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The Henry Fund

Henry B. Tippie School College of Business

Matt Hubbell [matthew-hubbell@uiowa.edu]

Digital Advertising Industry February 6, 2019

Communication Services Industry Rating Overweight

Investment Thesis Key Industry Statistics Digital advertising is a growing industry. Google and Facebook hold the most market share. Other companies such as Twitter, Amazon, and Microsoft are also competing in the industry. All companies are finding ways to customize their advertisements to potential consumers, which in turn leads to high growth opportunities. There has also been an increase in the number of users on their smartphones each day, which leads for opportunities for more mobile advertising. For this reason, we recommend an overweight position. Drivers of Thesis

We expect to see growth in the industry because we expect to see a growth of 7% of internet users’ year-over-year.

Technology on how to collect data is expected to increase, therefore consumers will find digital advertising more appealing.

Companies in the industry can make their advertisement appealing on mobile devices.

Risks to Thesis

There has been an increase in awareness on how companies collect data on consumers. Therefore, government regulation could hinder the way companies collect data.

Cyber hacking has been an increasing concern in the industry because hackers see value in consumer data. Thus, an increase in cyber hacking could hinder the growth in the industry.

Market Cap (In $ Billions) Facebook (FB) Alphabet (GOOG) Twitter (TWTR) Amazon (AMZN) Microsoft (MSFT)

507.49 766.06

25.24 829.38 826.94

Industry Ratios Price /Earnings EV/EBITDA EBITDA/Sales

41.11x 20.94x 32%

EBIT Margin Gross Margin ROE

19.1% 54.8% 31.7%

Source: FactSet

12 Month Performance Industry Description

The digital advertising industry is a form of advertising that uses the internet to reach their desired consumers. The industry includes email marketing, display advertising, search engine marketing, social media, and mobile advertising. Some companies have digital advertising as their main source of revenue while it is only one source of revenue for others.

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EXECUTIVE SUMMARY

The digital advertising industry is taking off due to the increased use of the internet and the increased use of mobile advertisements. Companies in the industry are also looking at ways to collect more data from their consumers. For these reasons, we recommend an overweight position for the industry.

We believe the digital advertising industry can continue the strong growth leveraging the increase in demand from retailers, financial services and automobile industry. With these strong relationships moving forward, it makes the industry poised to continue growth.

Companies like Google and Facebook hold the most market share in the industry. Their success can be attributed to their ability to track users and their ability to have their marketing seen on mobile applications. However, companies like Microsoft and Amazon see growth in the industry and are looking to increase their market share. These two players can do so because of applications they have on mobile devices.

The industry is facing risks with how they collect data. The European Union (EU) has strong rules how to collect the data of internet users. The United States could implement these strict rules in the future. This potential regulation could hinder the growth of the companies.

We are optimistic about this industry. We believe the positives outweigh the negatives. This view leads us to the overweight recommendation in the digital advertising industry.

INDUSTRY DESCRIPTION

There has been an increase in the users of the internet over the last 5 years. Therefore, digital advertising has become one of the most popular forms of advertising. The number of internet users in 2018 is 4.021 billion, which is up 7% year-on-year1. The spending on digital advertising has increased because of this opportunity to reach more potential consumers. Google, Facebook, Twitter, Amazon, and Microsoft are the main players in the industry. More companies are now spending on digital advertising. On the next column is a breakdown of spending on various types of digital advertising.

Source: Statista

Search Advertising

Search (pay-per- click) advertising is commonly seen on search engines such as Google. Verizon owns Yahoo and AOL which also competes in search advertising. Google remains on top of search engines accounting for 87% of all internet searches2. However, Google has seen an increase in their Traffic acquisitions Costs (TAC)3.Google has seen an increase in TAC as percentage of revenue. For example, Google claims their TAC increased from 21.2% in 2016 to 22.7% in 20173. This increase in costs could make it more expensive for Google to have effective advertisements.

