Pubmatic (NASDAQ:PUBM), a global digital advertising supply side platform (SSP), has carved out a series of competitive advantages that could help it become one of the winners in a consolidating industry. Trading now at a reasonable valuation (the current P/E is a little misleading), if the company can execute on its ambitious long-term goals – or even if they fall somewhat short of them – it could be a market-beating investment for those that are willing to hold through advertising market volatility.
Pubmatic went public on 9 December 2020 at $20 a share and finished the day up 47%. It reached an all-time closing high of $69.92 on 1 March 2021 before falling to an all-time closing low of $11.16 on 1 November 2023. This wild ride is a familiar story of an unprofitable tech stock that went public in the great IPO boom of 2020/21, was accorded an absurd valuation and promptly fell to earth as interest rates rose and the rose-tinted assumptions of excitable investors began to fade into a less attractive but more realistic hue.
The previous sentence accurately describes Pubmatic’s story, except for one word: unprofitable. The company has been GAAP profitable every year since 2018 while growing revenue at a 20% CAGR, though recently it has been slower. The company has ambitious plans to continue their profitable growth, and I think they are well-placed to execute. The fact that Pubmatic operates in a large and growing market, and that they have the ability to take share within that market while maintaining or even improving profitability, suggests that the company could have a bright future.
The Evolution of the Digital Advertising Market
The movement of global advertising spend from legacy media to the internet has been happening for a long time, but the trend is nowhere near finished. This report is just one among many that forecast the space to grow around 10% a year over the next decade, during which it ought to become a trillion-dollar industry. In their investor presentation Pubmatic points out that they are involved in some markets which are set to grow faster than digital ad spend as a whole, though, as they don’t break out any segments or verticals, it’s difficult to tell how much of an impact this is likely to have on their overall growth.
With Pubmatic’s 2023 revenue of $267m, there is a lot of room to grow. They estimate that they currently have 4%-4.5% market share in the markets in which they operate, but they have been expanding their TAM in the last few years.
Before going any further, I ought to explain a little about the digital advertising marketplace and how it works. It is a fairly complicated beast, but it has a simple goal. The goal is to connect Advertisers, who want to buy ad space to market their products (e.g. a hotel chain), with Publishers, who want to sell ad space to monetize their business (e.g. a newspaper’s website).
Where it gets complicated is the multitude of paths that can be taken to achieve this. First of all, Advertisers and Publishers sometimes choose to outsource the buying and selling of their ad space to an advertising agency. Then we have the technology platforms that connect the buyers and sellers. Demand Side Platforms (DSPs) like The Trade Desk (TTD) provide a platform for Advertisers to buy space to fill with their ads. Sell Side Platforms (SSPs) like Pubmatic provide a platform for Publishers to sell their ad space to advertisers. Pubmatic shows this relationship in a very simple diagram in its investor presentation:
But it gets more complicated. Firstly, there is sometimes an Ad Exchange (like OpenX) which sits between the DSP and the SSP. But furthermore, the boundaries between DSPs, SSPs and Ad Exchanges are blurred and getting more blurred as time goes on. For example, The Trade Desk’s investor presentation lists Pubmatic as an Ad Exchange whereas the company profile on Seeking Alpha says they run an SSP. One of the reasons for this is the trend of Supply Path Optimization (SPO).
Supply Path Optimization and its Role in Industry Consolidation
In the simplest terms, Supply Path Optimization means considering all the complicated and varying paths you can take to connect the Advertiser and the Publisher and finding the optimal one. In practice, for an SSP like Pubmatic, this means that instead of relying on a DSP to provide ads to fill their ad space inventory, they make an agreement with an Advertiser directly. Cutting out the middleman, one might say. However, DSPs like The Trade Desk are also doing this, which raises questions like “who is the middleman?”, “whom does this benefit?” and “what defines a DSP and an SSP if they are serving both sides of the market?”.
