Watching movies with happy endings
The Rubicon Project (NYSE:RUBI) is one of the largest players in what is called the ad tech space. The world is full of the bleached bones of various ad tech firms that have come and gone - more of the later lately. There really is little contention about the ultimate automation of digital ad spending. It is happening now and it will continue to happen probably at accelerating rates for a few years. The problems in this space are, however, manifold. Pricing and competition especially from giants such as Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and Facebook (NASDAQ:FB) are the most generally cited villains, but there are many other pitfalls in running a successful ad tech company. So far, the pole position in the race has to be given to RUBI. Part of that has to do with its technology, part of it is execution and part of it seems to be that it has a better understanding of what buyers and sellers of ads want in a digital exchange. The company's CEO, Frank Addante, is an industry veteran who sold his first ad tech company to DoubleClick several years ago.
Having said all of that, perhaps it wasn't too surprising for the company to provide what might best be called mysteriously conservative guidance during the course of its 2/23 call. To the extent that the guidance was conservative as I believe likely, it is a set-up for significant upsides and share price appreciation. To the extent that there is no upside, the shares are still modestly valued.
For those readers unfamiliar with ad tech, it has evolved as a way of connecting buyers and sellers of ads on all kinds of digital platforms and venues. On the conference call, RUBI's CEO talked about an ad placement on a faucet. And with IoT on the horizon, it will not be that long before our refrigerators and ranges will be ad targets as well. Science fiction, not really, although the concept of buying something because of an ad on a talking refrigerator is a bit scary, at least to this writer.
At the moment, from a business point of view, the frontiers in the space are video and mobile. Mobile is already one-third of RUBI's managed spend. Video hasn't quite happened yet in terms of revenues. A potential buyer of ads can scan the world for ad availability on the Rubicon platform. The world in this case typically includes both Google and Facebook platforms, although many other "publishers" make ad space on their platform available to RUBI's software. If the buyer finds what he wants at a price he wants to pay, he simply buys the "space" online. He also can bid on the space and other buyers have a chance to bid more. Rubicon describes the total spend metric as managed spend, which was over a $1 billion last year for the first time. The company takes a fee on the ad sales that it generates, which doubled last year to $227 million. The company's take rate, as it is called, is the amount of the spend it collects as its commission. The take rate increased last year by a significant amount because the company's customers moved to what is called RTB, or real time bidding. The take rate on RTB is significantly higher than the take rate on static ads which do not involve the usage of much of the company's technology. RTB is part of an industry-wide trend toward buying ads "programmatically." Rubicon is the leading independent provider of programmatic services and it seems likely to maintain that role for the foreseeable future.
Rubicon like some other companies has a history of under-guiding. I was going to say long history, but the company has only been public two years. But under-guiding is like an old, predictable movie. We have all seen this movie time and time again. The company is in a hyper-growth phase. Management is concerned that estimates are getting frothy. Management issues conservative guidance and the shares underperform. The company beats reduced guidance by a country mile. Shares recover, but investors no longer accept management's guidance.
That hasn't been quite the scenario for Rubicon's shares sitting as they do at what are close to all-time highs. Part of that, to be sure, was the king size beat the company reported for its Q4 2015 when it reported numbers almost two months ago. But that beat was no new thing for this company. It beat estimates by more than 100% each quarter - the smallest upside it printed was $.14 on a base expectation of a $.02 loss. The Q4 beat was $.39 on a base expectation of $.33 in the December quarter. In all, this company earned $1.08 in 2015, and analysts are now estimating EPS of $.75 for 2016, not because they do or do not think that to be a reasonable estimate, but because that is what the company guided to during the call.
This is neither the largest nor most profitable company in the world. There ought to be plenty of greenfield space as the CEO put it on the call. Either the opportunity is far smaller than observers have been led to believe or the space is becoming far more competitive or management simply doesn't want the troubles that can emanate from frothy expectations. In fact, during the conference call, management suggested that the opportunity for its solutions, the TAM, if you will, is growing because of new ways to automate the buying and selling of online ads. The funniest comment, however, came from the CFO who observed that Q4 2016 was too far away for him to raise guidance based on expectations for that quarter. So, the company gave guidance for the whole fiscal year, but said it couldn't give guidance for Q4 as it was too far in the distance.
