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Reviewing A Recent Visit With ironSource Management
There is not much positive to said for the current phase of the market. Indiscriminate selling, margin calls, an atmosphere of fear. While the Fed’s latest set of what are called dot plots is relatively benign, investors seemingly believe more apocalyptic scenarios. More and more economists, corporate executives, and other commentators are expecting a “hard landing” with some kind of recession and a downturn in corporate profits. Inflationary pressures haven’t eased yet and prices for oil and food may be difficult to control.
One of the few positive elements of this back drop is that stocks have reflected the dim outlook by reaching valuations expected only in times of a deep crisis. One of the ironies of this situation, at least as regards to the enterprise software space, is that the economic woes which the market has discounted, in whole or in part, have yet to be reflected by most IT vendors. Indeed, the largest enterprise software vendor, Oracle (ORCL), surprised some investors last week with a quarter whose results surpassed expectations (part of the rather sizeable EPS beat was a lower tax rate accrual) but more significantly, suggested business growth was accelerating! Oracle, and its current CEO, are well known for their promotional stance on the outlook for the business… but the conference call transcript resonated with me.
Of course, IT vendors, who are obviously aware of the economic risks out there, can only reflect the facts they see before them. So far, and with notable exceptions such as DocuSign (DOCU), and perhaps Adobe (ADBE), companies just haven’t seen the impact of a potential economic storm. While ironSource (NYSE:IS) is an enterprise software company, it is also solidly, an adtech company, and I don’t want to suggest it has particular demand analogs with Oracle. But again, this management has talked about current demand, and the macro environment and like Oracle, signs of massive or any deterioration in demand have not been seen.
The fear of recession, and lower earnings has meant that there are a lot of what seem to be cheaply valued software companies these days. Basically, investors seem to have a far different set of expectations for growth, earnings and cash flow than that which is being presented by many companies. In terms of its valuation, ironSource, appears to me to be a company whose relative as well as its absolute valuation has reached exceptional levels, and it is because of its valuation that I reached out to company management to review the current state of the business, particularly in the wake of management’s decision to reduce guidance when it reported numbers last month. Just how cheap are IS shares? Based on company expectations, which most covering analysts as well as this writer find credible, the company is expected to earn $.18 in the current year. That is a P/E, a valuation metric not seen in some time, of about 13X based on the current share price of $2.30 as I write this on Friday morning, June 17th. That P/E combined with strong growth and a high level of free cash flow conversion presents investors with a substantial opportunity, I believe
These days when I prepare articles, I often comment that it seems unlikely for shares of different companies to sustain a rally while the market as a whole has been imploding.ironSource shares have become so cheap, and so undervalued relatively, because of supply/demand issues with regards to the shares, that the shares could see some kind of bounce from their particularly compressed valuation.
ironSource shares have performed abysmally since the company made its public debut about one year ago. The shares started trading at $11 and of course they are now selling for less than $2.50, a drop of almost 80%. Part of the problem for the shares is that this company chose to go public via the SPAC route, basically as a strategy to secure an investment from Thoma Bravo. A year ago, SPAC IPO’s were all the rage; now that market is totally dead, and many investors consider SPAC financed companies to be spawn of the devil.
I am not going to try to settle the debate as to whether or not SPAC IPO’s should be considered the devil’s spawn. There is less disclosure using the SPAC route than there would be from filing a typical S-1. On the other hand, typical S-1’s run to more than 200 pages these days, and the interminable listing of risk factors really doesn’t help investors to determine the actual worth of an IPO. The odds are that it will be some considerable time before a new SPAC emerges, and so far as that goes, it is also likely to be some considerable time before there is another substantial tech IPO.
But the SPAC process has seemingly led to an inexhaustible supply of shares. Management suggested to me that numerous of its venture investors had sold something like 300 million shares since the IPO. The latest substantial seller, according to the IR VP, has been Tiger Global, once a significant hedge fund, now losing assets at a prodigious rate. As recently as March, Tiger Global owned 20 million shares of ironSource. Management has suggested to me that their (Tiger Global’s) selling had concluded recently. Management, needless to say, has been tracking the situation, but there is no real remediation strategy available.
