The Trade Desk: Battling Macro Headwinds To Achieve Growth And Strong Cash Flow

Why should investors deal with the macro headwinds that are buffeting the Trade Desk and its shares?

This has not been the easiest season for investors. There is a weather theory that addresses why there can be equinoctial gales and storms. Of course, as the definition says, there isn't much substance behind the theory. I am not sure if there another theory that say the equinox is a peak season for financial storms, But the financial markets are reeling from one blow after another. And while financial markets and the real world can be and often are disconnected, there is likely some connection between the malaise of some significant banks, and the overall state of the economy. The latest retail sales report and the woeful NYS and Philly Fed indices suggest an economy on the precipice of recession, if not already in a recession. On the other hand, there were the first time claims data of 3/16 and housing starts/permits data of the same date that paint a different picture. This is not an article that tries to figure out which data is more important and predictive. For the little it might be worth, color me as believing the economy is tipping into a recession, with impending deflationary pressure. But that does not animate this article.

Lately stocks have oscillated based on alarms and rumors of salvation in the banking sector. The prompt settlement of deposit access for customers of Silicon Valley Bk. (SVB) and Signature Bk. have eased some angst. This was followed by a bailout of First Republic Bank (FRC) led by major US banks-although perhaps the latest alarm is that the bailout might be inadequate and the bank is borrowing heavily from the Fed. These have been positive developments, but it hard to imagine that this turmoil, despite some resolution of the worst fears of investors, won't take a toll on the overall economy. The comments from Secretary Yellen regarding the possible extension of elevated levels of deposit insurance to small and mid-size banks was not helpful in that regard. Now CSFB has been bought in an arranged marriage to solve that risk to the international banking system.

This is an article recommending a purchase of Trade Desk (NASDAQ:TTD) shares. That said, given the environment, I certainly am not suggesting that the quarter closing in less than 10 days is going to be some kind of blowout quarter for the company, or even that it will exceed expectations as has almost invariably been the case for Trade Desk since it has been public. This article isn't going to try to dissect how macro headwinds are going to affect the volume of ads transacted on the Trade Desk platform in the next quarter or two, because there is really no way of knowing the correlation between digital ad spend and business confidence in the economy. At some point, as has been true in other stock price recoveries, investors will choose to "look through" current conditions and start speculating about a recovery. And it is on that basis, and not on the basis that Trade Desk is going to exceed its estimates, that I am recommending the shares.

I think it would be naïve not to imagine that there will not be some global growth issues in the wake of all that has transpired in the banking system. At times of risk and stress many organizations are going to seek to constrain spending, and that inevitably means ad spending along with everything else. Just how much, and for how long, is not something I know, or which is readily determinable. On the last conference call, the CEO presented a thesis that the strong relative performance of Trade Desk in the prior quarter, and through at least the first half of the current quarter, was in part a function of advertisers looking to use platforms that provided a verifiable and objective ROI to justify spending in the midst of macro headwinds. It is a nice theory, but I would, nonetheless be surprised if there were any upside to the current expectations for TTD, or if the company's forecast for Q2 did not turn out to be below the current consensus which calls for revenue growth of 18%. But I also have to wonder if that isn't well known by every investor and analyst considering investing in Trade Desk at this point. Again, this is a long-term focused article on the merits of Trade Desk as an investment, based on the likelihood that it will outperform other adtech companies, and that its business model, for a variety of reasons, will hold up better in the current environment than alternative investments.

When I consider stocks on which to write articles these days, the absolute top criteria is market share gains. The tide is going out on IT spending and much business spending, and it will continue to do so, at least until the Fed stops its tightening policies and the banking crisis is viewed as resolved. There are basically no IT or ad tech vendors that are escaping from macro headwinds completely unscathed. All of the companies about which I have written recently, without exception, would be growing faster if there weren't significant macro headwinds. On the other hand, those companies who are share gainers will probably see their valuation maintained, and ought to be the fastest gainers when a recovery arrives. The Trade Desk has been a market share gainer since I first started following the company a couple of years after its IPO in 2016.

