Internet Publishing, Broadcasting and Search February 10, 2015 Information Technology Sector Stock Rating Market weight

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1 The Henry Fund Henry B. Tippie School of Management Christina Erbe (christina Internet Publishing, Broadcasting and Search February 10, 2015 Information Technology Sector Stock Rating Market weight Investment Thesis We believe there is growth opportunity in the internet publishing, broadcasting and search industry because of increasing worldwide internet penetration rates and increasing individual usage times. However, we are seeing high valuations among these companies, which suggests growth has already been priced into the stocks. We recommend looking at manufacturers of servers and data storage hardware, which will be needed as the internet grows busier. Drivers of Thesis The number of Internet users is forecasted to nearly double, growing from 2.9 B in 2014 to 5.7B in 2019, giving companies a larger potential audience to sell to advertisers Smartphones, tablets, and laptop sales are expected to continue to grow at CAGRs of 17%, 32%, and 5.3% through 2017 leading to an increasing number of Internet access platforms available as well a growing number of people that own an internet accessible device. Average time spend online per month is forecasted to grow from 35 hours to 40 hours by 2018, giving companies the opportunity to generate more revenue off of each user. Digital advertising spending is expected to increase from $50.7B in 2014 to almost $83B by 2018 because of growing online consumer usage rates and a greater ability to track ad effectiveness. Risks to Thesis A slowing US economy would negatively impact the expected growth in advertising revenue. Weak mobile advertising rates could also prohibit companies from realizing any gains from increased digital advertising allocation. Changes in government regulations regarding net neutrality could benefit or negate the future competitive environment. Industry Earnings Estimates NetAdvantage Year E 2016E 2017E Rev. $49,810.7 $52,989.5 $55,848.8 $62,611.5 $66,571.6 $70,674.0 Growth 14.5% 6.4% 5.4% 12.1% 6.3% 6.2% 20% 15% 10% 5% 0% 5% Key Industry Statistics P/E EPS $5.52 Forward EPS $5.70 EV/Sales 5.7 EV/EBITDA 13.3 Growth 16.4 Capex Growth 37.7 Top Firms by Market Cap Google Inc B Facebook, Inc B Tencent B Baidu 76.97B Yahoo! 41.46B IAC Interactive 5.07B AOL, Inc. 3.49B LinkedIn Corporation 33.61B Apple B Microsoft B Profitability Operating Margin 32.4% Profit Margin 19.9% Return on Equity 13.0% Data: FactSet 0 P/E ROE Profit Margin Source: FactSet 12 Month Performance Industry Description S&P NA Tech Index S&P 500 F M A M J J A S O N D J Tech Sector Internet PB&S The internet publishing, broadcasting and search industry is composed of companies that publish, broadcast or aggregate content online as well as companies that operate websites that allow people to search and find content. Almost 70% of the industry s revenues are generated through advertising sales. Competition and concentration is high in the search category with a few, very large players but more fragmented in the publishing and broadcasting categories. 1 Source: MergentOnline Important disclosures appear on the last page of this report.

