#44: When Theory Holds True
Today is National Twilight Zone Day. If you live in Programmatic Land, it’s probably just another day.
Reading Time: 5 combined minutes.
Quo Vadis is ever-curious about all things adtechie, particularly when it comes to investment alternatives. One question that’s been on our community’s mind is whether total shareholder returns (TSR) across our QV AdTech18 portfolio correlate to actual returns on invested capital (ROIC).
When valuation theory meets practical reality as it should, which eventually happens even in mystical twilight zone sectors like adtech, then this common sense correlation should show up in the data. So, we built a neat model to check it out.
Looking at AdTechCo as one giant company
We call the data set “AdTechCo.” It covers all aspects of the programmatic supply chain from agencies to publishers and everything in between.
The first step was to build a data set that combines all 18 programmatic players into one single company by joining key income statement and balance sheet items. The result is a single entity with 32,000 total employees. The data set starts in the January 2020 quarter (when seven of the players were already public) and runs through the most recent reporting period ending in December 2022 (the rest IPO-ed during 2021).
Sure enough, fundamental valuation theory does in fact meet reality. It’s a grim picture, so consider this a trigger warning if you’re sensitive to value destructive businesses.
When combining financial data across 18 different companies the key is to focus on getting the best apples-to-apples picture. As our readers know, these kinds of thought experiments come with a few imperfections but hopefully remain instructive nonetheless.
Combining income statements into net adjusted operating profits
The first area to align is revenue. Some adtech players report gross ad spend as topline revenue (e.g. Criteo) while others only show net revenue (e.g. PubMatic). AdTechCo is aligned on net revenue which is all that matters because this is the money they extract from ad budgets. Total annualized net revenue for AdTechCo on a TTM basis was just under $13 billion as of December 2022.
Food for Thought: We hope advertisers got more than $13B in cash-on-cash returns, but nobody really knows… least of all advertisers. This absence of buyer knowledge is probably the most important growth driver in the space.
The second key treatment is to take operating profits (or losses) and adjust reported taxes into a cash tax estimate using a 27% marginal tax rate assumption. Estimating cash taxes also requires adding back net deferred taxes assets.
ADTechCo’s reported taxes over the last 12 quarters were $22 million while cash taxes on an as-if basis would be $137 million. While the difference is not material with respect to generating sufficient returns on capital, it’s more about being as precise as possible. With a decent estimate of cash taxes in hand we get a clear view of real operating profits (aka NOPAT) for AdTechCo.
Combining balance sheets into invested capital
Step one is to total up all assets (cash, current and non-current assets). Next, we estimate operating cash (4% of net revenue assumption) because this is the day-to-day cash needed to run any well-capitalized business from a working capital perspective. The remaining cash is all excess (“cash is trash”) and removed from invested capital.
Next up, all accounts payables and accrued liabilities are removed. These two working capital accounts make up the bulk of current liabilities for AdTechCo. That leaves us with all-in invested capital inclusive of goodwill.
The last step is removing goodwill “assets” to get the clearest view across all 18 players. In effect, we are impairing goodwill and valuing it at zero. Let’s face it, most of the goodwill was booked when acquisitions were done in a hot ~0% interest rates environment making valuations over-the-top crazy. Moreover, TTD has zero goodwill so we’d need to remove it across the board to get the cleanest like-for-like perspective on invested capital across AdTechCo.
What else piqued our interest?
Perhaps the most compelling thing about building a data set like AdTechCo is what you find along the way. We’ll share more nuggets in future posts, but the most important observation is AdTechCo’s inability and low prospects to generate economic profits (aka cash flow returns).
Economic profit happens when a company produces returns above its cost of capital which is the only outcome investors want to see happen. You can talk a great game promising unicorns and rainbows, and you can even play sleight of hand with accounting adjustments (e.g. adjusted EBITDA), but eventually, reality kicks in and trumps all the nonsense.
The first issue for AdTechCo is about business model basics. There simply is not enough ad spend for these players to get their hands on and there is only so much wiggle room to extract take rates. Growth will be increasingly hard to find and even harder to keep.
Looking no further than the war going on between DSPs and SSPs. The Trade Desk shot the first bullet with OpenPath to bypass SSPs. Then Magnite’s ClearLine shot back along with PubMatic’s Activate to bypass DSP (aiming squarely at TTD). These direct-to-publisher strategies purportedly allow agencies and brands to buy inventory (online video and CTV) directly via programmatic pipes but not via real-time bidding (aka “programmatic guaranteed”). In essence, they are going after direct manual insertion orders. What investors should consider from the hillside above the battlefield is if this intensified competition will more likely lead to lower take rates and less likely lead to incremental topline growth. From what Quo Vadis can tell, the battle looks more like a hail mary than a growth play.
Even if revenue pressures are solved (unlikely), cost controls are probably even more challenging. Despite the common belief that “adtech” equals automation and productivity enhancement, it’s actually very labor intensive. For example, from FY20 to FY21, AdTechCo grew net revenue by 43% on a TTM basis and employee count grew by 45%. The following year net revenue grew by just 15% and the employee count grew by 26%. One bright spot area where AdTechCo will likely invest quickly to remove people costs is to go all-in on A.I.
Besides labor costs, treating stocked-based compensation as a real expense, and factoring in the hard reality of cloud-based variable cost (data syncing and auction crunching), AdTechCo will very likely face an uphill battle to find operating profits.
We assume all the folks with big stock incentives vesting over the near term see a ticking alarm clocking clock on the wall and hope to exit the building before it rings. Add in the rising cost of capital and that’s the last thing AdTechCo needs.
Given what we can see today, it will be tough sledding ahead. Investors also know where the door is, they see the clock ticking too and the exit signs are getting brighter everywhere.
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Disclaimer: This post, and any other post from Quo Vadis, should not be considered investment advice. This content is for informational purposes only. You should not construe this information, or any other material from Quo Vadis, as investment, financial, or any other form of advice.