Description

Outbrain 

Outbrain is a duopolistic advertising technology business with secular tailwinds trading at 1x forward EBITDA and 50% of its enterprise value comprised of net cash.  

Background 

Outbrain is known for its “chumbox” ads on major news websites.  Anyone who has used the web will recognize these ads.  Here is what you’ll see if you go to CNN (or any of their other major partners such as Foxnews.com, MSN, etc.): 

These ads tend to be at the bottom of articles and if a user continues to scroll it turns into a social media-like feed with ads interspersed with related content.  These ads are useful for both publishers and advertisers: 

• Publishers: Publishers like CNN would not be able to develop the technology or have a deep enough network of advertisers to create these types of ad units.  Outbrain (and its primary competitor Taboola) turn a part of the page that was considered dead space and use it to drive revenue and user retention (by driving users to more content from their site).  In short, a lot of the news we read for free on a daily basis wouldn’t be possible without Outbrain’s “spammy” ads.  Outbrain also offers long-term contracts with guarantees to many of its partners, giving them a more reliable revenue stream when the market turns lower in times like these (more on this later) 
• Advertisers: Outbrain unites thousands of publishers to create a large platform that gives advertisers a direct-response (i.e. measurable) and low-cost advertising alternative to Facebook and Google.   

One thing to note is that both advertisers and publishers benefit from Outbrain being an integrated advertising system, similar to Facebook or Google.  They represent both seller and buyer.  Therefore, they can offer a lower take rate to both sides of the transaction, increasing advertising efficiency.   

Outbrain is also building a software solution to take over a significant amount of the advertising and optimization on a publisher’s page.  This software solution is called Keystone and charges SaaS fees instead of a take rate on advertising revenue.  This is an exciting growth area, but much further out from having a meaningful contribution to revenue. 

Recent results and the future 

No one would deny that 2022 was a tough year for online advertising.  The flow of easy money evaporated from the system and major advertisers like auto companies, mortgage brokers, and crypto companies all but disappeared.  Other major advertisers, fearing a recession, immediately pulled back advertising spend.  

Since OB is a major advertiser for news with significant exposure in Europe, they also suffered earlier than others when online news outlets ran non-stop news about Ukraine.  This was a topic news publications didn’t want to use as an opportunity to put ads in front of people.  With 2/3 of its revenue outside of the US, the company was also impacted by huge swings in FX. 

Despite these major headwinds, OB’s revenue has held up well.  Revenue was down 2.3% y/y in 2022, but more recently it declined 11% in Q4.  However, ex-TAC gross profit (the revenue OB receives after paying out ad dollars to publishers) has been less impressive, down 14% y/y and >20% in Q3 and Q4 of 2022.  OB guided Q1 ex-TAC gross profit to be down 20% in Q1 2023: 

The reason for larger declines in ex-TAC gross profit is simple – OB provides revenue guarantees to ~20% of its partners.  With pricing down 20%+, this resulted in significant operating de-leverage. OB also signed up a large number of new partners last year and these take a while to ramp up into profitability.  However, OB will lap the bad pricing environment and ramp those new clients from last year starting in Q2.  They are guiding for a “minimum” of $28m of EBITDA which is based on a continuation of negative industry trends. (“We assume no meaningful improvement in the macro environment”, “We assume that current macro conditions persist with no material deterioration or improvements and regular seasonality”, etc.) 

OB has been able to navigate this environment with cost discipline that it started to implement in Q1 2022, well before many of today’s technology companies saw the need to do so.  OB has kept overall overhead expenses flat since Q3 2021 and the Y/Y change in costs is accelerating downwards. 

Expenses are clearly topping out and we think ex-TAC gross profit will likely grow for the following reasons. (Recall that ex-TAC gross profit is the revenue OB gets after paying out publishers) 

• Easy comps after Q2 as OB laps the worst digital ad environment in over a decade (maybe ever) 
• Continued optimization of click through rates using machine learning and AI techniques that are already seeing results 
• Ramping up of new media partners that they signed last year  
• The return of major advertisers in the auto industry now that supply chains are improving 
• Lower supply growth than last year which should contribute to improved pricing 

Extremely attractive valuation 

If you check Bloomberg for OB’s valuation, the data is wrong.  That is one reason this opportunity exists.   

Bloomberg shows OB having a ~$380m enterprise value.  On this basis, Outbrain looks like it trades for 13.5x 2023 EBITDA.  However, that couldn’t be further from the truth.  Based on the company’s “minimum” adjusted EBITDA guidance for 2023, the company trades for 3x.   

Bloomberg is still including $200m of convertible preferred stock from the IPO prospectus (which was converted to equity) and is neglecting to include $78.8m of cash.  This cash was moved to long-term investments when management shifted money from cash to 1-2 year maturity government debt and bonds to increase the return on their cash holdings and offset the interest on their 2.95% convertible bond due in 2026.   

As a result of this error, here is Bloomberg vs. reality – an almost 10 turn difference in EBITDA multiple.    Keep in mind that $28m is OB’s “minimum” guidance for this year which assumes the market continues to be difficult.  The real number could very well be higher as discussed above. 

Simply using sell side expectations for EBITDA and capex/capitalized software, OB’s year end 2024 EV will be $60m with EBITDA expectations of $54m, or 1.3x EBITDA 

We consider these expectations to be conservative with the digital ad market seemingly hitting a cyclical low (10% below 2019 levels on pricing) and OB is showing strong cost discipline. 

One last thing to mention is that TBLA, OB’s largest competitor in the chumbox space is trading for 11x EBITDA.  TBLA gets credit for not having any revenue guarantees and possibly for an acquisition in a mostly unrelated business (Connexity) in 2021.  Conversely, Taboola has shown a lack of cost discipline and has significantly diluted its shareholders in order to get a deal done with Yahoo!.  Therefore, even though Taboola is a larger company, we view OB as a much more disciplined (and far cheaper) company.  

Buybacks will drive the stock higher 

So how will OB and shareholders close the gap?  While earnings are likely to surprise to the upside over the next year, OB is taking steps to reward shareholders today.  OB repurchased 11% of its stock last year at an average price of $4.84/share ($30m buyback).  

After completing this buyback last year, OB put another $30m buyback in place that is currently in process.  This would retire 15% of shares outstanding at today’s prices.   

We expect management to continue to buyback a significant number of shares as long as the stock remains depressed.  The return to shareholders at these levels is extremely good and it would be hard to imagine better alternatives than buying a stock that trades at 1x its 2025 EV/EBITDA. 

Valuation 

We think that OB can generate $56m of EBITDA in 2024  (consensus calls for $43.7m) with modest revenue growth and continued cost discipline.   

Given OB’s proven business model, cost discipline, and capital allocation, we believe that OB deserves at least a 6x multiple.   

Even with a 4x multiple, OB has 60%+ upside.  A 6x multiple would deliver 115% upside and an 8x multiple would result in ~170% upside.   

Almost as important, with 50% of today’s market cap in net cash, OB’s capital structure provides ample margin of safety.  

Catalyst

• Continued buyback of a significant % of shares outstanding with existing cash on the balance sheet
• Lapping revenue downshift due to market pricing starting in Q2
• Continued cost discipline benefiting the bottom line
• Increased click through rate through AI optimization