A Company for all seasons
Investors are looking for companies that present an opportunity to recover from the substantial losses endured in many portfolios over the past couple of months. In considering the question, my own preference is to find great companies that are now on sale, rather than wounded companies that score at very low valuation metrics. Overall, the outlook for IT vendors in particular is probably the same as it was when their valuations peaked two-three months ago now. Some companies have seen their shares decline more than others on a peak to current share price basis, but relative forward expectations really haven’t changed. In that regard, shares of Square (SQ) and Splunk (SPLK) come to mind.
I think a more useful exercise might be to consider looking at shares of companies that investors had previously considered to be too expensive to qualify for their portfolio mandates. Here, the combination of share price decline coupled with strong operational performance can provide investors with some fertile ground in which to find potential investments. Like many other commentators/investors, I have been looking for a decent time and valuation at which to examine Trade Desk (TTD) carefully, with a view toward establishing a position. It has been one of the more disruptive companies in the tech space for some time now and has been valued that way. But the combination of another strong quarter with growth of 50%, coupled with a share price decline has brought the shares into a range that is far more palatable for most investors.
AdTech is obviously one of those things reshaping our daily lives. I am old enough to remember the days when the creation of advertising and its purchasing had a certain mystique. At one point, advertising was conceived of as almost an art form and its practitioners were almost considered as priests in the American temple. In Britain, a well-known author was able to write an extremely entertaining detective novel , “Murder Must Advertise” that took place within what was then the slightly exotic confines of a London advertising agency. And, to an extent, advertising agency chiefs were often cultural icons. At one point, a pioneering advertising executive, Bruce Barton, wrote a book that sought to cast Jesus as the world’s leading business executive. Fortunately for Mr. Barton, he had a far more successful career as an ad executive than as an author, and the agency he co-founded still exists as a relatively large business, now a subsidiary of the Omnicom Group (OMC).
The Trade Desk (TTD) has its own mystique, although that comes from its ability to maintain 50% growth at some scale and to generate significant margins and cash flow. And its leader, Jeff Green, while not likely a cultural icon of the notoriety of Bruce Barton, is a visionary who has been instrumental in developing a business that is disrupting the way advertising is bought and sold. I am not sure if programmatic advertising, the kind enabled by TTD will ever become as well known as some of the characters created by advertising agencies of the past such as Betty Crocker and Aunt Jemima. But the opportunity programmatic advertising has to reshape the business landscape is every bit as large as was the case when Betty Crocker and Aunt Jemima were developed.
The Trade Desk has been a somewhat controversial stock over the past year or so-because there are some who perceive its EV/S multiple to be extended-and frankly, because of its stellar share price performance. Whether or not Trade Desk had an excessive EV/S ratio at its peak valuation in late September is somewhat of a moot point at this writing. The combination of a falling share price, down 11% from its recent closing high, and rising sales estimates have changed the EV/S calculation in a hurry. In the case of Trade Desk, the EV/S multiple is now below 9.7X and is actually below the average EV/S ratio for my forward growth rate estimate (42%).
That wouldn’t matter all that much for me if it weren’t for the exceptional operational performance of the company. Trade Desk last reported its earnings in early November. The shares reacted poorly to the release; indeed the day following the earnings, the shares initially traded down by 10% despite what was called a beat and raise quarter. At this point, the shares are within a few percent of where they were before the last earnings release but estimates for both revenues and earnings have continued to increase. So, valuation has compressed, noticeably.
Should investors buy these shares. I heard a rather emotionally wrought Jim Cramer talk about his feelings on the market recently. Obviously, if readers believe that this is a bear market that will continue until Jerome Powell calls off interest rate increases, growth stocks are no place for investors. I have no intention of forecasting what actions may be taken by the Fed at its next meeting, or what it might say about the outlook. I will say that the collapse of the price of oil might be one factor that could be weighed by the Fed in evaluating how best to pursue its dual mandates.
But I do believe that Trade Desk is a name that most long-term technology investors will wind up owning sooner or later, and this recent market pull-back has provided a decent opportunity to enter the name at a more reasonable valuation than has been seen in last several months.
What’s an Omni-Channel Demand Side Platform
No, it isn’t an answer to a “Jeopardy” question, although it sounds as though it might be. Basically, Demand Side Platforms (DSP’s) are considered to be technology that “allows buyers of digital advertising inventory to manage multiple ad exchange and data exchange accounts through a single interface on a real-time basis.” And it seems reasonably clear at this point that DSP technology, based on what is called programmatic media spending is taking over as the preferred methodology for procuring ads.