Would ironSource have been better off going public through a traditional IPO process. I think the shares would likely not be at current levels if they had. But therein is part of the opportunity.
ironSource – Recent Results
ironSource is a adtech vendor, and adtech companies have seen their share of upsets in recent months. I am not going to attempt to analyze all the issues that have seen some companies falter in the adtech space. A few months ago, the changes in Apple’s privacy policies were in focus; they still are, to an extent, but really have had no impact on IS business. In the case of ironSource, its business has continued more or less along the lines that I had outlined when I first wrote an article about this company. Last quarter was no exception.
Last quarter’s results showed that ironSource revenues rose 58% to $190 million, and the company reported an adjusted EBITDA margin of 31%. The company generated $19 million in free cash, a margin of 10%. Free cash flow last quarter was constrained because of some items associated with other assets and liabilities. In addition, the company was absorbing the expenses of the rather sizeable acquisition last quarter of Tapjoy.
These results were a modest upside to previous guidance which called for revenues of $185 million and an adjusted EBITDA margin of 31%. The company does not guide to EPS; that said, management indicated that actual non-GAAP earnings will run to about 90% of adjusted EBITDA, the difference being the company’s tax accrual. EPS as reported in Q1 was $.05. Last quarter the company’s adjusted EBITDA was $58 million and its non-GAAP earnings were about $55 million
The company, as a few other software companies have done, reduced its guidance for the balance of the year, not because of anything it sees in its current level of business, but because the environment is treacherous, and there is concern with regards to future advertising spend if the economy starts to falter significantly. That said, the reduction in guidance was not huge. Management indicated to me that it anticipated that most of the impact it expects from macro factors will be seen in 2H more than in the current quarter. On the other hand, it is now forecasting that Q2 will show 2% decline in sequential revenues, although that would still be growth of 35% year on year. For the full year, the company trimmed its forecast by about 5% in terms of revenues to $770 million, and it has forecast an adjusted EBITDA margin of about 31%. That level of adjusted EBITDA equates to an EPS forecast of between $.18-$.19/share. The First Call consensus for EPS is $.09. Management said that not all analysts who “cover” the shares choose to update their EPS forecast because the company doesn’t explicitly guide to that metric.
Just how “prudent” is this guidance. The macro dynamics appear to be changing; the question really is just how rapidly and by how much. Part of the IS investment thesis is market share gains. I think the odds favor that trend to continue based on the company’s innovation, its platform approach which has led to land/expand revenue growth, and the ability the company has to poach some users from competitor APP’s recently acquired MoPub user base. I don’t think anyone really knows if, and by how much, adtech spending might decline. And even within adtech, there will segments that continue to grow. Essentially, the full year guide reflects no further sequential growth. I think that is carrying “prudence” to an extreme, but given the valuation of the shares, I don’t need to try to guess about how “prudent” the guidance might be.
Currently, the 1st Call consensus shows revenue growth for 2023 of 26% and for EPS of $.15. Of course the company hasn’t yet guided to any 2023 numbers. That said, management suggested that the company expects that growth next year will still top 30% with an adjusted EBITDA margin of about 32%. If it happens that way, EPS will probably reach about $.25.
The company expects that its free cash flow conversion rate will be about 75%-80% of adjusted EBITDA. At the lower level of the expected conversion rate, free cash flow will reach about $180 million this year, and $240 million in 2023. Those numbers would place the free cash flow yield at around 6.5% this year, and 8.7% next year. It is unusual, in my experience, to see free cash yields of that level for a company growing at 30%+/year on an organic basis. That kind of valuation is the result of a substantial supply/demand imbalance brought on by the impacts of the SPAC IPO during an environment in which new money is simply not flowing into adtech investments, regardless of their financial merits.
Reviewing The Business Of ironSource
ironSource is one of the leaders in a space known as ad mediation. Ad mediation is a technology that allows game/app publishers to optimize the yield of their creations, while helping advertisers optimize the value of their spend by allowing them to bid for inventory so as to achieve their exposure goals. ironSource is one of 3 of the most significant competitors who have software solutions to maximize the monetization of the apps one sees on a typical iPhone.
