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Baked In Or Not Baked In? That Is The Question
This has been a less than stellar year in which to invest in the adtech space or even in the tech space or in equity markets. But sometimes less than stellar investment results can result in investment opportunities. I think it would be hard for investors to have missed that two high profile adtech names, Meta (META) and Snap (SNAP) have reported disappointing results or provided disappointing forecasts. The impact on those shares has been exceptional. Snap, in particular, set off something of an adtech share price panic when it said that its business growth had deteriorated, and lowered its forecast by an as of yet undetermined amount. Its statement on May 23 spoke to a deterioration in the macroeconomic environment. It blamed the deterioration of the environment for the slowing growth of ad revenues on its platform. At this point, the number of warnings and alarms about an internet ad recession is pretty much universal. And that has been reflected in share prices as well.
This is not an article on either of those names, or about the adtech space in general. There have been no lack of articles on SA, and from brokerages either, suggesting to buy fallen angels or to avoid entering what is perceived to be a minefield. I am not going to attempt to provide a unique view; I am not too sure there are any unique views on either SNAP or META to offer.
I haven’t written about the Trade Desk in several years now. Much has changed at the company since 2019, most of it for the better. The Trade Desk shares have never been particularly cheap. When considered from an EV/S standpoint, and looked at on a relative basis, that is still the case. But the Trade Desk is an unusually profitable company, with a free cash flow margin last quarter of 44%. It is unlikely that full year free cash flow margins can sustain such a lofty level; I have forecast full year free cash flow margins of 37%, but the combination of free cash flow margins and a 3-year CAGR of 35%, makes the shares far more attractive than they might appear at first blush. A Rule of 40 metric greater than 70, based on my estimates, puts the company in a rather elite category.
This is an article about the fundamentals of The Trade Desk. Of course, the company exists in its environment, but it doesn’t necessarily follow that it will have the same issues that are apparently bedeviling the performance of either Meta or Snap. I don’t suggest that I have some unique view when it comes to the fate of internet advertising growth and the growth trajectory of buy side platforms in a recession or a “soft landing”. Digital advertising has reached a proportion of total ad spend – 63% of total advertising spend in the market research study linked here – that a notable growth slowdown will probably be seen in that market, with overall growth below expectations of double digit growth in 2023 and 2024.
But what does that mean for the operational performance of the Trade Desk? The growth of Trade Desk has been far greater, for the most part, than the growth in the digital advertising space for some time. Indeed, the CEO called out that point in the conference call script that was presented in May.
As a CEO, it’s always important for me to look at how we are performing relative to the industry. For example, the IAB and PwC predict digital advertising will increase approximately 8% in 2022. Publicis Group’s Zenith estimates the increase at about 14%. But either way, we continue to grow at a pace well ahead of industry estimates, which means we are gaining share and adding significant value. I continue to be extremely optimistic in part because of the combination of our exceptional 95% plus retention rate and our significant growth rate.
There are macroeconomic forces, which have changed the media and technology landscape dramatically in the last few months, especially in CTV, which also gives me optimism. As many of you know, I have spent many of the last 10 years publicly predicting that Netflix and nearly everyone else would eventually show out. Netflix recently announced that they are likely to make ads a part of their future. This and so many other great things are happening in CTV.
In fact, I can’t think of a time that the TV landscape has had more positive changes in a short period of time than what has happened in Q1 of this year. I want to spend the biggest lot of time on that. But in order to discuss the significance of what’s happening in CTV, we first need to discuss what’s happening with 2 foundational initiatives: first, our work on a new identity framework for the Internet; and second, our work to make the supply chain more efficient.
Even though Trade Desk is highly profitable, has a very differentiated offering and has continue to outperform it growth expectations, investors have not chosen to believe company management, or have found other reasons to be wary with regards to the shares. At this point, analysts’ consensus analyst opinion has become fixed with expectations that the company’s growth will slow, and that has produced a substantial share price pull back. Specifically shares of Trade Desk fell by 19% in the aftermath of the SNAP warning, and they still remain lower than where they were before that point. The shares are down by 54% so far this year, and down by 62% from their mid-November 2021 high (prices as of mid-morning 6/30). Sadly, that kind of share price compression is hardly unique; it is even more noticeable because the company has continued to grow at elevated rates while the share price has contracted.
