It’s Not Just Advertising … It’s New and Improved Advertising!

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Paul Sagawa

203.901.1633

sagawa@sector-sovereign.com

October 18, 2010

It’s Not Just Advertising … It’s New and Improved Advertising!

  • Advertising is a $200B+ market in the US. On-line accounts for less than 10% of total ad spend today, but the migration of video onto the internet and the proliferation of tablets and smartphones will make the $60B of annual ad spending currently directed to channelized TV, the $47B captured by print publishers, and the $50B+ direct marketing market addressable by web-based platforms. While traditional media has taken solace in the modest progress of the shift of advertising to the internet to date, we believe that a confluence of innovations – e.g. portable platforms, wireless broadband, social networking, media streaming, content delivery networks (CDN), etc. – will accelerate the adoption of on-line advertising over the next few years
  • Spending on internet advertising has been growing at a 10% CAGR over the past four years, but it remains a third the size of television advertising and less than half the size of print. However, a lackluster 2009, particularly relative to TV which performed nearly as well, has fueled concerns that the pace of transition will be measured. While the limits of current generation Internet advertising models – e.g. traditional paid search, sponsorship and on-line classified – may be conceivable, new models are emerging – e.g. mobile search, digital video, location specific advertising, etc. – that will be the impetus for the next phase of growth
  • At the same time, emerging technology is radically improving the ability to target and reach consumers on-line. Smartphones and tablets greatly expand the number of opportunities to reach consumers, with the added benefit of knowing their precise location. Upgraded 3G and 4G networks can deliver much richer media to these platforms, while content delivery networks accelerate response time and enhance the performance of streaming media. Social networking expands on the superior “targetability” of on-line ads, and the potential of raising impact through trusted recommendations. CDNs are enabling big improvements in the experience of streaming video just as Internet signal is starting to reach living room TVs. These technology transitions are still in their early stages and their effect on advertising is largely still in the future
  • The rise of Internet advertising has been largely at the expense of print. Newspaper advertising has plummeted, declining at a 21.6% CAGR since 2006, with classified ads the biggest casualty of the Internet assault. Magazine advertising has also suffered disproportionately, down 18% in 2009, vs. the 12.7% drop in overall measured ad spending. Looking at historical cost per million impressions for both suggests that advertising is reactive, lagging rather than anticipating industry change . As such, the rise of tablets and smartphones as e-readers portends further cannibalization of print advertising in the future
  • In contrast, television advertising has been more robust, dropping just 7.5% yoy in 2009, with cable networks holding almost steady despite the weak economy. Total television viewing has been trending upward for several years, likely driven by the penetration of DVRs and the increasing numbers of TVs in the average household, which could also yield an increase in “ambient” TV usage. This growth, undeterred by simultaneous increases in on-line video viewing, has yielded the robust ad spending and skepticism by many observers as to the longer term threat of Internet TV
  • However, to date, Internet video has been limited to PCs, inconvenient, small screen alternatives to cable TV on the living room wide screen. This is changing. New TVs are offering direct WiFi connections, a panoply of internet connected TV peripherals – e.g. game consoles, Apple and Google TV, etc. – are coming to market, and proposed FCC regulations could require cable operators to open the set-top-box market in a meaningful way. Tablets are also emerging as viable personal viewing platforms. At the same time, the quality and quantity of programming available on the web has been expanding dramatically. We believe that this an exodus of eyeballs from channelized entertainment to on-line video has begun, and that advertisers will surely follow, enticed by the growing audience, interactivity, far more precise targeting, and opt-in viewer choice. Thus, a virtuous cycle accelerates, attracting more content, more viewers, and more advertisers in turn
  • We believe that Internet TV, mobile search, location-based advertising, social network driven ads, interactive/rich media advertising, and other new approaches will eventually draw the majority of the 90% of the advertising market that remains off-line. The shift continues to lag the internet’s share of daily consumer activity, even considering Google’s strong recent results, but should accelerate with the rapid adoption of new, disruptive innovations. This multi-fold increase in the market addressable by web-based advertising will accrue enormous benefit to companies able to establish leadership in these new approaches. We believe the companies best positioned to do this are Google, Apple and Amazon, although several others – such as Microsoft, Yahoo!, Netflix, etc. – have credible plays at leadership as well. While all of the traditional media companies – e.g. Disney, News Corp, Time Warner, Viacom, Comcast, etc. – will vie to transition leadership into the new domain, we believe their incumbency makes them fundamentally disadvantaged in managing the transition

I Can’t Believe I Ate the Whole Thing!

