It seems that the computing and information technology sector forgot about its greatest strength: the ability to grow with little additional overhead expense. The beauty of a software-based business is that a product can be built once and be cheaply and easily maintained, while being copied and sold countless times. The main limiting factor is getting a software service marketed and sold.
For years, software companies were "eating the world" via this lucrative business model, but many of them overhired and expanded well beyond their means during the pandemic. As a result, tech layoffs began in 2022 and are poised to continue well into 2023. Thus far, it appears The Trade Desk (TTD -0.54%) hasn't fallen into this trap even as many of its peers have -- no layoffs have been announced at the digital advertising software company. Yet the company's shares did get beaten down during the bear market, so what could help The Trade Desk stock begin a recovery in 2023?
Valuation is rich, but that could quickly change
Many software companies were absolutely clobbered by the market in the past year, and The Trade Desk was no exception. Shares closed out 2022 down over 50%. Ouch!
But The Trade Desk's woes were not the same as those plaguing many other software technology companies. While many businesses have struggled because they were exposed for their inability to turn the corner on profitability, The Trade Desk has been highly profitable for years -- in terms of both GAAP net income and free cash flow. Net income has fallen recently due to stock-based compensation, but we'll discuss that in just a moment.
Data by YCharts.
So what caused The Trade Desk stock's demise? Sky-high valuation, primarily. As the U.S. Federal Reserve raised interest rates this past year to try to tame inflation, it sucked the wind out of high-growth and highly valued stocks like The Trade Desk (because higher interest rates lower the present value of stocks). At the end of 2021 and into the early weeks of 2022, shares of The Trade Desk traded for well over 200 times trailing-12-month earnings per share and more than 100 times trailing-12-month free cash flow.
A lot can change in a year, though. Besides its stock price coming down significantly during the bear market, The Trade Desk also ratcheted up its free cash flow generation. Through the first nine months of 2022, free cash flow was $334 million, double from where it stood in 2021 and good for a lucrative free cash flow profit margin of 31%. The Trade Desk has indeed proven it can not only grow quickly, but do so in a highly profitable fashion -- exactly the type of business model tech investors should be looking for.
Shares still carry a premium of 45 times trailing-12-month free cash flow as of this writing. But if The Trade Desk can continue to profitably scale, this rich valuation could come down in short order -- and pave the way for the stock to begin appreciating in value once again.
Keep an eye on stock-based compensation
But what about GAAP net income? As the chart above shows, there is a big discrepancy between net income and free cash flow right now. The primary culprit is employee stock-based compensation (a non-cash expense included in GAAP net income but excluded from free cash flow) of $371 million through the first nine months of 2022. Of that amount, $197 million is tied to a long-term equity award package for co-founder and CEO Jeff Green. It becomes awarded in tranches if and when the stock price hits $90 and above.
On one hand, shareholders might be pleased to see executive pay tied to stock price increases. It helps align management's priorities with growing the stock price. (That can sometimes cause other problems with business sustainability, but that's a topic for another time.) However, stock-based awards have a big drawback: They dilute ownership for non-employee shareholders of the company. Case in point, $371 million represents about 1.7% of The Trade Desk's current market cap.
Ongoing stock-based compensation that limits GAAP net income could be a serious headwind for The Trade Desk's stock in 2023. Investors should keep an eye on the pace of new equity payout to employees. The good news is that free cash flow could be used to repurchase stock to offset stock-based comp dilution. In addition to free cash flow, The Trade Desk has ample cash and short-term investments of $1.3 billion and no debt. Other free-cash-flow-positive tech companies have begun repurchasing shares to offset stock-based compensation expense.
The Trade Desk stock could mount a recovery in 2023 if the business can continue to scale its operations profitably. A share repurchase program would undoubtedly help investor sentiment, too. Is this a reasonable possibility? I believe it is. Even as the digital ads market has faltered, The Trade Desk keeps gaining market share and growing at a rapid pace. If it can continue expanding in 2023 and keep expenses in check, there's a chance the stock finds a bottom and starts to rally.