The share price weakness comes despite the company’s guidance reaffirmation of its guidance on May 26th through the filing of an 8-k form; most observers and holders are more concerned by the outlook that the company will provide when it next reports earnings, probably in the second week of August, than they are about the specifics of the results to be reported for the June ending quarter. And further, many traders have been, or are likely to, continue to see Trade Desk shares as analogs of Meta and Snap, so even if the company reports favorable results, and provides positive guidance, that may not be enough in the short term to reignite relative performance for the shares. Given the track record of this company, and the obvious signaling implied by the SEC filing, it seems highly likely that Q2 results will exceed the latest forecast.
Just for the record, the Trade Desk actually reported that its 1st quarter revenue growth accelerated noticeably to 43%; while the prior quarter had seen growth 24%. Of course, that Q4 number is reflective of the absence of political ads in 2021; in the prior year, political ads had driven Q4 revenue growth to 48%-adjusted for the absence of political ads, Q4 revenue growth was 36%. Full year growth in 2021 for the Trade Desk was 43%.
Q1’s performance exceeded its revenue forecast by 4% and it’s adjusted EBITDA expectations by more than 30%. More than all of the revenue beat turned into EBITDA, and 1st quarter free cashflow more than doubled year-on-year; the Q1 free cashflow margin of 44% is obviously remarkable. While the Trade Desk is self-evidently not a company with recurring, subscription based revenues, it has typically had a fair level of visibility into spend across its platform, and thus has a long-term record of beating expectations most quarters by varying amounts.
The company’s strong Q1 was achieved despite some softness in its European business in the second half of the quarter. Europe is not a particularly large revenue source at this point for the Trade Desk, and in any event, the company indicated that the European weakness had seen some recovery in April. Much European growth is being driven by the advent of Connected TV and CTV business did increase more than 2X in Q1 2022 in Europe, albeit compared against a year earlier period that had a minor revenue contribution from CTV.
As Trade Desk didn’t begin operations until 2009, and the digital advertising space was then in its infancy, there are no real analogs between the last recession and current economic trends that might be applied to assess the potential performance of the company. I have listened to TTD conference calls for some time now; with regards to management’s view of the future, and how the business might perform in a recessionary environment, this latest call was as positive as any. The company’s CEO has always been very positive but he was even more upbeat than usual during this call. The company, unlike some other IT vendors, has actually announced plans to accelerate hiring, and the CFO described his comfort with the current outlook for the company.
While the kind of valuation that The Trade Desk shares present has not appealed to the preponderance of investors in recent months, it seems likely, at least to me, that a category leader that has been a principle driver in what can be seen as a revolution in the way ads are bought and in which the value of content is optimized for its owners will return to investor favor. One friend of mine recently shared a chart with me relating to the positioning of asset managers going back for 15 years. The chart shows that this market cycle has reached depths not seen in the years for which data is available, even in the wake of last week’s rally.
This kind of sentiment has done in the shares of Trade Desk and many other high growth equities, and until it eases on a consistent basis, Trade Desk shares aren’t likely to show sustained upside. I haven’t the crystal ball to determine when sentiment will turn; there are probably as many views on that subject as there are grains of sand. But when the turn happens it is likely to be quite violent in nature, and to take place without warning. I have started to accumulate Trade Desk shares expecting/hoping for such a reversal.
Market cycles in terms of what investors look for turn. For me, at this time, the Trade Desk ticks too many positive boxes to ignore. The Trade Desk is a leader in a business segment that is called programmatic advertising – in fact the leading independent buy side platform. But much of the excitement about the company and its shares has been because of its position in the connected TV space. I will recapitulate some of the changes in the environment that are apparently driving demand for the Trade Desk platform and which are really quite disconnected from the effects that a recession may have on the market for digital advertising. If the Trade Desk continues to demonstrate that its business is not really an analog of some other more challenged businesses in the adtech space, eventually investors will perceive the value.
How Can The Trade Desk Grow If Digital Advertising Spend Atrophies?