The global advertising market has been estimated to be around $700 billion-according to the statistics cited by this company on various occasions. At this point, digital advertising is almost 50% of that total and within digital, programmatic appears to be one of the fastest growing segments. Programmatic advertising is typically referring to the use of software to purchase digital advertising. It is supplanting traditional processes that involve human interaction and it is dramatically cheaper and more efficient. I have linked here to a brief article that summarizes the benefits of programmatic advertising in the real world. Programmatic is not the same as on-line bidding and that is a rather significant distinction in evaluating what TTD actually provides users compared to some alternatives. In fact, over time, it would not be surprising to see programmatic technology used to sell non-digital ads along with ads seen on digital media.
From an investment perspective, I think investors are looking to understand just what the potential for programmatic advertising might be. Basically, the demand driver for programmatic is the need that advertisers see to diversify their ad spend on digital. I am not going to try to get into a debate about whether Google (GOOG) or Facebook (FB) or their little siblings and cousins providers advertisers with an optimal showcase for their wares. I do think, however, that it is more or less indisputable at this point, that advertisers, if they can, want to diversify their spending and to use a multi-channel approach to spending. And it appears as well, that some of the channels that advertisers want to use are rapidly fragmenting themselves. I confess that I am a terrible consumer of the new paradigm in terms of ad viewing. But apparently nowadays, 46% of the spend that Trade Desk processes is mobile. And mobile video growth has reached almost 100%. Just how those little ads with moving images actually help sell things is beyond me-but that happens to be a crucial element in the Trade Desk investment thesis.
According to the most recent statistics, the market for programmatic advertising spending has reached more than $100 billion, with about half of that spent in the US. By 2020, forecasts suggest that 90% of all mobile display ads will transacts programmatically and programmatic will then account for 80% of all ad dollars being spent. Overall, the CAGR of programmatic advertising is said to be in the range of 20%. Whatever the precise statistics might be, two things are self-evident. One of these is that the unrealized market opportunity for Trade Desk remains huge, even relative to its current growth. And the other is that Trade Desk is growing more than twice as fast as the market as a whole. Can that continue? That is really the key to making a case for owning the shares at these levels.
Market Share expectations for Trade Desk
Trade Desk has been growing its revenues more than twice as fast as the market for programmatic advertising as a whole, and it has maintained that kind of growth advantage for some quarters. I do not want to purport to suggest that I have some magical insights on all of the reasons for this company’s success as I do not. I think the key to the investment case for these shares really is based on its ability to continue to disrupt its space and sustain its growth rate at 2X or more the growth of the space.
The basic reason for the success of Trade Desk is a pretty straightforward concept-it provides users with an objective platform and its larger competitors, Google (GOOG) and Amazon (AMZN) do not. Obviously neither Google or Amazon will ever direct their users to an advertising platform that they do not own. And most users understand and accept that. But over time, users want to optimize their advertising spend and they can do so using Trade Desk in a manner not possible with either Google/Double Click or Amazon.
In addition to objectivity, advertisers are seeking to diversify their ad spend on different digital platforms. And advertisers want to use a data driven approach to their ad spend. Analytics is something that is sweeping the world; programmatic is a component of analytics and the various offerings of Trade Desk make it easier for advertisers to develop programs that optimize their spend and target viewers/listeners who they really want to target.
Another factor that is enhancing growth for TTD has to do with trends toward fragmentation. For the most part, if a user wants to advertise on search, that user will go to Google first. And the same is true for social media where it is impossible for an advertiser to ignore Facebook (FB) But in the world of other channels with which to reach consumers, fragmentation is growing. The Trade Desk sells ads on all of the major networks, but it also sells ads for virtual MVPD businesses. While agnosticism may not be a belief system of choice for readers-when it comes to advertisers and content providers, it is the path to insuring an optimal CPM. And optimizing CPM is the god of advertisers and content providers. The content owners realize higher revenues and the advertisers and their agencies get closer to what they want to pay for. Trade Desk is substituting its technology for many middlemen, who often lack the analytical tools, advertisers expect to review. Trade Desk is basically a poster child for analytics-it was founded on the premise that providing analytics and agnostic access was a solution the advertising world needed.
While I can’t know if linear TV will really die in the next 10 years (the forecast of this company’s CEO) it seems highly likely that Connected TV is going to be a standard in the not distant future. Quite clearly, Connected TV, where viewers can access basically limitless content, is likely to become a major demand driver for Trade Desk’s services. Does Trade Desk really deliver higher ROI and more granular analytics than its competitors? I imagine, based on the success of this company, that it really has been solving problems for advertisers and content providers that resonate. And that is why, the record suggests that it will continue its hyper-growth for some time into the future.
