It seems the IT and IT industry has forgotten its greatest strength: the ability to grow with little additional overhead. The beauty of a software-based business is that a product can be built once and maintained cheaply and easily, while being copied and sold countless times. The biggest limiting factor is marketing and selling a software service.
For years software companies have been “eating the world” via this lucrative business model, but many of them have over-hired and grown way beyond their means during the pandemic. As a result, tech layoffs began in 2022 and are expected to continue through 2023. So far, it appears The trading post (NASDAQ: TTD) didn’t fall into this trap, even though many of his peers did – no layoffs were announced at the digital adware company. Still, the company’s shares took a beating during the bear market, so what could help The Trade Desk shares start a rally in 2023?
The valuation is rich, but that could quickly change
Many software companies have been completely crushed by the market over the past year, and The Trade Desk was no exception. Stocks ended 2022 down more than 50%. Ouch!
But The Trade Desk’s woes weren’t the same as those plaguing many other software technology companies. While many companies have struggled because they’ve been exposed to their inability to turn the corner on profitability, The Trade Desk has been very profitable for years – in terms of GAAP net income and free cash flow. . Net income has recently fallen due to stock-based compensation, but we’ll discuss that in a moment.
So what caused The Trade Desk stock to disappear? Exorbitant valuation, mainly. As the US Federal Reserve raised interest rates last year in an attempt to tame inflation, it sucked the wind out of high-growth, highly-rated stocks like The Trade Desk (because higher interest rates higher will lower the current value of the shares). At the end of 2021 and into the first weeks of 2022, shares of The Trade Desk were trading at more than 200 times 12-month earnings per share and more than 100 times 12-month free cash flow.
However, a lot can change in a year. In addition to the significant drop in its share price during the bear market, The Trade Desk also increased its free cash flow generation. In the first nine months of 2022, free cash flow was $334 million, double from where it stood in 2021 and good for a lucrative free cash flow profit margin of 31%. The Trade Desk has indeed proven that it can not only grow quickly, but also do so very profitably – exactly the type of business model that tech investors should be looking for.
Stocks still carry a premium of 45x trailing 12-month free cash flow at the time of writing. But if The Trade Desk can continue to move profitably, that rich valuation could drop quickly – and set the stage for further appreciation for the stock.
Keep an eye on stock-based compensation
But what about GAAP net income? As the graph above shows, there is currently a significant gap between net income and free cash flow. The main culprit is employee stock-based compensation (a non-cash expense included in GAAP net income but excluded from free cash flow) of $371 million in the first nine months of 2022. Of this amount, $197 million is tied to a long-term equity award package for co-founder and CEO Jeff Green. It is awarded in increments if and when the stock price reaches $90 and above.
On the one hand, shareholders might be pleased to see executive compensation tied to rising stock prices. It helps align management priorities with share price growth. (This can sometimes cause other issues with corporate sustainability, but that’s a topic for another time.) However, stock-based awards have one big downside: they dilute the ownership of non-stockholders. company employees. For example, $371 million is about 1.7% of The Trade Desk’s current market capitalization.
Ongoing stock-based compensation that limits GAAP net income could be a serious headwind for The Trade Desk stock in 2023. Investors should keep an eye on the pace of new stock payouts to employees. The good news is that free cash flow could be used to buy back shares to offset stock-based compensation dilution. In addition to free cash flow, The Trade Desk has ample liquidity and short-term investments of $1.3 billion and no debt. Other free cash flow tech companies have started buying back stock to offset stock-based compensation charges.
Trade Desk stock could rally in 2023 if the company can continue to grow its operations profitably. A share buyback program would no doubt help investor sentiment as well. Is this a reasonable possibility? I think so. Even though the digital advertising market has faltered, The Trade Desk continues to gain market share and grow at a rapid pace. If it can continue to expand in 2023 and get spending under control, there’s a chance the stock will find a bottom and start to rally.
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Nicholas Rossolillo and his clients hold positions in the Trade Desk. The Motley Fool fills positions and recommends Trade Desk. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.