2024-01-04 14:15:02 ET
Summary
- The article will discuss the reason behind the stock's decline after its third quarter earnings.
- The Trade Desk's investments in Artificial Intelligence should start paying off in 2024.
- The company's development of a privacy-focused identity solution to replace cookies should pay off in the long term.
- The stock is a strong buy for long-term growth investors.
Now that I am older and wiser, it is time to revisit my opinions on my old friend, The Trade Desk ( TTD ). The last time I wrote about this digital advertising platform, I recommended a buy. My thesis for buying at the time was the following:
This stock has been one of my favorite growth stocks for the past several years because it is high growth, profitable and has no long-term debt. The Trade Desk also has a business model that produces operating leverage, has strong moats and the company is currently on the offensive by innovating around the numerous global changes in the ad industry. This stock is a buy for aggressive growth investors. Even though the stock sells for a high valuation, this company is very likely to grow into its valuation and beyond over the course of the next five years.
Source: Star Investments
I couldn't have had worse timing in the short term. The price at publication for that article was $111.64, which coincides with the stock's all-time high on November 16, 2021. Since then, the stock is down 35.54% on January 1, 2024, compared to the S&P 500's rise of 1.47%. However, my thesis for buying The Trade Desk remains intact, and I recommend long-term growth investors buy the stock in 2024 despite the stock's continued high valuation.
This article will discuss why the stock dropped after third-quarter earnings on November 9, 2023, the stock's valuation, a few risks, some of the stock's growth drivers that it added on since the last time I wrote about it, and why investors should consider buying today despite its underperformance compared to the market the last several years.
The stock remains highly valued
Even after a steep drop from its all-time highs, The Trade Desk has a high valuation relative to many of its peers. The stock trades at a price-to-sales (P/S) ratio of 20, among the most elevated valuations in the cloud space and the digital ad industry among publicly traded stocks. The company is valued in the rarefied air of cloud companies like Snowflake ( SNOW ) and CrowdStrike ( CRWD ), as seen in the chart below.
It trades at a price-to-free cash flow (P/FCF) basis of 61, which is high considering there are some decent, well-established growth stocks like Salesforce ( CRM ), Lam Research (LRCX), and Airbnb ( ABNB ) that you can buy in a P/FCF range of 20 to 30.
The company's reverse discounted cash flow ("DCF") analysis follows.
The Trade Desk Reverse DCF
The third quarter of FY 2024 reported Free Cash Flow TTM (Trailing 12 months in millions) | $602 |
Terminal growth rate | 2% |
Discount Rate | 10% |
Years 1 - 10 growth rate | 23% |
Current Stock Price (December 26, 2023, closing price) | $71.96 |
Terminal FCF value | $4.867 billion |
Discounted Terminal Value | $23.455 billion |
Expecting The Trade Desk's FCF to grow at 23% over the next ten years is an aggressive assumption, and some may even consider the stock priced for perfection .
Why some were disappointed in the latest quarter
The market had lofty expectations for The Trade Desk coming into its third quarter 2023 report, especially after Meta Platforms ( META ) showed signs that the digital ad market was turning around in its third quarter report. In addition, its competitor in Connected TV advertising, Roku ( ROKU ), reported an upbeat quarter, beating analysts' revenue expectations and including language in its third quarter shareholder's letter that management sees signs of a rebound in video advertising while giving a solid outlook for the fourth quarter of 2023. Roku's President of Media, Charlie Collier, said on its third quarter 2023 earnings call , " I fully expect the year-on-year growth rate of video ads in the fourth quarter to be similar to third. "
Investors in the digital ad market expected The Trade Desk to confirm an ongoing ad recovery. Instead, The Trade Desk was wishy-washy about the ad market recovering in the fourth quarter. In specific, analysts and investors did not seem to like this comment from Chief Executive Officer ("CEO") Jeff Green:
We represent the vast majority of the Ad Age top 200 advertisers, the largest advertisers in the world. Starting in the second week of October, we have seen some transitory cautiousness across some of those advertisers. These include, for example, industries that have been impacted by recent strikes such as the U.S. auto industry. Through the first week of November, we have seen spend stabilize and we are optimistic for the remainder of the year and for 2024.
Source: The Trade Desk Third Quarter 2023 Earnings Call
I believe the above comment from the CEO, combined with guidance coming in below analysts' consensus expectations, caused investors to sell off the stock by nearly 20% when the market opened the day after the company released earnings. That's what happens when a stock priced for perfection disappoints.