2 EXECUTIVE SUMMARY There will be significant growth opportunities in the Internet publishing, broadcasting and search portal industry over the next five to ten years. The penetration of the internet into developing countries and increase in the number of internet access platforms will bring in millions of new users, attracting more advertisers and other potential revenue streams. INDUSTRY DESCRIPTION The IPB&S industry is made up of more than 3200 companies that create, publish or help almost 3 billion current users find information and content on the Internet today. They include search engines like Google, Yahoo! and Microsoft s Bing as well as news, sports and entertainment sites, music providers, social networks and on line gaming sites. Most companies have an ad spending business model that creates two types of customer. One is the consumer who comes for the content. The other is the advertiser who is willing to pay for access to the consumer. Revenue Streams Advertising dollars make up over three fourths of the industry s revenue. Subscription 21% Source: IBIS World Sources of Revenue Licensing 1% Services/Mo bile Payment 1% Advertising 77% Advertisers can choose between different advertising formats including search and display options. The search format will link a user to a customer s website based on key word searches. Advertisers pay for words or phrases that relate to their site through auction like pricing. There is also the option for more traditional display ads, including banner ads, videos, rich media interactive ads and page sponsorships. These types of ads are purchased at a fixed fee, one price per so many impressions or views, or on a cost per click basis. Advertisers only pay when a user has clicked on the ad. (NetAdvantage) Some companies have had success introducing subscription fees around their content, specifically within online gaming, video streaming and music providers. However, most consumers are not willing to pay for general content. We believe the subscription model in the current market is only a viable option for smaller, niche companies. There are smaller revenue streams that include selling branded products, licensing proprietary products to other sites and marketing new services including cloud computing and mobile payment systems. Categories within Industry Company Mkt Share Mkt Cap FY14 Rev Product Search Google 67% B 66.0B Google Search Microsoft 20% B 93.46B Bing Yahoo 10% 41.6B 4.62B Yahoo! Search AOL 1% 3.1B 2.53B AOL Publishing and Broadcasting Google 23% B 66.0B YouTube, Blogger.com Facebook 17% B 12.4B Facebook Apple 11% B 199.8B itunes IAC Interactive 1.34% 5.68B 3.1B Match, Ask, Tinder, Vimeo LinkedIn Corp..37% 31.26B 2.22B LinkedIn Twitter.26% 31.92B 1.4B Twitter Source: Yahoo! Finance, emarketer While Google and Facebook are the giants of the industry, there are smaller niche markets within the publishing, broadcast and search portals that allow smaller entrants to be successful in a crowded space. These include travel search portals like Expedia, Travelocity and a newer entrant Trivago. While Apple is the biggest player in the digital music industry, sites such as Pandora and Spotify have found a place for themselves. This also applies to social networks, dating sites, news aggregates, mommy blogs and more. Capital Intensive This industry requires significant capital to stay competitive and relevant. Technology quickly becomes obsolete. To combat this, companies must have the Page 2

3 ability to invest in ongoing research and development or have the capital to acquire smaller firms that have developed innovative technology that will complement or grow their existing brand. Companies in this industry often reinvest 10% or more of their revenues into R&D. 2 The industry is also dependent on immense data centers that can house tens of thousands of servers, which need to be replaced every three to four years. These data centers also require constant air conditioning to keep the equipment cool and dry. Companies have found innovative ways to cool their data centers while saving millions in electricity costs including investments in solar farms, wind energy, and building data centers in the artic circle. 16 Human capital is another area that requires more investment than other industries. Skilled programmers, sales staff and management all come at a premium for these companies who are looking to recruit and retain the best talent. The average industry salary exceeded $250,000 in Wage expenses made up 16.8% of the total industry revenue. 5 Growth Expectations This industry is currently in a growth stage. However, growth is beginning to moderate as the industry matures because there is more competition for advertising dollars from traditional media sources and newcomers because of the low barriers to entry. 