The Trade Desk provided guidance for Q2 revenue growth of 30% which implies Q2 sequential growth of about 15%. In the prior year, sequential growth from Q1 to Q2 had been 27%; again, that kind of performance was in some way linked to the impacts that the pandemic had created on the trends in advertising spending. The company indicated that it had seen some faltering in advertising spend growth in Europe on its platform as Q1 ended, but through April, spending on the Trade Desk platform in Europe recovered to levels seen at the start of Q1. As mentioned, the company subsequently reaffirmed guidance in an 8-k filing, and used the term “at least” in terms of its forecast. It would be quite surprising if the company did not wind up achieving 35% growth in the quarter now ending.
The Trade Desk story, and the positive thesis with regards to the shares is one of market share gains. The market share gains are coming both because of innovations this company has introduced and also because of changes in the environment. Connected TV is part of the story. Connected TV is moving mainstream with companies such as HBO moving from a testing phase to scale in terms of the inventory they offer advertisers.
The company CEO, Jeff Green, is known as a visionary in this business and for presenting what might be termed as a charismatic view of the environment. But over the years, since I have followed his comments, he has wound up being more right than wrong, and I would thus place some credence into what he said about the opportunities for his company in the 2nd half of the year:
So with all these moves in advertising, especially from the global players of CTV, I think it really sets up the second half of the year for – around the world to see movement towards ad-funded CTV in a way that we started seeing early on in the pandemic. But I think we’re seeing even more of now. We didn’t spend a lot of time in the prepared remarks talking about shopper data. In the first quarter of this year, we also just had our first full quarter with Walmart and their DSP who’s just doing really well.
We have talked about new partnerships with Walgreens and Drizly. There have been others that have talked about our partnership with Target’s media company, Roundel. So to have Walgreens, Walmart and Target on the platform and partners as it relates to data and measurement, just unbelievable. But just again, nearing a perfect setup as it relates to shopper partnerships.
And then, of course, in the second half of the year, we’re also going to have a midterm election. From recent events, that seems to be one that’s going to be exciting as well. And I suspect just because of the momentum and attention that it will have more investment than most. And we think it’s – we’re very well positioned to have it be our biggest political year ever.
There are a considerable number of very specific demand drivers that will be driving 2nd half growth as the above quote makes clear. I think it is easy to underestimate the impact of the merchant DSP’s which are based on the Trade Desk platform in terms of their potential to accelerate growth. Walmart, for example, was just in its trial stages last quarter, with 200 advertisers providing test budgets. For advertisers, the advantages in securing data and being able to measure impact are key in terms of how they allocate their budgets. These merchant based platforms are substantial opportunities for Trade Desk to further differentiate its offering.
In addition, the company is likely to benefit in terms of demand growth from some specific technologies that are seeing broad acceptance. The company announced Solimar about a year ago, and most of its business has migrated to that platform. Solimar is another example of the use of AI technology. In this case, using AI has been designed to improve the optimization of campaigns and to tie ad spend to specific desired business outcomes. Solimar’s advantages, are, in part, based on the ability of the platform to on-board what is called Unified ID 2.0 data, basically replacing cookies (not the cookies you eat – nothing is ever going to replace the cookies one can buy at Levain Bakery in NYC – but cookies that serve to identify users on a web site).
Another technology offering from Trade Desk that is likely to drive demand is an offering it calls OpenPath. OpenPath was launched in the middle of last winter. It is a technology that allows advertisers direct access to premium digital advertising inventory. The company has announced some high profile content providers. Despite the fact that it seems as though this product might propel the company into the supply side of the digital advertising marketplace, it doesn’t appear that the company is going to be offering traditional supply side services, particularly including yield management.
With the introduction of this product, the company departed from Google’s Open Bidding platform a couple of months ago, although it continues to buy inventory from Google’s (GOOG) (GOOGL) Ad Exchange. Offering an alternative to Open Bidding is a big deal, apparently, and has been underappreciated in terms of its overall potential for the company.
One of the principle upsides to estimates for this company is the potential opportunity to obtain inventory from Netflix (NFLX) when/if it starts to show ads on its platform. Jeff Green has been forecasting that eventually Netflix would start selling advertising on its platform and in turn that would provide a tailwind for Trade Desk demand. It appears as though the forecast is finally playing out, and it may have some impact on results in 2023.