The benefit of an SPO to an advertiser is the simplification of their distribution system, with more of it consolidated on a single platform. Other benefits are potential lower costs and better access to data. What is the benefit to an SSP? Pubmatic’s 10-K states the following: “As advertisers and agencies increasingly consolidate their spending with fewer larger technology platforms, we seek to increase the proportion of their digital ad spending on our platform through direct relationships…The effect of these SPO agreements is to increase the volume of ad spend on our platform without corresponding increases in technology costs.” Effectively, it’s about winning business. With SPO agreement accounting for 50% of spend on Pubmatic’s platform as of the most recent quarter, and other platforms choosing to enter into similar agreements with advertisers it could leave smaller platforms, who are not able to offer as compelling SPO deals, competing for a smaller piece of the pie.
This dynamic has already begun. This article details how some SSPs are shutting down while others like Pubmatic look to consolidate ad spend on their platforms through SPOs. Pubmatic CEO Rajeev Goel is quoted in this article saying “The industry is consolidating down to fewer, bigger platforms…and we certainly see ourselves as a winner in that process.”
Competitive Positioning
Pubmatic has some significant advantages which should help it thrive in an industry which is likely to consolidate.
1. Technology-First
Superior technology is absolutely key in this market for the following reasons:
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Simplicity: Advertisers and Publishers don’t want to deal with the complexity of the digital ad market. They just want to easily find a buyer/seller at a sensible price, with low fees. Simplifying this complicated business involves knitting together the complex web of businesses and creating a simplified user interface. Integrating omni-channel advertising into a single platform is also a simplification which customers will appreciate. Pubmatic offers simplification across its suite of products.
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Targeting/ROI: Programmatic advertising is supposed to increase ROI by showing different ads to different viewers based on their preferences. The companies which manage to most effectively drive ROI and can prove it to their customers will win business. To do this, you need superior technology. Pubmatic provides detailed ROI data and targeting capability across its product suite, especially through Identity Hub and Connect.
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Lower Fees compared to ROI: Businesses that run more efficient ad marketplaces and have a better designed and better executed technology stack will be able to charge lower fees to customers while maintaining profitability. Pubmatic believes that its owned and operated infrastructure allows it to bring down its cost to serve each impression (see 3. Operating Leverage below).
So does Pubmatic have superior technology? It’s difficult to know for sure, but there are some very good signs:
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CEO is a software engineer: Rajeev Goel, the CEO, has a master’s degree in Computer and Information Technology from the University of Pennsylvania. He used to work for a technology consultancy and was VP of Technology at an online retailer of golf equipment he co-founded. His company bio states: “PubMatic’s trajectory has been fueled by a commitment to strong company culture, rapid innovation, and owned and operated technology infrastructure.” Pubmatic is clearly a technology first company. Goel co-founded the company in 2006, so he has a lot of experience in the industry.
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Product cadence is impressive: A sentence from the 2023 annual report stood out to me: “Our agile development process and flexible, service-oriented architecture empower our development teams to routinely convert a requirement into working software within a typical time frame of two weeks or less.” In 2023, they launched two major new products, Activate and Convert, and they claim in their investor presentation that they had a 60% year over year increase in software releases.
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Recently landed technology enabled clients: Just this year, Pubmatic has announced partnerships with Instacart, Roblox and GroupM. These are three technology-first companies who, I imagine, would be keen to partner with companies offering a differentiated, reliable, secure and efficient technology stack.
2. Profitability
As previously mentioned, Pubmatic was a consistently GAAP Net Income profitable company even before it went public. Its median free cash flow margin since the first year of available data is higher than its net income margin, 21.3% vs 8.5%, and it hasn’t had a year of non-profitability on either of those metrics. This gives the company a significant advantage over its competitors, including its closest publicly-traded comp, Magnite (MGNI). Magnite has managed to turn a GAAP net profit twice: in 2015 when it eked out $0.01 EPS, and in 2021 when the profit was so marginal that it shows as $0.00 in EPS. They have fared better on free cash flow though, attaining a median 10-year margin of 13.2%. Pubmatic has a debt to equity ratio of 0.09, whilst Magnite’s is 0.9. There are many other private companies that offer SSPs, but Magnite is the main public competitor. We can only speculate as to the profitability of the private companies.
