Why I Bought PubMatic Stock (NASDAQ:PUBM)

I recently bought PubMatic (NASDAQ:PUBM) in the low $20s. As with other high-tech growth stocks, PubMatic stock has gotten destroyed and is down ~50% the last twelve months. PubMatic is a smallcap growth story that may have years of growth in front of it, is in pristine financial condition, and looks undervalued.

Digital Advertising – PubMatic’s Role

PubMatic is a middleman in digital advertising. The company runs a digital advertising Sell-Side Platform (SSP). SSPs provide a variety of software solutions that help publishers of Internet-based content find the best advertisers to advertise on their sites (websites, apps, video games, podcasts, Connected TV channels, etc). PubMatic’s core competitors are other SSPs, notably Magnite (MGNI), Google (GOOGL), among others.

Another popular company serving as a middleman in digital advertising these days is The Trade Desk (TTD) – however, The Trade Desk is not a competitor to PubMatic. The Trade Desk operates a Demand-Side Platform (DSP). While SSPs like PubMatic help publishers find the best advertisers, DSPs like The Trade Desk help advertisers find the best publishers.

A Great 2021

The company IPO’d in December 2020 as the advertising industry began to see financial recovery from the effects of COVID-19. In the five reporting quarters since its IPO, the company has performed well, beating analyst revenue and EPS expectations in every quarter.

For FY 2021, PubMatic reported strong financial and operational metrics compared to FY 2020:

	2021	2020
Revenue	$227M	$149M
Revenue Growth	52%	31%
Gross Margin	74%	72%
Operating Margin	26%	21%
EPS	$1.00	$0.46
Free Cash Flow	$58M	$150k
Cash	$83M	$34M
Publisher Customers	1,450	1,200
Ad Impressions Processed	92 trillion	47 trillion
Net Dollar-based Retention Rate	149%	122%

Content publishers are PubMatic’s customer base. PubMatic gets a cut of the advertising revenue paid to the publishers by advertisers. Revenue is variable and based on volume – it is not a fixed recurring revenue model.

Revenue generated is also dependent on the mix of media platforms on which ads are being placed. CPM rates vary by type of media.

In a recent interview, CEO Rajeev Goel noted that Connected TV (CTV) is one of the highest paying CPM models. Conversely, traditional banner ads are one of the lowest paying, he said. CTV is one of the company’s newer verticals and growth here has been robust. In Q4-21, CTV revenue was up six-fold yoy.

In 2021, the company’s customer base of publishers grew by 21% to 1,450, representing more than 97,000 individual domains and apps worldwide.

PubMatic’s net dollar-based retention rate increased to 149% from 122%, which is impressive compared to other prominent software-as-a-service companies. Magnite may have similar figures, but I couldn’t find a reference to net dollar-based retention rates via a quick search through recent Magnite earnings releases, transcripts, or SEC filings.

One of the key differentiators cited by PubMatic is that it owns its technology infrastructure. Competitor Magnite, on the other hand, uses cloud-based service providers.

Goel also stated in the interview that advertising’s uniqueness led PubMatic to bring data center operations in-house ~decade ago. He said PubMatic did this because advertising is unique in two ways:

1. Transactions must be processed in real-time;

2. A lot of data is generated in the ad placement process.

Goel has argued that by owning the infrastructure, PubMatic delivers better outcomes for customers. Goel also stated that in-house data operations is one of the core reasons why PubMatic’s net dollar-based retention rate is so high.

The company employs artificial intelligence (A.I.) and machine learning that PubMatic claims increases advertiser return on investment and publisher revenue and improves PubMatic operational efficiency. Cost of revenue per ad impression decreased by 28% in 2021 after decreasing by 32% in 2020. Over the last two years, the company has posted 20%+ operating margins and is a strong generator of free cash flow.

Regarding A.I./machine learning for competitor Magnite – I did another quick search through Magnite’s recent earnings releases, earnings transcripts, and SEC filings for references to these topics but I couldn’t find anything.

Market Potential

When PubMatic IPO’d in 2020, the company claimed to have 2-3% market share and now claims to have 3-4% market share. The company generated $227 million in revenue in 2021. Using PubMatic’s 3-4% market share estimate, the current SSP addressable market is ~$5.7- $7.5 billion.

Goel recently said he expected the market to nearly double in 5-7 years and said PubMatic could achieve double-digit (at least 10%) market share.

If Goel’s estimate holds, my conservative math shows that PubMatic could see >$1 billion annual revenue in 5-7 years, which would be >4x increase from current levels. The company has stated that its ultimate market share goal is >20% and that it has multiple growth drivers to achieve this.