Trade Desk Competitors
When many investors think of digital advertising they are most focused on the efforts of companies such as Facebook, Google and a raft of social media vendors rather than a company such as Trade Desk which operates a platform that is not wholly understood by many.
The competition between Google and The Trade Desk is basically existential. I mentioned OpenPath earlier in this article. That offering is obviously intended as part of an overall strategy to compete against the grip that Google has over managing ad auctions. Google’s Open Bidding technology has been the industry standard for publishers seeking bids from many advertisers for years now, without a viable alternative.
It is not necessary to think that Google has to lose substantial share for Trade Desk to be very successful. Many advertisers and agencies have long searched for a platform outside of the Google “walled garden.” The Trade Desk offers such a platform, and part of its success is just that it is the non-Google in the adtech space.
Alphabet’s basic offering in this space is called the Google Marketing Platform. I have linked here to an evaluation by a 3rd party research firm that shows the differences and the similarities between the two offerings. Most advertising agencies, the typical user of the Trade Desk service, find it simply works better than what is available from Google, and others in the space. Here is a typical review from a Trade Desk user:
Use Cases and Deployment Scope
The Trade Desk is our agency’s preferred demand-side platform and data management platform to manage our clients’ programmatic advertising campaigns. We use The Trade Desk (NASDAQ:TTD) across our Client Services department. We have licensed TTD’s platform since 2015. We use TTD to develop data-driven media plans for our clients – this includes developing an analysis of the best ways to target our clients’ audience(S) and to forecast available impressions, CPM rates, and the optimal allocation of media budget across a variety of targeting tactics. Our Client Services department develops customer audiences in TTD’s DMP. We then set up and manage campaigns and the underlying ad groups in a “full service” capacity for our clients. We use a third-party reporting dashboard that imports performance data from TTD to report on programmatic performance for our clients.
We compared The Trade Desk against a number of competing programmatic media buying platforms including Google’s DV360, Centro’s Basis platform, Adobe Advertising Cloud, and the Simpli.fi platform. In the end, we felt that The Trade Desk provides the most tools, options, advanced technology, and access to third-party solutions than anything other DSP/DMP on the market. TTD has leaned into forming a long-term relationship with our agency, and they continue to provide great strategic service.
After extensive research of DSP and DMP platforms in the market, our agency made the wise decision to license TTD’s platform and develop a long-term partnership. TTD continues to innovate and offer cutting-edge media buying solutions, access to more audience data segments, and access to new and emerging media channels like CTV/OTT and digital-out-of-home. We couldn’t be happier with TTD’s technology and is one of the most advanced agency users of TTD is a key differentiator for our agency.
Trade Desk currently has around 1000 users of its service, and with the advent of OpenPath and the merchant partnerships the company has been creating, that number is likely to expand quickly and substantially. The company’s CEO maintains that Trade Desk is the go-to platform for agencies/advertisers. As mentioned, the CEO is highly positive in his presentations, but in this case I see no real reason to question his assertion.
Connected TV: A Cornerstone Of The Future Of Advertising
There are many companies offering different kinds of solutions in the connected TV space. It is perhaps the fastest growing advertising channel. Linear TV advertising is declining precipitously, according to the study linked here, while connected TV advertising spend is expected to double over the next 5 years. Linear TV viewership is dropping, while the connected TV audience is thought to be growing to 235 million.
There are many terms in the CTV segment to define various technologies. But as most readers are not ad buyers, but are trying to decide if there is an investment opportunity in the space, it is not really necessary to define each term in this article. The basic definition for CTV is that it is digital content accessed by apps and streamed over smart TV’s and mobile device via an internet connection.
Trade Desk is certainly one of the leaders in selling ads on CTV, and last quarter, revenues from CTV traded across the company’s platform continued to achieve the strongest growth in the company’s offerings. According to the CEO, the gold standard in what advertisers want today can be found in what is called premium CTV. Some premium CTV relates to subscription based video on demand, but often it will mean viewers see ads in exchange for free content. Most recent studies have indicated that the majority of media buyers planned to allocate larger budget percentages towards CTV. Consumers are apparently rapidly making the jump from traditional TV to digital streaming services. Advertisers believe that ads seen on premium CTV are simply more effective because of their context, because of user engagement and because viewers are far more likely to view and remember ads run on CTV than other kinds of ads. CTV is also said to provide brands with viewer safety, in other words brands are less likely to face liability claims if their ads appear on premium connected TV. Further, and perhaps self-evidently, it is much easier to quantify the number of impressions that viewers actually see. I have linked here to a discussion from a market research firm called Strategus which details a number of these trends.