All in, the US advertising market represents more than $200B in annual spending, and accounts for more than a third of global spending on traditional “measured” media. Of this, roughly $62B is spent on television, $47B on print media, $14B on radio, $6B on outdoor advertisements, and $75B on a grab-bag of promotion, direct mail, and idiosyncratic alternative approaches (Exhibit 1). The remaining 10% of the US advertising market is the Internet. Historically, the advertising market has been very sensitive to changes in the overall economy, with the current economic conditions no exception to that rule. Total ad spending was down sharply in 2009 and the overall recovery in 2010 has been modest.

US on-line advertising nearly quadrupled from 2002 to 2008, before posting its first decline since the aftermath of the Internet bubble burst in 2009 (Exhibit 2 and 3). Thus far in 2010, the on-line market appears to have regained its footing, posting 11% growth in the first half of 2010 with signs of further acceleration evident in Google’s 23% sales growth for 3Q. Within the nearly $23B in 2009 Internet ad spending, almost half went toward paid search, another 22% on display/banner ads, and 10% toward on-line classified. Of the various categories, search, display/banner and video/rich media categories have been steadily growing as a percentage of the on-line pie, while classified, lead generation and sponsorships have declined. It is also a very concentrated market, with the top ten internet advertising sellers generating 70% of the total revenue, a percentage that has been fairly stable over the last several years.

It’s Not Your Father’s Newspaper

Between 1999 and 2009, the Internet gained nearly 600bp of the share of spending of the leading 100 US advertisers, as measured by Ad Age, essentially replacing the 640bp share lost by newspapers over the same time period. This follows an erosion in the daily circulation of American newspapers that began in the early ‘90’s and accelerated over the past 8 years (Exhibit 4). Classified advertising, once the backbone of newspaper economics, has fallen 70% over the past decade, with annual declines in newspaper sales of classified ads accelerating to more than 35% in recent quarters. This pattern is reminiscent of the decimation of the printed Yellow Pages franchises with the rise of on-line search. In contrast, magazine share of spending by the 100 leading advertisers has been largely stable over the past decade (Exhibit 5). However, US circulation has shown a marked downturn in both 2009 and 2010, a harbinger for a shift away from the media by advertisers, and an opportunity for on-line to step into the breach once again.

Better Living Through Technology

Aiding and abetting the Internet’s assault on print media advertising is the revolution in portable devices. Until recently, it was difficult for computer accessible on-line media to compete with the morning paper or a stack of magazines for a lazy breakfast at the coffee shop or a shuttle flight. Smartphones, e-readers, and especially, tablets change all of that. Gartner projects that global sales of tablets will hit 150 million units by 2013, which corresponds to 150 million additional people who will have far less reason to buy newspapers or magazines.

But, that’s not all! The explosive demand for Internet connected portable devices is buttressed by the simultaneous roll out of 3G upgrades and the pending launch of 4G service which give mobile devices access at speeds on par with most wireline connections. Both CDMA and W-CDMA wireless networks now provide real throughput in the 1Mbps range as a baseline, with limited, but growing coverage available in enhanced 3G (HSPA+) and 4G (WiMAX and soon, LTE) capable of multimegabit per second operation. Moreover, most portable platforms are also equipped with WiFi, enabling wired internet speeds wherever wireless LAN connectivity is available. These networks enhance the browsing experience on portable networks and offer sufficient throughput to support good quality video and rich media advertising too.

