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Those who know me understand that I have been bullish on programmatic ad buying for a number of years. Even when Invite Media was bought by Google back in 2010, I believed that the market was only beginning its growth trajectory and that the performance/metrics driven direct marketing model would ultimately capture a large share of overall online ad spend before becoming an integral part of media buying in traditional media (see "addressable [cable TV] advertising"). So, I am not at all bearish on programmatic ad buying.

Rocket Fuel (NASDAQ:FUEL)'s pre-announcement of better than expected revenue (coupled with roughly in-line losses) was met with enthusiasm even as there was substantial (>$180 million) insider selling in the recently completed follow-on offering. Television pundit Jim Cramer reacted positively to the recent developments, as well. While programmatic ad buying is a very hot space, nowhere in any of the recent commentary was there a discussion of how Rocket Fuel differs from competitors like Media Math, DataXu, TheTradeDesk, Invite Media/Google, Criteo (NASDAQ:CRTO), Turn, AOL AdLearn, [x+1], and others. Instead, the massive rising tide is expected to lift all boats and public market investors, who are left with few alternatives that allow them to ride the wave, are flocking to Rocket Fuel.

The most important difference between Rocket Fuel, and most other leading programmatic buying platforms, is the company's revenue model. While most demand side platform (DSP) companies charge a fixed percentage of ad spend for a platform license or full-service campaign management, Rocket Fuel is able to generate larger than usual margins by charging clients a specified rate for media and then capture the arbitrage spread between what clients pay and the actual media cost. For example, if Client X is used to paying $10 per lead, Rocket Fuel can offer them leads at $8 per lead while using its technology and services teams to generate leads at $4 per lead--thereby generating 50% gross margins. This seems like a win-win model; the client pays less than they are used to while Rocket Fuel can generate abnormally large gross margins (in return for taking on the risk of the campaign performance).

This model, however, is only attractive to advertisers who are either (1) risk averse and unwilling to invest the "sunk cost" to create and optimize a campaign at their own direct expense, (2) ignorant of the actual media cost of the campaigns and/or (3) lacking the resources (internal or external) to run the campaign at the reduced cost. Given that the market is early in its development, it is understandable that uncertainty about performance, talent shortages, etc. make Rocket Fuel's model attractive to a subset of advertisers. However, Rocket Fuel is a growth company valued at a high multiple of current revenue; investors seem to expect it to be able to scale its business without significant contractions in gross margin even though trade publications like AdExchanger have been critical of FUEL's and CRTO's "opaque arbitrage pricing tactics."

Large publishers and advertisers, however, are already beginning to recognize the flaws in the arbitrage model and are requiring transparency from the DSPs. Facebook has banned price arbitrage and mandated transparency from agencies and DSPs buying on its platform as of July 2013. An AudienceScience survey conducted in November 2013 found that 40% of advertisers already understand that transparency is the single most effective way to control waste (link). As the market matures, there will be even greater pressure for transparency from agencies and DSPs. Put yourself in the position of a large advertiser; what possible advantages are there in not having transparency from your agency or DSP?

Rocket Fuel would argue that their "black-box" approach is more effective than a self-managed or full-service campaign run with another DSP. However, the distribution of expenses at Rocket Fuel is telling; compare R&D expenses (including capitalized software development) with sales and marketing costs in the most recent quarter. In its Q3 10-Q, the company reported $4.5 million of R&D opex and $1.7 million of capitalized software development relative to $21.6 million of sales and marketing opex. When AOL launched its AdLearn DSP in 2012, it said that it had invested "more than $100 in AdLearn over the past 10 years" (link). Meanwhile, MediaMath also markets itself as having an advanced optimization engine while offering clients a non-arbitrage based pricing model. In short, Rocket Fuel is not the only game in town and, as advertisers become more sophisticated, they will run bake-offs, opt for lower cost pricing models, or negotiate down Rocket Fuel's margins by playing competitors' pricing models against them.

Furthermore, analysts who measure market share by revenue should really be looking at the estimated volume of media spend that flows through each platform. DataXu, MediaMath, Invite Media/Google, Adobe/Efficient Frontier, TheTradeDesk, agency trading desks, and others that offer lower cost platform licensing fees and full service campaign management (and may not book 100% of media spend as net revenue) may have a disproportionate amount of spend flowing through them relative to their revenue levels. A pure revenue comparison therefore yields an inflated market share number for Rocket Fuel.

In short, the programmatic ad buying market is an exciting one, and one which I am very bullish on. However, it is also a competitive market. Valuing Rocket Fuel at >8x trailing sales and ~1/2 the valuation of all of AOL seems a bit absurd. The long-term precariousness of Rocket Fuel's revenue model only adds to the risk. In my opinion, there is no question that ad dollars will shift to programmatic buying. But, like any nascent high-growth market (we are only in the third or fourth inning of the market's development, in my opinion), there are likely to be winners and losers. While I am not counting Rocket Fuel out, by any means, its current valuation does not adequately take into account the competitive risks and the risks to its business model.

Source: Why Rocket Fuel Is A Very Risky Bet, Even For A DSP Bull