The Trade Desk potentially has limited upside
According to Visible Alpha , as of March 2023, Alphabet's ( GOOGL ) ( GOOG ) Google and Meta Platforms ( META ) make up 65% of the digital ad market, making it challenging for other players outside of those two behemoths to gain significant market share and potentially capping upside. CEO Jeff Green refers to Alphabet and Meta Platforms closed ecosystem as the "Walled Gardens" and the digital ad market open to competition as the "Open Internet." The Trade Desk competes in the Open Internet, a fragmented market, with many players vying for a smaller share of the pie. The fragmentation of the open internet can make it more challenging for any one player to gain economies of scale and drive significant growth.
The digital ad market is intensely competitive. Although The Trade Desk has done well since CEO Jeff Green founded the company in 2009, the company is at constant risk of being disrupted. The company acknowledged this risk in its 2022 10-K:
New technologies and methods of buying advertising present a dynamic competitive challenge, as market participants develop and offer new products and services aimed at capturing advertising spend or disrupting the digital marketing landscape, such as analytics, automated media buying and exchanges. We may also face competition from new companies entering the market, including large established companies and companies that we do not yet know about or do not yet exist. If existing or new companies develop, market or resell competitive high-value products or services that result in additional competition for advertising spend or advertising inventory or if they acquire one of our existing competitors or form a strategic alliance with one of our competitors, our ability to compete effectively could be significantly compromised and our results of operations could be harmed.
Source: The Trade Desk 2022 10-K
If you decide to invest in The Trade Desk, considering the risk of other players disrupting the company is prudent, even though the company appears to have the upper hand in the open internet digital advertising market for now.
It needs the ad industry to adopt UID 2.0
Google's plan to phase out third-party cookies in 2024 could present a considerable challenge for The Trade Desk, as that could neuter user ad targeting based on third-party data. Also, Google could gain the upper hand with its first-party data and identifier solutions in a cookie-less world. Therefore, The Trade Desk developed a privacy identifier for the open internet named Unified ID 2.0 , also called UID 2.0 or UID2 . However, for UID 2.0 to succeed, it requires adoption from publishers, streaming companies, ad agencies, and other advertisers.
However, The Trade Desk is not the only outfit developing an identifier solution. In addition to Google's efforts to build a solution in a post-cookie world, LiveRamp ( RAMP ) is developing a solution named RampID . Since The Trade Desk has integrated UID 2.0 into its platform, the more other players in the digital ad market adopt its identifier, the better. On the other hand, the more other players in the ad market adopt other identifiers, the higher the chances that the identifier market could become segmented, resulting in The Trade Desk's ad platform becoming siloed and losing its competitive edge in an already fragmented open internet. Therefore, if you decide to invest in The Trade Desk, it is vital to monitor the progress of UID 2.0, RampID, and other privacy and identifier initiatives to determine whether the company can maintain its competitive advantages.
Why investors should remain optimistic
Although the threat of other identifiers competing remains, there is a reason The Trade Desk called its identifier Unified ID. According to LiveRamp , " UID and RampID have been interoperable from the beginning. " So, the two identifiers are not competing. Additionally, The Trade Desk built interoperability into UID 2.0 so that it operates with other identifier technologies, too.
The Trade Desk Third Quarter 2023 Investor Presentation.
So far, UID 2.0 adoption appears to be advancing briskly. The Trade Desk establishing a partnership with Disney ( DIS ) in 2022 and its adopting of UID 2.0 has gone a long way to establishing the identifier as an ad industry standard given the ubiquitous nature of Disney's media empire, lessening the risk of the digital advertising devolving into siloes and strengthening The Trade Desk's position in the digital ad market. Disney is not the only company that adopted UID 2.0. CEO Jeff Green said on its third quarter 2023 earnings call, " Over the last couple of years, a who's who of major publishers, advertisers and data partners have announced their commitment to UID2 and now we're seeing the positive impact of adoption on our platform. " He also said:
They [publishers] understand that if advertisers only advertise on users likely to be interested in their products, then advertisers will pay meaningfully more for those impressions. With UID2, content owners [publishers] don't have to share data. Instead, advertisers can use their own data and to do so, they're willing to pay more. One leading streaming platform recently implemented UID2 and the results have been remarkable. Their average daily revenue from The Trade Desk has increased 150%.
Source: The Trade Desk Third Quarter 2023 Earnings Call.
Another reason for optimism is its use of Artificial Intelligence ("AI") to improve advertisers' results. Long before generative AI became popular and turned AI into a buzzword, The Trade Desk delivered Koa , its first AI-powered product, in 2018. The simple way to explain what Koa does is that the company designed it to guide advertisers in setting up ad campaigns and suggests changes to the campaign based on Koa's analysis of how the ads performed. The AI acts like a trusted advisor but allows advertisers to tweak settings as they see fit.