Wait, there’s more! In the last four years, the very structure of the Internet has changed dramatically. Most consumer traffic is now served off of content delivery networks that store multiple copies of content on servers distributed across the country. With the data geographically close to the users, Internet sessions involve far fewer router hops, and thus, much faster response times and many less errors (Exhibit 6). Eliminating delays greatly enhances the user experience and enables the delivery of richer and more interactive forms of advertising to both fixed and mobile users. This makes the Internet better for advertisers as well.

We’re not done yet! The emergence of social networking applications, the location-aware aspect of mobile platforms, and the interactivity and user-orientation of the Internet in general offer substantial advantages to advertisers in reaching interested customers. Unlike other media, Internet users have a history that can be used to screen high-potential targets and to shape the advertising approach that might be most effective. This is enhanced by social networking, which can yield groups of like-minded consumers and, if handled appropriately, generate word of mouth within a circle of trust. In the mobile context, these advantages are enhanced by an ability to pinpoint location, allowing advertisers to reach possible buyers at a time and place when they may be most able to execute a physical transaction. For example, grocery shoppers could receive e-coupons while in the aisle containing the advertised product or hungry workers on lunch break could be alerted to daily specials while passing a local restaurant. Finally, unlike any other major medium, the Internet is interactive. Advertisers can choose to pay only for consumers who opt to click on their advertisements, assuring that they reach interested parties (Exhibit 7). Interactivity also improves the impact of the ads themselves.

And if you act now! To date, internet video has been largely limited to PC monitors, as the cable industry control of the set-top-box has effectively monopolized access to household TV screens. This is changing. First, new televisions are coming with internet built in, often in the form of integrated WiFi connections, specially configured browsers, and advanced remote controls. Second, a new class of connected boxes – e.g. game consoles, BluRay/DVD players, etc. – are also offering an end-around the cable box. Third, well connected, well respected and well heeled competitors, like Google, Apple, and others, are launching a frontal assault on Internet free set-top-box hegemony via turnkey solutions that tie together many media sources, including the Internet, for the living room TV. Finally, the FCC has proposed a new mandate that cable operators terminate their channelized service to a simple decoder box, decoupling that basic required function from the higher level applications of recording and navigation. If enacted, consumers would have a direct choice of Internet connected television boxes.

It Takes a Licking, but Keeps on Ticking

For Internet ad sellers, television is the holy grail. TV advertising is 30% of the total US market and 60% of the “measured” media buys by Ad Age’s leading 100 advertisers, figures that have been fairly stable over the past decade (Exhibit 8). TV viewership, as measured by Nielsen right off of cable boxes, has been rising over the past two years (Exhibit 9). The phenomenon of a rebounding primetime audience may be linked to two factors. First, the average number of TVs per household has been rising, which enables families to avoid conflict by allowing more than one show at a time but also may increase the amount of “ambient” TV use. By this, we mean TVs that are on, but are not the primary focus of those in the room. Second, the rapid rise of DVR set-tops enables users to shift programming to more convenient times for consumption (Exhibit 10). At the same time, the DVR is a point of contention for advertisers, who are vulnerable to users fast forwarding through ads. As such, rising viewership has been met by falling ad rates.

The stability of the television audience despite ongoing growth in Internet usage has yielded an air of confidence amongst cable and network executives confronted with the potential of on-line incursion into their living room citadel. Cable is moving to offer online access to channelized entertainment to its paying subscribers as a means to forestall any migration of consumers to Internet delivered competition. While we believe that this is a highly effective tactic to sustain a near term hold on advertising revenues, we also believe that the threat to channelized entertainment remains grave in the longer term for several reasons.