At the end of the day, my own impression for what it is worth, is one of a company almost afraid of the success it has achieved. Q4 was considered by management to be one of those "the beer can't get any colder" quarters and hence the guidance. But the fact is that the company grew revenues this past year by over 80% to $227 million and grew non-GAAP EPS to $1.08 up from a minimal number in the prior year. Revenue growth actually accelerated in Q4 to 100% while EPS for the quarter at $.72 was up 168% from the prior year period. For a company like this with a very significant level of fixed costs in the short term, the beat on revenues brought an even larger beat in earnings. Indeed, almost all of the metrics that this company uses to measure its performance, and most specifically the amount of managed spend on their platform and its take rate, showed accelerating growth in Q4 as compared to the growth in the first three quarters of the year - although that growth was by no means shabby either.
There is, no doubt, much to be said about a conservative approach to guidance. There is, however, much to be said for a reasonable approach to guidance. The company had a very high "take rate" in Q4, which it forecast would not be sustained. But it also said that the decline in the take rate would be compensated for by users migrating to a more lucrative format for buying.
I don't do models here despite their utility in understanding companies. But were I to do a model and base it on extrapolating trends in some fashion, my model would show top-line growth of well above 25% and concomitantly would forecast EPS to be far above $.75.
What is Rubicon's secret sauce?
There is much that could be and has been written about the ad tech space in general and there are 13 analysts who cover the shares of RUBI. You can access more than everything you need to know about the space online and there is no point in reprising that. In this section, I'm going to try to point out what I believe to be RUBI's competitive differentiators. Without reasonable and sustainable differentiators, there is no potential investment case that can be made for this company, or so far as it goes, any other independent vendor in this space.
Rubicon in the US is the 600-pound gorilla of the independent providers of ad automation solutions. It does have one competitor, Criteo (NASDAQ:CRTO), based in France that is somewhat larger and has a similar set of solutions. Criteo's 2015 also was very strong indeed with constant currency growth of 46%. It has significantly lower EBITDA margins compared to Rubicon. Criteo uses a "retargeting" technique which shows multiple instances of the same product ad to be placed on several sites. Rubicon and Criteo can coexist readily in a burgeoning market where both of the companies were able to grow by 40% last year and improve profitability.
Without a secret sauce, no independent company will ever be able to succeed in ad tech. It's too competitive and it has giant competitors. The WSJ in an article from Jan. 4 of this year went through a litany of the problems in the ad tech industry these days. One thing is quite clear and that is that the industry is consolidating rapidly and many of the 79 firms in the space that have been identified will either have to sell out or close. Venture investors seem far less ready to fund continuing losses at ad tech vendors. The growth potential for ad tech is substantial - huge is more like it. One analysis based on extensive primary research suggests that independent vendors, i.e. those not affiliated with either FB or Google, will achieve a CAGR of 33% over the next three years. But there is always a significant risk that some of that growth could be captured by either Google or FB or that ad sellers might even launch their own platforms to transact with potential buyers.
RUBI's platform is called the Ad Automation Cloud. Rubicon has invested thousands of person-years and scores of millions of dollars in just one thing - advertising automation - and I suspect that none of its independent competitors have the resources to match that level of commitment. At the moment, the company has more than 45,000 CPUs and 5.0 petabytes of storage in its data center. In this industry those are significant figures, but there are now some cloud data centers with 1 million CPUs. It appears that the potential for scale economies are more in front of this company than behind it. A second differentiator is the 50,000 algorithms to execute real-time transactions. I'm not going to pretend that I can prove that the RUBI algorithms are better or worse than the algorithms used by other platforms. Essentially algorithms are the life blood of any ad automation platform. In particular, they make sure impressions are priced accurately and that they create a fair market for both sellers and buyers. But the algorithms really ensure that the platform can process literally millions of discrete transactions each second. The Rubicon platform is an excellent example of Big Data technology in use.