On June 6, 2023, the company announced a new AI innovation to its platform called Kokai . Although some characterize Kokai as an upgrade to Koa, that's not entirely true. Koa is still a relevant product, and Kokai doesn't obsolete the older product. The Trade Desk describes Kokai as building upon the foundation of Koa's AI capabilities. Still, instead of focusing solely on setting up and optimizing ad campaigns like Koa, Kokai applies AI algorithms to various areas needed to bid for ad slots on a publisher's content, where the AI needs to make decisions in milliseconds. It is involved in areas like predictive clearing, which means the AI predicts the best bid levels for an ad spot before the auction. It also scores the relevance of each ad impression to the target audience and performs many other functions outside of Koa's area of focus. On the company's third-quarter earnings call, CEO Jeff Green said the following about AI:
We have been going through every part of our platform and making investments and/or plans to inject AI in the places where data sets are rich, big and high quality. Large language models, the basis of ChatGPT, aren't the highest priority places for us to make investments in AI right now. Deep learning models pointed at bidding, pricing, value and ad relevance are perfect places for us to concentrate our investment in AI. All 4 categories have private betas and some of the best engineers on the world pointed at these opportunities.
Source: The Trade Desk Third Quarter 2023 Earnings Call.
One thing to admire about The Trade Desk in my view is that it invests in the areas that can meaningfully improve its platform for its advertising and does not invest in the eye candy of generative AI, attempting to create buzz around its stock. Instead of investing in buzzwords, the company heavily invests in benchmarking measurement tools, something potentially attractive to advertisers. Kokai includes the following new benchmarks:
Retail Sales Index : Measures sales data from retailers. The Trade Desk designed this index to show brands how effective their ads are in creating sales and precisely where the sale occurred with participating retailers on The Trade Desk's platform.
Quality Retail Index : This index measures how relevant a brand's ads are to the people that the ads are reaching and whether those people are in the brand's desired audience. This index can help advertisers create more effective ad campaigns to reach the right audience.
TV Quality Index : This index measures the value of different types of video content. The TV Quality Index could be interpreted as a dig at Google and Facebook as it highlights the value of professionally produced content over user-generated content on social media platforms like YouTube and Facebook. The index shows why allocating more ad budget to premium TV channels can justify the potentially higher cost of advertising on premium TV versus user-generated video. According to The Trade Desk's website , " With every 10-point increase in TVQI, we see conversion rates [people taking the desired action after seeing the brand's ad] increase by an average of 15 percent. "
The most important aspect of The Trade Desk's AI initiatives is that the company made it easy for third parties to integrate on its platform. Jeff Green said on its latest earnings call:
And we're making it easier than ever for thousands of data, inventory, measurement and media partners to integrate with us. In doing so, I believe that The Trade Desk will become an essential innovation hub of the open Internet .
Source: The Trade Desk Third Quarter 2023 Earnings Call.
The best part is that the market has yet to see the full impact of Koa and Kokai. Management believes investors will start seeing Koa and Kokai produce a sales impact in 2024 and 2025. So, pay attention to what management says about AI in future quarters.
Its two biggest competitors have problems of their own
Some analysts believe that Google's and Meta's dominance is already declining . Additionally, an antitrust lawsuit from U.S. regulators threatens Google's ad business, accusing the company of alleged monopolistic practices. A court loss could even further loosen Google's grip on the ad market. CEO Jeff Green said the following about the lawsuit and the competitive environment in its fourth-quarter 2022 earnings call :
Of course, I would be remiss to not mention the recent Department of Justice lawsuit against Google. It's a comprehensive look at how Google operates including many of the draconian measures they have implemented to tilt the market in their favor. The Trade Desk has not been as impacted as much as others in the ecosystem, and I believe that's because our mission has always been to provide an open objective and transparent alternative to the walled gardens. We focus on objectively serving the buy side. And with that objectivity, we will win no matter what. To be clear, this is not us versus Google. It's the value and opportunity of the open Internet versus the limitations of walled gardens. We have been winning for years in an unfair market with some systemic obstructions working against us. Imagine what we can do as the market becomes more fair which we predict it will one way or another.
Source: The Trade Desk Fourth Quarter 2023 Earnings Call.
The Trade Desk's other significant walled garden competitor, Meta Platforms, faces a massive risk that advertisers could shift ad budgets from social media platforms like Facebook and Instagram to contextual advertising on independent publishers' websites. The Trade Desk website defines contextual advertising as a way to " deliver relevant ads by analyzing the content being consumed instead of the person consuming it -- providing advertisers an alternative to cookie-based advertising. ?"