A further profitability advantage for Pubmatic is that, according to their 10-K, 537 of their 948 employees are located in India, including many of their software engineers. This ought to give them a labor cost advantage and reduce stock-based compensation compared to similar companies.
Pubmatic’s consistent profitability puts it in a very strong position as it has maneuverability. They could choose to invest in sales to accelerate growth. They could choose to invest in R&D if they need to improve their products. They could pay higher salaries if they need to engage in a war for talent. They can lower prices if they need to win a price war. And if they have enough spare cash left over, they can choose to distribute it to shareholders through buybacks, which they have been doing.
3. Operating Leverage
Pubmatic sees the fact that they own and operate their infrastructure, as opposed to relying on a cloud computing service as a differentiating factor. They claim in their 2023 10-K that this “saves significant costs compared to companies that rely on public cloud alternatives due to the data-intensive nature of digital advertising and the immense volume of ad impressions”. On the Q4 2023 earnings call, CFO Steve Pantelick stated the following: “Our owned and operated infrastructure provides tremendous leverage in our business. On the back of CapEx investment in 2021 and 2022, our focus in 2023 was on driving increased optimization. These efforts resulted in more than 20% additional capacity on our platform, while allowing us to reduce CapEx by more than 70% versus 2022. In addition, our efforts delivered an 8% reduction in cost of revenue per impression processed.”
Having this lever to pull certainly has its advantages, but there are risks that come with this setup as well. It may be harder to scale up or scale down operations as quickly as if they were using a cloud provider, and they may be taking on more legal risk in case of a security failure or data leak. Overall though, I think it is an advantage which can help Pubmatic outcompete competitors.
4. Scale
Pubmatic is by no means the largest fish in this pond but it has achieved sufficient scale to benefit from network effects. The proof of this is in the fact that they have entered into SPO agreements which now account for 50% of the ad spend on their platform. They clearly have a large and broad enough inventory of ad space to attract large players on the demand side.
As SSPs like Pubmatic move closer to being ad exchanges by signing these direct agreements with Advertisers and Advertising Agencies, they ought to start to see the benefits that come from network effects. As they are adding both on the supply side (Publishers) and on the demand side (Advertisers), Publishers will be more certain that all their ad space can be filled and Advertisers have a wider range of locations to choose from. In a system like this, size ought to beget size.
Risks to the Thesis
To play devil’s advocate, here are some of the biggest risks to the thesis developed above.
I have identified scale as an advantage in this market but Pubmatic is certainly not the largest player. As I mentioned, Magnite’s revenue is more than double Pubmatic’s. But perhaps of more concern is the fact that, by virtue of having its own SPO agreements in place, The Trade Desk is effectively now going after similar customers to Pubmatic, starting from the opposite end of the market. In terms of independent players, The Trade Desk is the 800-pound gorilla of the ad tech market and will certainly be stiff competition. Although I don’t see this being a winner-takes-all market, The Trade Desk 2023 revenue being seven times as large as Pubmatic does give it quite a lead.
As I mentioned earlier, the fact that Pubmatic owns and operates its own infrastructure might expose it to more regulatory risk than other similar firms. Given that it deals with personal information, Pubmatic has an important duty to protect the consumer, which will be enforced by regulation and litigated in court if they are derelict in it. In 2023, they were accused of running foul of the European GDPR regulations, although there seem to have been no serious consequences on that occasion. This is an inherently difficult risk to predict, and an impossible one to price, but potentially significant.
The fact that the company has a dual class share structure may be of concern to some investors. Because of this structure (1 vote per Class A share, 10 votes per Class B share) insiders control more than half of the company, making stockholder votes nominal.