Search advertising was once the main source of digital advertising on the internet. However, recently it has not been as popular. They can be inefficient for many reasons. First, small businesses stay away from these advertisements because competition for keywords has increased over the years. Furthermore, only 10% of internet users click on the ads4. Therefore, there has been a change for internet advertisers to spend money on display advertisements because of the increase of the chance of potential customers seeing the advertisement. On the top of the next page shows a switch from using display advertisement.

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Source: eMarketer

There has been a CAGR of 3% of spending in display advertisement20. We believe this trend will continue because internet users find these advertising more appealing.

Display Advertisement

There has been an increase in the amount of display advertisement globally on the internet. Companies find it effective because it will ensure the chance of an individual reading the advertisement. Display advertisement is expected to have an annual growth rate of 13% from 2017 through 20205. This type of advertisement can be effective on social media websites. We believe display advertisement will remain effective because internet users causally scrolling on the internet have a high chance of seeing the advertisement.

Native advertisement, which is advertisement that tries to blend in, has been a popular trend in the digital advertising industry. From 2016 to 2017 there was an increase of 50% spending on native advertisement, and a 31% increase of spending on the advertisements in 20186. However, the high growth in native ads are projected to slow down in the next couple years. Projections show marketers will not be able to increase the budget for native ads as they had in the last few years, which could potentially harm social media companies, where native advertisement is

common. We believe that native advertisement will remain prevalent because internet users do not like obnoxious advertisements.

Mobile Advertising

Americans spend about 5 hours a day on their smart phones, which in turn leads to a great opportunity for digital marketers to reach their potential customer base. In 2017, mobile advertising accounted for 70% of digital advertisements7. Marketers are now able to reach 60% of their potential customer base on mobile devices6. Furthermore, the advertisement blocking technology on smartphones is less common on smartphones compared to desktops, which is another appealing aspect for mobile advertisements. Studies show 17.7% of laptop users have an advertisement blocking technology on them, where smartphones have around 9.6% of ad blocking technology on installed on the phone8.

Mobile advertisement is also one of the most effective advertisement because 58% of users can recall advertisements on smartphones8. This ability to reach potential customers shows why revenue has increased from mobile advertisement.

Source: Statista

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The graph on the last page shows how there is an increase in revenue for mobile advertisement relative to desktop advertisements. From 2018 and further on, the mobile revenue surpasses desktop advertisement. Mobile advertisement has a CAGR of 6.23%20. Therefore, the main companies in the digital advertising industry are trying to take advantage of the increase in mobile revenue.

Google is projected to have 33.8% of the market share of mobile advertisement and Facebook is going to have 26.5% of the market share in 2019. One major reason Google and Facebook can continue their dominance in the digital advertising industry is because of their ability to transition their advertising to mobile advertising. Below, attached a breakdown of company revenues by mobile shares.

Source: eMarketer

Video Advertising

Video advertising is also a common way for advertisers to reach their attended audience. Studies show 72% of internet traffic is video based content9. The high traffic on videos and can be an effective way to reach customers. Digital advertisers have been spending more money on video advertising year after year.

YouTube is one of the main websites where video advertisements are the most prevalent. The key for the video advertisements are to have a click on the video. The click through rate (CTR) on YouTube is 1.84%9. Advertisements with a length less than 15 seconds will be

interacted with 2.2% of the time, 30 seconds 2.5%, and more than 30 seconds 1.3%9. These statistics show the most effective advertisements are the ones that around 30 seconds9. We believe video advertisement can be more effective if the video is an outstream video because consumers do not like to be forced to watch an advertisement.

MARKETS AND COMPETITION

The digital advertising industry varies on what websites advertisement can be seen on. Social media websites, search engines, and videos are the most common place to see advertisement. The main competitors in the industry are: Google, Facebook, Amazon, Microsoft, and Twitter. These companies differ in the fact that some companies in the industry main source of revenue is digital advertising while others have other capabilities. Facebook makes approximately 97% of their revenue from adverting and Google makes 86% of their revenue from digital advertising3, 14. On the other hand, Amazon and Microsoft earn revenue from selling other products. Google and Facebook combined have 56.8% of the market share. This market share includes mobile and desktop advertising. We expect both companies to be the strongest players in the future. However, their market share could decline because of the increase of spending Amazon and Microsoft could put towards digital advertising. Below is a graph of the market share in the industry.

