Connected TV [CTV] is only about a $7 billion-a-year industry today, but it's projected to get much bigger. Plus, it only accounts for 3% of media ad spending, while streaming video is just getting bigger. In this week's episode of Industry Focus: Tech, host Dylan Lewis talks with Fool.com's Daniel Sparks about three CTV ad plays that can win big from industry tailwinds: Roku (NASDAQ:ROKU), The Trade Desk (NASDAQ:TTD), and Telaria (NYSE:TLRA). Tune in to learn what each of these businesses does, how diverse their offerings are, what their most recent quarters looked like, some risks for investors to keep a watch on, and more.

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This video was recorded on Nov. 15, 2019.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, November 15th, and we're talking about the connected TV ad market. I'm your host, Dylan Lewis, and I've got fool.com's Daniel Sparks with me on Skype. Daniel, what's going on, man?

Daniel Sparks: Nothing much, just enjoying this nice weather. We had a storm a couple of weeks ago. I remember, Lauren was wondering where Evan and I disappeared to. We were missing for a few days, I guess. Sometimes you forget, these geographical differences, you guys don't realize that we could have ice all over the roads here in early November, late October. Back to warm weather.

Lewis: We got our first signs of flurries here in the D.C. area this week as well. It's coming. We know it's coming. It's just a matter of time.

Sparks: They must be ready to shut down the whole city, huh? All the schools?

Lewis: [laughs] Yeah, the slightest hint. As someone that grew up in the Northeast -- I grew up in New Jersey, went to school in Boston, then moved down to D.C. -- the first time we got like an inch and a half of snow down here, I was like, guys, are you serious? We're closing schools? We're closing roads for this? All right, let's do it! [laughs] No such thing in Colorado, though, Daniel.

The reason I'm having you on today is, we are talking about the connected TV ad market. You are someone who follows this very closely. We've got a couple of big names in the space, some of them followed by a lot of Fools already. We're going to get into it in a minute. But I think it's helpful to paint a picture of what this market looks like. When people think digital ads, they tend to think Facebook and Alphabet's Google, that duopoly that has just run the table on digital ads over the last 5 to 10 years. The reality is, there are these smaller markets within digital ads. The connected TV space is an increasingly growing one, and one that people are paying much more attention to because some of the stocks we're going to talk about today have really put up some incredible returns for investors already, and it seems like the growth is going to continue.

You look at some estimates for what is going on over in the connected TV market, eMarketer ballparks that there's almost $7 billion spent on connected TV ads in 2019. That may sound like a lot, but it's only 3% of the total media ad spend, and it's supposed to grow over 20% year over year for the next few years.

So, Daniel, big market here, and a lot of runway, it seems.

Sparks: Definitely. Traditional TV and CTV -- meaning connected TV -- combined, you're looking at just over $70 billion. A huge portion of the viewing time has already shifted. About 29% of viewing time is shifting over to streaming, but those ad budgets are very slow to follow. That's where Roku, The Trade Desk, and Telaria, these companies we want to look at today, come in.

Lewis: They all operate in slightly different spaces within connected TV. I think what makes them so appealing both to marketers and investors is the fact that they are allowing for targeting, and they are allowing for tracking, in a way that conventional big-brand TV ad spots simply don't. It's the natural evolution. It's the same we've seen with general digital ad trends. If you were to put out a newspaper ad 10 years ago, you'd have very little sense beyond just the core subscribers of that newspaper who was seeing that ad, and what that influenced in terms of their buying decisions. We now know on a very granular level online activity, for better or worse, thanks to the data collection done by Google and Facebook. I think we're starting to see a lot of the same stuff happening over in the connected TV market.

Sparks: Absolutely. These companies specifically, too, boil it all the way down to programmatic advertising. Believe it or not, a lot of digital marketing within video is still sold directly, which is similar to the way it was sold in newspapers, where there's some big negotiations. That's why Roku, The Trade Desk, and Telaria are so hot. Using software and markets for these ads, they're able to match the right buyers to sellers at the right price.

Lewis: The reason we are talking about these businesses is, we have a fresh slate of earnings releases from them. Why don't we talk about Roku first, Daniel?

Sparks: All right, Roku. Big quarter for the company. Revenue was up 52% year over year, surpassing their revenue guidance there. You got platform revenue up 79% year over year. Really, more of the same for Roku for the most part here. But of course, we continue to have margin compression. That's something that we could take a further look at. As long as gross profit is growing rapidly, we can handle a little bit of gross margin compression. But we want to make sure that in exchange for that compression, we're really seeing a huge jump in gross profit.