The second significant criteria I maintain these days is that of free cash flow generation. Unlike many other IT companies, the Trade Desk has been generating cash since it first went public. I also like to screen for companies with the best visibility, i.e. those that typically exceed their forecasts. This company scores strongly on that metric as well.

The Trade Desk is not going to have a "normal" year for growth in 2023. If there isn't a recession in the overall economy as defined by the NBER, there is certainly a recession in the advertising space. I have linked here to a recent article recounting bleak conditions in the space. In the last recession, advertising spend fell by 13%. The ad market is far different now than was the case in 2008, and thus far this has been a very atypical recession which usually features significant job losses. The principal debate, at this point, is not that digital ad spend growth won't see some contraction this year-but just how much better TTD can do than the overall market.

It can be frustrating as an analyst to try to make sense of all the market share data that is floating around with regards to digital advertising spend these days. There is no single statistic that says that Trade Desk has a certain percentage of the digital advertising spend, and that compares to a different percentage in the year earlier period. Last quarter, spend on the Trade Desk platform was $7.8 billion and that produced revenues of $491 million. In the year earlier period, platform spend was $6.2 billion and revenue was $396 million. Growth of 25% last quarter was obviously substantially greater than the results reported by most other participants in the digital advertising space although a stepdown from growth earlier in 2022. Guidance for Q1-2023 was for revenue growth of "at least" 15% for the quarter. The Trade Desk does not provide full year guidance, a long standing practice; the current consensus for revenue growth for all of 2023 is a bit greater than 19%. That suggests a percentage growth rebound in the second half of the year, which probably is a stretch at this point. The company is not in layoff mode; its expectation is that the increase in opex for the year will be muted in percentage terms as its hires at half the rate of 2022.

The Trade Desk, as mentioned earlier, is the leading independent demand side, digital advertising platform. By all accounts this has been an incredibly difficult environment in which to sell ads of almost any kind, digital, print, TV etc. Many companies in the space have seen revenue declines. Yet last quarter, Trade Desk revenue was consistent with the company's prior forecast, far better than feared, while adjusted EBITDA of $245 million exceeded the company's forecast for the quarter of $229 million. Can this be a decent time in which to invest in the shares of anything to do with the advertising space? For the most part, investing is a forward looking activity. The question is how forward looking and what are the future opportunities.

I have written about Trade Desk several times over the years for the SA site. The last time was back in June of 2022 when I recommended the shares based on the differentiated performance of the company compared to supposed analogs, particularly Meta (META) and Snap (SNAP). Trade Desk shares are actually noticeably higher now than they were at the time of my last recommendation, a significant out performance considering how much of tech has been decimated over the past 10 months. I believe the out performance is mainly because the fact is that Trade Desk is growing considerably while Snap and Meta are showing negative growth and revenue growth for Alphabet GOOG) has disappeared. The macro environment is obviously more difficult. The latest analyst ratings have been less than enthusiastic, with a downgrade from Benchmark and a neutral initiation from BTIG.

The macro headwind story is about as well-known now as anything else in the IT investing world. Many companies who sell digital ads on their platform have seen their growth shrivel or have seen outright declines in revenue. Advertisers, reacting to deteriorating macro trends, are cutting their marketing budgets, more or less indiscriminately. The bear case, as stated by Benchmark, is that consensus revenue expectations, which call for almost 20% revenue growth this year, are unrealistic The analyst is basically not buying any kind of recovery scenario in the second half of the year, which is what is imbedded in the consensus. He believes that the company's identity currency solution, UID2 is not being well received by the market. He believes overall digital ad spending will be flat to down 5% this year. And finally, he maintains that investors have no appetite for high multiple shares. BTIG, in its initiation coverage, also called out slightly aggressive consensus expectations.

