courtneyk
Direct Digital Holdings (NASDAQ:DRCT) is an advertising agency that participates in both demand and supply side commercialization.
The company has seen explosive growth in the last few years, particularly during 2022, which is odd considering advertising had a rough year.
A few aspects of the company make me doubt that revenues are sustainable, like the amount of growth compared to the market, customer concentration and receivables accumulation.
Even ignoring these aspects, the company trades at a significant premium to annualized cash earnings. This implies the company has to grow to provide a more adequate return. Considering the explosiveness of previous growth, I prefer to wait, for a more stable company, or more attractive share prices.
Note: Unless otherwise stated, all information has been obtained from DRCT’s filings with the SEC.
Business description
Advertising on both sides of the counter: DRCT was born of the merger of two advertising agencies, Huddled Masses and Colossus SSP. Then Orange142 was acquired as well. The agencies still operate independently.
HM and O142 operate on the demand side of the business, by providing programmatic tools for small and medium sized businesses to contract advertising. They make money on a purchase by purchase basis, as businesses contract impressions or hire their services to design advertising campaigns.
Colossus operates on the supply side, connecting publishers with advertising exchanges or directly with advertising clients, and getting them the best price for their advertising space. Colossus charges part of its services on a fixed basis and another portion on the volume of advertising sold. Because it acts as principal, Colossus recognizes the whole advertising revenue and cost on its income statement.
Both businesses are competitive, and generating a moat is difficult, given that the barriers to entry are very low. Not much is needed to set up an agency.
Public on an UpC structure: DRCT operated as an LLP before going public, and indeed the operational aspects are still carried through an LLP. In order to go public but for early investors not to lose the tax treatment granted by the LLP, an UpC structure was generated. In this methodology (explained here by Deloitte) the founders give LLP units to a PubCo for which they carry no economic interest but 100% voting interest, which then is sold to the public. Founders can then continue exchanging LLP units for shares of PubCo, while keeping their tax treatment advantages through a Tax Agreement.
Operationally, this is not something that really affects DRCT, but it can be tricky to understand from the company’s financial statements so I believe it is better to explain it here.
Explosive growth: DRCT went public in 2022, and has only published financial data since 2018. This data shows explosive growth in revenues and margins, added by substantial operating leverage. Part of this growth was fueled by the demand side business with the acquisition of Orange142. The underlying operating company was generating $20 million in revenues in FY20, and is now generating $70 million on a TTM basis.
Expensive debt: DRCT has significant levels of debt, and that debt is expensive. As of 3Q22, the company carried $26 million in notes payable, paying LIBOR + 6% to 9% (depending on leverage). This is very expensive. To get an idea, in 3Q22 alone, the company expensed $1 million in interest charges (3.8%), which comes to an annualized interest cost of 16%.
Growth has risk
Growing in a bad industry context: In 2022, DRCT has grown very fast, as shown above. This is especially true of the supply side business, which is showing 500%+ YoY growth rates, organically generated.
This has called the attention of analysts on the company’s earnings calls, because the advertising industry is not doing remotely as well. 2022 was considered a bad year for the industry.
Concentration of customers: When asked (several times) about how this explosive growth was generated (for example in the 3Q22 or 2Q22 earning calls), management answered that the company’s products are getting adopted by small businesses. However, the company’s 10-Q for 3Q22 shows that 70% of revenue is concentrated on a single customer, that only represented 16% of revenue one year ago. Management does not mention this special customer on any earnings call.
Explosion of receivables: Although normally working capital grows during the expansion stage of the business, DRCT has been accumulating receivables with a single customer. This customer (it is not disclosed if it is the same that concentrates revenue) represents 85% of receivables. Fortunately, a big part of the receivables has been financed through payables. The concentration of receivables is mentioned in page 10 of the company’s 10-Q for 3Q22.
Valuation
Current annualized profitability: 3Q22 was the best quarter in the company’s history. It generated $1.8 million in income from operations. Annualized these become $7.2 million a year, or maybe more considering that the third quarter is a seasonal low for the industry. On top of that, the company’s cash profitability is better, because DRCT is expensing $2 million a year in intangibles from the acquisition of Orange142, but this are not cash expenses.
If the company can continue generating the current level of business, it would be generating $7 million accrual operating profits. From there, it has to pay $5 million in yearly interest at current rates (LIBOR3M stood at 3% in September 2022 and 5% in January 2023). This leaves the company with $2 million in pre tax income, which becomes $1.5 million after being taxed at an average 25% effective rate (21% federal + 4% state taxes). Finally, on a cash basis we add back $2 million in intangibles amortization, which after-tax becomes another $1.5 million. This indicates that if the company maintains its current business level, it will eventually generate $3 million in net income.
P/E multiples and implied growth: With the company trading at a market cap of $85 million, investors are paying P/E ratio of 28x on current annualized cash earnings.
For the investor to receive a 10% earnings return on the investment, the company should generate $8.5 million in net income sometime in the future. This implies $11 million in pre-tax income, and $16 million in operating income to cover interest expenses. At current operating margins of 10%, the company should generate $160 million in revenues, or grow approximately 60% from current levels.
Truth is, other aspects could reduce the company’s implied growth requirements while delivering the same profitability yield. If the company repaid $3.5 million in debts in the first year, the interest expense could be reduced by as much as $1 million in the following one (implying $10 million in lower required revenues at a 10% operating margin). Operating margins could also improve, but this is only if the buy side (higher margin) business grows faster than the supply side business, which has not been the case for FY22.
Bull thesis
Although I am not recommending shorting the stock, but rather to avoid investing in it, I believe it is necessary to comment what is the bull thesis and how could the company deliver on it.
Explosive share price growth: In 2023 alone, DRCT’s share price has increased 140%. There are fundamental and market drivers behind this move, in my opinion.
The fundamental driver is DRCT’s top and bottom line growth in FY22 despite their industry’s less than spectacular environment. As was mentioned, the supply side of the business has shown 500% YoY growth rates. Compare the company’s top line growth with that of its competitors in the chart below.
The market factor has been renewed confidence in the profitability of the advertising industry in 2023 and ahead. As the general macroeconomic consensus seems to lean towards the famous ‘soft-landing’ of the economy, cyclical businesses are favored by investors. Although DRCT’s direct competitors above have not seen their shares appreciate much, other micro cap companies of the advertising space have seen their share prices climb substantially.
Return to the mean: My main argument behind the idea that DRCT’s revenue growth is not sustainable at these rates is the concept of return to the mean. That is, a company cannot outgrow its market forever.
However, DRCT could very well outgrow its market for a significant amount of time, and deliver the growth that its current share price implies. In fact, a counter-argument to the ‘bear thesis’ is that if DRCT was able to grow during FY22 (a bad year) then it should be able to grow even more during FY23, if the market believes it is going to be a better year.
Although customer concentration and receivables growth are aspects that have to be monitored, they do not indicate that revenues are unsustainable by themselves.
Conclusions
DRCT has shown growth, but it seems difficult to sustain at current rates (as much as 500% YoY in one of its segments).
I have not found the explanations from management convincing enough to justify the divergence between industry and company performance. In fact, management did not mention the most important factor in FY22 growth, a specific customer, and investors may have come away with an incorrect impression of customer concentration.
The company trades at a multiple from current annualized cash earnings that implies tremendous growth ahead, as much as 60% on the top line.
Although the company could deliver this growth, I believe that the investor does not have a sufficient margin of safety at current share prices. For that reason, I prefer to wait on DRCT.
Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
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