Market, Earnings, and TTD - August 19, 2023
Market commentary, portfolio company earnings results, and closer look into The Trade Desk (TTD)
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The market has been on a gradual decline over the last few weeks, grinding lower by the day. In our last post, we identified the 430 level as the one to watch.
Yesterday, on Friday August 18th, the market opened in the red, teasing with another decline. Bouncing off the 433 level, the SPY closed the day with a slight gain. The current pullback has been healthy after a long period of gains.
Going forward, 430 level will be an important level to hold. If the market can turn up from here, it will preserve the higher low pattern. Otherwise, the market rout may gain momentum.
Year-to-date performance across indices:
S&P 500 +13.8%
Dow Jones +4.1%
Yields continue to push higher in the wake of the US downgrade by Fitch. High rates act as gravity on equities, as they offer competitive opportunities to receive a solid return with less risk.
The 10-year yield is teasing the prior peak set in March, just before the collapse of Silicon Valley Bank.
The 2-year yield already cleared its October high.
In 2022, the Nasdaq was particularly sensitive to yields. Inverse price movement was highly correlated – as yields went up, stocks went down nearly in lock-step. That has changed this year as the Nasdaq has unexpectedly continued to climb side-by-side with yields. The result: equity-risk premium has continued to narrow. From this perspective, the current pullback is even less surprising.
High yields have a lagging impact on the economy. Mortgage rates breached 7%, surpassing the peak set in October 2022. A $1 million home with a 20% down payment costs an additional $2,200/mo. That is cash that will not be spent in the broader economy.
Higher yields draw more investment to the US Dollar, which has been building strength from the bottom set in July. A strong dollar negatively affects companies that have international sales.
Headlines of professional investors shorting the market are making the rounds.
Well-known hedge fund manager Bill Ackman is betting yields will continue to climb, alluding to more pain ahead for equities.
If rates were to come down, it would ease a lot of the ongoing pressure.
Markets expect the Fed to hold rates steady until at least March, after cuts are expected.
Note that the market has continually pushed out expectations of rate cuts. About a year ago, the market was expecting cuts as soon as this summer or September.
One thing that has changed: Fed officials are starting to express concern about high rates.
What to make of all these signals? Markets are forward-looking. Information known today is rapidly priced in. Market prices often start to move in advance of any news.
As part of our investment process, we try to take in all the information we can and project out the next 12-18 months.
Q2 2023 Earnings
Over the last two weeks, 3 portfolio companies reported earnings.
All three companies sold off after their earnings releases, albeit for different reasons.
Datadog (DDOG) continues to hold a conservative outlook, citing ongoing cloud optimization and a cautious approach to usage expansion. The business is operating well. Revenue guidance came in slightly lower than expected. Datadog has a consumption-based business model.
Upstart (UPST) reported a more profitable quarter than expected. With a stabilized operational model, any prior concerns about their business continuity can be comfortably squashed. UPST shares did take a big cut though, primarily due to muted revenue growth. With the announcement of capital partners and upbeat sales numbers in the prior quarter, investors had been expecting that to be an inflection point. Short sellers were rushing to exit. After this quarter, it is clear the business needs more time for the economy to work through the high yields.
The Trade Desk (TTD) – see below.
The Trade Desk (TTD)
Founded in 2009 by CEO Jeff Green, The Trade Desk is a digital platform for buying advertisement placements known as “demand side platform.”
Agencies and brands use The Trade Desk platform to pick from over 500 billion digital ad opportunities every day, across connected TV, online video, display, mobile, audio, and much more. Connected TV, which continues to gain rapid adoption amongst consumers, is one of the most important channels for The Trade Desk.
The Trade Desk is keenly focused on demonstrating the return on ad spend. Whereas traditional advertisement (say a billboard) provides limited insights into productivity, online platforms can connect data efficiently to give very precise return on investment details.
This is a very similar model to Google and Meta, and one of the reasons TTD was able to grow so large so quickly.
One key difference between the digital ad incumbents and TTD the approach placing ads, specifically closed vs. open ecosystems.
Google and Meta own their properties. Google owns Google, YouTube, YouTube TV, Gmail, Android, Google Ads, etc. When someone buys ads from Google, they can only buy placement on Google properties. Similarly for Meta. They operate within their own network only – their “walled gardens.”