In the end, running a platform that optimizes transactions for all users is the key to user satisfaction. Recently, Pixalate named RUBI as the top global platform on its Global Seller Trust Index with a score of 96, a few points ahead of the next nearest competitor, Google Advantage. Rubicon enjoys a more significant advantage when it comes to mobile advertising, the growthiest area of the company's business. There are loads of competitors out there including Kenshoo, Sizmek (NASDAQ:SZMK) and Marin (NYSE:MRIN) that are said by one research firm to be the most popular alternatives to Rubicon. But there are other more sizeable competitors including DoubleClick, Adobe (NASDAQ:ADBE) and Google AdWords. Many of these competitors do not have a platform with all of the functionality that is built into Rubicon's ad automation cloud and most of the companies are far smaller as well. So scale, performance and features and more things to sell. The company has something it describes as a buyers cloud. The buyers cloud puts RUBI in the position of having buyers always interacting and interacting across all potential platforms as well. The company's R&D spend while substantial at 15% of revenues last quarter is within normal ranges for software companies of this size. R&D as a percentage of revenues is already declining, going from 18% to 15% of revenues measured year on year in Q4. I would like to include some summary of Gartner's research on ad automation platforms. Sadly, for the first time in my experience, there is an area that Gartner does not yet analyze and this is it. Gartner does rate digital marketing hubs, but Rubicon is not a digital marketing hub.
I think that in summing up, this company surely has a lead when compared to all of the other independent providers of advertising automation and programmatic ad spend. Some of the lead is simply that this company is larger and has been better able to invest in infrastructure when compared to its competitors. Some of the lead is that this company is larger, and as a result, it has more features and a broader product footprint. Part of this company's differentiator is that it is profitable and financially stable and many of the competitors in the space are not. I have no objective way of proving whether or not this company's algorithms that execute the transactions are better than the algorithms from its competitors. All that one can objectively say is that its platform encompasses more algorithms that cover potential situations than its other independent competitors. Rubicon has spent over $100 million developing its algorithms and invested thousands of man-years. It has apparently paid off.
In trying to address the competition or the defensive moat between this company and the large gorillas in the space, it is important to note that even gorillas do not care to eat everything in the forest. Some years ago, when web analytics was the hot new thing, it was believed that at some point Google's offering in that space would crush Omniture, the then leading vendor. GOOG certainly had a free product in that space - after all if a Google customer was going to spend dollars on placing an ad on Google, they wanted some way to know something about the number of clicks that ad was receiving and if the ad induced a user to actually buy something from the advertiser. I suspect that if it had been a priority for Google, it could have brought Omniture to its knees in a matter of quarters. In the end, it didn't happen because Google never decided that tracking web clicks at a granular level of detail was something it wanted to do or needed to do.
The situation is perhaps a bit different here. The concept of getting the fox to run an exchange for the chickens is a bit off-putting. Very few of the potential users of AdX, Google's advertising exchange, are particularly excited about the incestuous relationship between AdX and GOOG's DoubleClick for Publishers. The programmatic buyers like the concept of what is called header bidding that allows them to bypass the relationship Google has set up between its own ad server and its own exchange. Rubicon appears to be the leader in header bidding with what it calls Fastlane. Late last month, Rubicon announced its first header bidding solution compliant with Google AMP. The Rubicon solution is the first header bidding solution in the industry to be accepted by Google for its AMP Project which offers users a faster and more streamlined web user experience. Perhaps the lion and the lambs will play nicely together. But should Google feel otherwise, it has many levers it can pull.
All of that being said, I imagine if the situation arose where header bidding was starting to nullify some of Google's advantages in the marketplace, the company would and could respond with various tactics that could potentially impact Rubicon. I simply do not think, however, that the situation with header bidding is enough of a problem for Google that it will concern itself with trying to dominate that space in an anti-competitive fashion that is likely to bring regulatory scrutiny. Rubicon's shares are never going to sell for a valuation they would if the gorillas in the space weren't Facebook and Google. But regardless of that, this company has a surprisingly modest valuation for its current earnings and cash generation capabilities.
Is it worth crossing the Rubicon?
At some point in this article, it was probably inevitable that I used the company's name in some historical context. For those not historically minded, the Rubicon is a river in northwest Italy beyond which it was forbidden by the Senate of Rome to take armies from the provinces. Of course, Caesar did just that, and in a few months, he became the dictator of Rome. No one these days is quite sure which river the Rubicon actually is, but the question is no more than apocryphal in any event.
