#48: Post-2Q23 Earnings, Portfolio Update
When the dust settles; Investors not impressed with growth and profits; AdTechCore10 falling back toward support levels
Today is National Tell A Joke Day. I was having dinner at an Italian place with Garry Kasporov the other day in New York. There was a checkered tablecloth. It took him two hours to pass me the salt.
Reading Time: 6 reality-sets-in minutes
We posted our Q2 earnings pre-read a little over a week ago on August 7. At the time, six players in our AdTechCore10 had yet to report: TTD, MGNI, PUBM, TBLA, OB, and RAMP. Now the dust has settled and the results are not great. Both Magnite and PubMatic got clobbered as SSP business model reality is making investors reconsider value creation space which is not a fun place to be.
Before Q2 earnings, things were looking mostly okay for eight AdTech18 players. But after earnings news settled in investors were clearly soured taking the AdTechCore10 and AdTech18 down ↓29%.
Jeff Green summed up Q2 and the near future:
“What’s particularly notable about our performance is that most advertisers are still dealing with some degree of uncertainty in their business. Even though certain macro indicators are improving, there’s still a sense from many advertisers that we are in an unpredictable environment… So while many indicators and advertiser sentiments are improving, there’s also a sense that it’s more difficult than ever to predict what’s coming next.”
Notably, the NASDAQ and S&P500 were only down around 11% over the same time period so AdTech’s demise appears to have little to do with broader sentiment and more to do with adtech fundamentals with respect to value creation.
Last week we said:
“Not only has the QV AdTEch18 busted through the $406 level, but it also smashed through all the intermediate retracement levels except for the old high of $662.”
With that in mind, we revised our retracement bands setting a new support level at $425 but keeping upside resistance staying at $662. If the sector does not start showing investors better expectations of future cash flow then our lower-boundary support reset at $425 was a mirage. We’ll revisit it in a few weeks.
Let’s look at how things were going for the AdTechCore10 two days before earnings vs. two days after.
Six players felt the pain, and four of them took big hits — MGNI, PUBM, DV, and IAS.
Four players were up — one of them just a bit (TBLA) and one (DSP) gave investors meaningful enthusiasm (for now at least).
Why so much pain for AdTech in Q2?
It’s really quite simple as far as we can tell. Revenue growth is falling across a maturing sector coupled with nervousness from marketers around ad budget cuts. Brian Wieser at Madison & Wall picked up on this sentiment in his post Top 100 Marketer CEO and CFO 2Q23 Commentary.
Turning to operating profits tells a bleak picture for investors. As a whole, AdTechCore10 players produced 9% operating margins when things looked great during the pandemic but have since fallen below zero.
When you combine declining revenue growth which is currently close to single digits with business models that have a hard time generating operating profits investors are probably thinking twice about holding on for the long term compared to shifting money to better alternatives.
PubMatic Case and Point:
From FY21 to FY22, PUBM grew net revenues by 13% to $256 million with a 13% operating margin.
PUBM’s trailing twelve-month operating profit margin has fallen to 3.7% as of Q2 while Q2 operating margins were –11%.
All the while, stocked-based compensation expense has grown from 8% in FY22 of net revenue to 12% in 2Q23. Go figure.
Let’s assume management finds a way to grow net revenue by around 9% every year over the next five years to $400 million. That means PubMatic will likely beat overall media spend growth and take share along the way. It will not be easy but it’s doable.
Let’s further assume PUBM achieves 20% operating profit margins five years from now in 2027. That's a big “what if.”
If PubMatic pays a cash tax rate of 20% (favorable assumption), then after-tax operating profits in 2027 would be $64 million.
As of FY22, PUBM had $176 million in invested capital (including goodwill) and generated a capital efficiency rate of $1.50 (net revenue generated from one dollar in invested capital).
If management grows invested capital by just 7% per year over the next five years, capital efficiency will improve slightly to $1.60 (a good thing), then average net investment outflows will be $14 million per year, and free cash flow in 2027 will be $50 million.
Working backward from $50 million in free cash flow in 2027, we make a reasonable assumption such that PUBM captures increasing portions of that future $50 million in free cash flow as the next five years go by.
PUBM’s cost of capital is 13% with a 4.2% risk-free rate, 4.9% AA corp debt rate, 5.7 risk premium, and sector beta of 1.6.
With a 4% terminal growth rate on free cash flow after 2027, PubMatic would be worth exactly what is trading at today ($12.60/share on 15AUG23).
Best Case: If 9% revenue growth on 20% operating margins with a 7% re-investment rate happens for PUBM, then the stock would appear to be correctly priced today.
Worst Case: If management can only squeeze out 10% operating margins at some future point in time and only grows revenue at 5% instead of 9%, then more pain is likely in store.
It’s the same story across the sector — more or less.
Quick take on the agency scene… yawn.
We mainly care about what’s going across AdTech Land, but we also keep track of the agency world. It’s not the most exciting space, but certainly good to keep an eye on from time to time.
With Q2 earnings done and dusted agencies did not fair very well. Our QV Agency8 portfolio includes the big five plus three smaller players Stagwell, S4 Capital (aka Media.Monks), and Next Fifteen Group. The portfolio is down –16% since we started tracking these companies as a basket of equal holdings in January 2018.
Our Agency Big 5 portfolio only tracks the five giant holding companies which are doing a bit better but still off –2% overall. But any way you cut it, Q2 earnings did not impress investors.
Looking back to 2018, agencies are getting lapped by the S&P 500. Why? From our perspective, the agency business is quickly finding itself approaching a fork along a winding advertising road. Agencies have known the juncture was coming for years, but most have procrastinated on taking serious action.
The agency business model is still mostly based on billing out FTEs with neverending fee pressure from clients. It’s a labor-based model that desperately needs to tap into giant productivity gains but can’t cut bait on the old ways of working. The best agencies have been able to manage small incremental steps while the digital ad world that they need to master is changing by leaps and bounds.
As far as investors are concerned, half the agency world (IPG, NFG, PUBGY, and OMC) is making more progress while the other half is either subscale, not winning, and/or moving too slowly toward productivity gains compared to reliance FTE dependencies.
Then again, perhaps there is a better explanation. If digital advertising is eating the majority of all advertising, and if big adtech (Google, Meta, Amazon, TikTok, and increasingly Apple and Netflix) is feeding on digital, coupled with an agency model stuck in an FTE world, then it stands to reason that investors are better off owning stock in the eater, not the eaten.
With that, we leave you with Slave by the Rolling Stones…
Ask Us Anything (About Programmatic)
If you are confused about something, a bunch of other folks are probably confused about the same exact thing. So here’s a no-judgment way to learn more about the programmatic ad world. Ask us anything about the wide world of programmatic, and we’ll select a few questions to answer in our next newsletter.
Join Our Growing Quo Vadis Community
Was this email forwarded to you? Sign up for our monthly newsletter here.
Get Quo Vadis+
When you join our paid subscription, you get at least one new tool every month that will help you make better decisions about programmatic ad strategy.
Off-the-beaten-path models and analysis of publicly traded programmatic companies.
Frameworks to disentangle supply chain cost into radical transparency.
Practical campaign use cases for rapid testing and learning.
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.