PUBM - PubMatic: Cheap And At Inflection For Return To Growth

2023-12-27 15:20:00 ET

Summary

• PubMatic, a digital advertising growth company, has experienced a period of flat to down performance, resulting in a decline in valuation.
• The company's Q3 results showed flat revenue but beat expectations, with the decline in CPM (offsetting impression growth) starting to stabilize. The Q4 guide finally signals a return to growth.
• PubMatic's new product launches, including its CTV and online video monetization platform, could contribute to long-term growth and market share gains. PubMatic touts large TAMs.
• Overall, given little to no red flags, the risk seems low. The stock represents a reasonably cheap bet for (very bullish case) a return to higher growth or (bullish case) some long-term growth.

Investment Thesis

PubMatic ( PUBM ) is a digital advertising growth company coming out of period of flat to down performance, resulting in the decline of a valuation that never was very expensive in the first place. So as perhaps a new upturn starts combined with recent new product launches, the stock, while probably not meeting the most bullish case being the new The Trade Desk ( TTD ), could nevertheless be a solid and reasonably non-risky bet for long-term growth from market and market share gains and valuation expansion.

Background

It has been a while since I covered PubMatic, one of my largest investments. In 2021 my original thesis , alongside a Strong Buy rating, for this digital advertising growth company was based on replicating the performance of the likes of The Trade Desk, which is a buy-side company as opposed to PubMatic on the sell-side. The company also had a compelling valuation combined with being profitable. It did deliver stunning growth across 2020, but this seems to have stalled, and as such this will be the key question for the thesis going forward. Note that since the market is large, some part of the thesis is simply gaining market share.

Q3 results

Revenue of $63M was basically flat (a 1% decline), although it was a decent beat. The original guidance was $58-61M compared to $66M expected at the time. Overall, an increase in ad impressions was offset by a decline in CPM, although PubMatic said this decline has started to stabilize. Adjusted EBITDA came in at a healthy 29% margin. EPS of $0.14 ($0.03 GAAP) represented a $0.13 beat. So while the company is slightly outperforming expectations, the absolute performance isn’t very noteworthy. (Nevertheless, the flow-through of the revenue beat was mostly responsible for the EPS beat.)

For comparison, TTD reported 25% growth and guided for 47% EBITDA margin (PubMatic has guided for a 43% margin for Q4 to $32-35M). For this performance, the market has rewarded this leader with a 6x higher P/S multiple at ~18x compared to PubMatic’s ~3x.

Capex was down 70%, perhaps signaling the company’s ability to shift towards profitability/cash flow generation in the case of softening growth. PubMatic did confirm it expects this to result in some margin expansion. The CFO stated:

We converted the majority of our revenue beat into incremental profit dollars which highlights our ability to expand margins. Our CapEx optimization and working capital efficiency resulted in $17.2 million in free cash flow, the highest quarterly level in nearly two years.

Guidance: Turning point

For Q4, PubMatic has guided for $76-80M revenue, which would represent a slight increase from $74M last year. In the somewhat bullish case of a slight beat (looking at the last few quarters, the beats have been around $2-4M), then for example $82M revenue would represent a double digit (10%) increase in revenue, which would be the first quarter of such meaningful growth since Q3 2022.

So on first sight, PubMatic might nearing a turning point of returning to growth. Even just within Q3, PubMatic highlighted a recovery from a “challenging” Q3.

Earnings call: New product launches

PubMatic reiterated some of the points and trends that it believes are favorable for the company, such as the phasing out of the third-party cookie (for which it has its Connect platform) and owning its own infrastructure (improving its cost structure). The company also noted its two new software launches this year, Activate and Convert.

Activate is platform for CTV and online video monetization, representing PubMatic’s investment in this growth segment. Partly because of this, SPO (supply path optimization, which it sees as another differentiator, especially as its customers consolidate ad spend across fewer platforms, and in general represents more sticky revenue/partnerships) has also improved to a record 45% of activity.

Convert represents PubMatic’s expansion into commerce media, both offsite and onsite. PubMatic touts a $10B TAM for this platform, and $65B for Activate. PubMatic has also touted pipeline activity and growth for both products, although these should be seen as multiyear efforts for generating meaningful revenue.

Yahoo transition

PubMatic also mentioned Yahoo during its call as having some impact, for example resulting in a lower Q4 guide. Nevertheless, the statement of “ramp[ing] up Yahoo monetization” seems to suggest there could even be some upside.