Competition & Some Risks

PubMatic is a leading SSP in an industry that is witnessing both consolidation and rapid technological change.

Competitor Magnite has 2x more revenue than PubMatic and is the largest standalone SSP in the market thanks to acquisitions, including the merger of Rubicon Project and Telaria that was rebranded “Magnite” in 2020. There is a litany of small SSPs in addition to SSPs that are subsidiaries of major corporations like Comcast, Google, and Amazon.

One of the major perceived risks in recent months has been a project called OpenPath. This is a solution that was introduced by The Trade Desk that creates a direct link between publishers (PubMatic clients) and The Trade Desk, which represents advertisers.

Question: If OpenPath is designed to simplify the ad buying process, could this eliminate an SSP like PubMatic from the digital advertising marketplace?

No, says PubMatic. Evercore analyst Shweta Khajuria has posed this question to both PubMatic and Magnite on recent earnings calls, and she received similar answers from each company.

While there are slimmed down competitor SSPs that are simply pipes between a publisher and advertiser, PubMatic says it is differentiated from these simpler SSPs because it offers value-add services to publishers. One of those services is something called “yield management.”

Yield management consists of managing prices and ad placements to improve ad space fill rate. If a publisher has its own technology for yield management, OpenPath is a solution for that publisher if the publisher prefers not to use an SSP.

But PubMatic says that that same publisher would still see a benefit to being a PubMatic customer because PubMatic offers other solutions to improve the publisher experience such as OpenWrap header bidding, Identity Hub, Audience Encore, among other solutions that optimize digital ad placement for publishers.

At this stage, it appears an SSP like PubMatic has strong relevance to publisher clients moving forward unless publishers are intent on developing these solutions in-house, which seems unlikely.

Another question: Could The Trade Desk itself become an SSP – in addition to a DSP – and cut PubMatic off at the knees with OpenPath?

No, The Trade Desk has said. The Trade Desk has noted that it has no intention of becoming an SSP because the value it provides to its customers as a DSP-only provider helps ensure its objectivity in assisting advertisers find the best publishers for ads.

It remains to be seen if other technological developments alter the SSP marketplace and present competitive risks to PubMatic in what is a highly dynamic and quickly evolving industry.

The Year Ahead

The company has guided for FY-22 and Q1-22 revenue growth of 25%. This muted guidance – coming on the heels of >50% rev growth in 2021 – is one of the reasons the stock dropped after earnings.

However, we’ve seen this story before. For 2021, the company guided for conservative revenue growth of 21-24%, which it beat markedly. Statements from executives about the upcoming year and beyond for PubMatic’s business were highly optimistic.

Of course, there are several macro risks in the market that could hurt business this year. We may fall into a recession. The war in Ukraine could remain a drag on the global economy this year and beyond.

The company plans to double its engineering team (in India) within the next 12-18 months, and will continue global expansion of its sales team. The 2021 10-k notes that the company has more than 700 employees, 367 of which are in India.

A surge of hiring in the hundreds will boost costs and, presumably, stock-based compensation. In PubMatic’s 2022 guidance, the company estimated that its adjusted EBITDA margin would be 36-37% vs. the 42% margin we saw in 2021.

The company has declined to give net income guidance, in part because it has declined to predict what stock-based compensation will be for 2022. Stock-based compensation in 2021 nearly quadrupled to >$14.1 million.

Valuation & Conclusion

If the company meets its 25% revenue growth goal for the year, adjusted EBITDA could be $102M vs. $95.2M in 2021. If taxes, stock-based compensation, and depreciation and amortization as a percentage of EBITDA remain similar to the percentages we saw in 2021, that leaves PubMatic with ~$53 million in net income. This excludes the $5.4 million unrealized gain on an equity investment the company reported in its 2021 financials.

Worst case, net income could contract this year. In 2021, EPS was $1.00. Consensus analyst estimates for 2022 are at an average of $0.64.

Company and analyst growth estimates may be low based on what we’ve seen PubMatic deliver over the last year. The company has a history of issuing conservative guidance. And the company’s commitment to hiring and continued global expansion shows that the company sees ample growth opportunities ahead.

At low end $0.64 2022 EPS, PubMatic today is trading at ~40x 2022 EPS at $26/share, assuming no share dilution this year. The stock is actually up about 30% since I bought at ~$20 in mid-Mar. ’22, which is what the IPO price was in Dec. 2020.

I may add more if PubMatic stock stays in the $20s given the company’s growth profile, its massive addressable market, its financial strength, and its continued investment in growth.

I had considered investing in competitor Magnite as well, but I have decided to pass for now for several reasons, including Magnite’s high debt load and lack of profitability.