How to Play the Internet Ad Explosion

Wednesday was a good day for the markets, but a great day for a company called The Trade Desk. It was also a day that bodes well for one of my Profit Catalyst holdings.

Smart investors are looking for a way to capitalize on the explosive growth in Internet advertising, and on Wednesday Internet ad firm The Trade Desk went public. The eagerly anticipated initial public offering was priced at $18 by its underwriters, and it rocketed up to close above $30.

This is great news for the ad tech sector, a group that’s been in the doldrums recently. But while we’re impressed with The Trade Desk’s growth we think there are better options for investors and have one of our favorites in the Profit Catalyst portfolio.

Internet advertising is big business. According to International Data Corp., $640 billion was spent on advertising in the U.S. in 2015.  And roughly $14 billion has already migrated to the Internet, with more flowing over every day.

The Trade Desk, founded in 1991, provides technology to advertising agencies to help them manage data-driven ad campaigns. Its growth has been explosive in recent years. Revenue grew 155% in 2015 and 83% in the first six months of the year. Profits, often elusive when a company grows so quickly, rose 71% to $18 million in the first half of the year.

Yet the stock is not without warts. Given that 67% jump from its IPO price, the stock trades at a pricey 50 times annualized profits. And The Trade Desk’s profit growth has been slowing. That 71% growth is less than 83% in the prior year and included an odd 7% decline in profits in the first quarter, something you almost never see in a growing company.

While earnings are nice to have, cash is king for a growing company. Unfortunately, positive cash flow is nowhere to be seen in The Trade Desk’s financials.

Despite generating $16 million of net income in 2015 up from a minuscule $5 million the prior year, use of operating cash more than doubled to $36 million. Imagine that your household tripled its net income (your salary less expenses) this year, but your bank account dropped by twice the amount from the previous year. This is the situation The Trade Desk finds itself in.

The Trade Desk’s cash balance dropped $13 million to $4 million at the end of 2015 even after debt increased $30 million during the year.

And the worst part is that the cash is not being used to hire a massive sales force to seed the country with its product. This critical cash is being used to finance the everyday needs of running a business, otherwise known as working capital.

The Trade Desk has a problem because it needs to pay its suppliers for the advertising space it requires in 64 days but doesn’t get paid by its customers for close to 90 days. This negative cash cycle may work itself out as The Trade Desk gets bigger and negotiates better terms with its suppliers and customers, but right now it’s a risk.

I’d argue there are better options to ride the wave of Internet advertising. Alphabet (nee Google) or Facebook, the two primary beneficiaries of the migration of advertising to the Internet, are nice, but their mega caps are too big for me.

Right now the best option to tap this growth is a relatively small company, one of my Profit Catalyst holdings. It’s trading at half the multiple of The Trade Desk, and unlike the latest darling of Internet advertising, it’s generating operating cash flow, and banking it.

For more information on my letter and this special stock, please check out this video.