Source: Market Realist

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Peer Comparison

We have compared companies this industry on many different metrics, first we have compared them using different profitability ratios. We have attached a chart below comparing ROE, ROA, and Net Margin.

Source: FactSet

Facebook has the highest ROA and the highest Net Margin. Microsoft has the smallest ROE. We believe moving forward Google and Facebook are best positioned because of their market share in the industry. We have not seen a trend that will break up their strong market share.

Below we have attached a graph showing the operating margins for the companies.

Source: FactSet

We notice these margins differ depending on if the company has more capabilities. However, Facebook and Twitter are good comparable companies because of limited capabilities outside of digital advertising. We believe Facebook will continue to have stronger margins then Twitter because Facebook’s continued growth of Monthly Active Users.

Amazon has seem an increase in their operating margins. However, we are still bearish on their ability to continue to grow market share in the digital advertising industry. We believe Amazon has to make significant changes to their Amazon prime application to stay competitive. There is an older population that prefers the desktop version because this version shows better comparable products. We believe this change needs to be made for Amazon to continue their growth in the industry.

Cost of Advertising

The cost of advertising differs for the companies in the industry. Therefore, it is useful to look at the TAC for companies in the industry. There is a difference in costs for companies whose main revenue source is digital revenue compared to companies with other capabilities.

Google, Facebook, and Twitter are comparable because digital advertising is the main source of revenue. Facebook over the last 3 years have had an average TAC of revenue to be 14.33%14. Google has had an average of 19.09%3, and Twitter’s 3-year average is 35.00%15. We believe this high cost of TAC for Twitter is because of declining advertisement earnings that fell 4.9% in 201815.

Microsoft and Amazon are comparable because they have other capabilities because outside of digital advertising. Microsoft had an average TAC of revenue over the last three years of 16.00%16. Amazon’s three-year average is 7.59%1 . Below is a graph showing how Amazon is expected to increase their market share in digital advertising.

Source: Emarketer

ROA ROE Net Margin

Facebook 24.30% 27.90% 39.60%

Twitter 13.70% 20.30% 39.60%

Microsoft 13.00% 39.30% 28.40%

Google 14.30% 18.60% 22.40%

Amazon 6.90% 28.30% 4.30%

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2014 2015 2016 2017 2018

Operating Margin

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Growth expectations

Digital advertising has benefited from the increase demand from retail, financial services, and automotive industries. Since 2013, the industry grew at annualized rate of 14.4%, which included a 6.6% jump in 201818. More potential customers want to advertise to websites that can market to a niche market.

Companies will be able to expand their ability to develop more in-depth tools to improve the growth in the industry. For example, they can create new data mining techniques, and applications to analyze consumer behavior. The forecast for annualized revenue is supposed to increase at a rate of 4.7% over the five years to 202318. We expect the capabilities of these companies to expand. Below we have attached is a graph to show how there will be an increase in spending in the industry.

Source: Statista

We have found display advertisement to have a CAGR of 14.07%20. We are bullish that this spending will continue during the next five years.

Barriers to entry

The success of Google and Facebook can be attributed to the use of mobile advertising. Furthermore, the use of their mobile applications. Google owns YouTube, Google Search, Google Maps, and the Chrome browser. Facebook has the Facebook app, Instagram, and Facebook Messenger. Therefore, if companies do not have capabilities to make applications it would be hard for them to have significant market share in the industry.

There has been an increase in advertising targeting their potential audience. Google’s search engine tracks users by the queries in the search engine. Facebook tracks the user by given information such as: age, gender, and location. Therefore, companies that do not have search aspects to them or given information makes it harder for them to gain advertisement revenue. We believe social media websites and search engines have chances to grow because of their ability to track the user.

