Digital Advertising: The Runway is a LOT Longer than it Looks

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Tejas Raut Dessai

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September 17, 2018

Digital Advertising: The Runway is a LOT Longer than it Looks

Digital advertising is more than 43% of $634B in global measured media (MM) spending. Even with the likely absorption of the 32% of that spending now going to Linear TV, total MM ad spending has tracked the economy for 100+ years and many ask if digital could soon run out of runway. We think this will happen later rather than sooner. First, MM – TV, radio, print, outdoor and digital – is an incomplete metric for marketing spending. The TAM for digital ads, including events, sponsorships, couponing, in-store promotion, and many other categories, may be nearly double MM alone. Second, digital ads deliver an ROI that is often a magnitude better than other media, driven by microtargeting, and accurate response tracking. With evidence of effectiveness, advertisers spend more. Pay-per-click models with zero upfront costs are disrupting ad buying mechanisms, empowering small advertisers with the same tools used by the big buyers. This too expands the market for digital platforms. Lower value segments and under-advertised markets, often in emerging economies, may be greenfield opportunities made realistic by the new economics and reach of the digital economy. Given all this, we believe deceleration from the current 20% annual growth in digital ad spending is likely to be gradual, remaining comfortably into the double digits over the next five years and ahead of industry analyst projections. While privacy regulation and pressure will require margin-sapping investment, GOOGL and FB, the behemoths at the lead of the digital ad market, will be substantial beneficiaries. It will also help contenders like MSFT, TWTR, AMZN and possibly NFLX (if it opts to realize its potential as an ad platform).

  • Is digital advertising nearing the end of the runway? Digital platforms account for 43.8% of the $634B global measured media advertising market, growing their ad sales at a ~20% annual pace, with the mobile segment ($132B and growing 40% YoY) the biggest driver. Linear TV, another 32%, of measured spending, appears a ripe target for digital platforms, but there are concerns that the law of large numbers means internet advertising must soon slow. We are not so pessimistic.
  • Digital platforms address more than measured media advertising. Traditionally, analysts have defined the global ad market as the spending in a handful of easily measured buckets – TV, radio, print, outdoor, and in the modern era, digital. While convenient, measured media fails to include many categories of marketing and promotional spending (e.g. direct marketing, sponsorships, market research, PR, etc.) that are addressed by digital platforms. Indeed, Yellow Pages ads, decimated by Google Search, were not a part of the “measured media” metric. We estimate that these additional categories could increase the TAM for digital ads by 75% or more, leaving us much further from market saturation and the asymptotic approach to 3-4% annual growth.
  • The effectiveness of digital ads could spur greater spending. Digital platforms have clear and significant advantages over traditional advertising. Ads can be targeted at precise microsegments, down to individual consumers, and delivered in tightly defined context (e.g. specific queries, locations, times, content, etc.). User response to advertising can be registered through clicks, online behavior or increasingly, actual purchases. Advertising can by integrated with e-commerce through one-click buying. These advantages are increasingly measurable with effectiveness – GOOGL and FB tout ROIs a magnitude higher than traditional media – that could catalyze overall advertising spending growth.
  • Digital ads can serve new types of advertisers. Digital ad platforms utilize self-serve real-time auctions to sell ads, with the ability to scale from a few hundred clicks to multi-million-dollar campaigns. Local advertisers can start small, use in-app tools to evaluate effectiveness and facilitate one-click buying, and scale up as appropriate. These buyers may not have participated in measured media, which typically have higher budget thresholds and are more difficult to gauge for effectiveness, creating another catalyst to expand the addressable market.
  • Digital ads can reach under-advertised segments and markets. The effectiveness of digital ads and the reach of mobile platforms will allow advertisers to target consumer segments that might not be cost effective for traditional media. Serving isolated or economically depressed communities could add meaningful growth to the addressable market. The explosive growth of smartphones in emerging markets potentially presents an even larger opportunity. FB makes 10 times more revenue per user in the US and Canada than it does in Asia. Closing the gap, even slightly, would be enormously lucrative.
  • Digital ad platforms are improving their product. Despite the headwind of consumer privacy regulation in the EU and elsewhere, the top digital ad platforms are working to enhance targeting, to close the loop from ad impression to purchase, and to expand markets. GOOGL’s partnership with MC can map search queries and shipping data with POS transactions to provide proof of effectiveness. Similarly, FB has reportedly discussed a similar approach with card issuing banks and plans a one-click commerce platform to be integrated with Instagram. AMZNs PillPack acquisition gives it access to prescription information that it didn’t have before.
  • GOOGL and FB have deep moats. GOOGL and FB each reach 2B+ users across multiple franchises with extraordinary engagement. Each has developed precise targeting capabilities based on detailed user profiles. GOOGL, whose services (e.g. search, maps, etc.) are more closely tied to the data it collects, is better positioned vis a vis privacy regulation, and has a strong suite of emerging services (e.g. Shopping, Assistant, Waymo, etc.) with the potential to add to the reach and effectiveness of its ads. FB has built strong momentum with advertisers across its franchises and may finally crack the e-commerce code with a planned shopping service on Instagram. GOOGL and FB are negotiating deals to track ads through to purchases, a capability that would extend their already huge advantages over would-be rivals.
  • AMZN, MSFT, NFLX, TWTR benefit from focus. AMZN has the closest perspective on customer purchase decisions – brands can use the data to drive switching, sustain loyalty and offer product introductions. A Forrester survey showing top spenders keen on expanding their ad budgets for AMZN, and the company’s “Other” segment, which includes ad sales, jumped 132% YoY to $2.2B in 2Q18. MSFT’s LinkedIn is growing sales at 39% YoY with specific strength in B2B ads. TWTR remains an unchallenged platform for global news distribution, with unique targeting capabilities based on interests. NFLX, which has shunned advertising model until now, has proposed a potential ad driven tier and could reap serious benefits, especially in emerging markets where its traditional plans are pricey.