15% 10% 5% 0% Forecasted Revenue Growth Rate for Industry 5% 6% Source: Mergent FirstSearch 9% 11% 11% 11% * 2016* 2017* 2018* The biggest factors that will drive growth for this industry in the coming years will be the further penetration of broadband Internet around the world and the continued growth in Internet access platforms. However, for individual companies to profit from this growth, they must be able to recruit and retain users. Continued development in their mobile apps and user experience will be crucial. 100% 80% 60% 40% 20% 0% Source: Statista Mobile Phone & Internet Usage Penetration 67% 73% 39% 44% 79% RECENT DEVELOPMENTS Net Neutrality legislation 84% 87% 90% 49% 52% 56% 58% * 2016* 2017* Internet users Mobile phone users The concept of net neutrality has been around since the early 2000 s but has come to the national forefront in the past year because of the new FCC policy that was passed in February The committee voted to regulate the Internet under Title II of the 1934 Communications Act, essentially defining it as a public utility. The FCC has proposed new rules that will restrict Internet Service Providers (ISPs) from manipulating how quickly or slowly sites are transmitted along their networks. 19 The main rules proposed are: No blocking Providers cannot block access to legal content, applications, services or non harmful devices No throttling Providers cannot slow down or diminish the quality of lawful Internet traffic No paid prioritization Providers cannot give preference to some Internet traffic over other traffic, no fast lanes. This rule also restricts ISPs from showing favoritism toward their affiliates 20 We believe that the industry will benefit from the passing of the policy. Industry giants like Netflix will be protected from paying fines or tolls to maintain the streaming speeds needed for its video heavy content. It also protects start ups and smaller websites that may not be able to afford to pay for prioritization. Page 3

4 Investment in Innovation Because of the heavy reliance on advertising for revenue, companies in this industry are continuously looking for additional revenue streams. The bigger players have moved into the mobile pay arena. Apple recently rolled out its new Apple Pay program and in response, we have seen Google start talks with mobile payment platform Softcard. Google also made a major investment in SpaceX. We believe this is to help advance their efforts to bring highspeed Internet access to the developing world through a collaboration of Internet satellites. In addition, it recently rented capacity from Sprint and T mobile to allow itself to begin selling wireless service directly to the user. Mobile Usage INDUSTRY TRENDS Mobile devices usage, whether it is a smartphone, tablet or laptop, is expected to continue to grow through Companies in this industry have to be ready with products and service that are optimized for mobile usage. Forecasted Compound Annual Growth Rate of Mobile Units and Data Traffic The Cost per click (CPC) was also significantly lower for smartphone vs. computers at $.58 and $.83 respectively. The average conversion rate of those clicks into sales is still slightly lower for smartphones at 4.4% vs. computers at 5.3%. However, smartphones conversion rates increased by 57.1% versus the 35.9% growth in computer conversion rates. 21 Mobile Desktop Click Thru Rate 3.75% 2.29% Cost Per Click $0.58 $0.83 Conversion Rate 4.4% 5.3% CR growth, Y to Y 57.1% 35.9% Source: Marin Software White Paper Digital & Mobile Advertising Rates Digital rates have been declining over the last three years because the supply of ad space has grown much faster than the demand for it. However mobile rates have stayed steady or even seen a slight increase in the past year as advertisers are finding greater value in the mobile space and are more willing to pay for it. 18 Mobile advertising rates are typically 50% less than desktop rates because of the smaller screen size but are expected to grow and even surpass digital rates in the next two years % 100.0% 80.0% 60.0% 40.0% 20.0% 0.0% 16.7% 60.1% 32.0% 83.4% 22.3% 5.3% 45.5% 102.7% Smartphone Tablet Laptop M2M module Source: emarketer Devices Mobile data traffic This increase in mobile usage is expected to drive mobile ad spending to almost $42 billion dollars by 2018, rising by a 5 year CAGR of 43%. Search and social media will account for the largest share of the ad revenue during this period. 17 Advertisers dollars may also be better spent on the mobile ads. According to Marin Software s 2014 Mobile Advertising paper, the average click through rate (CTR) on smartphones is 3.75% vs. 2.29% for desktop computers. Source: Statista Google has seen twelve straight quarters of negative year over year CPC changes, including seven consecutive periods of quarter over quarter CPC decreases. 23 At the same time, it has seen its revenue grow 17% from last year because of the increase in internet users. INDUSTRY COMPETITION The Internet broadcasting, publishing and search portals industry is an interesting study of stability, fierce competition and unlikely partnerships. Companies Page 4

