CRTO - Criteo: Cheap And Cash-Generative But Significant Risks On The Horizon

2024-01-08 07:19:04 ET

Summary

• Criteo is an online advertising company historically focused on retargeting, but over the last 3 years developing a strong presence in the retail media segment.
• It is profitable (~28% adjusted EBITDA margin), cash generative (USD 100m Unlev FCF generated in LTM), and keen on buybacks (USD 180m spent in LTM).
• However, a strong growth in retail media may be curtailed by a shift in the business model, limiting value potential. Thus, despite attractive multiples in my view, the current stock price.

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Investment thesis

Due to an imminent shift in the business model of retail media, although Criteo ( CRTO ) at first glance looks like a good value opportunity it is rather a value trap. A promise of strong growth and a large addressable market in the retail media segment is undermined by an imposed transition from a supply-side platform to a technology provider, that is just starting.

As a pure technology provider, Criteo will not benefit from an increasing value of ad inventory in retail media, and despite seemingly attractive multiples, its current price reflects its fair value.

Initial background

Criteo is an online advertising technology company, originally from France, but currently based and listed in the US. After initial success with retargeting - the first product, it had to pivot its business model towards retail media SSP and there are signs on the horizon that it may be forced to make the switch once again. Let's start with some background.

Criteo started its journey as an ad-tech company with a very powerful tool - demand-side-platform ((DSP)) specialized in retargeting. It helped online retailers to bid for advertising inventory (mostly display) across the open Internet. High efficiency in performance marketing attracted huge clients' ad budgets, created space for hefty margins, and allowed to quickly build a very profitable company. Problems started around 2017, when Apple started a crusade against 3rd party cookies with an introduction of ITP (Intelligent-Tracking-Prevention) (you can find more info on that here and here ). Without data stored in 3rd party cookies, solutions like retargeting suffered from a lack of signal, and Criteo was not able to grow as quickly as before. Criteo had to reinvent itself.

Retail media - potential driver for growth

Retail media (or more broadly commerce media as it includes also non-retail platforms – think Uber) became over the last years a new engine of online advertising growth. Many retailers and e-commerce platforms realized they have millions of eyeballs browsing through their pages exactly at the moment people are ready to transact and that has tremendous value from brand advertisers’ perspective.

Criteo has been greatly placed to help retailers monetize this value. Firstly, it specialized in bottom-of-the-funnel conversion, similar to what brand advertisers expect from the retail media. Secondly, Criteo already had many relationships in that area, as many retailers were its clients in the retargeting segment. That is why, it looked and still looks like an opportunity for Criteo to succeed in a quickly developing segment with a large addressable market (estimated by the company at USD 110bn in 2025 - as presented on Investor Day 2022). To achieve that, the company also brought in 2019 a new CEO – Megan Clarken, to lead this change.

The transition has been so far very successful. Criteo kept its total revenue line flat, as Retail Media (SSP offering to retailers and platforms) and Commerce Audiences (DSP offering i.a. access to retail media inventory) substituted quickly falling revenue in retargeting, helped also by an acquisition of Iponweb – a supply-side technology provider.

In the first 3 quarters of 2023, retargeting accounted for only 53% of revenue – great success given that the company started diversification just 3-4 years ago.

Criteo stock – the long case

If you would just extrapolate trends, it is easy to see that over the next years, dynamically growing retail media and commerce audiences segments (CAGR ~30%) would bring the whole company back on a growth path. If you looked at this stock in mid-2023 you could have seen the following:

• Expected revenue CAGR of 15% until 2025 (as per guidance);

• Strong profitability (28-32% EBITDA margin) and cash conversion;

• Reasonably sized SBC – not diluting shareholders excessively (please compare to The Trade Desk);

• The significant share-buyback program given low capex intensity of core business;

And you would get that for a dirt cheap multiple: ~6x EV/EBITDA (or ~9-10x EV/EBITDA without SBC deduction – my preferred metrics). To be clear, Criteo historically (since 2018) has been constantly trading at lowish multiples due to the uncertain future of retargeting – an issue that is now in the process of being resolved giving a glimpse of hope for some re-rating. In short, you had strong upside potential (business growth and maybe re-rating), with the downside protected by cash generated and distributed to shareholders. It looked like a buy, for me at least.

Signs of a fundamental change in a business model

However, as the stock dropped 21% after 3Q2023 earnings (the day ended at -12% after a strong intra-day rebound) it is worth looking into reasons and analyzing whether it was just a market overreaction or a fundamental change in value. First of all, results for 3Q2023 were very solid, above guidance provided in the earlier quarter and with nice profitability growth y/y.

