Investors Discuss the Fed's Latest Rate Hike

In this podcast, Motley Fool senior analyst Ron Gross discusses:

• The positive reaction in the stock market to the Fed's move.
• Prospects for much lower inflation in 2023.
• Borrowing costs going higher.
• Expectations for more rate hikes later this year.

Motley Fool senior analyst Asit Sharma talks with Pubmatic (PUBM -0.14%) CEO Rajeev Goel about why his company is becoming more predictably profitable, and the growing opportunity in connected TV.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on June 15, 2022. 

Chris Hill: It's the biggest interest rate hike since 1994. What it means for businesses is coming up next. Motley Fool Money starts now. I'm Chris Hill and I am joined by Motley Fool Senior Analyst Ron Gross. Thanks for being here.

Ron Gross: Yeah, my pleasure, Chris.

Chris Hill: Let me time stamp this because normally we record this podcast earlier in the day. It is 2:49 PM on the East Coast and we're recording much later than usual because of the Fed. Because at two o'clock this afternoon, the Fed came out with what we thought was going to happen, which is always comforting. I find with the Fed coming out and saying, 'We're raising interest rates 0.75 percent." I think that's what most people were expecting and what most people were looking for. The headline, of course, is, that this is the biggest rate hike in 20 years. We'll get into some of the particulars in a minute. But I couch that by saying most, is this what you expected as well?

Ron Gross: The market had a 95 percent chance had it placed that bet, that it would be 75 basis points. As I said to our Chief Investment Officer this morning, the safe bet is that 75 percent basis points will be the number. We said back and forth, if it's 50 basis points, the market is going to be down four percent. If it's a 100 basis points, then you're up to the whims of the market because you can get some people saying, "Yeah, way to go Fed. Way to rip the band-aid off. Let's get this done" and then you get the other half going "This is much worse than we thought it would be." I wouldn't even know how to predict what would happen if they've gone to 100-basis-points. Just recently, they were saying 50 and that 75 wasn't really on the table. That gives you some indication of the need that they feel, to really be aggressive here. If you look at their expectations right now, that benchmark funds rate is at 1.5-1.75, that's after this raise, this increase. They see it go into 3.4 percent by the end of this year. It was still a significant amount of hikes on the way. They also cut their outlook for this year's economic growth. Now they expect just 1.7 percent gain in GDP.

That's down from 2.8 percent from March. You see the economy is slowing. It's probably important to note that the inflation projection as gauged by the personal consumption expenditure index also rose to 5.2 percent this year from 4.3. What we're having here is you got interest rate rising because the Fed is taking them there and then the market takes the two-year, the 10-year mortgage rates higher as well. We see expectations for economic growth slowing, which is, by the way, after all, the idea here is literally what the Fed is trying to achieve to cool the economy, to bring down inflation. The trick is not to slow us down so much that we end up in a recession which many people are already calling for a soft landing. A so-called soft landing is the desired outcome where we remain positive on the growth end, while at the same time bringing down inflation.

That's not the easiest thing in the world to achieve. They're going to go for it. You see the market almost immediately traded down on the headline news of a 75 percent basis point increase. Now you see the market rallying significantly. As we speak, the Nasdaq is up 3.5 percent, the S&P is up 1.13 percent not as robust, but still strong and the Dow up 1.5 percent. The market is digesting this. They think they like what they see. Powell came out and actually spoke. I'm trying to decipher all this on the fly wall or docking. But I think obviously he made some comments that people were happy to see. Even in the statement, the Fed was pretty optimistic, or at least they pretended to be saying things like overall, economic activity appears to have picked up. Job gains have been strong. Unemployment remains low, inflation is elevated versus reflecting supply and demand imbalances related to the pandemic, higher energy prices, broader price pressures, "Broader price pressures". Lots of them happening that we all see in our everyday world but this is important. They did see inflation moving sharply lower in 2023 down to 2.6 percent. That's almost normal. They also reiterated they're committed to that, returning to that two percent inflation objective that they've had for so long. But if they're right and we'd honestly don't know if they are, we're going to get close to that by the end of 2023, which is probably what the markets are reacting to.

Chris Hill: There's a lot there and a couple of reactions to what you just said. First, I appreciate that you reminded everyone that I don't want to say this isn't about faced by the Fed because it's not. But the last time we were in this situation, Jay Powell was asked directly about a 7, 5 rate hike and basically said no, that's not something we're considering. Clearly in between then and now they have considered it because they've done it. The inflation for next year, I think, is really important. Again, thank you for doing this because you and I are slightly disadvantaged by the fact that Jay Powell's press conferences are going on as you and I are speaking, so more information is going to come out. But on the balance, this does seem to be good. I'm wondering, who is this bad for? This is one of those situations where it appears to be what needs to happen, cooling off the economy. As you indicated, there are a lot of macroeconomic data points that are strong. If you look at unemployment, wages, and consumer spending in general, all those things are strong. A rate hike of this size with more to come, most likely later in 2022. Who's not happy about that?