The website CMSWire states the following about contextual advertising:
As businesses move away from cookies, contextual advertising is becoming one of the most viable options for marketers and advertisers. It offers a privacy-focused approach to targeted advertising and is known to improve the relevancy and success of ad campaigns.
Source: CMSWire
Since The Trade Desk specializes in contextual advertising, it could gain a leg up and gain market share at the expense of social media websites like Facebook.
The company has solid fundamentals
Despite high inflation, rising interest rates, a downturn in the overall economy, a downturn in the ad industry, and Apple's privacy initiatives hurting many digital ad players, this company has maintained solid double-digit revenue growth and profitability over the last several years while even its larger competitors like Google and Meta suffered. The Trade Desk has never gone below 20% quarterly year-over-year revenue growth over the previous several years, compared to Meta, which had revenue shrink for the first time in its history in the second quarter of 2022, and Alphabet, which had overall revenue growth near zero, and YouTube revenue shrinking in the third quarter of 2022.
The Trade Desk recently reported third-quarter earnings of $493 million, up 25% over the previous year's comparable quarter, beating analyst consensus forecasts by $6.02M . On a trailing 12-month ("TTM") basis, its revenue was $1.83 billion in a total addressable market ("TAM") that experts expect to reach $1 trillion in 2024. So, the company has barely penetrated its TAM.
The Chief Financial Officer Laura Schenkein said about the quarter:
We continue to win spend as marketers increasingly focus their investment on platforms that deliver value, particularly in premium video like CTV. This is a dynamic we've seen many times over the years. When the macro environment presents challenges, brands shift to platforms and channels that offer flexibility and measurable results.
Source: The Trade Desk Third Quarter 2023 Earnings Call.
The Trade Desk's performance over the last several years is incredible since it uses a fee-based business model that typically gets paid based on the percentage of media spend. The company has endured significant headwinds in ad spending since the end of 2021. Can you imagine what this company can do when the ad market turns and headwinds become tailwinds? Adweek reported in November 2023 that " In 2024, global ad spend growth will turn a corner, rising to 8.2% from a modest 4.4% in 2023. " If that proves true, 2024 has the potential to be a fantastic year for The Trade Desk's revenue growth.
When The Trade Desk's revenue growth outperforms, that outperformance tends to drop down to the bottom line, resulting in the company generating approximately $200 million in adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), a 40.5% adjusted EBITDA margin in the third quarter. Its non-GAAP (Generally Accepted Accounting Principles) net income was $167 million. Non-GAAP earnings-per-share ("EPS") was $0.33 beating analysts' estimates by $0.04.
The Trade Desk Third Quarter 2023 Investor Presentation
The company was also profitable on a GAAP basis. It produced $39 million in net income, or an EPS of $0.08.
The above chart shows that The Trade Desk produced positive quarterly free cash flow ("FCF") of $184 million in the third quarter and $602 million in TTM FCF. The company also had $1.52 billion in cash and short-term investments against no long-term debt at the end of the third quarter 2023. The Trade Desk's solid balance sheet, profitability, and positive FCF put the company in a strong position to continue investing in vital business areas, like AI, to drive future revenue growth.
Should you buy, sell, or hold?
If you're an investor with a year or less time horizon looking for a catalyst to invest in The Trade Desk in the near term, avoid investing in the stock. The economy and the ad market are not totally out of the woods yet, and since this company gets paid based on how much media spend occurs, if the ad market retreats from here, the company's fundamentals could deteriorate. With the stock priced for perfection, investors might exit the stock stage left.
The story is different if you are a longer-term investor with a time horizon exceeding three years and believe in CEO Jeff Green's vision for digital ad technology. Suppose the ad market rebounds over the next several years, coinciding with the company's identity and AI initiatives starting to pay off in a re-acceleration in revenue. In that case, the stock price has considerable potential to beat the market despite concerns about overvaluation. Several weeks before The Trade Desk reported third quarter 2023 earnings, Seeking Alpha wrote that Loop Capital gave the stock a buy rating. The article stated the following:
Loop Capital initiated coverage of the stock at Buy, calling it "one of the best long-term growth opportunities available to technology and media investors today." The ad industry is heading into a "holy grail" moment driven by data and technology, analyst Rob Sanderson said, with advanced targeting, measurability, transparency, and "ultimately efficacy of budget deployment for marketers." And The Trade Desk is enabling much of the change on the open internet, he said.
Source: Seeking Alpha.
Not much has changed between the time that Seeking Alpha published that article on October 24, 2023, and today, except some investors are worried about the short-term future of the business. Still, the long-term thesis remains intact. I recommend the stock as a strong buy for long-term growth investors.
For further details see:
Why The Trade Desk Remains A Strong Buy For Long-Term Growth Investors In 2024