First, as YouTube and Netflix have shown, traditional and cable networks do not have a monopoly on entertaining content (Exhibit 11). As alternative programming becomes available for consumption on an increasing base of Internet connected TVs, people will watch it. Second, networks do not own all of their programming, and cable operators own very little programming at all. The most valuable content, live sports, is under contract and must be renewed on a regular basis. With the rise of direct to consumer Internet streaming, the negotiating leverage of the channelized networks will be greatly compromised. On the other side, it will be increasingly enticing for content owners of all ilk to explore their options for bypassing networks and cable operators, an option that will be more and more viable with the increasing connectedness of the potential audience. Third, a la carte content offers advertisers better opportunities to take advantage of the targeting and interactivity of online video vs. channelized entertainment ported to the streaming environment, while avoiding the commercial-skipping that is endemic to DVR time shifting. As a result, CPM (cost per million) for online video is higher than for network programming (Exhibit 12). Fourth, cable operators are almost universally disliked amongst consumers, most of whom restrict their viewing to a relatively small subset of available channels. As valued content finally becomes accessible over the internet on the living room TV, we believe subscribers will begin to cut the cord, although the process may take several years to play out.

Try it, You’ll Like it!

Nonetheless, the incremental opportunity for online video advertising is considerable, given that it represents only 2% of total video advertising today and that it is growing at a 40% annual pace. This tracks to growth in traffic from major video streaming web sites, such as YouTube and Hulu. If we are correct that technology innovations that enable consumers to easily enjoy internet TV on their living room screens and on personal tablet devices will stimulate an accelerated expansion in its audience, we would expect the ad dollars to follow accordingly. Of course, if this is correct, we would then expect to see content hold-outs move more aggressively to the net, which would in turn pull more viewers, who would spend more time watching web TV rather than cable. Eventually, a noticeable portion of these users will cut the cord on cable, and as the cycle turns, more advertising, content and users will follow. Virtuous cycle or death spiral? It depends on your perspective.

Given traditional television’s dominant share of the total advertising pie, a significant video shift to the Internet could easily double or triple on-line’s slice (Exhibit 13). For companies taking a leadership role in this transformation, it will be a windfall. On the flip side, we believe that it is a matter of time before scheduled broadcast channels are obsolete, in favor of a la carte programming on-demand over the Internet. The ramifications for the business of packaging programming into channels and packaging channels for distribution over cable or satellite are serious indeed.

As a side note, radio appears vulnerable to the same transition, but has been temporarily protected by the glacial pace of technology adoption within the automobile industry, and the age of the nation’s installed base of cars. As such, it may be that traditional broadcast radio outlives traditional broadcast television. Who would have thought it 50 years ago?

Where’s the Beef?

We expect on-line advertising spending to accelerate into 2011 and to sustain comfortable double digit annual growth rates for the foreseeable future, as economic recovery sputters along and the web picks up its furious assault on traditional print and broadcast media. Within that, we believe that industry forecasts for search advertising growth of under 10% CAGR to 2014 are likely conservative, as the value of search has been well established and the rapidly advancing base of portable platforms extends the application to the fully mobile domain (Exhibit 14). We do not believe that topic specific shortcuts and apps are likely to seriously dampen the use of search on mobile platforms, as widget real-estate issues and the benefits of a comprehensive search beyond the content available from a single source seem to assure the primacy of the search engine. While search is nearly half of all on-line ad spending in the US, we believe growth can keep pace with the overall Internet advertising market for several years.

Display advertising, roughly 22% of total on-line advertising spend, is advancing beyond the eminently ignorable banners that once littered the top of most popular web sites (Exhibit 15). The ads now may involve video, animations, interactive games, and other rich media content crafted to appeal to users as something of a mini-website. They are much better targeted to the viewer of the page, based on the increasingly rich information about web surfers gathered by the companies that manage the placement of these ads. Advertisers can now track who sees the ad, who clicks on it, and who follows through with a transaction, allowing a very detailed understanding of the effectiveness of the campaign. Some ad sellers have begun to allow advertisers to pay only for those displays that generate a click through, an innovation that lets costs track more closely to effectiveness. Ad sellers can also give users direct input into the ads that they are served, thus assuring interest, and limit the repetition that a specific user may have to endure as he or she surfs around the net. All of this makes on-line display a more attractive option for advertisers relative to print, before considering the impact of tablets and readers on would-be readers. As such, we expect display to continue solid growth as well.

