Digital Advertising Market Remains Strong Amid Regulatory Risks

We expect the economic recovery, which Morningstar forecasts to continue through 2025, will drive solid overall advertising growth.

We foresee a 12.6% increase in total ad spending this year in the U.S., and 9.5% growth in 2022. Within this market, we project that digital advertising will grow 22.5% this year and 17.5% in 2022, continuing to take share as it provides more flexibility, does not require up-front commitments, is more quickly and easily measurable, and allows for adjustments in real time.

Regulatory risks, such as possible limits on data utilization, remain. But given the continuing transition to digital by consumers and businesses, we expect advertisers to keep increasing their digital ad spending.

Keep Alphabet and Facebook and Get Into Pinterest

We continue to favour Google parent Alphabet (GOOG) and Facebook (FB) as the most straightforward ways to play this growth in the digital advertising market. Both companies have Morningstar Economic Moat Ratings of wide.

We think Alphabet stands to gain more than most of its online advertising peers. We believe brand advertising will benefit more than direct response as ad spending growth accelerates, providing further YouTube monetization opportunities, particularly as connected TV usage surges.

In addition, while Alphabet is facing more scrutiny from the Justice Department and lawmakers regarding its market leadership, decisions on the various antitrust cases against the firm likely will take a long time. Even if the firm is forced to spin off its different businesses, our sum-of-the-parts valuation of US$4,232 per share (32% above our base-case fair value estimate) indicates that shareholders will benefit.

Our forecast is similar for Facebook. Though Apple's (AAPL) IDFA policies will hurt the effectiveness of the company's individual-user target advertising, we believe Facebook's nearly 3 billion monthly active users will keep its network effect for digital advertising intact. The firm will also benefit from increasing small-business formations during an economic recovery, many of which likely will use Facebook's platform to market their offerings.

Shareholders may also benefit if Facebook is forced to break up, as we estimate the sum-of-the-parts valuation for the firm will be 21% above our base case at US$492 per share.

However, we believe Alphabet and Facebook shares are now nearing fair value. As shown below, their stocks have increased nearly 70% and 40%, respectively, thus far in 2021 compared with a 23% increase in the Morningstar US Market Total Return Index. While we believe these firms remain attractive holdings for long-term investors, we recommend waiting for a slightly wider margin of safety before allocating additional capital to those names.

For those looking for a way to gain exposure to the digital advertising market, we recommend narrow-moat Pinterest (PINS). The company's share price has declined 16% year to date and now trades at a more than 20% discount to our fair value estimate.

We believe Pinterest will benefit from the return of brand advertising spending in addition to growth in e-commerce. We also expect the firm will continue to attract more direct-response advertising as most of its users access the app with the intention to purchase immediately or in the future.

We expect revenue growth at Pinterest will average 34% over the next five years (ahead of the 16.5% average annual growth we estimate for digital advertising spending) as the platform becomes more attractive for advertisers, with average revenue per user increasing 23% annually. The firm turned cash flow positive in 2020, and we expect it to hit GAAP profitability next year.

The Macro Environment Is Looking Better for Digital Ad Spending

As the economy continues to recover from the pandemic, we have increased confidence that growth in digital ad spending will accommodate--and in part drive--increased business activity.

As mentioned above, we have raised our total advertising spending estimates from 10.5% growth this year to 12.6%, with similar expectations for 9.5% growth in 2022. Digital advertising, which will grow at a higher rate in both years than we initially anticipated, will drive this additional increase.

These estimates build on 2020 figures that were also stronger than we had expected. Based on data from GroupM, U.S. advertising spending last year was approximately 13% higher than we had expected in November, declining nearly 5 percentage points less than our assumption.

The continuing adoption of and growth in digital advertising were the major drivers of 2020's relatively strong performance. It's true that many advertisers slashed overall ad spending in 2020, but this was mostly taken from their traditional ad budgets. Many then used digital ad dollars to target individuals and more quickly create conversions and generate sales.

Economic Growth Prospects Are Picking Up--Benefiting the Advertising Market

Importantly for advertisers, Morningstar's increase in expectations for the U.S. economy’s growth hinges on our assessment of potential economic supply. Advertising spending tends to move along with growth in consumption, which is the largest driver of economic growth in the U.S.