Ron Gross: Well, in general, businesses, and companies are not happy borrowing costs are now significantly higher and going higher still. Again, that's the point. That will slow the economy. That is the goal here, doesn't mean you have to like it, but it is necessary because inflation is more troubling than a slower economy is. You have to just accept that. If you're buying a home, you're probably not the happiest camper in the world. Interest rates used to be three percent and seemingly overnight we're above five percent, maybe even approaching six percent at this point on the 30-year. That's not great. You can afford less of a home. I'm not necessarily seeing house prices come down as a result, but I think that's bound to happen. We've even seen some real estate companies like Compass and Redfin announce layoffs in recent days.

That's interesting. But if you're sick of paying five dollars a gallon of gas or forget about sick of it, if it's really troubling you and it's very burdensome to your family, you need to see these prices come down, same with food. You need to see these prices come down, even if that means we're going to have to live with slower growth for a while, again, hoping that it doesn't turn into negative growth, which would be a recession. But even if that happens, we will get out of that too. I'm an optimistic realist. The way I think of it as even if we do go into recession for a short period of time, we will build our way out of it. We always have, sometimes it takes longer than others, depending on what decade and what the reason is. But we will return to some normalized growth. The market will move higher. We just have to be patient and be long-term focused.

Chris Hill: Just real quick on the housing. You're right. Across the board, we haven't really seen housing prices come down. As you indicated, we've seen layoffs in the industry due to the fact that activity, buying and selling itself seem to be dropping off. Presumably, that makes its way to prices at some point. In terms of the Nasdaq and then I'll let you go. Are you surprised that the Nasdaq is reacting the way it is? Because we had seen earlier in the year, part of the sell-off of particularly younger Nasdaq, tech companies that aren't yet profitable. Part of that sell-off was due to the narrative. Like we'll look, if interest rates go up, the cost of borrowing money is more expensive for these companies and it's harder for them to raise money or it's more expensive for them to raise money. Given all that, are you surprised that the Nasdaq at least in the time since Jay Powell started talking at 2:30, has rebounded the way it has?

Ron Gross: Yeah. Nasdaq's actually up two percent now, some a little bit of steam has come off. But I'm a little bit surprised it's a balancing act. Higher interest rates are definitely detrimental to growth companies whose stock prices and valuations are dependent on future cash flow streams, so it is bad interest rates negatively impact that. However, an economy in shambles is worse than that. You just have to pick your poison and you pick the least lethal, I think. Plus Nasdaq, innovative tech has been hurt so bad that perhaps, where the market is telling you we're somewhere close to a bottom. I don't know if it's now or within five percent or even 10 percent, or it's happening already. It's OK for these stocks to come rebounding even with higher interest rates affecting valuations, because some of these stocks are down 30, 40, 60, 70, or 80 percent. I think that's probably what we're seeing as we see a rebound.

Chris Hill: Ron Gross, really appreciate the time, particularly during the day.

Ron Gross: My pleasure, Chris. Thank you.

Chris Hill: One part of the economy we're spending continues to rise is advertising. One of the companies benefiting from that trend is PubMatic. PubMatic helps publishers sell advertising using automated systems. If you're playing a free mobile game, there's a good chance PubMatic is selling those ads. They process more than 340 billion ad impressions every day. Asit Sharma caught up with PubMatic CEO Rajeev Goel, to talk about why his company is becoming more predictably profitable and the growing opportunity in Connected TV.

Asit Sharma: Rajeev, I wanted to ask you about this most recent quarter that you all reported. Interesting to me. The last time we spoke, I asked you about your long-term growth cadence and one of the things you mentioned was you had an increased confidence level in being able to predict results. Back in December, you said, hey, we'll be growing next year, somewhere around 25 percent year-over-year. Between then, we've had I think another little surge, a mini-surge in the coronavirus pandemic around that time, we have a lot of geopolitical turmoil, interest rates have spiked, and yet the first quarter was largely according to plan. One of the reasons you cited for your confidence was the increasing importance of something called supply path optimization. Could you explain that concept again? I noticed that in this quarter that you reported, that played a large role, it was 27 percent of activity on the platform. Almost seems like a way to look at more predictable cash flows when you look at this business. Could you explain this concept to us and the increasingly important role it has in PubMatic's future?

Rajeev Goel: Yeah, absolutely. To your point, we had a terrific Q1. We were right on target with revenue growth of 25 percent year-over-year at 55 million and we beat on profitability. Adjusted EBITDA was 17 million or 31 percent of revenue. GAAP net income was nine percent of revenue and importantly, I think particularly in this environment, 19 million of cash flow from operations. I think again, we see a really strong balance of revenue growth and profitability than we have historically delivered and continued to deliver even within a challenging environment. One of the dynamics in the business as you mentioned, is supply path optimization.