5 directly compete with each other in certain subsectors and then form strategic partnerships in others. Peer Comparisons The major players in the industry are shown in this chart: Stock Current Price P/E EPS Google Facebook Yahoo Microsoft Apple IAC Interactive Data: Yahoo! Finance The largest companies compete against each other for search traffic Google, Bing, Yahoo as well as with value added services like Gmail and Microsoft outlook. Each company does have its own core competencies so we see strategic partnership forged with its competitors. For example, Apple uses Goggle as its default search engine in its Safari browser, a partnership said to be worth as much as $8.8 billion. Yahoo! recently switched to Microsoft Bing and saw a 4% uptick in its market share while Google subsequently lost 3.8%. 15 Google is currently at its lowest percentage of market share since Yahoo!, on the other hand, is at its highest since Bing 12.56% Yahoo! 10.45% Source: BusinessInsider Ask.com 0.44% Aol 0.71% Google 75.84% U.S. Search Market Share Dec 2014 As we stated before, competition is high in this industry. The top 50 companies account for around 80% of the revenue. 7 They not only compete against each other but against more traditional advertising platforms (for dollars) and information outlets (for eyes). There is definite risk of disruption or substitution in the industry. Technology companies that are not constantly innovating or improving will be pushed out by someone that is. While the biggest companies can benefit from economies of scale, smaller companies can also be quite successful by focusing on niche markets or maintaining a regional presence and taking advantage of local expertise. Source: IBIS World Broadcasting & Publishing Market Share HuluYahoo Google 3% 2% 23% Other 44% Facebook 17% Apple 11% Companies that make up the "Other 44% of the market share include social media sites like Twitter and LinkedIn, Match.com or eharmony; travel search sites including Expedia, Orbitz and Hotels.com; news aggregates and publishers like Huffington Post and Slate; as well as music and video services like Pandora, Spotify and Vimeo. ECONOMIC OUTLOOK (YouTube, Blogger) (itunes) The economic factors that impact the IPB&S industry the most are GDP, consumer spending and exchange rates. Historically, technology companies performances have been closely tied to the direction of the GDP, They tend to overperform with GDP growth, specifically with strong fixed investment numbers. We are forecasting the GDP to continue to grow at 3.05% over the next two years. GDP growth is a sign of a healthy economy which leads to higher consumer confidence and in turn higher consumer spending. The IPB&S industry is significantly impacted by consumer spending because of its correlation with advertising spending. When consumers reduce their spending, advertisers tend to respond by reducing their advertising dollars. We believe that consumer confidence, and in turn consumer spending, will increase over the next two years. This spending should translate into higher CTRs as well as higher conversion rates. These rising metrics should encourage Page 5

6 advertisers to continue to open their pocketbooks and boost the industry s revenues. Changes in exchange rates do not affect all the companies in this industry but play a large role in the top firms because of their global reach. As the dollar strengthened over the last quarter, Google alone reported a $541 million dollar hit to its revenue. 3 The top players in this industry each have a varying degree of exposure to international sales. Percentage of Overall Sales Domestic International Google 43% 57% Apple 38% 62% Facebook 46% 54% Yahoo! 73% 27% IAC 60% 40% Expedia 53% 47% Source: Company FY ks Demographic changes will always be a factor in this industry as well. Because advertising is the major source of revenue, companies have to be aware of who their users are and how that may change over time because of adaptation lifecycles and social trends. To remain relevant, companies need to provide products and services that the target demographic (25 40 yrs) want to use. INDUSTRY CHALLENGES Advertising dollars are two thirds of the industry s revenue and can be volatile. Finding other significant revenue sources would be extremely valuable. Technology is always changing and the companies in this sector have to continue to invest in research and development. Retaining Key Personnel is critical because of the extensive time commitment it takes to develop and launch the type of innovative products these companies work with. It is an industry where the top workers are always in demand and someone is willing to pay for them. Monitoring and managing legal issues including intellectual property and copyright disputes, liability of online service for user s behavior, privacy complaints and other lawsuits has become a costly reality for many of these