However, during the 3Q2023 Earnings Call, management withdrew from 2025 targets presented on investor day a year earlier, most specifically from the USD 1.4bn target for revenue ex-TAC, with one of the reasons being a different fee model for their largest clients in retail media. Criteo introduced (rather not voluntarily) a SaaS-like fee structure including fixed component and variable volume-based fees.

In my opinion, it is a sign of a very important shift, especially as it was further accompanied by the following comment from the CFO:

As a result of these changes, while we expect our Retail Media gross media spend to continue to outpace the market, we currently anticipate that our 2024 Retail Media Contribution ex-TAC growth rate could be lower than in 2023.

Source: Criteo's 3Q2023 earnings call

In simple words – in a new model retail media take rate is much lower.

What are the reasons for such change and why do I think it is just the beginning? It must have been pressure from those retailers who have scale and own relationships with large brands, to cut the middleman. While the existence of supply-side platforms in ad-tech historically resulted from the market structure consisting of a large number of dispersed small webpages – owners of ad inventory, it does not make sense in retail media, where the largest retailers are more concentrated and apparently have significant bargaining power. They do not need a sell-side platform like Criteo to unlock new demand through open bidding. They need someone to have reliable plumbing to manage the technical process. It leads to a retail media platform becoming a relatively commoditized technology for which a SaaS-like fee structure is more relevant.

By the way, something similar is happening in the connected-TV advertising segment with SSPs like Magnite ( MGNI ) growing revenue from their technical-side services (ad serving) but not converting it into commercial-side services (actual inventory bidding).

The consequences of the shift in the economic model, if it spills over to more customers, are obvious. The growth profile of Criteo deteriorates, as it will have an exposure to the volume of ad inventory served, but will no longer get the benefits of an increase in the dollar value of this inventory. Given that retail media growth was an equity story for Criteo’s stock, a massive price drop is not surprising. Over the previous quarters retail media take rates were quite stable (after a post-COVID drop in 2022), but this is the metric to watch over the next periods.

There might be some long-term positive effects – companies providing valuable technology in the SaaS model usually are traded at high multiples reflecting the predictability of their recurring revenue. However, it may take some time, until this business will be perceived like that.

Valuation

The narrative presented above needs to be quantified to check whether the stock price reflects the value. Please find below a short DCF model in two scenarios.

The base case reflects my current view and shows that the current stock price fairly reflects business prospects.

However, it can be argued that it is a very conservative view presenting a business model shift that ultimately might not happen. That is why I added an upside case to show how much potential the company would have if it continued retail media growth.

In both scenarios, I assume:

• further decreases in retargeting, a little bit quicker in 2024-2025 to reflect Google's 3rd party cookie deprecation;

• cash conversion rate and capex as % of revenue at average for 2021-2022;

• my expectation of results for FY2023 based on results for 9M2023 and guidance;

• discounting rate of 14% based on a 4% risk-free rate, 5% equity risk premium, 5% additional premium to reflect the uncertainty of the sector and company, and no debt.

Key differences are:

• much lower retail media growth in the base case (starting at 10%), also reflected in lower Iponweb and Commerce Audiences growth rates as those segments are intertwined to some extent;

• lower margin in the base case to reflect lower take rate in retail media, while cost base would stay similar.

Base Case DCF

Upside Case DCF

Other drivers to look at

Before conclusion just a couple of points to have in mind regarding Criteo:

• As an ad-tech company, it is by nature exposed to general macro conditions. If sentiment is positive, ad spend increases, and players like Criteo can increase their revenue.

• The industry is expecting a final episode of third-party cookie demise, as Google intends to deprecate 3rd party cookies in Chrome and Android in 2024 ( Google's announcement ). They will be substituted with Privacy Sandbox, which tracks cohorts, not individual users and as such makes retargeting much harder. Criteo, in its later revoked target for 2025, estimated the impact of a “signal loss” at USD 140-160m.

Conclusion

To conclude, although I was positive regarding Criteo stock, due to its low multiple, cash generation profile, and return-to-growth prospects on the back of retail media, information disclosed on the last Earnings Call prompted me to re-evaluate my view.

Given the potential shift in the economic model in retail media, growth prospects became lukewarm, while retargeting revenue will continue to decrease, it is a HOLD for me. On the one hand, valuation already reflects my view on growth prospects and a strong cash flow directed into buybacks provided some floor on pricing. On the other hand, if the company would be able to defend its current retail media profile, there might be a lot of upside.

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