Aug 07, 2014

Ken Allen's Market Commentary: Perspectives on the Digital Marketing Ecosystem

Turbulence from the First Half Continues

It has been tough to be a publicly traded Marketing Technology company of late.  The share prices of companies such as Rocket Fuel, Criteo, The Rubicon Project, and Tremor Video have been punished over the past several months, with such stocks down as much as 50% or more from their peaks.  This pricing pressure caused recently IPO’d TubeMogul to revise its pricing range downward by 38% (at the mid-point of the range), from $11-$13 to $7-$8, before pricing at $7 (it is currently trading at ~$10). Interestingly, while stock prices in the sector are down, the growth outlook for many companies within it continues to be quite robust, with consensus forward revenue estimates largely unchanged from peak to trough.  Along with the decline in stock prices, we have similarly witnessed a significant compression in valuation multiples, with many of the Marketing Technology leaders trading at forward revenue multiples at or below those of the advertising agencies, such as Publicis and WPP, which grow at much lower rates.  The table below illustrates these trends.

So how can such massive compression in valuations take place in the face of a relatively stable financial outlook?  Such is life in the public markets, where investors’ short-term outlook can push valuations to stratospheric highs, followed abruptly by head-scratching lows.  One day, investors believe Marketing Technology, as a theme, sits alongside Social, Mobile, Big Data, and Cloud as the next big thing.  Seemingly the next minute, all is forgotten and the sector is doomed to suffer the same fate as (gasp) the ad networks.

The public market pessimism surrounding Marketing Technology stocks is in direct contrast to the strength we see in the M&A markets.  In the first 6 months of the year, we witnessed 60 Marketing Technology deals, compared with 26 over the same period from a year earlier, an increase of 131%.  A number of interesting examples serve to highlight the trend:  Oracle / BlueKai, Acxiom / LiveRamp, Google / Adometry, Facebook / LiveRail, the list goes on.  Acquirers’ appetite for more, and larger, deals is a reflection of the land grab that currently exists in the sector.  For many large companies, innovation cannot happen fast enough on a purely organic basis.  Companies are increasingly realizing they need to acquire technology in order to further their product roadmaps.  This is a persistent theme across all of technology, but particularly so in the Digital Marketing arena, in which we witness Oracle, Adobe, IBM, and doing battle in an effort to provide a ubiquitous ‘CMO dashboard’, a control panel of sorts for Chief Marketing Officers to run a full spectrum of cross-channel marketing campaigns and analytics.  None of these companies has the full stack yet, but each is quickly assembling its arsenal in an effort to offer a fully integrated marketing technology hub.  M&A is a critical component of such a strategy, to ensure not only that your stack is complete, but also that certain critical components do not fall into your competitors’ hands.  On the private capital side, the trends are similar.  Witness the recent capital raises of MediaMath and Datalogix, which raised $74 million and $45 million, respectively.  Private investors’ continued appetite for Marketing Technology companies suggests a belief in continued strong exit opportunities down the road, be those through the public markets or M&A.

The volatility we see in the public markets is a reflection of investors’ uncertainty around the sustainability of the business model of various Marketing Technology companies, and of their ability to at some point to turn a profit.  As such, we see significant variations in the valuations for different companies depending on whether those companies have business models that are recurring in nature, or campaign-driven (e.g. revenue is a percentage of campaign spend as opposed to a recurring subscription fee).  SaaS models are seen as having stickier, long-term revenue; in contrast, investors typically view campaign-driven models as more transient in nature and are willing to pay less for each dollar of revenue generated.  For example, Marketo, a SaaS company, trades at 6.8x 2014E revenue, versus Rocket Fuel and Criteo, each of which have campaign-driven revenue models, and which trade at 1.7x and 1.5x 2014E revenue, respectively.

The differences in revenue multiples between the two groups can partially be attributed to differences in gross margins between them.  Campaign-based models book revenue as a percentage of advertising dollars flowing through the platform, and are required (per GAAP accounting) to book the full amount of media spend as Gross Revenue.  Much of that revenue is simply a pass-through of the inventory cost; the Gross Revenue minus this inventory cost is known as ‘Net Revenue’ and is arguably a better measure of the value added by the company.  Since media costs can often amount to over 50% of Gross Revenue, campaign-based models typically have low Gross Margins relative to their SaaS models, as shown in the chart below.

Investors view Gross Margins as a barometer of how efficiently a company can scale, and as a measure of how profitable a company will ultimately be (even if it is losing money now, as many Marketing Technology companies are).  A company that converts a high proportion of its Revenue into Gross Profit, all things equal, will generally be valued higher than one that converts a lower proportion.  This helps explain part of the delta in valuations between various marketing technology companies:  the higher the Gross Margin (Adobe, Marketo), the higher the multiple, as shown below.

What is most interesting about the chart above is that, even when the multiples are ‘normalized’ to reflect Net Revenue by backing out media costs, the campaign-based companies still trade at lower revenue multiples than their SaaS counterparts, despite, in many cases, having much higher Revenue growth rates.  This again underscores the pessimism investors have regarding campaign-based models.  The often-cited bear case is that these companies will never make money and that their business models are unsustainable:  marketers can easily switch media-buying tools and, as such, campaign-based revenue can evaporate quickly.  Another frequently made point is that such companies are not truly technology companies, but rather technology-enabled services companies, ones that will have a difficult time scaling once the sales & marketing spigot is turned off.  The bull case is that the hyper-growth experienced by these companies will continue and that there is a fundamental mispricing of these stocks in the market. Time will tell if the bulls or the bears have it right.

Irrespective of the valuations and trading performance in the public markets, there are a number of reasons to be optimistic about long-term growth in the Marketing Technology sector.  First, programmatic marketing technology is a disruptive theme that represents a fundamentally better way to target optimized advertising messages to the right users based on an intelligent use of data, in real-time.  It removes inefficiencies from the digital advertising value chain and results in higher return on investment for marketers; such value propositions tend to have significant staying power.  Indeed, forecasts for next-generation marketing technologies support this assertion:  programmatic advertising is expected to grow at a 36% CAGR, from $6.0 billion in 2013 to $27.7 billion by 2018 (Business Insider).  Second, I believe advertisers are growing tired of paying huge fees to the holding companies for solutions that lack transparency.  There is a fundamental principal-agent problem without such transparency, which sophisticated marketers will put up with only for so long.  (Indeed, I have heard of major advertisers that are in the process of reducing spend through their agency relationships on the display side as they shift dollars directly into buy-side software platforms with no agency involvement.)  Lastly, the marketing departments of most companies have underspent on IT for years, which I believe represents a state of disequilibrium.  IT, which has traditionally been under the watch of the CIO, is underpenetrated in the CMO suite; given the dramatic gains in performance and ROI attributable to the use of programmatic technologies, this has to, and will, change.

A long-term belief in the sector is reflected in the long-term bets made by acquirers and venture capitalists, even if that enthusiasm is lacking, at present, from the public markets.  Great companies in the Marketing Technology sector will continue to have great outcomes, one way or another, even if certain recent new issues have stumbled out of the gate.
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