Trade Desk and its valuation-A lesson worth relearning
No one has ever described Trade Desk as a value name and I certainly don’t suggest that it is-at least based on traditional metrics. But value is in the eye of the beholder. I make no secret that I would rather buy/own a high-growth name at a somewhat reasonable price, then own a so-called value IT name that simply doesn’t have a hyper-growth demand profile. It has been my experience that the returns are greater, on average, even if one deals with some clinkers along the way.
And I always attempt to evaluate management as part of my valuation parameters. Jeff Green, the CEO of Trade Desk has a great profile in this space. He has founded and sold several companies. The last one he co-founded and sold was AdECN which was shut by Microsoft 7 years ago-wrong management to understand that business. Green is known for being brash and promotional but he certainly is as knowledgeable about this space as anyone out there-and the track record of this business is certainly one that suggests visionary leadership. The other day, the company announced that its COO would be leaving the company. It is a long good-bye with the executive staying through the first half of 2019 to ensure a seamless transition.
As it happens, the current consensus growth rate as portrayed on 1st Call is for the company to achieve revenue growth next year of 32%. I think I would have to go behind those numbers to understand how they were derived. Indeed, the consensus growth for this quarter’s growth has it declining to 45% and then reaching 35% the following quarter, and presumably the high 20% range by the end of fiscal 2020. Those numbers simply are both exactly at odds with management commentary on the conference call, but also with regards to the land and expand paradigm of TTD users as well as the commentary that the outlook for the new fiscal year is stronger at this point than it has ever been in prior years.
I am not saying that the current First Call consensus forecast is absurd-most people prefer to forecast disruptive technologies as though there advantages are very finite. But I do think in compiling some reasonable expectations that ought to undergird a valuation analysis, using 32% growth is simply far from the most likely scenario. Indeed, as the CEO pointed out, the forecast provided by the company continues to show growth re-acceleration and not decline. And the inference I drew from the conference call commentary is that the company anticipates exceeding the ”forecast” it provided on the call.
As many readers will have read elsewhere, SaaS companies often have an aspirational goal based on the “rule of 40” It will come as no surprise that very few companies in the space are achieving that kind of performance metric which is based on adding the growth rate and operating margin percentages. There are various ways to measure the rule of 40 and some analysts like to use an ARR number to compute revenue growth. Because of the business model of TTD, it has no real ARR metric. But at this point, this company, in terms of Rule of 40 calculation is actually running at 2X the so-called goal, both because it is growing rapidly and it is so profitable. Trade Desk likes to use adjusted EBITDA in making its “rule of 40” calculation, but I prefer to stick with just plain old operating margin.
On a GAAP basis, the company reported operating margins of 18% last quarter and for the first 9 months of the year, the GAAP operating margin has also been 18%. On a non-GAAP basis, which is generally how Rule of 40 calculations are made, the company had margins of 28.5% for the quarter and 27% on a year to date basis. The company achieved 50% growth last quarter-so its “rule of 40” calculation was very close to 80-and that is one of the highest such metrics to be found in the IT space.
The company has been far more profitable than other high-growth IT vendors because it spends far less on sales and marketing and a bit less on research and development when compared to other hyper-growth IT vendors. That isn't terribly surprising as what it is selling, essentially is access and that simply doesn't require the same kind of sales effort to sell, as opposed to other forms IT solutions. Its gross margin, as I call it (the cost of platform operations), was 76% a bit below its year earlier gross margin level, mainly a factor of opening offices in different geos which tend to build up the cost of platform operations until they reach a certain scale.
Because of its business model, Trade Desk has a different balance sheet profile than other It vendors. Receivables, which are mainly generated by the billings for ads that have been paced are far greater than would be normal for other companies in the IT space. These receivables are basically offset by payables, again, a factor of the ads that Trade Desk contracts with its advertisers and content providers. The balance sheet has very little else-the model doesn’t feature any level of deferred revenues and while there is stock based comp, it is relatively low as a percentage of revenues.
The company has seen accelerating levels of cash flow so far this fiscal year-indeed, overall, cash flow has grown by 5X although the free cash flow margin is still just at 9%. The increase in cash flow this year is based on rising profitability and higher levels of stock-based comp., somewhat offset by balance sheet items.
The risks to the share price performance of this high-profile growth machine
Just about any company that grows at 50% for a few years at some scale is obviously faced with some risks. Growing at that speed, in and of itself, can be all consuming for a management team and executions risks are always lurking. But specifically In the case of this company, inevitably the risks come down to both competition and pricing coupled with broad acceptance of some of the new platforms that are being counted on to fuel hyper-growth into the foreseeable future.
Management is very positive about the opportunities that are inherent for its service with the broad commercialization of connected TV. The CEO said during the course of the call that ”when we see surprises, they are typically to the upside.” By that he meant that technology trends, and consumer acceptance were broad based tailwinds. Braggadocio? Perhaps, but even braggadocio might be connected to reality.