On-line video advertising is just 5% of total on-line spending and less than 2.5% the size of traditional television advertising (Exhibit 16). Given that the category has delivered better than 40% growth in the past year, in the teeth of a recession, and without meaningful access to the living room or to the still nascent tablet category, the potential for another wave to break in the next few years appears to be substantial. We believe that Internet video advertising will eventually overtake traditional television, perhaps as quickly as a decade from now (Exhibit 17).

Several other forms of on-line advertising tracked by the Internet Advertising Bureau – e.g. classified ads, lead generation and sponsorship – have been declining. We expect that the users of these categories have found other forms of on-line marketing to be more effective, and have no reason to believe that there will be a substantial turn-around in any of them. Conversely, there may be new categories of on-line advertising emerging, particularly in the arena of social networking. Clearly, establishing close-knit in-groups with common interest opens unusual opportunities for advertisers, who hope to stimulate word of mouth recommendations within the environment of trust.

Just Do It

Several companies appear to be particularly well positioned for the next wave of on-line advertising (Exhibit 18). Google stands out, not just because of its strong results and indomitable search franchise, but because of its full range of technology-driven strengths. The Android platform puts Google in a measure of control over a metastasizing mobile ecosystem that could become a majority of the portable platform world. Its network of dozens of data centers puts its hundreds of thousands of servers much closer to users than the competition and gives it an extraordinary performance advantage in serving video content, not just via its ubiquitous YouTube franchise. Its recently introduced Google TV is the first volley in what should be a rapid fire barrage of iterations, as it moves to build an Android-like ecosystem around the living room TV. To borrow another advertising tag line, when it comes to on-line advertising, Google is Everywhere You Want to Be.

Apple comes to mind next. It is a bit of a latecomer to the advertising party – its flagship iTunes web presence began to introduce ads just four years ago and its iAd platform for the iPhone was just launched earlier this year. Nonetheless, the popularity of the brand, the growing installed base of iPhones and iPads, and the company’s well-earned reputation for innovation puts it in position to challenge for leadership in the fastest growing parts of the on-line advertising market – mobile and video. Its second generation Apple TV fixes many of the problems inherent with its initial release, and its iTunes franchise is already a leading distributer of television programming on the net. While Apple does bring these considerable market and technology assets to its pursuit of the ad market, it will need to work on the “plays well with others” section of its report card if it is to build a truly cross-platform advertising presence. Of course, the unchecked ardor of the Apple fan base is legendary, reducing the imperative for reaching beyond its own sandbox.

Amazon will also play a big role in the advertising bazaar of the future. First, it is the largest on-line retailer with hundreds of millions of loyal users who trust its tailored product recommendations. Second, after Google, it has the second most impressive network of data centers and servers ready to distribute advertising content. Third, Amazon is staking its own claim to the on-line video distribution market, an obvious adjunct to its leading position as seller of DVDs. Finally, its Kindle program has been ported off its hardware and is the early leader as a book, newspaper and magazine reading platform on both Apple’s X OS and Google’s Android systems.

Yahoo had been the 800 pound gorilla in the on-line display, a title it recently ceded to Facebook and its 500 million friends. While Yahoo has been successful in building a business selling ads for a network of third parties, the core of a display advertising franchise has to be the popularity of its owned properties. This is the sticking point for Yahoo, and for other players on the display ad leaderboard, like Microsoft and AOL. These companies are all in the right place, but appear to lack momentum at a time when competitors like Google, Apple, Amazon, Facebook and Twitter are charging ahead.

We also expect that some subsection of the traditional media category will successfully make the shift from print and broadcast to on-line. However, while companies like News Corp, Time Warner, Disney, Viacom, CBS, New York Times, and others can address the opportunity afforded by this change, it will impossible for them not to take damage from a battle fought in their own front yards. As McKinsey’s Dick Foster summed it up – innovation is the attacker’s advantage. It is very difficult for an incumbent to play both offense and defense at the same time in any market, and so it is likely to be in this one.

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