I believe that the Benchmark analyst is right about the current published consensus for Trade Desk revenue growth being overly optimistic. That is particularly true as credit becomes less available and more expensive and as there are global liquidity challenges of various kinds and magnitudes. But I think that is already a factor in the investment consideration of most investors. I would be surprised if most investors weren't already aware that the 19.4% projected revenue growth for Trade Desk for all of 2023 is probably beyond reach in this environment. I think investors are forward looking and are trying to find companies who are gaining share and who will perform better than average when a recovery comes to pass. And that, at least to my thinking, is Trade Desk

I think it is more or less impossible at the time of this writing to resolve whether or not Trade Desk revenues will grow 20%, 15% or some other value. Both of the analysts mentioned above seem to agree that TTD is gaining share, the main question is just how much. The CEO of Trade Desk, Jeff Green, presented a rather detailed update on the success of UID2 in his remarks during the last conference call. Needless to say, his take on the acceptance of the technology is diametrically opposite to the thesis presented by Benchmark's analyst. And whether or not investors choose to value high growth shares more or less depends on macro conditions. If/when the Fed stops raising rates and pivots, high growth shares seem likely to return to favor, and of course the valuation implosion suggests, at least to me, that many investors have fled high growth shares already.

While Trade Desk shares are up from last June, which proved to be a trough point, they have lost significant value since they hit a peak in Aug 2022. Overall, the shares are down about 15% over the last year, and are up by 30% since the start of 2023, propelled significantly by the strong Q4 earnings (much better than feared) that was released in mid-February. But as is all too typical these days, the spike after earnings has dissipated, with the shares most recently down by about 17% since that interim peak.

I don't want to begin to suggest that I know when, and to what extent, a risk-on paradigm sets in for an extended period. Presumably it will take some kind of Fed pivot and some kind of belief that monetary authorities have moved rapidly to stem the risks of contagion from significant bank failures.. While I believe that a pivot is more and more justified, forecasting when it might happen is not something I choose to do.

The macro environment is affecting digital ad growth like much else. Digital ad spend is already a high proportion of total ad spend, and ad spend has proven to be conspicuously cyclical. But I believe that this is a reasonable time to take a look at one of the leaders in the ad tech space, now before everyone starts investing for a recovery. Trade Desk will grow in 2023 and much else in the ad tech space will battle just to stay at zero revenue growth. Trade Desk will not have to make substantial layoffs, and that will reinforce its ability to gain share both now and in the future. Recommending Trade Desk shares when the macro environment is becoming progressively more difficult is a bit of a contrarian call. But I think when the bad news is already so well-known and dissected is a good time to consider an investment in the ad tech leaders.

Why is Trade Desk gaining share and is it sustainable

There are two overarching themes here and one sub-theme. One is that Trade Desk gets a disproportionate share of its revenues/growth from its position in the connected TV space and the connected TV space is growing and will continue to grow far more rapidly that the rest of the digital advertising market for the foreseeable future. The other theme is that piece by piece the walls of the walled gardens that have surrounded the content offered by Meta and by Google are getting dismantled. This is not an article about the outlook for Google and Meta. It is an article, one of the themes of which, is the market share gains Trade Desk is making, and will enjoy as advertisers seek to utilize digital technology to most objectively measure ROI, and the utility of their ad spend.

As many readers are aware, there is currently a law suit brought by the Dept. of Justice against Google on the basis of that company monopolizing search and search advertising. The suit is scheduled to go to trial in Sept. of this year. Google recently lost a procedural motion to move the case to New York where it could join several other cases brought by state attorney generals. To repeat, this is an article about the prospects for Trade Desk, and its ability to continue to grow faster than the market. There is no way I think I can offer some kind of valuable insight into the potential outcome of this suit, or likely remedies that might be imposed on Google in the event it loses the case. What I do think I can suggest is that regardless of the ultimate disposition of this matter, it will lead to a more level and open playing field, and will result in practices that allow advertisers more open access to consumers and to do so using the Trade Desk platform. I will leave the issue of whether or not Google is a good investment to other authors.

There has been much written about connected TV on SA and by many other brokerage analysts. I certainly don't suggest that I know everything there is about trends in the advertising world. But the fact is that the overwhelming trend toward the acceptance of connected TV as simply the most effective venue on which to purchase and run ads is a key part of the investment thesis and the invest dialogue with regards to Trade Desk.

Why is connected TV important in the advertising world.

