors to compare 0% FB GOOGL AMZN MSFT BABA positioning and valuation in the market. In the digital advertising space, we believe Facebook and Google are North America Europe Asia Other best positioned to continue to dominate the space. Google is poised to do very well in search and Facebook is poised Sources: 18-21 in references to do well on its social media platforms. In the chart below you can see how Facebook and Google are also heavily Relative valuations are heavily based on common valuation rations. When looking at these companies

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forward P/E you can see that Facebook is slightly Going forward we believe GDP will stay roughly constant underpriced compared to its competitors. We believe this at 2.35% in 2020 supported by historically low is because its competitors have divisions other than digital unemployment, low inflation, strong consumer confidence advertising that analysts are projecting to grow at a faster and market friendly monetary policy. This constant GDP rate. We think Facebook is slightly underpriced based on growth will drive the digital advertisement industry to this comparison but in the technology/communications perform well in the U.S. where 40% of all digital sectors, there is generally a wide variance in company’s advertisement dollars are spent5. valuation ratios. Inflation Market Cap Forward EV/EBIT Profit Ticker (billion) P/E DA Margin Inflation has been slowly creeping up sense 2015 as low FB 599 19.26 18.680 26.15% rates and an increased money supply have people GOOGL 1020 23.69 19.050 21.22% spending more. In 2019 average inflation came in at 2.3% which is in line with the feds target10. We believe this will AMZN 1040 52.14 29.450 4.13% increase to 2.4% in 2020 as companies struggling to find MSFT 1360 28.35 21.400 33.02% qualified workers will raise wages to attract talent. This is BABA 580 31.22 28.100 35.21% bad for these technology companies who generally must Source: FactSet pay high wages for qualified workers and most of them are headquartered in large cities where the cost of living is ECONOMIC OUTLOOK high. The advertising industry’s success strongly correlates to Consumer Confidence how the country is doing as a whole. When consumers have money to spend advertisers target those consumers We believe consumer confidence is one of the top and those lead to a growing economy. If people are indicators to watch in relation to how the digital not spending, companies have less money to advertise and advertising industry will do in 2020. Companies spend the industry will also slow. more money on advertising through Facebook, Google, ect. when consumer confidence is high to drive sales in GDP Outlook optimistic times. If this outlook changes and people stop spending as much, companies will also cut back their In the US we have experienced steady GDP growth over spending on advertisements. the last few years and we expect that to continue into 2020. In 2019 U.S. GDP grew 2.33% which was a slight 2019 consumer confidence held near all-time highs and we slowdown from 2018’s 2.93%9. Below is a chart showing do not expect this to continue. Heading into the election the annual GDP growth rates going back to 2015. we expect consumer confidence to decrease back historical averages. While we do not see this to have a major impact on GDP or the digital advertising industry in 2020, we do think it a leading indicator for a potential downturn in 2021. INDUSTRY POSITIVES

 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 Source: FRED social media and less on T.V.

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IMPORTANT DISCLAIMER  Digital advertisement is expected to be 54.4% of total advertising expenses by 2020, paving the way for the Henry Fund reports are created by graduate students enrolled in the Applied Securities program at industry dominates such as Facebook, Google and the of Iowa’s Tippie College of Business. These Amazon to capitalize reports provide potential employers and other interested parties an example of the analytical skills, investment INDUSTRY NEGATIVES knowledge, and communication abilities of our students. Henry Fund analysts are not registered investment  Changes in the regulatory environment could hinder advisors, brokers or officially licensed financial companies’ ability to collect useful customer data professionals. The investment opinion contained in this resulting in less effective advertisement targeting report does not represent an offer or solicitation to buy or campaigns sell any of the mentioned securities. Unless otherwise noted, facts and figures included in this report are from  The U.S. market is maturing and seeing slowing year publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. over year growth. We predict 8% revenue growth in From time to time, the University of Iowa, its faculty, staff, 2020 for the digital advertisement industry students, or the Henry Fund may hold an investment position in the companies mentioned in this report. KEYS TO MONITOR

Within the industry the growth rates of the U.S., European and Asia Pacific markets are most important to look at. With slowing growth in the U.S., we believe the potential for growth abroad is what is driving the stock today. If this optimism fades, we think the industry will plateau.

Other key influencers to look out for are changing regulations that could fundamentally impact how digital advertisers make money. This especially pertains to Facebook and Google as they have been most consistently under scrutiny for these types of lawsuits. REFERENCES

1. AI News: How Coca-Cola Uses AI to Stay Ahead 2. Marketing Land: Advertisement 3. eMarketer: Time Spent with Mobile 4. Statista: Digital Advertising Spending 5. Blomberg 6. HubSpot: Google Search Statistics 7. Wall Street Journal: Political Ad Spending 8. Facebook 10k 9. FRED 10. The Balance: GDP Growth 11. Politico 12. Forbes: How Privacy Laws are Changing 13. Microsoft 10k

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