One questioner on the call asked if Trade Desk was an outlier in terms of other SaaS companies because of its extremely positive take on 2019. I actually do not think that to be the case-many SaaS companies, as they report are indicating strong 2019 outlooks-but we really have no experience as to how this company’s business might perform in an economic downturn. It is a risk to mention; but unlike those selling stocks on Monday, it isn’t one I evaluate as something about which to be unduly concerned when it comes to Trade Desk.
While I personally have little use for mobile video adds and think it fair to say I will never be tempted to buy something advertised on that channel, 100% growth, which the company achieved from that source last quarter, probably should put paid to lots of negative speculation about the correlation between Trade Desk’s revenue growth and that of the overall economy. It is probably worth noting briefly management commentary on the source for its positive spin on its outlook over the next 12 months made the following commentary, “ I said the most bullish thing I'm reporting in this report is that inventory for Connected TV went up by a 1000%, went up by 10x. And then the next quarter, I said the most bullish thing that we've said year-to-date, even more bullish than the thing I said last quarter is that our Connected TV spend went up by 1000%. And when I said that, I never anticipated that when we are giving our Q3 results as we just said, that I would once again say that Connected TV spend went up by 10x quarter-over-quarter Q3 2018 over Q3 2017.
I’d never expected that to happen. And that once again is wind at our backs. So to give you an example of where the inventory is coming from, more and more of the channels that are not included in the skinny bundles, they have their own channels popping up on the Roku and Amazon Fire and equivalents."
In addition, whether or not I believe that TTD is a very fairly valued name, it will be tarred with the valuation brush in a market that is increasingly nervous regarding higher multiple, hyper-growth names. While most VCs certainly look at the “rule of 40” metric in calculating valuation, many investors, both retail and institutional will not be attracted to that kind of performance benchmark. And so, Trade Desk is going to go up and down to some extent, dependent on market sentiment toward higher-growth, higher valuation shares.
But at the end of the day, since I am not trying to call the short-term share price/performance for Trade Desk, I will just comment briefly on the two issues that concern some observers and often lead to negative articles on this site.
One issue, of course, is the potential that either or both Amazon and Google will attempt to grow or maintain their market share in this space through various kinds of pricing plans. As management has commented, at some level, its users look at CPM first, last and always, and any kind of pricing for content that may allow a competitor an advantage in that way is a threat. Of course it hasn’t happened. And the odds are, it will not if for no other reason than despite price, the reach of the Trade Desk platform with multiple content providers and multiple distributors is not something that can be readily duplicated by its competitors. But it is certainly an issue and one that cannot be satisfied on a prospective basis.
There are many competitors who do or try to do what Trade Desk does. But for now, the game is mostly about what Google and Facebook are doing and how that might be impacting Trade Desk. Again, rather than me interpose some filter, I think readers will be best served by reading the answer provided by CEO Jeff Green. "You bet. So, first on the competitive stuff for DoubleClick, when they made that strategic choice to remove the DoubleClick ID, or Google's sort of common currency, which was the DoubleClick ID, from sharing with our clients. It created a huge opportunity for us and it also effectively said we're making the strategic priority that within Google we are de prioritizing DBM or that part that is formerly known as DBM.
So that's been humongous for us and it means that in more and more head-to-head, we have advantage and as we continue to build out our offering, especially like the cross-device, our offering is getting more competitive more quickly, as we're more focused, because I would just summarize their value proposition is, hey, we have a unified stack and maybe end of buying tools, but we're not as competitive as The Trade Desk, but we have, we're more integrated to other parts of your advertising and marketing stack.”
Will Trade Desk face some existential competitor in the future? I imagine that will be the case. But I would not put competitive pressures at the top of my list in terms of threats to the positive investment case for these shares. Is there going to be a world-wide slowdown not in growth percentages but in the economy as a whole? Will it hurt Trade Desk if the growth in digital media spending abates? I have tried to suggest just how that might be exactly wrong given this company’s belief in its value proposition and in the growth of its inventory of Connected TV opportunities. Without commenting on the economy or the specifics of Facebook’s revenue growth decline, I will simply say that from my perspective, these are weak if not to say non-existent straws on the part of observers who simply refuse to play in the growth sandbox.
It is absolutely the case that even with the 7% pullback represented by the company’s after hour price, that Trade Desk shares have appreciated by no less than 191% YTD. And there are investors who will not buy shares with that level of appreciation over the course of a year. But again, given how I calculate valuation, and the relatively unique valuation points that are offered by this company, I think looking ahead rather than backward makes far better sense. I believe that this will be a company that will be delivering positive alpha for some time to come.
Disclosure: I am/we are long TTD. 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.