For those unfamiliar with connected TV, it is a service that allows devices connected to the internet to receive videos and music, and to browse the web. It is essentially the replacement for cable. Connected TV advertising enables brands to place ads within streaming content. The ads are shown alongside of or as part of TV shows and livestreams on the streaming devices. Interactive ads, are those shown to a specific universe of buyers and include actions that viewers are encouraged to take. Connected TV allows advertisers to effectively reach the cord cutters and those who have never signed up for cable but who still stream entertainment.

The connected TV paradigm is based on an automated system in which advertisers can place their ads based on optimized prices and specific placements. They place their ads programmatically, using a digital technology. Advertisers love CTV because it allows them to target the audience for their ads, and to pay for their ads based on a completion rate, or cost per completed view. Generally, the completed view ratio is high because many streaming services do not allow their users to skip ads. It has been suggested by some advertising industry pundits, that in this environment of constrained household budget, viewers are more likely than ever to allow advertisers to place ads, rather than paying elevated subscription costs for an ad free experience. Connected TV enables brands to improve their reach, to improve what is described as lift, which is a brand's perception, and CTV ads often provide a call to action.

Many readers/subscribers will have seen and heard much discussion about how issues with privacy have plagued the digital advertising space, and the business results of some prominent vendors. That has not been the case for Trade Desk, and I do not think it will prove to be the case. There are certainly other opinions on the topic, and it is a key premise of the investment thesis for the company.

Trade Desk has been active in creating an alternative to cookies since 2018. UID2, introduced last year, is an update/upgrade of the initial technology. It is based on a user's email address or phone number, supports the needs of advertisers to run personalized ads targeted to a particular set of consumers without compromising their privacy. At this point there are literally dozens of UID2 partners including publishers, supply-side platforms and data providers involved with the technology. In addition to those listed by TTD in the link above, there is, of course, the partnership with AWS. While the statistic may sound self-serving, as the linked article suggests, a Trade Desk research project indicates that the use of UID2 improved the effective CPM by 116% compared to ads that use third party cookies! Of course, I have no way to validate that kind of result, but it may explain the rapid adoption of the standard by many stakeholders.

I have taken the liberty of inserting a rather lengthy quote from the CEO regarding the adoption of UID2 which validates this piece of the Trade Desk investment case:

At the beginning of our fourth quarter last year, around 15% of the third-party data ecosystem was estimating on UID2. This is essentially a very large sample of the entire data ecosystem of the entire Internet. By the first half of this year, we expect we will be in the 75% range. Levels of activation that high mean we will have effectively solve the identity matching challenge of the entire open Internet on a scale well beyond anything cookies have ever accomplished and all while providing consumers with much greater control over their privacy.

To be clear, I am talking about companies adopting UID2 such as AWS, Snowflake, Salesforce and Adobe. We always said this change to the Internet required adoption of the infrastructure players of the Internet, not knocking on 2 million publisher or content owners doors. By upgrading the data infrastructure of the Internet, there is now a significant mathematical incentive for every reputable player involved in digital advertising to lean in to UID2. This is already happening with thousands of publishers in all channels of the open Internet. UID2 adoption by publishers is creating the richest, most privacy-centric identity environment we have ever seen for advertisers. And it also means an advertiser's first-party data becomes exponentially more valuable.

As I have mentioned in this article, the advertising business is facing ferocious macro headwinds, and those headwinds have probably intensified in the wake of the still evolving banking crisis and its resolution. I have linked here to a recent analysis of the ad space which projects spend for both connected and linear TV in the current year. Not terribly surprisingly, connected TV ad spend growth, although well down from prior periods, is still expected to grow by 14% this year, while traditional cable and broadcast ad channels are expected to experience a 6% decline. At this point, digital video, which is inclusive of CTV, is forecast to be 22% of all advertising, up from 19% last year. Digital advertising as a whole, which used to be about half of total market spend, is now closing in on 70% of total market spend. Of that amount, Google and Meta are now less than half of the total, having lost substantial share in the last several years. It is that kind of math that has been a factor in the rise of Trade Desk and its ability to grow when the overall advertising market is either flat or contracting.