We're just going to break that down for a second, look at what's going on with that gross margin compression. Basically, that boils down to, in within-platform revenue, Roku has their subscription-supported video platforms, which is like Netflix, no ads there. And then they have their video advertising. Video advertising is growing a lot faster than the revenue they're getting from subscriptions. But the advertising revenue is a lot lower margin. That's OK. We can handle some gross margin compression, as long as we're seeing huge, massive growth, and that's what we're seeing. That's why the platform revenue was up 79% year over year. It's primarily driven by video advertising. There was more than a doubling of monetized ad impressions on the platform. As long as we're seeing that sort of incredible growth on the platform revenue, pushing that gross profit higher, we can handle some of that platform gross margin compression. And it was a huge compression. It was down 800% year over year. Definitely way narrower. But gross profit is soaring.

Lewis: I think it's worth bolding and underlining what is going on there on the ad side for Roku for a second. I remember doing the S-1 show, where we looked at the prospectus and broke down exactly what was going on with this business. At that time, they hadn't really proven out this platform business. It was something that management talked about a lot, but at core, they were a hardware company that had an interesting but unproven platform revenue opportunity. You fast forward a year and a half, two years, and it's clear they have really made that happen. And they needed to. I think they recognized that the life of a hardware company is going to be pretty short-lived because you have all these deep-pocketed competitors when it comes to hardware. You can't talk about smart TVs without also talking about the fact that Amazon's in that space, Google's in that space, Apple's in that space. So, for them to differentiate themselves, they need to be somewhat willing to compete on price and offer something really sticky with the platform. It seems like they've achieved that.

Sparks: Exactly. Again, that's why investors are so forgiving here to watch gross margin continue to compress. They've really made this transition. Gross profit since their IPO has just continued to soar as we've really seen them go from a huge majority of their revenue coming in from hardware, now it's just a small fraction of revenue, and you have a higher margin. So, even though that segment is lower margin, it's still a higher-margin segment, much higher than hardware.

Lewis: You mentioned the dynamic between direct and programmatic advertising. I think it's worth diving into that and exploring it a little bit for folks that may be unfamiliar. There are basically two ways that ads wind up appearing, whether it's on a website, via these digital video channels, what have you. Either there are relationships that are directly brokered and sold, and you'll hear that direct sold, or they are programmatic. That's much more of an auction-style approach to advertising. As you might imagine, the more you are directly working with points of contact from these firms, and from the people that are trying to sell these ads, the longer it takes to do these things. It's much more of a hands-on approach. The programmatic side is far more marketplace oriented. So what you'll often see with a lot of these businesses, and this is what we saw with Snap when it first went public, was it was heavily reliant on direct sold. Those were great, because they were able to really control the rates that were coming in from advertisers. But what it did was, it limited the scope that they could have advertisers come onto the platform. With programmatic, what you're able to do is open your marketplace up, make it a lot easier for people to hop on and spend advertising dollars. You lose a little control over what's going on with ad prices, but for that, you get scale.

Sparks: Exactly. In fact, Roku made an acquisition during the quarter of Dataxu, which is a demand-side platform, which was basically a very small version of The Trade Desk. That was because they really believe in programmatic. They acquired them for the tools, but they still want to be open to the internet. They're not trying to create this walled garden thing. So really, that acquisition was to open them up and be more available to this massive programmatic trend -- which can transition us over to The Trade Desk, also benefiting from connected TV, but also from all the areas of programmatic advertising. We can get into that.

Lewis: Yeah, let's talk Trade Desk. This is a heavily followed Fool stock. It's been a great performer for a lot of people, maybe not so much for folks that have owned the stock over the last couple of months and are a little bit shorter in their holding period. But certainly a lot of Fools eagerly watching the recent earnings release.

Sparks: Exactly. Huge Motley Fool stock. It's been really fun to watch the recommendations and this company do so well. Like you said, obviously some pressure in the shares lately.

We look at this quarter, again, big growth, but it is decelerating. Revenue growth up 38% year over year, which is the lowest revenue growth rate since the company's IPO. But I think investors should look at that and get some historical context. Back in 2017, The Trade Desk finished up the quarter with a growth rate around 40%. But then, in 2018, the full-year revenue growth was 55%. You don't want to just pin down that fourth quarter and think that that's the way things are going to look here. Non-GAAP earnings per share up 15%. That also beat analyst estimates. But, again, we're looking at the big story here.

Lewis: Yeah. I think great businesses are capable of finding the ways to reaccelerate revenue growth over time. Sometimes it's a step change in how you're operating as a business. Sometimes you're able to get into a new space and unlock a whole new field of growth. I think what's reassuring here is, yes, there's a deceleration, but the tailwinds pushing this business continue to be pretty strong.