Rubicon has an enterprise value of $767 million. The revenue forecast for this year is $293 million although as I have tried to suggest that forecast seems unduly conservative. But in any event, using the consensus forecast of 13 analysts publishing on this name yields an EV/S 2.6X. Again, the consensus earnings forecast is probably unduly conservative. But if the company were not to earn more than $.75, its current P/E would be 27X. Last year was the first year in which this company had significant free cash flow which came to $56 million. That puts the free cash flow yield at 7.3%. Stock-based compensation at a bit over $30 million is not an insignificant item for this company. Stock-based comp is greater than 50% of free cash flow, but a rather more modest 12% of last year's revenues. That metric was down substantially from 18% of revenues the prior year.
Rubicon is to report its quarterly earnings on May 3. Analysts have projected 60% year-on-year revenue growth for the period, which is then forecast to decelerate markedly to 35% for Q2 and to 29% for the year. With 43% of revenues forecast to occur in the first half, growth in the back half of the year would have to slow to a bit under 20% in the second half of this year and then reaccelerate to 24% in 2017. If the company has had a reasonably good Q1, and by that, I mean that it has exceeded sales estimates by an amount consistent with the other quarters it has printed as a public company, it is inevitable that full-year guidance will be materially increased. There was nothing particularly anomalous in Q4 other than lots of customers used the RUBI platform. This company has no large deals to sell. It has no big new customers to announce. It gets a transaction fee on literally billions of transactions. No doubt retail sales have been weak this quarter, and at some point, Rubicon's results are going to be correlated with retail sales. But not yet. So, I imagine that the odds really do favor an upside of some visible amount when Q1 is announced, leading to a re-evaluation of full-year guidance.
There are many considerations that go into determining an appropriate valuation for a company like this where comparables are scarce on the ground and which growth both in margins and revenues and cash flow was at historic levels in the past fiscal year. The closest analog company that competes to an extent in the space of Rubicon is Criteo. Criteo has somewhat different technology, an emphasis as mentioned above, but it is the closest thing to an analog company that is publicly traded. Criteo has somewhat less growth than Rubicon, although still very impressive at its scale. It is far less profitable than Rubicon with EBITDA margins of less than 10% compared to the 26% EBITDA margin achieved by RUBI. Its valuation metrics are reasonably consistent with the current valuations of RUBI.
It is my belief that despite reasonable analyst coverage, RUBI's shares suffer from investor malaise regarding ad tech in general and concerns about the potential for Google competition at some point. But it seems to me highly probable that if the company continues to grow at 30% for a couple of years more, it will be significantly revalued. 32% of the shares are still held by insiders. The CEO is known as a serial entrepreneur. The potential for this company to be consolidated by anyone of a number of large tech vendors is not insubstantial. The company has been recently initiated by Citi and Cantor as buys. I think the shares offer significant upside potential, even at current levels.
Some final thoughts
Rubicon is the leading independent company in the ad automation space, an emerging niche in the world of digital marketing. While many ad tech vendors have fallen on hard times, Rubicon's 2015 was a home run with regard to all financial metrics. Q4 was particularly strong and was not dependent on large deals. This company basically sells access to its ad trading platform that is undergirded by 50,000 complex algorithms that facilitate commerce and ensure fairness to both buyers and sellers. The company enjoys significant scale advantages over its smaller competitors in an industry that is likely to significantly consolidate.
Management has chosen to provide unusually conservative guidance, perhaps frightened by the over attainment of last quarter. And yet the last quarter was not one characterized by some unusual business event, it simply was a quarter that saw use of the platform grow beyond anticipated levels. Even using the management guidance as a reasonable set of expectations, the shares are reasonably valued relative to their growth and significant EBITDA margins and free cash flow the company has started to generate. If, based on historical performance, the company significantly over-attains again, the shares are an unusual bargain. The shares closed today at almost an all-time high in the midst of overall market enthusiasm and enthusiasm for tech shares in particular. It might be prudent to scale into this name although I do believe that the print scheduled for May 3 could prove to be a catalyst.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.