There are many demand side platforms and that has been the case for many years. But for many years, Trade Desk has grown faster than its competitors. I have linked here to a Gartner evaluation of the competition in the market. What is notable when looking at this analysis is that users universally rank the Trade Desk at "Better at service and support", and most often rank the TTD platform as "easier to integrate and deploy." That is true for reviews of Meta (META) for Business and for Google (GOOG) Campaign Manager 360 as well as Amazon (AMZN) and Adobe (ADBE) Advertising Cloud. There are, to be sure, other reasons why some advertisers choose the larger, integrated platform vendors as their choice when purchasing ads, but the Trade Desk advantage has been consistent for many years, and has been a significant factor in its market share gains over an extended period.

The final major piece of the Trade Desk investment thesis has been its success in what is called shopper marketing. Shopper marketing has lots of components. Some of shopper marketing, and what many will recognize, has to do with retail operations software, which of course is not the field in which Trade Desk operates. Essentially, the paradigm is about making a last-minute appeal to shoppers while they are making their buying decision in a store. This has been a significant growth area for advertisers, and about 80% of the leading retailers in the US have partnered with TTD, which has allowed it to offer ad inventory to brands who use it to develop shopper marketing campaigns. Apparently, these campaigns are similar to connected TV in that they provide advertisers better measurement that doesn't exist elsewhere in the digital marketing space.

As the linked article suggests, retail media represents 11% of ad spending, and it is expected to grow by 60% over the next 5 years. Many readers might think of Amazon (AMZN) when they think of retail marketing spend, and of course Amazon results indicate that this particular business is growing rapidly for them. But many other retailers including Walmart (WMT), Kroger (KR), Tesco (TCSDY), Target (TGT), DoorDash (DASH) and Instacart all offer ad inventory to brands and this inventory is available on the Trade Desk platform.

The Trade Desk business model

Trade Desk has a very profitable business model and generates lots of cash. It is one of the rare companies in the IT space that hasn't been required to embark on substantial layoffs in the wake of declining growth. It has become common for many analysts to admire the financial discipline of companies that are laying off team members. I actually admire companies more that have managed their finances more efficiently and don't have to undertake layoffs. In my own experience, layoffs usually have consequences beyond the one-time expenses of severance and extended benefits. Often, talent flees enterprises that are laying off personnel or are exerting draconian expense discipline, necessary as those strategies are in this environment. But the fact that TTD already has a profitable business model and will continue to hire, albeit at lower rates than in the past, is an intangible asset that is part of the long-term growth story.

As an advertising platform, Trade Desk has a very seasonal pattern in its revenues. It has been typical that Q4 revenues are more than 30% of the total for the full year, and because of that seasonal factor, sequential comparisons are not meaningful. I consider platform operations as the equivalent as the cost of goods for this company. Also, unlike many other IT companies, TTD accrues taxes at a significant level.

The Trade Desk uses stock based comp. and a significant component of stock based comp. has been the accrual of that expense for the company's CEO. Last year, when the CEO was awarded a comp. plan, much of that expense showed up in the stock based comp line. This year, without much of that expense, stock based comp. was 26% of revenues. The plan awarded the CEO significant grants of shares, but only if the stock price reaches levels far above what they were at the time the shares were granted, and even further above their current prices. Most shareholders would be more than happy if the CEO could get the shares in the grant; as a shareholder, I know I would.

As I have written in the past in other articles, I evaluate stock based comp based on its impact on outstanding shares as that is the real cost of stock and RSU grants. Overall, outstanding shares have not changed over the past year, and the company's share buyback plan means that outstanding shares will most probably decline in the next 12 months. In my valuations, I have used 500 million outstanding shares, the same level as reported at the end of 2022.

Last quarter, the non GAAP gross margins were about 85% of revenues, compared to 84% of revenues the prior year. Sales and Marketing expense last quarter was 16% of revenues, compared to 15% of revenues in the prior year. Given that Trade Desk is selling access to a platform rather than a specific software solution, its sales and marketing ratio has always been dramatically less than companies who directly sell software.

Last year the company spent 12% of revenues, non-GAAP, on research and development, comparable to the spend ratio the prior year. Finally, the company spent 11% of revenues non-GAAP on general and administrative expense, compared to 12% the prior year. Overall, the company's adjusted EBITDA margin reached 42% last year, comparable to the level for the prior year.