More Than Measured Media

The global advertising market is often represented by “measured media” spending, traditionally ad venues where the impressions could be reliably estimated, e.g. TV, radio, newspapers, magazines and outdoor displays. In recent years, digital advertising has been added to the metric, which many analysts use as a proxy for the total market. Against this definition, digital platforms now compose 43.8% of the $634B market and, given 20% annual growth for digital ad sales in an overall market that has stayed in a narrow low/mid-single digit band for over 100 years, it would seem fair to be concerned that the runway was growing short.

We are not yet worried. First, digital has only begun to metabolize the 32% of measured spending currently going to linear TV. That should be nourishment for a few more years of growth. At the same time, we believe the measured media metric obscures substantial opportunities to address marketing spending outside the traditional categories, such as direct marketing, promotions, product placement, co-op ads, events, coupons, etc. This spending may be nearly as much as the more easily tallied measured media categories, particularly when considering B2B and small business marketing. Unlike traditional media, with its broad targeting and consumer focus, digital platforms are well suited to address this part of the market. Indeed, much of GOOGL’s early success can be tied to its annihilation of Yellow Pages advertising, an unmeasured but once lucrative platform. Including non-measured marketing in the denominator makes digital’s market penetration far less alarming.

We also note that the sheer effectiveness of digital ads may prompt advertisers to raise their budgets. With digital, ads are targeted to carefully defined segments that may be as small as a specific individual. Consumer behavior can be tracked after a message has been delivered, with recent deals with the financial industry suggesting that the effectiveness of an ad might soon be followed all the way to a sale. Already, GOOGL and FB report that the ROI for ads on their platform can be as much as 10x the typical return for traditional media. This revolution seems likely to expand the market.

Digital operators with their reach to billions of users worldwide and tens of billions of hours of daily engagement, accessible via scalable self-service platforms, may also open new markets for advertising. Small businesses can buy 100 impressions in a local market on comparable terms using the same tools as a big brand with a national campaign. This is not true for the rest of measured media, opening the door for a new class of advertisers to raise their budgets. Similarly, lower income segments, particularly in emerging markets, have historically been uneconomic to target. The ubiquity of smartphones is changing this.

The top digital ad platforms are also improving their products – reaching for the Holy Grail of ad tracking straight to verified purchase. GOOGL’s deal with MC, and FB’s negotiations with top credit issuing banks have us almost there. We believe that these dominant digital advertising leaders have too many advantages to give up their leadership, despite pressures from privacy regulators. AMZN, which we expect to be the developed world’s largest retailer within a year, can already close the loop for its brand advertisers with its small but rapidly growing ad platform. MSFT’s LinkedIn has a strong B2B franchise and TWTR remains the dominant real-time news distribution service – we expect both to maintain healthy, well-focused, ad businesses. Finally, NFLX has long eschewed advertising, but an ad-supported lower tier remains an attractive option should the growth of its subscriber base slow. We note that the company has changed its mind on strategic issues in the past and could easily do so again.

Are We There Yet?