About 80% of ironSource revenues come from solutions that monetize revenue that publishers receive for their games. It may come as a surprise, but these days the largest single category of game players are no longer young males, but females in the 18-44 age bracket who play what are called hyper-casual games. This is a very favored demographic for many classes of potential advertisers. The link above actually has many interesting and some fun data about just who are playing mobile games and how much they spend as part of the process.
The company has two growth initiatives outside monetization of mobile game ads. One of these is an offering called Aura which is about 10% of the company’s current revenues. Aura is the part of the business that competes with Digital Turbine (APPS) for providing telcos with a platform to monetize their interaction with the owners of their phones. It really isn’t necessary to believe that Aura is going to unseat some major Digital Turbine telco customers to believe in Aura’s success. Aura has relationships with Samsung, Orange and Vodafone, with something more than 1.1 billion devices connected to the platform. The device count has grown 6X in the last year.
It also gets about 10% of its revenue from helping mobile app site owners outside of the gaming space develop demand for their products and services. The category is called Apps Beyond Games, and will probably be the fastest growing segment for ironSource over the coming years. Apps Beyond Games is really the potential game changer-ok, no more puns after this one-for this company. Most readers have many non-game apps on their phone that they use on a daily basis. These apps are probably a very effective advertising platform. For example, Uber (UBER) is a platform that is in wide use, but which thus far doesn’t serve as an advertising platform. Even the Netflix app is a possibility. When ads come to these platforms, they will, almost inevitably, adopt some kind of mediation software to optimize their revenue, and advertisers are going to want to be connected to the inventory of available ads.
An example of a recent new Apps Beyond Games customer is a business called Sweatcoin. Sweatcoin has nothing to do with the crypto currency space. It is an app that is domiciled in the UK and is sponsored, in part by the NHS in that country. It rewards walkers with Sweatcoins for the steps that take, which in turn is supposed to prevent heat diseases and lead to healthier users. It is a platform whose audience appeals to certain classes of advertisers and it has become an ironSource customer.
ironSource does have an app publishing business, Supersonic, in which it helps a selected number of game creators publish their games. The Supersonic offering was rolled out about two years ago. So far, Supersonic has published about 50 games, and last year, games published by Supersonic ranked as the third largest published games in the US in terms of downloads. While Supersonic is not a huge revenue contributor, it does have a drag impact because the games published through Supersonic use all of the mediation/revenue optimization capabilities of IS. Last quarter a Supersonic game called Color Match was the most downloaded hyper-casual game in the world.
The company’s mediation platform is built on the data it collects from its users who wind up using the ironSource software development kit (SDK). ironSource says that its SDK has been adopted by many leading developers, and that last quarter 89 of the top 100 games in the US used the ironSource platform. It also gets 1st party data from the activity of its Supersonic publishing effort, and on-device data that it gets from users of its Aura service. Basically, the advantage that ironSource has is its data flywheel which has been able to navigate the shoals of the privacy controversies that have been obstacles to mobile ad growth for some of the social media vendors.
The ad mediation space is marked by a plethora of features and buzzwords and I am not going to try to address all of them in this article. A recent product introduction by ironSource was a feature that supported Apple’s customer product pages, and most recently the ironSource launched Luna search ads, a successful channel that has seen increasing spend in the last year. Another new product is a marketability testing tool for mobile gaming apps.
The company, as is typical of just about all enterprise software companies these days, has a unified platform and many specific solutions to solve specific marketing requirements. The company’s success is very much based on a land/expand sales motion, and the companies DBE ratio has remained at exceptionally strong levels; it was 153% last quarter The company’s research and development spend has been substantial; it was 13% of revenues on a non-GAAP basis last quarter, growing by 65% year on year. About half of the company’s employees are engaged in research and development activity.