Industry Trends

There are trends in the digital advertising industry that will be prevalent throughout 2019 and beyond that will change the industry. Consumers are increasingly turning to the internet throughout the day, therefore the industry is adapting to the more traffic on the internet.

Content Marketing

Content marketing is becoming the most popular trend on how to advertise in the digital marketing industry. Content marketing tracks users and ensures everyone’s advertising experience is unique to that individual. Facebook is known to have a personalized advertising campaign. This strategy is done by management collecting data on each user from interaction with customer and the company. This process is called the learning relationship11. There is high emphasis on the learning relationship for marketers in the industry.

Studies show 97% of marketers agree that personalization is one of the main keys of success in the industry12. Therefore, a majority of spending is on content marketing. We believe that the process of tracking the data for the consumer will only increase in the United States.

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Location-based advertising

Mobile advertising is becoming more popular because of the increase use of smartphones. Mobile devices have made it easier to track consumers than ever before. Mobile devices have GPS and geo-targeted features that can pinpoint the location of the consumer. Below shows how there has been in increase in location-based advertising in the digital advertising industry. In 2016 smartphone location targeted advertisements was 38% and projected to be 45% in 2021. Below, we have attached a graph showing the increase in digital advertising.

Source: BIA/Kelsey

The digital marketing tactics that use location-based tracking are app push notifications and text messaging12. The way these factors track location is the user doing such activities like making purchases or interacting with other data online. In 2019, we expect digital marketers to continue to utilize smartphone capabilities. We also expect that companies will be active having their advertisement be prevalent on smartphones.

Outstream video advertising

There has been a popular trend of Outstream video advertisements. Video advertising is projected to be a major type of advertising technique in 2019. However, the traditional advertisement before a video on the internet can seem annoying for consumers. Therefore, there has been an increasing number of marketers going towards outstream video advertisements. Outstream video advertising is a video shown on a page while there is no intention of the consumer to watch a video. For example, while reading an article online a video can pop up in the middle of it and play. Sound will not be played in the

advertisement unless the user clicks on the advertisement. This tactic makes the advertisement experience less annoying for the consumer. Research shows that more Americans dislike advertisements before a video more than advertisement on a website.

Risks for Growth

The increase of potential regulation looms over business that are strong players in the digital advertising industry. The uncertainty of cyber hacking can also hinder the growth in the industry.

Regulation

The increase in potential government regulation is a risk in the industry. It is possible that countries could try to censor content on Facebook and Google, which would decrease the demand for industry. For example, user access to Facebook is currently restricted to in whole or part in China, Iran, and North Korea14.

Google was recently fined $57M by France for breaking the European Union’s strict data privacy rules. Google did not disclose to all of their users how they collected all of their data. New strict data collection laws could be coming to the United States. Apple CEO Tim Cook said he expects to see these data collection laws to come to the United States. However, we believe these stricter data privacy laws will not come into effect for at least 2 years. The Trump administration tends to not put regulation on business. Therefore, it is likely these laws could come into effect depending on the outcome of the 2020 presidential election.

We view this increase in regulation as the biggest threat to companies in this industry. This regulation could increase the cost of advertising to ensure companies comply with these regulation. The Trump administration has not shown much interest in topic, However with the upcoming 2020 election could lead to an administration change which could lead to cha

Cyber Hacking

There has been an increase awareness of potential cyber hacking that can happen in companies that have use online advertising. This has become more popular because the cyber hacks occur on companies that have a lot of personal

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data of their users. For example, in December 2016, Twitter got hacked into which lead to incorrect reporting of video advertising metrics for an entire month.15 Thus, any bugs that get into systems could make companies resistant to advertise with the company in the future.

In the United States, cyber hacking is still considered a grey area because a lot of information is still unknown. We believe laws to understand more about cyber hacking will not be funded by the government anytime soon. We believe this idea because the Trump administration is looking to fund other projects.