Sparks: Exactly. The Trade Desk, like I said, programmatic platform that caters to the entire internet. If you look across their channels, desktop is probably on the decline. They're not breaking that out, the ad spend on its platform that's going toward desktop. But generally, that's not a growth tailwind here. But mobile comes in and about half of revenue. Then you've got mobile video ad spend in the quarter up 50% year over year. Mobile in-app up 48% year over year. These are really in line with growth rates in the previous quarters. Not much of a deceleration there. Then you have audio ad spend up 160% year over year. Slight deceleration, but still massive tailwind to this business. Obviously, it's way higher than the consolidated revenue growth that The Trade Desk is seeing. And then, of course, you have CTV, that connected TV ad spend, up 145% year over year, which is actually almost in line with the growth in ad spend we saw in the prior quarter, which The Trade Desk said was above 150%.

As you look at all of that, we have to assume that probably the pressure on that top line came from desktop. But desktop is shrinking as a portion of revenue. So as these big, fast-growing items grow as a percentage of revenue, I don't expect to see that deceleration really play into The Trade Desk going forward. In fact, during the earnings call, Jeff Green, the CEO of The Trade Desk -- super smart guy. If you haven't listened to an earnings call, I'd really recommend you check it out, because he has the beat on this market better than anyone else. He spent a lot of time talking about Q4 in 2020. Basically implied that there could be an acceleration of the company's revenue growth rate going forward. That was really encouraging. He talked about throughout the third quarter, The Trade Desk actually saw an acceleration in the new ad inventory coming onto its platform from connected TV and then the uptake from its customers of that ad inventory coming from connected TV. He painted a really optimistic picture going into 2020 as we see CTV grow to a larger portion of revenue.

Lewis: Daniel, the thing I love about this company is -- I was reminded of it as you were going through all the different business segments -- you mentioned desktop, you mentioned mobile, CTV, audio. That pretty much covers all the different ways that people are consuming content. I think about my daily routine. I am listening to a podcast on my way to work, sometimes one of our Motley Fool podcasts -- shameless plug. I am reading stuff online on my phone. I get to work, I'm on my desktop. I go home, I'm watching stuff on Hulu. There are all these different markets where I am regularly giving advertisers the opportunity to serve me ads. They seem to be in pretty much every location that people are consuming content. So I am generally bullish on this company if for no other reason than the tailwinds are there, and they seem to be playing in all the right spaces to enjoy the growth that's there.

Sparks: Yeah. That's really part of The Trade Desk's value proposition. Marketers can come in, create a cross-channel campaign, and have all the data from all these channels. Super helpful. Also, The Trade Desk has a booming data business. And by really just having a huge grasp on the market, The Trade Desk has become ultimately by far the leader, at least when it comes to being independent and not trying to push advertisers toward their own ad inventory, like someone like Google or Facebook might have, because they don't have any ad inventory. They're just there to help the buyers. And they say, "Here's the entire internet. Let me help you buy the best ad for the best price."

Lewis: We mentioned Hulu. That's a business that The Trade Desk works with. It's also a business that Telaria works with. This is a company that some folks might know. But if you're not as familiar with the connected TV market, probably a business you haven't heard of before.

Sparks: Yeah. Here we have another company, a different competitive advantage for a very different reason. Much smaller, but they've really homed in on that connected TV space. And unlike The Trade Desk, they're not helping advertisers buy ads, they're helping video publishers specifically sell their advertising inventory. Both companies focus on the programmatic advertising space. They're just on different sides of the equation. Telaria is representing the seller. The Trade Desk is representing the buyer.

When it comes to connected TV software platform that helps video publishers sell ads programmatically, Telaria is pretty much the leader there. A really exciting company. Of course, all three of these companies reported earnings in the same week, so we might as well cover a little bit of Telaria here, too.

Lewis: Yeah. Some strong results from this business. People might look at the valuation for this company and be a little confused with 23% revenue growth, and people generally being OK with that. To your point earlier about the business units, and what is growing, and how much of those results are being driven by those business units, huge growth when it comes to connected TV. 115% year-over-year increase. That's the thing that really has people excited with this company.

Sparks: Yeah. We got 115% year-over-year growth in connected TV, which was a big number. Revenue up 23% year over year was a slight deceleration, but really, that boils down to the video publishers they're helping outside of connected TV, which comes down to desktop and mobile. Likely the headwinds are primarily in desktop. That's what's going on there. That's not their core businesses, it's not their bread and butter. Management's goal is to keep that running, keep pushing it. All of their investments, all of their time and energy, is all going into connected TV, which is where investors should want it to be. Connected TV revenue for Telaria is approaching 50% of revenue. That's really exciting. An interesting time for investors.

Lewis: Similar to Roku, we have a situation where gross margins narrowed a little bit for Telaria in this most recent quarter. I think they went from about 86% to about 79%. When you look at that, Daniel, is that something that's got you worried at all?