companies. INVESTMENT POSITIVES Revenue should continue to come in. Digital ad spending increased 17.7% in 2014 but remained only 28.2% of the total ad spending. Digital spending is expected to increase another 15.5% in 2015 as well as continue to gain for the next four years growing from $133 billion to $194.5 billion by 2018 (CMO Council, 9). Source: Strategic Analytics US Ad Spend by Media Type in % 15% 28% 5% 42% Internet enterprises are very scalable because of the global reach of the Internet and minimal need for investments in PPE. If the product and business model is sound, it should be easy for companies to grow. INVESTMENT NEGATIVES In its current model, the industry is extremely reliant on advertising dollars for revenue. Company revenues will react to a change in consumer spending making it a systematic risk. There is also the risk mobile advertising rates will not rise as more advertisers allocate dollars to the platform. Without higher rates, companies could see major losses. The US dollar is currently strong. If it maintains its strength, companies with large portions of their business overseas Google, Yahoo, Facebook will face large exchange rate losses. VALUATION We believe that the internet publishing, broadcasting and search engine portal industry is well positioned to take advantage of the growth opportunities it will be presented with over the next five years as internet penetration rates and mobile usage grows in the TV Digital Print Radio Outdoor Page 6

7 developing countries. Their business models are scalable and can easily expand to meet growing demand. There is both short term and long term revenue growth including reallocation of advertising dollars into the digital and mobile space, to the potential millions of new consumers that will come with the increase in internet penetration. We expect continuing capital expenditures as the top companies race to expand into all facets of online services. We will continue to follow the privacy and liability lawsuits that several companies are currently entangled with. We would not like to see more strict regulation because of the tendency to curb growth and innovation. KEYS TO MONITOR This industry is driven by advertising revenues, so the overall health of the US economy is a key to the industry s continued success. We must also watch out for continued adverse effects of the exchange rate on the larger companies if the dollar remains strong. We need to monitor company investments and cash flows. We need to look critically at their investment decisions and whether the projects fit within their core competencies while pushing technological innovation. We do not want to see companies dumping money into projects or acquisitions that don t make sense with their core business. Because revenue from mobile search is going to become such a large factor in these companies revenue compositions, we need to stay informed of the search partnerships that are formed or dissolved between the mobile browsers and the search engines. If Apple decides to remove Google as its default search engine on its mobile devices, we could see a big change in both the US and international search market share. REFERENCES 1. S&P NetAdvantage, Computers: Consumer Services & the Internet, Industry Report, November Mergent First Research, Internet Publishing, Broadcasting and Search Portals Industry Report, December Google 10 k, December FactSet, North American Internet Services Report 5. IBIS World, Internet Publishing and Broadcasting, US Industry Reports, December IBIS World, Search Engines, US Industry Reports, December Mergent First Research, Internet Publishing, Broadcasting and Search Portals Industry Report, December Highlights.pdf 9. merging trends in mobile and what they mean foryour business.html /01/12/how internet marketing will affect variousindustries in 2015/2/ y/google attorney general jim hoodlawsuit.html?_r= CMO Council, categories.php?view=all&category=marketingspend 14. Bureau of Economic Analysis, =1#reqid=9&step=1&isuri=1 15. Bloomberg: downplays importance browser search html /11/14/facebook altoona data center/ / is growingfaster than all other ad formats emarketer Mobile Display Ad CPMs: The Going Rate Dec. 11, neutralityruling what it means for you/ reclassifybroadband title ii explained/3/ 21. Marin Software 2014 Mobile Search Advertising Around the Globe white paper searchmarket drop mozilla s ad ratedeclines continue 12th straight quarter/295450/ IMPORTANT DISCLAIMER Henry Fund reports are created by student enrolled in the Applied Securities Management (Henry Fund) program at the University of Iowa s Tippie School of Management. These reports are intended to provide potential employers and other interested parties an example of the Page 7

8 analytical skills, investment knowledge, and communication abilities of Henry Fund 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 a financial interest in the companies mentioned in this report. Page 8