In less than 20 years, digital advertising has gone from a blip to more than 43.5% of the $634B global market, as gauged by spending in the relatively easy to track traditional ad categories – TV, radio, magazines, newspaper, outdoor display, and now digital – that are part of “measured media” (Exhibit 1, 2). Measured media spending has picked up a bit of late (likely the result of the rise of digital) but historically, advertising spending has closely tracked the larger economy, averaging a bit less than 3% growth over the past 100 years.

Exh 1: Global Measured Media Advertising Spending Forecast, 2017 – 2023

In this context, the sustainability of the digital ad market’s robust 20% YoY growth is a fair question. Indeed, sustaining 20% growth against 3% growth in the denominator would see digital up to 80% of total spending within 5 years. Even 10% growth would push close to 60% share for the category – seemingly plausible but suggesting little further runway. Has the law of large numbers caught up to ad leaders Alphabet and Facebook, and should investors begin hedging down expectations for continued growth?

Not yet. We see four ways in which this narrative is too gloomy (Exhibit 3): 1. Measured media metric understates the addressable market; 2. Increased digital effectiveness stimulates demand; 3. Digital scalability brings new buyers; and 4. Digital reach opens new segment and geographic markets. Adjusting for these factors suggests that digital platforms likely have a smaller share of a much larger addressable market, and that increased reach and effectiveness could allow meaningful growth in that market beyond historical averages – all driven by the digital category.

Exh 2: Global Measured Media Advertising Share Forecast by Medium, 2017 – 2023

Exh 3: Diverse Factors Favor Growth of Global Digital Ads Addressable Market

Measure Twice, Cut Once

Measured media is called that because it is easy to measure. Newspapers and magazines have circulation statistics. TV and radio have ratings agencies that estimate their audiences via survey. Outdoor display operators measure the traffic on the roads and sidewalks in view of their installations. Digital ads, which offer precise accounting of views and click, have been welcomed to the club. The big ad industry analysts – Kantar and Zenith chief amongst them – track measured media closely and it is almost uniformly used as a proxy for the total advertising market. For ad agencies and media companies, this has always been adequate, as ad campaign spending is somewhat fungible amongst the media categories, while spending on other marketing and promotional categories is a bit ignored as not directly addressable.

Digital is a bit different. In 15 years, it has gone from a negligible slice to more than 43% of the measured media spend. The effect on newspaper, magazine and radio advertising has been devastating. US newspaper ad sales dropped 60% between 2006 and 2009 and have deteriorated from there (Exhibit 4). Magazine ad revenues have suffered a bit less but are still down more than 30% from their peak and readership is down more than 25% since 2014. Radio is holding on to about 5% of the total measured media total, off a couple of percent from its position at the turn of the millennium. Only TV, which still holds a third of the market, has held serve vs. digital, although deteriorating viewership and shrinking subscriber rolls are ugly harbingers for the future.

Exh 4: Marketing Shift to Digital Devastated US Newspapers Ad Revenues

Measured media has been growing at double the rate of the economy in recent years, with all the growth, and then some, coming from digital. While online platforms are likely stimulating some new spending, they are also capturing spending from those categories not included in the measured media metric. Direct

Exh 5: Global Unmeasured Media Spending Forecast, 2017 – 2023E

Exh 6: Global Yellow Pages (SGX:AWS) Sales were hit hard by Google Search Ads

marketing, promotions, product placement, experience marketing (events), coupons, loyalty programs, directories and other spending categories are more than 75% the size of measured media, harder to measure but addressable by digital platforms (Exhibit 5). For example, printed Yellow Pages books were a $15B business in the US as of 2002, a more than $40B business globally as recently as 2008, and now an anachronistic memory destroyed by the ubiquity of Google (Exhibit 6). Catalogues, once an advertising staple for retailers, are being crowded out by online shopping alternatives.

Including this spending in the denominator of the digital market share drops it to a far less scary 25%, more indicative of the runway left than the arbitrary measured media subset (Exhibit 7).

Exh 7: Digital as a Share of Total Global Ad Spend, Including Unmeasured Spend

Now with Improved ROI!

The 18th century department store magnate John Wanamaker once said: “Half the money I spend on advertising is wasted; the trouble is, I don’t know which half”. That sentiment sums up the more than a century of advertising since. Media could get a message in front of a crowd, but it was difficult to ascertain which amongst them had taken it to heart.

Digital is solving that problem (Exhibit 8). First, ads can be targeted to very precise audiences – by interests, by demographics, by location, by query, by browsing history, down to the individual. Second, the behavior of the user upon receiving the message can be accurately tracked – e.g. click throughs, skips, app installs, subsequent browsing, etc. Google’s recent agreement with Mastercard and Facebook’s negotiations

Exh 8: Digital Ad Platforms offer Inherent Advantages to Buyers