Sparks: It's something to look at, but there's pretty clear explanations going on here. In the summer of 2018, Telaria bought SlimCut, which has proved to be an incredible acquisition. Very accretive business. Basically, SlimCut they brought in and reinvigorated the non-CTV CTV part of the business, the mobile, desktop video. But the downside of this is, even though they're getting more gross profit out of it because that business operates at a lower gross margin than CTV does. As we see this business help out the non-CTV portion of Telaria's business and really grows a percentage of that non-CTV revenue, then we're seeing some pressure on the gross margin.

But really interesting, during the earnings call, I'm not sure if they said this in previous earnings calls and I missed it, I think this is maybe the first time they've broken it out -- management said that the CTV business operates at an 88% gross profit margin. Obviously, as we see CTV cross over 50% of revenue, my guess is that gross margin is going to head back in a better direction.

Lewis: When you have a business that puts up gross margins like that, you tend to have a lot of cash on hand, Daniel, to work with. Telaria is not a big company. I think they're about a $350 million market cap right now. For context, The Trade Desk is about a $10 billion business. But they have a ton of cash on the books for the size of the company. I think just over $60 million in free cash flow. They're sitting on a decent amount of cash with very little debt or no debt. What's the plan with all of this?

Sparks: Yeah. We're looking at $66 million on the balance sheet, no debt at all. $15 million of free cash flow in the trailing 12 months. So, yeah, really exciting as far as the cash there. And it's only going to improve. Like you said, less than a $400 million market cap. Historically, Telaria has actually announced a few repurchase programs. I think that the board has done a really good job of being strategic about those. When the share price was much lower, at the end of 2018, they rolled out a $20 million repurchase program. They executed that almost immediately. Went through all $20 million, repurchasing shares. I'd definitely like to see something like that again, especially when you look at the valuation, Telaria trading at just 6X gross profit. This is a very easy comparison -- 22X gross profit for The Trade Desk and 36X gross profit for Roku. Obviously, you could argue that The Trade Desk and Roku have better competitive positions, are larger, more stable, and in this most recent quarter, are growing faster with their consolidated revenue. But when you look at all these underlying catalysts, I think it would be really nice to see maybe a repurchase program, or at least bolt on some accretive acquisitions, like that SlimCut acquisition in 2018. I think investors should really keep an eye out to see if management can deploy this cash and build shareholder value.

Lewis: When you're talking about how we're going to hit the point fairly soon where connected TV winds up becoming a pretty big chunk, if not the biggest chunk of revenue, and it's extremely high margin, do you see it possible at some point in the near future for either revenue growth to accelerate or for the financials of this business to start looking a little bit different now that the bread-and-butter business for them, the one that they are most excited to grow, is becoming a much larger piece of the pie?

Sparks: Yeah. It's definitely on the way, where revenue growth could accelerate. This is a really seasonal business, increasingly so, because as TV represents a larger portion of revenue, it's more seasonal. In the summer, people aren't going to be watching tons of TV. It's really when the kids get back in school, get back in those wintertime routines, all the new shows start coming out. That's when TV starts ramping up. As we go into the fourth quarter, we could see even more seasonality. This time, unlike the summer, that could play into Telaria's favor. We could see some big growth in connected TV, and that rise to an even larger portion of revenue. You look at 88% gross profit margin, and just the lucrative economics of this business, I think that it's just inevitable that the underlying fundamentals are really going to improve here. Definitely an exciting time.

Lewis: We talked about three different businesses. I think the beauty is, you don't necessarily need to just buy one. I look at these companies and some of the other digital ad players out there -- I'm a shareholder of Google, Facebook, I own Telaria, and I own The Trade Desk as well. I think that all these companies benefit from the same tailwinds. It's OK to spread your bets a little bit. Understand that there's a good chance that there's a lot of room for all these companies to play together. I like the fact that Telaria is small. A $350 million company. It's easy to project them out to being a $1 billion company at some point, a $2 billion company at some point way down the road. The Trade Desk has already enjoyed some of that growth, but at $10 billion, it seems like there's a decent amount of room for them to grow, too.

Sparks: Yeah. Just like we did on this podcast, it's a great way for investors to cross-learn by, listen to The Trade Desk's earnings call, you might hear them talk about Hulu, which might apply to Telaria on that sell side. You listen to Roku, and he's giving perspective on the broader market, competition. That's another really exciting thing about investing. Hopefully we're able to do that here, look at one industry from very different angles.

Lewis: I'm always happy to have you on to do that, Daniel! Thanks for hopping on today's show!

Sparks: Yeah, no problem! Thank you!

Lewis: Listeners, that's going to do it for this episode of Industry Focus. If you have any questions or you want to reach out and say hey, shoot us an email over at industryfocus@fool.com, or you can tweet us @MFIndustryFocus. If you want more stuff, subscribe on iTunes, or you can catch videos from the podcast over on YouTube. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass today! For Dan Sparks, I'm Dylan Lewis. Thanks for listening and Fool on!