Outbrain: The Capital-Intensive Advertising Business That’s Faltering (NASDAQ:OB)

General overview

outer brain (NASDAQ: OB) is a programmatic advertising company. The company’s core technology is an advertising platform that integrates between publishers (media companies) and advertisers in order to deliver targeted advertising on both desktop and mobile. As always in the program advertising, the firm bids on media ‘real estate’ and then places ads there if it is able to ‘win the auction’.

The company was founded in 2006 and entered the public markets through an initial public offering in the second quarter of 2021 at $20 per share. Since then, the stock has depreciated significantly to a current price of under $5 per share, while materially underperforming the S&P500 index.

While the growing difficulties of the digital advertising landscape are well known, Outbrain is certainly a recognized entity and player of scale in the space. As such, it is worth appreciating the stock to see if it may have become cheap relative to its fundamentals.

finances

Outbrain has generally been a growing firm over the past 10 quarters, though the most recent quarter saw its top line degrade for the first time in recent memory. It’s worth noting that analysts had actually expected a decline in revenue, and that this performance beat the consensus by $19.5 million.

Management made it clear in the earnings call for the period that this decline was due to lower yields (cost per mile, cost per click) in digital advertising. Currency movements, namely the strength of the US dollar, also appeared to take 6% off the top line.

The increase in the US dollar during this period ended up being a material factor because Outbrain’s business was predominantly (60%) outside the US.

This factor is numerically less important now, as the US Dollar Index (DXY) has seen a 9.5% decline since Q3 2022; future earnings for Q4 2022 may be slightly less affected by this.

However, a decline in earnings is not something every investor likes to see. The company expects this trend to reverse as the macroeconomic situation improves and ad buying recovers. This could take a year or more, however, in my view, as we do not yet appear to be out of danger of inflation or a return to core GDP growth.

Looking towards profitability, we see that Outbrain presents a relatively volatile earnings picture. While it has been able to post a profit during some quarters, it just as often posts a loss; Q3 2021 was particularly negative in this regard. Furthermore, the company has not been profitable for 3 quarters.

The company also appears to have an operating cycle that could easily turn into a loss; this has happened in the last 3 quarters out of 5. Since its operating expenses as a percentage of revenue are relatively low, hovering around 20%, this means that it is forced to spend significant amounts of capital to generated income.

The firm’s management states that this is due to investments in technology, namely ‘service capacity’ and algorithmic optimization.

However, we can see that Outbrain generally has fairly high costs of revenue – especially for a technology entity. This may be due in part to their accounting philosophy, where they bill technology expenses as a cost of revenue. The main reason this is so, however, is because Outbrain’s business in digital advertising involves ‘bidding’ for screen space. The way an algorithmic digital advertising company like this works is in some ways similar to a liquidity search algorithm. The firm must bid for digital ‘real estate’ in order to place ads there, via an auction. This happens through ad networks like Google’s DoubleClick. Clearly, Outbrain has to spend roughly 80 cents for every dollar of revenue it ends up generating; this is the norm. With another 20 percent or so of revenue for operating expenses, the difference between profit and loss ends up being pretty thin — and volatile. I wouldn’t have much confidence in any projected growth rate for this company as a result of the variance within these numbers.

Due to the volatile nature of its business and operating cycle, Outbrain is forced to use debt for its operations. This has become especially evident as the digital advertising landscape has encountered weakness. As of Q3 2021, the firm took on $236 million in long-term debt — and has yet to repay any of it.

Debt, of course, comes with interest. The company is now servicing this debt without actually cutting the principal. This debt appears to be structured so that payments are made semi-annually. While the interest itself doesn’t seem to be too significant – 1.6% of revenue last quarter – I’m concerned that they haven’t returned any of the principal. The figure is much more significant when we consider that debt service of $3.6 million was a significant 78.3% of its net loss for the last quarter. A continued situation like this, along with the thin margins and volatility inherent in the digital media business, will make it difficult for the company to generate a profit unless conditions improve significantly.

Expanding on our cash flow objective, it shouldn’t be too surprising to see that the firm posted negative FCF for the most recent quarter. The figure here again reflects the variance they encounter in their business. I would take no comfort that this company can generate consistent cash flow for its shareholders. Its free cash flow loss last quarter amounted to a relatively significant 5.99% of its share price.

ASSESSMENT

On the valuation side, Outbrain presents a much better picture. This indicates that the market is pricing the firm so that it will continue to underperform the way it has been. This presents a potential opportunity for alpha generation in case we can get in at the right time – although that time does not appear to be now.

Notably, the company only reports GAAP revenue—something truly unique for software companies. Here, we see that it is trading at a 7.9% discount to the GICS Communication Services sector.

On a sales basis, things look even better. The firm is quite cheap compared to its peers, with a discount of 79% on the current price.

Of course, the company has been losing money, so we can’t really scrutinize that valuation.

The reason for all this is that the growth of digital advertising globally has been increasing. The chart below shows the results for 2021 and 2022, with projections thereafter. Outbrain has seen a decline in its business performance even as it has been part of a ‘rising tide’. This makes me skeptical that it can regain its footing even as macroeconomic conditions improve. After all, there are heavy hitters in the digital advertising space to contend with.

CONCLUSION

There are better stocks for an investor who wants exposure to the digital advertising space. Although US spending on digital advertising has fluctuated over the past few years, this has not been the case internationally. However, Outbrain failed to capture this growth in 2022. It appears that the business is struggling beyond its target market – I would certainly consider competition and a capital intensive business to be important factors.

This is a company that needs to spend very significant amounts of capital (80 cents on the dollar) to generate revenue. The debt he has taken on and the overall negative cash flow picture make me even more pessimistic. If this stock wasn’t already discounted, then I’d call it a sell. The market seems to have priced all of that in already, though, so I’ll call it a hold. Current owners should think carefully about whether they want to stay, and individuals considering a purchase should look elsewhere for this type of exposure.