With CTV, advertisers are willing to pay much more if there is a reasonable chance that viewers are interested in their product. Advertisers are seeing reach and impact erode from traditional cable and they are focusing on migrating their spend to premium streaming content. The migration of advertising spend to CTV has obviously been one of the principal revenue tailwinds for this company, and it has been a factor in the company’s consistent market share gains. The nature of advertising on CTV, which provides advertisers with a medium in which there is lots of data to measure engagement and impact, plays specifically to the strength of using a data flywheel of the kind offered by the Trade Desk. With the use of CTV transacted over the Trade Desk platform, advertisers can have clear insights into the viewership and engagement they are getting for their investment. This is the best way they can optimize their spending. When considering the potential growth of Trade Desk in a recessionary environment, the tail wind of CTV is likely to play a significant part in mitigating issues with overall advertising spend.
Trade Desk: A Very Profitable Business Model
Trade Desk has been an exceptionally profitable business for some time now, and while the non-GAAP operating margins of Q1 are likely to prove to be an outlier, this company is achieving substantial leverage at scale and is likely to continue to do so. Advertising is typically a seasonal business, with a peak in Q4, and usually a trough in Q1. Seasonality was upended to some degree because of the influence of the pandemic on advertising spend over the last few years. It seems likely that seasonal factors will resume a normal cadence this year, although it can be a bit difficult to determine a normal pattern given the prior ups and downs in particular quarters.
Looking at 2021 as a whole, non-GAAP operating margins reached 38.6% up from 30.6% in the prior year. GAAP operating margins were positive at about 10% last year compared to 17% the prior year. Last year, in Q4, the company CEO received a $158 million performance grant which reduced GAAP margins by 1320 basis points. The company recognized an additional $66 million of SBC expense related to the grant. GAAP accounting and the use of Black-Sholes can make it difficult to evaluate the real worth of a grant. In this case, the value of the grant is essentially “0” unless the TTD share price is greater than $90, and significant payouts only occur if the shares trade at around $200 and stay there for 30 days. The grant has been expected to incentivize and retain Mr. Green for several years, and no further grants are likely.
There are doubtless some readers who will feel that such a level of CEO compensation is excessive. There aren’t all that many CEO’s who have gotten performance grants of whatever kind that are worth $224 million. To that, I can only suggest that a significant part of the success of this company, and its high level of operational performance is clearly a function of Mr. Green who cofounded the business and is being well rewarded for his expertise and his record in over-attaining planned levels of revenue and profitability.
Non-GAAP operating margins in Q1 reached 34% up from 27% in the prior year. There was noticeable leverage in every one of the opex categories on a non-GAAP basis. Platform operation expense, which is equivalent to cost of sales, fell to 18% of revenues down from 20.5% of revenues in the prior year quarter. The company is ramping its development expenses significantly; they rose by 32% year-on-year and were 16% of revenue compared to 17% the prior year. Sales and marketing expense fell to 17% of revenue compared to 17.7% of revenue the prior year. Overall, opex rose about 30%, including the cost of platform operations while revenue growth was 43%.
The company has forecast that in Q2, its adjusted EBITDA margin will be 33%, down from 38% in Q1. The company said it was still benefitting from virtual cost shedding arrangements in Q1 which not be present in Q2. I have to confess that I am a bit mystified as to why the company is seeking to end the cost advantages of a virtual model. Obviously, this company has achieved a great deal in terms of the productivity of its product development and marketing investment while in virtual mode, and just how much more is possible is something I would regard as tendentious at best. Overall, I am not sure just how serious that sequential expense growth forecast is; it would imply about a 23%+ sequential growth in non-GAAP opex which even with accelerated hiring and an end to some virtual arrangements does seems not terribly likely. Last quarter, the sequential growth in non-GAAP operating expenses was essentially nil; they actually fell slightly which mathematically makes it difficult to foresee 23%+ growth in opex excluding platform expenses.