Heavy stimulus payments have left consumers ready to spend. And while various government stimulus plans and unemployment benefits will eventually subside, Morningstar projects that the growth in consumption brought about by these programs is likely to remain as consumers gradually spend down increased savings that accrued during the pandemic.

We expect ad spending growth to modestly remain above economic growth and growth in overall consumer spending during the next five years. Historically, advertising and consumer spending have had around a 65%-70% positive correlation.

Several other factors also affect our forecast of digital advertising growth:

• We expect e-commerce spending to increase at high-single-digit rates through 2025. The pandemic experiment with e-commerce was a resounding success for both consumers and firms, and we expect it to alter long-run behavior. In turn, this will drive growth in digital and overall ad spending.
• Continuing improvement in unemployment numbers also supports our higher expectations for ad spending. Our projection that the unemployment rate will decline below levels seen before the pandemic and remain low through 2025 bodes well for advertising demand.
• More new businesses will be created during the economic recovery. After a brief pause at the outset of the pandemic, business formations took off in mid-2020 and have remained sharply elevated since. New businesses need to efficiently create awareness and generate demand, making digital channels like Facebook and Google especially attractive.
• Demand for digital advertising will grow at strong rates throughout a full economic cycle. The continuing increase in digital ad inventory, more measurable and higher returns on investment on the ad spending, and more time spent online by consumers will drive further transition to a higher digital advertising mix.
  
  

Data Restrictions Will Hurt Digital Advertising Effectiveness, but Some Less Than Others

Despite our growth expectations, regulatory and legal changes do threaten to limit access to data, including compilation and storage, sharing, and utilization of information concerning online user behavior across sites, apps, and devices. This data allows ad tech firms and advertisers to target individual users with relevant and likely higher-return-generating ads.

In addition, ad buying may become less efficient and possibly more costly as programmatic buying, based on user-behavior data-matching using cookies, will have to be redesigned.

Restrictions on data access affects publishers because they cannot make advertising inventory available at the right time for advertisers to purchase as effectively as before.

Still, we don't expect these restrictions to reverse the network effects of Google and Facebook. We believe that limitations on data access or usage will apply to all firms. Plus, we are confident that the large user bases of Google and Facebook and the continuous usage of their apps will attract advertisers. Marketers will have other platforms to purchase ad inventory from, but given that restrictions on data may reduce ROIs on targeted and retargeted advertising, the large audiences that Google and Facebook attract will continue to bring demand for the two firms' ad inventories.

Lawmakers Are More Aggressively Pushing Changes to Antitrust Laws

On the antitrust front, which is mainly applicable to Google and Facebook, the Democratic-controlled U.S. House of Representatives has already taken steps to amend the Clayton Act and Sherman Act antitrust laws. In late June, six bills were introduced to and approved by the Judiciary Committee.

We think the bills will be watered down by the time they are passed, if they pass at all. But as they stand, they could make the ad tech space more fragmented (which would hurt efficiency and create additional costs for advertisers), force firms to invest more heavily in research and development (which would affect margins), and hurt overall innovation in the technology industry.

Regardless of whether some version of these bills become laws, we expect the Biden administration to continue to put pressure on Google and Facebook regarding their market share in digital advertising.

Despite Google and Facebook's Dominance, Smaller Firms Continue to Prosper

While Google and Facebook are the market leaders with what we estimate are 36% and 26% shares (based on the firms' net advertising revenue and our estimated overall digital ad spending), other firms such as behemoth Amazon.com (AMZN) plus smaller firms like Snap (SNAP), Pinterest, Twitter (TWTR), and TikTok are gaining traction.

While it is not likely that these firms will displace the two at the top, their continued growth indicates that digital advertising remains a healthy and competitive market.

This is also supported by participation of ad tech firms like Criteo (CRTO), The Trade Desk (TTD), PubMatic (PUBM), and Magnite (MGNI) in this industry. Retailers like Walmart (WMT) and Target (TGT) that have invested in operating their own digital advertising platforms (similar to Amazon) should also be considered as competitors of the larger players.