Mobile digital ad spending has been estimated to at $295 billion last year and is projected to be $350 billion this year, and its growth trajectory remains steep. Overall, the company has projected it TAM to be around $50 billion, which may seem high, but suggests the very large growth runway the company is addressing. While some social media platforms have reported sharp declines in the growth of ad spend, the trend for the growth in spending for mobile digital ads hasn’t really seen a setback. In talking with management of ironSource a few days ago, and asking about the current state of their business, I was told that so far through early June, there had been no change in the tempo of ad spend or the acquisition of new customers. The company is concerned that the growth in ad spending might slow in 2H, but that hasn’t happened at this point.
Competition In The Space
There are numerous competitors in the space. The best known vendors include AdMob by Google (GOOG), Unity (U) and AppLovin/MoPub (APP). In addition, as mentioned Digital Turbine is a competitor in that part of the company’s business that addresses telecom devices. The company has various strategies to gain market share, and so far as I can determine, these strategies have been effective. One of its advantages has been the ability it has had to circumvent some of the privacy issues that have plagued other contenders in the adtech space.
It is not really possible to evaluate, with any degree of precision, the different feature and functions that are available from IS and which are unique to its offering. I have included a link here to a competitive synopsis, but at the end of the day, there is nothing dispositive in that analysis. The size of the market, and particularly the opportunities that exist outside of just the gaming space, coupled with the opportunities the company has with its Aura offering, suggest to me that this company is going to be able to achieve strong growth over many years to come.
Unity Software is a significant competitor of ironSource with its Operate business, and Operate had significant performance problems last quarter. This should not in any way be read through to ironSource. Unity’s platform was rocked by a software issue that resulted in declining accuracy for that company’s Pinpointer tool. In addition, the company ingested bad data from a large customer. As I have written earlier in this article, the data resources provided by customers are crucial in targeting customers which is of paramount importance to game developers.
Unity had been scheduled to release a mediation product this year; it has now announced that because of reprioritizing its development activities to fix its software issues, the introduction of the company’s mediation product will be delayed. The problems of Unity are those of Unity, and not of the space. At the least, it presents an opportunity for IS to displace some of Unity’s Operate customers with some of its own solutions. Just how large this opportunity might be is not easy to handicap.
This is not an article about Unity and its prospects or the time line of its recovery. Again, owning IS shares is not an “either or” proposition in terms of evaluating Unity vis-à-vis ironSource.
Probably the most significant competitive development in the space In the last several months has been the AppLovin’s purchase of MoPub, previously owned by Twitter. MoPub was a significant factor in the market and AppLovin paid Twitter more than $1 billion to acquire the business. AppLovin paid out $210 million in what have been called publisher bonuses to move the MoPub base of the APP platform. Subsequently, on March 31,2022, APP shut down the MoPub platform.
The publisher bonuses were one time payments-APP is not continuing to pay them and the bonuses did not obligate the publishers in any fashion to continue to use the APP platform. Not terribly surprisingly, management at IS indicated to me that they were having some success poaching some of the former MoPub installed base. For the most part, mediation is a typically sticky application and switching costs are not insubstantial-hence the publisher incentives to move that were provided by APP. But apparently there has been some movement in the MoPub base, and it would surprise me if there were not more movement over the next couple of quarters.
Overall, the absence of MoPub as a competitor is going to self-evidently enhance the competitive position of IS; it basically now faces two significant competitors in its principle space; heretofore it had to fight 3 rivals and earlier this year, it acquired Tapjoy, another competitor in the space.
The leaders of IS have as much experience in this space dating back for more than a decade as anyone. They probably have as good an understanding of what it takes to appeal to publishers and advertisers as anyone. I think the company’s strategies to grow faster than the market seem reasonable, but this is not going to be a space with a single winner.
Taking A Detailed Look At IS Financials
One of the attributes of this company that has led to me to devote some attention to the details of is operations is that it already has a highly profitable business model. Over the last two quarters, ironSource has completed two significant acquisitions. The company acquired Bidalgo which added additional features to its existing platform. The acquisition was a relatively small transaction. Of greater significance was the acquisition of Tapjoy. Tapjoy had been a competitor in the market. These acquisitions had some impact on Q1 margins, but are expected to be accretive in 2H and beyond. Tapjoy, by far the larger of the two acquisitions had achieved revenues of $81 million last year, and it was highly profitable. Because of these mergers, sequential comparisons are not terribly relevant, in my opinion.