A final risk: Pubmatic gets acquired. The fact that it is a fairly small player in a consolidating industry suggests that it could be an acquisition target. I think this is unlikely given the Founder/CEO is quite young and enthusiastic and if it were to happen in the near term, investors would likely make some return on their money from here, just much less than is possible if the thesis were to play out.
Valuation
Given the four competitive advantages identified above (technology, profitability, operating leverage and scale) Pubmatic seems well placed to take market share over the coming years. But has its share price come down enough to make it interesting for a long-term investor? The current P/E around 100 suggests it is very expensive but the Price to Free Cash Flow tells a different story at under 20. Given the current profitability metrics are noisy, simply growing these into the future is going to produce a wildly different answer between earnings and free cash flow. It makes more sense to grow revenue into the future and apply a terminal net margin to estimate earnings. I have made the following assumptions for my model:
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Revenue: The digital ad market is slated to grow at 8-10% a year for the foreseeable future depending on what study you look at, and Pubmatic intends to take market share. Their long-term goal is 20% market share up from 4%-4.5% now. If they were to achieve this 20% market share in 10 years and the market itself grows 8% a year, their growth rate would be 27% a year, but that’s a bit too heady for me. Since revenue growth between 2018 and 2023 was around 21% CAGR, I have applied future revenue growth of 17%.
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Net Margin: Estimating a terminal net margin is difficult given the inconsistency Pubmatic has exhibited in the past. Management has indicated that long-term they would hope to sustain 30%+ EBITDA margins. Using data from QuickFS, it seems that the median delta between EBITDA margin and net margin for all the years of data available is 13.5%. This suggests a net margin around 20% is achievable. This is comparable with other successful companies in the Software – Application industry group.
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Shares Outstanding: As Pubmatic ought to produce surplus cash over this period as it has since it went public, I would expect management to buy back a lot of shares. The extent of stock-based compensation is less clear. The diluted share count has come down slightly in the last few years, so I project this to continue with less than 1% annual reduction in share count over the next 10 years.
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P/E Ratio: A consistently profitable company with no debt and with the potential for high margins across the board might be expected to command a high multiple. But I want to be conservative here because it has a lot of competition, it does not really have a moat (though it has some competitive advantages) and it operates in a somewhat cyclical industry. Its revenue is dependent on the volume and cost of ads on its platform, both of which are potentially volatile and out of its control – so I would imagine it could be more cyclical than the average software company. Therefore, I have applied a terminal multiple of 25, a premium to the market but not stratospheric.
These assumptions are fairly conservative compared to the goals the company has set itself, but will nonetheless require solid execution. From today’s stock price in the mid-20s, my 2033 price estimate (around $125) would represent a CAGR of 18%, a market-beating return. If we require a market-equalling 10% CAGR, a fair price today would be $43.88, just less than a double from today’s share price.
If we stick with the assumption that the digital ad market grows at 8% a year, my revenue growth assumption of 17% would leave Pubmatic with a market share still under 10%, well short of their goal. Of course, if Pubmatic fails to execute and/or is outcompeted by the many other players in the ad tech industry, such lofty heights cannot be expected. But if they execute according to their own plan, revenue growth could be more explosive.
Conclusion
Pubmatic has positioned itself well to be one of the winners in the ad tech industry and to capture a big share of a very big pie. Even if they fall short of their own expectations, it’s still possible that the stock could be a multi-bagger over the next 10 years. If they execute very well, and end up with 20% market share, greater returns are possible. Therefore, I think that investors looking for profitable growth stocks with a bright future should consider Pubmatic at the current valuation. In terms of position sizing, I would be loathed to heavily overweight the stock given that it is in a very competitive industry and there is no guarantee that it will be one of the winners of the likely consolidation.
As I follow Pubmatic’s story I will be looking for signs of gaining market share, maintaining and ideally improving profitability, and staying at the forefront of the industry both in terms of trends (e.g. SPO) and technology.
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