Display revenues were 67% of total revenue and declined less than anticipated at 4% [ph] year-over-year. Revenues improved sequentially through quarter driven by incremental impressions sold. These display results were particularly notable as we managed through Yahoo's technology transition related to its own and operated inventory which is predominantly desktop display. Yahoo has now shut down its sell-side platform. We anticipate it will take several quarters for us to ramp up Yahoo monetization as they migrate their inventory to a new technology stack. In Q3, our revenues excluding Yahoo owned and operating inventory grew in the low single digit percentages on a year-over-year basis.

Over the last several years, Yahoo's proportion of our total revenue has declined as we have expanded and diversified our customer base and increased our revenue mix towards faster growing video formats. In the third quarter, Yahoo's revenues represented less than 5% of our total revenues. On a trailing twelve-month basis, Yahoo revenue represented 9% of total revenue.

This upside potential was indeed confirmed on the call:

Rajeev Goel: So just on Yahoo!, I think it is a growth opportunity going forward. So as Steve commented on their migrating, they've shut down their historical SSP or tech stack. And then, they've transitioned to a new third-party tech stack. So I do think there's some upside opportunity there. So we're working closely with them. They've been a great long-term partner. But I think there's work to do over the next several quarters. Steve, anything you want to add to that before we turn it over to OpenPath.

Steve Pantelick: Yes. I concur with your description, Rajeev, I think the way we're looking at it is we've been a long-term partner with Yahoo! but we are confident that we can continue to be a very positive partner in the future and it's based upon our innovation and our focus. So I fully expect that business to continue to ramp.

Valuation and risks

As mentioned, PubMatic trades for just ~3x P/S, which given its history of profitability and strong (non-GAAP) margins arguably provides quite some safety (and hence potential upside). For example, extrapolating the $0.14 EPS to perhaps $0.60 annual EPS would represent a less than a 30x multiple, which is certainly reasonable for a growth company. Similarly, annualizing the Q3 FCF represents a ~10x multiple, and an even lower multiple for EBITDA (although the full-year guidance represents a bit lower 28% margin).

Regarding risks, reading through the earnings call shows quite some optimism from management. This hasn’t changed from a few years ago, so given perhaps insufficient financial progress one could draw the conclusion that the thesis isn’t working out. For example, at the time of my prior coverage the company was touting the target of improving its market share from 4% to 20% over time, but stating such goals (which in this case would imply 5x revenue before any further market growth, more than its current market cap) is easier than achieving them.

So investors have to balance actual performance with progress on product launches and the marginally improved outlook. Since advertising could be seen as a reasonably cyclic market, there is certainly a case to be made to invest in the stock in order to reap the returns as financials improve.

Given its low market share, there could be some concern regarding competitiveness, but overall the company seems to have a solid platform and cost structure, and the numbers of active customers, publishers (monetized inventory) and advertisers continues to grow, with some further evidence from the growth of SPOs.

Investor Takeaway

Given how much the market (sentiment) has changed since 2020, perhaps one could argue that PubMatic’s quite low valuation even then (around 6-8x P/S) has prevented the stock from much further downside than some/many other growth stocks. In that regard, the thesis of a company with a balance of growth and valuation has partly worked out, although the growth part of the thesis has not.

Looking ahead from the current point, arguably the fundamentals regarding the company remain unchanged, with the valuation even lower still. This provides multiple avenues for upside.

One is perhaps some more investor enthusiasm as the market looks towards an improved macro environment, including lower interest rates, which could result in valuation upside. Second is a return to more pronounced growth, as evidenced by the Q4 guide (although still far from a full recovery, with October revenue disclosed for example at 5% and CPM merely reported as having stabilized). Third is additional (long-term) momentum from new product launches, although these new products will probably take a few years to reach any significance, but overall reaffirming the original thesis for both market and market share growth. A fourth point could be improved margins, and while the second half performance/guidance seems to indicate some recovery, the company has also indicated it is still investing for growth.

Overall, although admittedly the company hasn’t quite lived up to the prospect of similar (financial) performance as TTD, the very reasonable valuation nearly by itself would still yield a bullish rating. There is quite clearly some potential for outsized performance, but the probability for this is unknown as growth likely would really have to step up for a significant revaluation.

Altogether, PubMatic could certainly warrant a (small) position, but until there's tangible evidence of returning to higher/durable growth (as in the past), the stock remains more a bet (with a low probability of a high return and a large probability of a medium to low return) rather than a true investment.

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