Overall, organic growth for ironSource seems to have been in the high 30% range last quarter, although it does not report that specific metric. The company’s non-GAAP gross margins fell to 85% this past quarter compared to 87% in the prior year, a function of the costs of integrating the Tapjoy and Bidalgo businesses onto the IS platform.
The company’s non-GAAP research and development expense rose by almost 65% year on year and was around 13% of revenue. Non-GAAP sales and marketing expenses rose by 45% year on year and actually declined to 34% of revenue. The company’s non-GAAP general and administrative cost more than doubled year on year, reflecting some of the costs of the mergers previously described. That drove non-GAAP general and administrative expense to 7% of revenue compared to 4% in the year-earlier period.
The company’s Adjusted EBITDA margin fell a couple of hundred basis points to 31%. The company anticipates that its adjusted EBITDA and non-GAAP profit margins will return to former levels in the 2nd half of this year. The company is actually profitable on a GAAP basis. Last quarter, stock based compensation was 12% of revenue compared to 13% of revenue the prior quarter, despite the impact of the acquisition of Tapjoy on that metric.
Free cash flow in the quarter was $19 million, or 10% of revenues; it rose 4X on a year on year basis. Because of the nature of the company’s contractual arrangements, it does not generate deferred revenue nor does it have RPO balances as do other software companies. For the most part, therefore, the company’s free cash flow is going to track reported non-GAAP earnings over the course of a full year. That said, on a quarterly basis, free cash flow and reported non-GAAP income will diverge, primarily as the result of balance sheet items.
IS has a highly efficient business model for a company of its size, and its cash generation and strong balance sheet should provide some comfort to investors as they worry about the impact of a recession on so many businesses. Given the multiplicity of opportunities in the markets the company serves, I think its current level of opex investment should make sense to most investors.
Wrapping-Up – Making An Investment Case For IS Shares In A Deep Bear Market Environment
ironSource is one of the leading competitors in providing app developers solutions to monetize their creations The company also offers its Aura solutions for telecom operators to facilitate app engagement touch points. One of the more interesting growth potentials for the company is the company’s Apps Beyond Games initiative.
The company’s competitive position has been enhanced by a stumble of its potential rival Unity Software, some growth issues at Digital Turbine, and most significantly, AppLovin’s absorption and termination of the MoPub business it acquired from Twitter. In all, one growth vector for the company is likely to be continued market share gains.
The outlook for the space in which IS operates is murky-as is the outlook for most businesses at this point. Evidence about the health of the digital advertising business is, to some extent mixed. The company, despite itself experiencing no current demand headwinds, modestly reduced its guidance at the time of its last earnings release. Is that guidance derisked? Will game developers, and advertisers draw back from the market? I really don’t think there is enough evidence to state dispositively that IS is going to be able to grow by 30% every year. That said, its guidance for the balance of this fiscal year of no further sequential growth seems exceptionally conservative given all of the demand headwinds I have seen, especially after my conversations with company management.
The company’s public company origin as a SPAC has been one culprit in the extreme valuation compression of these shares. The continued share sale by private equity investors, and most lately by Tiger Global has created a significant supply/demand imbalance for these shares. Management has said that the supply of additional shares into the float is at an end. If so, and I have no reason to doubt their assertion, then the relative out-performance of these shares seems very likely
The market carnage of the past several months has been deep and broad. I doubt that “no individual of woman born”, to adapt and modernize a quotation from Shakespeare’s Macbeth, can really forecast the end of this bloodletting. That said, the relative valuation of IS is almost unique. A P/E of 13X, a free cash flow yield currently at 6.5% expected to reach nearly 9% in 2023, a free cash flow margin of nearly 25%, an EV/S of 2.5X-these are all remarkable valuations metrics for a company that is one of the leaders in a hot area with a multi-year growth runway.
The company appears to have one of the most experienced and knowledgeable management teams in this space. I expect that the hallmarks of the company such as innovation and efficient execution are likely to continue. All of this adds up to a highly positive set of risks and rewards, even in this current market environment. I expect the shares to produce significant positive alpha over the next 12 months.
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