This is a process by which the major buyers of advertising, so think of big advertisers like Procter & Gamble or agencies like GroupM, WPP and others. They are consolidating their ad spend onto fewer larger technology platforms like PubMatic. They are doing this because particularly in this environment, everybody has to become more efficient as well as becoming more effective when the economy is facing some of the headwinds that you mentioned. If you're a major buyer of advertising, you're looking at your digital advertising supply chain and saying, OK, how can I achieve the goals that I want to achieve, but do it with fewer partners, partners that are more innovative, that can help me with bigger parts of my business and partners that are going to deliver more value in the future than they delivered in the past.

That's exactly the position that we have put our company in, which has really been known as a leader in driving increased ROI, so return on investment for the buyers of advertising, such that they go out into the market and say, you know what, I don't want to spend more with PubMatic. We do that through technology integrations, automating workflows, and data, through the efficiency of our platform. To your point, two years ago, Q1 of 2020, 10 percent of the activity on our platform was via supply path optimization. At the end of Q1 it was 27 percent. I've seen huge share gains in just two years and that's been a business that grew over 50 percent last year. The underlying rate of growth is very significant. That's a key driver of revenue visibility for us because we know that these big advertisers and agencies, they spend on a pretty consistent basis year-in and year-out on advertising and as we grow that portfolio, that smooths out the volatility even further and it does give us increased visibility into our revenue growth.

Asit Sharma: You all cited that revenue from the connected TV. I think it's quintupled versus the quarter.

Rajeev Goel: That's right.

Asit Sharma: The quarter. Can you talk a little bit about this opportunity as it relates to PubMatic specifically?

Rajeev Goel: Connected TV is obviously a very exciting high-growth area of the ecosystem. It's roughly a 30-$35 billion opportunity in the next couple of years and obviously, consumer time is shifting from linear TV to streaming. Then the ad dollars need to follow. The reality is that the vast majority of how connected TV transactions are done today are through the traditional or old-school insertion order process, where a buyer and a seller connect and then they do a deal. That's a very non-automated or non-programmatic way of transacting. There's nothing wrong with it other than the fact that it doesn't create as much value for the buyer or for the publisher as can be created via programmatic methods of transacting. We know that when we use data when we automate things when we move to an auction type of format to support the scale of thousands of different apps that are supplying inventory and then tens of thousands of advertisers that want to buy it, that creates a much more efficient and effective market where advertisers can get higher ROI. When they get higher ROI, they're willing to spend more and so the publishers can generate more revenue.

That's really our vision for how CTV will be transacted and that's exactly the platform that we built. Within this high-growth auction environment, we have now 176 publishers as of the end of Q1, up from zero, two years ago. The growth rate as you mentioned, is significant. We have hundreds of publishers' inventory representing an even greater number of apps and we highlighted in the earnings call, the variety of different types of content. We have content owners like the TV manufacturers, so we're working with three of the top five manufacturers. We have Tier 1 broadcasters. We have more niche apps that are more specialized, slightly smaller audiences. We also have free ad-supported TV folks where you can watch for free, different programming content. We have built a marketplace for all of these folks and what you are seeing is a strong validation of that approach, where again, that publisher growth, the overall growth rate, and our GroupM's supply path optimization announcement all point to the fact that this is the future of how CTV will be transacted and our approach is really resonating in the market.

Asit Sharma: What would you say to an investor who is a little worried about the current macro-environment? I mean, we've seen interest rates rising, inflation is creeping up and hitting the consumer in the pocketbook. For the investor who's a little worried about what this might mean for the digital advertising agency over the near term, how would you frame that if you're having a conversation with an investor?

Rajeev Goel: Yeah, absolutely. I think there are a couple of things the investors should keep in mind. First is that what we've seen in prior, let's say economic dislocations or periods of stress, is that there's actually a shift toward more accountable, more measurable forms of advertising. Advertiser budgets may be in flux, they don't go to zero. What do advertisers do? They think and look at what are all the channels of advertising that I'm engaged in. Can be traditional means like radio or linear TV, and can be digital means of course.

They say, OK, which are the areas that are the most flexible that I have the clearest measurement of the return on investments? Where I can clearly see, is this working or is it not? They tend to shift more of their ad budget into those environments. We saw that real-time bidding arguably came out of the '08, '09 time frame, 2010 financial stress. We saw that again midway through the last decade. this type of acceleration toward digital and programmatic. The second thing I would say is that my focus is really on how do we continue to innovate and deliver value for our customers and use these periods as market share gain opportunities. Whatever the economic environment is going to be, we obviously go into this environment with a very healthy business. No debt, 175 million of cash on the balance sheet.

Long track record of profitability, significant EBITDA margins, well over 30 percent. I think we come at this from a position of strength to really say, hey, look, whatever the near-term dynamics are, that's what it's going to be. How do we find the right path to continue to invest given the strength that we have and keep innovating so that when the market does become more stable, we can use that as a market share gain opportunity? By the way, we did exactly that two years ago during COVID. Where in Q2 of 2020, we had a four percent shrink in terms of our revenue growth rate. Others were down about 20 percent, but we still delivered mid-teens EBITDA margin. I think you would be challenged to find any technology company back in Q2 of 2020 that can still deliver that level of profitability even with revenue coming out.

Chris Hill: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against them, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening, we'll see you tomorrow.