The Trade Desk offers the same insights to buyers, while offering a much broader range of properties. Advertisers can buy ads on ABC, Hulu TV, Disney+, Samsung TVs, Roku, mobile apps, audiobooks, podcasts, in store placements, and many more. They can purchase, manage, and compare performance across all of these within The Trade Desk. They can even buy ads to Google and Meta through here, comparing those investments across the entire universe. This open ecosystem gives buyers much more control and perspective to optimize their spend to their needs.
Jeff Green is seen as a visionary in the ads market. With him at the helm, The Trade Desk has been big on innovating in the space. They have focused on tying data together to increase targeting and, therefore, advertisement performance. TTD established Unified ID, an upgrade to cookie tracking, where advertisers can better track identities across platforms. They partner closely with their customers, connecting their customers' deep data sets to the marketing platform. For example, Walmart is able to leverage their broad audience and consumption data coupled with data from The Trade Desk to optimize their campaigns.
The company has been profitable since 2013 and growing at a very fast rate. The Trade Desk has a large market opportunity and has been executing well.
Turning to the financials:
Q2 quarterly y/y growth shows acceleration from from 21% to 23% – potentially an important inflection point. One data point doesn’t make a trend – it will be important to see what next quarter brings.
TTM revenue growth of 25% is very healthy. Revenue growth has been surprisingly resilient, especially when compared to other software companies.
Gross margins for the quarter showed an uptick to 81% from 78% prior. Gross margins have been pretty steady in the 78-82% range.
TTM gross margin ticked down slightly to 81% from 82%. This looks to be the product of the prior quarter, as the current quarter is showing improvement.
SG&A and R&D expenses as a percentage of revenue declined. Good to see them benefit from their growth – revenue is growing faster than expenses.
EBITDA margin improved to 40%. They have generally held steady between 38-42%.
FCF margin held at 31%. This is a very profitable business and is able to convert their profit effectively to free cash flow.
The balance sheet is very healthy. They are holding over $1.4 billion in cash with limited liabilities (these are lease liabilities; they have no cash debt).
Share dilution has come down significantly. The last two quarters have had less than half a percentage point of dilution y/y. For context, some high growth companies expect and guide for 2-4%, as TTD has had in the past. Less than 2% is very healthy, especially for a highly profitable company growing in the high 20-30%s. Annual shared dilution beyond 4% should be scrutinized.
TTD is a very efficient business with strong return on capital metrics. EBITDA ROC of 30% and FCF ROC of 23% are very impressive. For every $100 invested in the company (since inception), TTD generates $23 of free cash flow per year. These ratios have been increasing over time, clearly demonstrating their scale advantage.
Over the last few years, TTD has been a volatile stock, oscillating between $110 and 40. This year, the 50-day moving average convincingly surpassed the 200-day trend line. TTD was up over 120% YTD going into earnings. Even though Q2 posted strong results, shares sold off. Shares are down 24%. The market seemed prepared to sell regardless of what was announced. Their announcement also coincided with the broader market pullback. A retracement was not unexpected – prices don’t go straight up forever.
As for the valuation:
TTD trades at 14.5x EV/NTM revenue. This is on the punchy side, even after the recent decline. For context, the highest valued growth stocks these days are trading for 18-20x.
From an EBITDA perspective, 37.2x is not too expensive for such a high quality company.
The TTM FCF yield of 1.7% is quite low compared to risk-free rate.
The high price the market sets on TTD is a result of their proven execution and strong business model, with high margins, durable growth, and high efficiency. Investors need to consider their own appetite for long-duration holdings.
The following table shows potential annualized returns over the next 5 years given a spectrum of revenue multiples and growth rates. This model incorporates share dilution of 1.5% per year (higher than the current 0.5%).
Assuming slight compression to the current multiple (12-14x EV/NTM revenue) and achievable growth of 20%, investors could reasonably expect annualized returns of 13-16% over the next five years. Any additional improvement or enhancement could yield a higher return.
The market often presents conflicting signals. Many investors have been in disbelief of this year’s strong performance. Strength begets strength in the market, as momentum and trends are powerful drivers.
The current market pullback has been healthy so far. It will be important to see how things develop from here on out.
At Torre Financial, we remain focused on finding the best investment opportunities at any time. We focus on companies that have high returns on capital, competitive advantages, and durable growth. We look at the first fundamentals, yet continually re-evaluate and rebalance positions according to what the market is offering.
The Trade Desk is an excellent example of a long-term compounder, with many positive traits. They are executing on all cylinders and have a long runway ahead.
Next week we will hear earnings from Snowflake, Intuit, and Workday.
Torre Financial is an independent investment advisory firm focused on emerging and established compounders – companies with high return on capital, competitive advantages, and durable growth.
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