As mentioned, the company does not provide full year projections and thus I have no basis to comparing full year actual results against start of year targets. That said, the company has typically exceed guidance by varying amounts on a quarterly basis.

The company is forecasting an adjusted EBITDA margin of 22% in this current quarter; it was 38% in the year earlier period. Some of that has to do with the timing of various events, some of it has to do with the end of Covid era travel limitations and some of that had to do with significant revenue over-attainment in Q1-2022. But I believe, based on the CFO's commentary during the conference call Q&A session that some of it is reasonable conservatism in this very uncertain environment.

Wrapping Up-The case to buy Trade Desk shares

Trade Desk shares are certainly not the cheapest investment available in the IT or the ad tech space. And the company is facing and will face macro driven headwinds, the same as just about every other company in the ad tech, and IT spaces. But the shares, despite some fits and starts, are still down by about 15% over the last year, a period in which revenues grew more than 30% and which free cash flow grew by almost 45% and reached a free cash flow margin of just less than 30%. Presumably, that kind of valuation contraction has been a function of significant investor angst about the current and future decline in percentage growth, and percentage growth expectations.

My current EV/S estimate for TTD shares is a bit less than 14X. And I have estimated a 3 year CAGR 0f 30%, although my revenue estimate for this year is for growth of 18%. Obviously, that EV/S ratio is above average for the company's 30% growth cohort. On the other hand, the company is very profitable, with very high free cash flow margins. My free cash flow estimate for the year is $600 million, and that is likely conservative based on historical performance of that metric in particular. The company's Rule of 40 metric is likely to be at or above 50 despite the macro headwinds, and considering free cash flow and revenue growth combined, the valuation premium is quite modest.

It can be a bit unsettling to recommend the shares of high multiple growth companies in the midst of so much economic turmoil. It is my view, however, that with the valuation reset that has already taken place, a significant level of likely revenue growth deceleration this year is already imbedded in the valuation of the shares. In this kind of environment, in which performance of almost all tech companies is going to be constrained by macro conditions, and in which digital advertising specifically may see limited growth, the relative performance of Trade Desk is likely to stand out.

One of the principal elements in my recommendation is that the Trade Desk has been and should continue to achieve significantly differentiated growth in these challenging times. This is a function of the company's substantial position within the connected TV space. It is also a function of the company's seemingly very successful initiative, UID2 to deal with the privacy issues that have significantly impacted the results of many other ad tech businesses. And superior growth is a function of the gradual turn by advertisers away from the "walled garden" approach that has long dominated the market, but which has steadily been losing traction. Finally, the company is and should continue to be a beneficiary of the growing advertiser commitment to the shopper marketing paradigm.

Enjoying market share gains enables greater visibility. In this kind of environment, basic growth trends are likely to be modified or even derailed. Advertisers in various segments all of a sudden feel they have to cut back as their own businesses and financial models become challenged. So, in order to sustain growth, market share gains are required, and that is what TTD enjoys, and is not enjoyed by many other ad tech competitors.

Finally, Trade Desk is profitable, and has been able to maintain margins despite slowing growth and without layoffs. I think profitability without layoffs is important for a company in order to provide the best environment to start growing at higher rates when the current macro headwinds abate. It is lots harder to start growing from a dead stop than from an organization continuing to expand.

I don't purport to have second sight, or anything resembling that capability. To what extent the results of Trade Desk might be challenged this quarter, next quarter or even beyond because of bank liquidity issues is unknown and really not knowable in advance. An economist at GS said that the issues with some banks would be the equivalent, in terms of economic activity with a 25-50 bps rate increase. The Fed chairman and his colleagues essentially punted on their own views of the economy based on likely tighter credit in the wake of the bank crisis. I have no way of knowing if the GS estimate is reasonable-it seems so-or just how much it might Trade Desk results.

Bear markets have typically ended when investors have chosen to look through earnings and start to discount recovery scenarios. In a recovery scenario I believe that the Trade Desk business will resume much higher growth than is now the case, and I think that investors will be willing to discount that return to higher growth. It is on that basis that I recommend the shares and believe they will deliver significant positive alpha over the next year.