Economic Outlook

The current state of the economy has an impact on the digital advertising industry. The consumer confidence and goods being produced impacts if companies want to spend on digital advertising. The industry moves with the economy.

Gross Domestic Product

The current GDP in the United States is at 3.4%.We believe that GDP will increase in the United States. When there is an increase in GDP there is a higher chance that there will be an increase in the industry as a whole. Below we have attached a graph of the United States GDP.

Source: U.S Bureau of Economic Analysis

Digital advertising relies heavily on the ability that goods will be produced and therefore have to be marketed. Products that have slowed in the process because of the government shutdown may have prolonged the process, which in turn could potentially lead to companies lead to delaying the use digital advertising to market their product.

Consumer Confidence

In the short term, we expect consumer confidence to decrease because of the partial government shutdown that has recently ended. There is still uncertainty regarding if the government will shut down again in the future. 800,000 employees were going without their paychecks because of the partial government shutdown, which in turn hurts morale. If the government could shut down in the future, people would be less likely to interact with advertisements which would decrease demand in the industry. Below is a graph that shows how consumer confidence is decreasing recently.

Source: Conference Board

Since 2010, there has been an increase in the consumer confidence in the United States. Consumer confidence influences the digital advertising industry because most companies in the industry have short term contracts with consumers. If confidence is low, this result may lead to less advertising revenue.

Exchange Rates

Companies in this industry have their advertising shown across the world. Therefore companies are exposed to exchange rate risk. For example, Facebook makes 54% of their revenue outside of the United States14. A strong US dollar could lead to a decrease in revenue for Facebook. However, these companies could particpate in hedging to minimize exhange rate risk. Facebook and Google have been known to hedge their position to decrease their ability to exhange rate risk. We believe companies will

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contuine to hedge as the internet is becoming more popular around the world.

Source: Statista

The above graph shows the strength of the United States dollar over the previous 5 years. During 2017, there was a decrease in strength for the US dollar. However, in 2018 there was an increase in the strength of the US dollar. We believe the US dollar will keep getting stronger for the remainder of 2019. This view is due to England dealing with Brexit issues and other European countries facing government issues. Therefore, companies in this industry could lose money due to strengthening of the dollar.

INVESTMENT POSITIVES

• Increase in internet users leads to a higher chance of advertisers to have their ad seen, thus there is a higher demand in the industry.

• Mobile advertisement has increased, and companies are making advertisements friendlier for mobile devices.

• Expect for companies to increase tracking abilities to personalize advertisements.

INVESTMENT NEGATIVES

• The government could regulate the way companies can collect data which could lead to less effective content advertising.

• Cyber hacking has increased and companies could have their data breached would could lead to less demand in the industry.

REFERENCES

1.Wearesocial: Digital advertising 2.Motleyfool: Digital advertising 3.Alphabet 10-K 4.Vicimediainc: Search no longer king 5. Marketingcharts: Spending in digital advertising 6.WSJ: Native advertising growth projected to slow 7.V12data: 8. Statista: Digital-advertising 9.Invespcro: Online video advertising 10.Smartinsights: Digital advertising trends 11.Sciencedirect: Content marketing 12.Smartinsights: Digital advertising trends sky rocket 13.Insatastats: Digital advertising trends 14.Facebook 10-K 15. Twitter 10-K 16. Microsoft 10-K 17.Amazon 10-K 18.Ibisworld: Digital advertising industry. 19. FactSet 20. Statista

IMPORTANT DISCLAIMER

Henry Fund reports are created by students enrolled in the Applied Securities Management program at the University of Iowa’s Tippie College of Business. These reports provide potential employers and other interested parties an example of the analytical skills, investment knowledge, and communication abilities of our students. Henry Fund analysts are not registered investment advisors, brokers or officially licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any of the aforementioned securities. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold an investment position in the companies mentioned in this report.

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