PubMatic's Momentum Suddenly Slows -- Is It Time to Sell the Stock?

It should come as no surprise that PubMatic (PUBM 1.75%) experienced a sharp drop in its growth trajectory in the third quarter. With the global economic outlook getting murky and the U.S. Federal Reserve still hiking interest rates amid a clearly slowing business environment, the correct assumption was always that advertising activity was going to take a hit. Queue the music -- that's exactly what happened.

PubMatic's meager 11% growth rate in Q3 gave me pause, and it should give you pause too if you're a shareholder. But is it time to sell the stock and move on?

Growth slows, but earnings fall

Tiny PubMatic's revenue of $64.5 million in Q3 wasn't all bad. The company operates on the supply side of the digital advertising industry. It works primarily with media publishers selling ad slots, versus demand-side platforms like The Trade Desk that work with buyers of ads (marketers). Growth is growth, and many industry players have experienced even more abrupt slowdowns as of late.  

However, ad activity has slowed dramatically in the second half of 2022, and the values of many ads have also fallen off a cliff because of Apple's user-tracking transparency changes. Now, iOS device users are given prompts asking them whether they want to allow each app to track their activity (data that marketers and publishers use to target audiences with relevant ads), and many of those users are opting out. Given that the iPhone now holds a more than 50% share of the U.S. smartphone market, that change has thrown the ad industry a vicious curve ball.  

Thus, while PubMatic's 11% growth rate in Q3 (down from 27% in Q2) is concerning, it's consistent with what's happening in the digital ad space overall. But what is more of a concern is the significant drop in profitability that accompanied this cool-off. Across all metrics, PubMatic's profit margins declined significantly last quarter.

Data source: PubMatic.

Infrastructure spending takes a bite out of profits... for now

What was the reason for PubMatic's declining profits? Unlike a lot of other digital ad technologists, PubMatic owns its own computing infrastructure, rather than renting it from a public cloud provider. The company continued spending on this hardware and related software during the quarter even as the ad industry hit the skids.

Through the first nine months of 2022, money spent on network and computing hardware has increased by 38% compared to a year ago to $128 million. Internal-use software development has gone up 34% to $40.9 million. Additionally, PubMatic acquired an AI ad start-up called Martin last quarter for $30.8 million.

PubMatic is still profitable, and it has a healthy balance sheet with $166 million in cash and short-term investments, and zero debt. However, investors should keep an eye on the pace of its investments, and watch for signs it can ramp its profit margins back up again.  

Time to sell PubMatic stock?

If you're tempted to hit that sell button, consider first this significant statement the management made on its latest earnings call. After spending heavily on its infrastructure for the last three years, the company believes the time has come to focus on "optimizing our infrastructure and increasing utilization, which will allow us to materially reduce next year's [capital expenditure] spend." PubMatic will also begin slowing its rate of hiring.

All of that suggests that a big rebound in profitability is coming in 2023. And if you think the digital ad industry will also make a recovery starting next year (contingent on economic conditions getting a little better), PubMatic's revenue growth could accelerate again too. I'm not ready to sell this stock.

Nevertheless, it has been a rough year. Shares are down more than 50% so far in 2022, and trade for 21 times trailing-12-month earnings (or just under 19 times trailing-12-month free cash flow). Given that the outlook is for revenue to be up just 1% year over year in Q4, the stock isn't cheap.

But investing in small companies like PubMatic requires patience and some long-term vision. Among sell-side ad platforms, I like the strategy here. The investments the company made during difficult times could also pay off once the next economic uptick occurs. It could take some time for the computing hardware investments to pay off, but I still believe that patient PubMatic shareholders will be rewarded.