Last quarter, the free cash conversion ratio was very elevated, primarily a function of balance sheet items – particularly the increase in payables balances. Over time, the company’s free cash flow generation is likely to track quite closely to adjusted EBITDA. Last year, free cash flow wound up at 75% of adjusted EBITDA; that level of free cash flow conversion was depressed due to a very substantial decrease in the growth of payables.
Unlike many other software companies, Trade Desk has just begun to ramp its international business. Last quarter, business outside North America was just 12% of revenues, down slightly from the percentage contribution in Q4 and the prior year. One concern of many with regards to a difficult business climate in Europe will have proportionally less impact on The Trade Desk than on other high growth IT vendors.
Stock based compensation, excluding the payments to the company co-founder was 18.7% of revenue in Q1 compared to 23.6% of revenues the prior year. For the full year 2021, SBC expense was 15% of revenue, excluding the bonus paid to Jeff Green, which compares to an SBC expense ratio of 13.4% the prior year. If the company ramps research and development spend significantly, as the CFO suggested, I would expect SBC expense to trend higher although the less constrained market for IT talent may cap that growth.
At this point, it seems obvious that Trade Desk management has seen no signs of a slowdown in the growth of spend across its platform and is seeing success with its important growth initiatives. When a company is attempting to grow opex spend at a rate of 35%+, there are many levers it can pull in order to maintain margins should revenue growth not continue at elevated levels.
Wrapping Up: The Case To Buy Trade Desk Shares
Like almost all IT companies, the valuation of the Trade Desk has been shredded since the shares reached a high point in mid-November 2021. The shares have had the further burden of warnings from other ad supported tech companies such as Meta and Snap.
On the other hand, it appears as though the company’s outlook for growth hasn’t dimmed despite significant concerns with regards to the trajectory of advertising spend during a recession. The company’s newest initiatives including its privacy framework, Unified ID 2.0, the company’s growing roster of merchant partnerships including those with Target (TGT) and Walmart (WMT), and the company’s OpenPath offering that connects content providers and advertisers directly are likely to show continued secular adoption and are highly significant revenue growth tailwinds. In addition, the company has called out ad spending on the mid-term elections as a further counter-cyclical demand driver.
Undergirding the positive outlook for growth is the well heralded, but still under-appreciated shift to connected TV and now premium connected TV. To reiterate, part of the case for the shares is the rapid migration of ad spend from linear TV to connected TV, and the combination of connected TV with the company identity framework, and use of AI technologies is bringing advertisers the ability to optimize their campaigns through the use of data across the Trade Desk platform.
Of course, since the Trade Desk did not exist at the time of the last recession, its operational performance during a period of economic stress has no real analogs. But overall, given the relatively undemanding set of expectations that comprise the consensus, I think the probability is high that the company continues to exceed 1st Call consensus estimates over the next several quarters.
Trade Desk faces numerous competitors in its space of which the Google Marketing Platform is probably the most prominent. The company’s target market for years has been agencies, most of whom seem satisfied customers. The company’s latest offering, OpenPath is a direct shot at Google, and has seen early signs of success.
Trade Desk shares have never been “cheap” and they aren’t cheap in terms of EV/S at this point either. Currently, as of mid morning, June 30th, the shares sell at an EV/S estimate of less than 12X. But looking at the combination of free cash flow margin + growth shows a different picture with the shares valued at far closer to the average for the company’s growth cohort. The company achieves a Rule of 40 metric in excess of 70, The company’s DPV based on my current estimates, is more than 65% above the company’s current share price. That being said, as a caveat I have repeated many times, Trade Desk shares are not going to appreciate consistently and materially, until sentiment changes with regards to the valuation of high growth technology shares.
This has been a humbling 8-month hurricane with regards to the valuation of high growth shares – as bad or worse than anything I have seen. But cycles change, and rather than attempting to position a portfolio defensively to take account of the probability of a recession, after the valuation compression, it seems that at least part of a high growth portfolio should be considering companies to own when the cycles turns and a recovery emerges. Trade Desk is surely a name that should be considered in that context and that is why I have initiated a position in the shares.
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