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Morningstar | Criteo Reports Strong 2Q Results but Provides Disappointing Guidance; Lowering FVE to $35. See Updated Analyst Note from 01 Aug 2018

While Criteo reported better-than-expected second-quarter results, it provided disappointing third-quarter and full-year net revenue guidance as it anticipates Apple’s Intelligent Tracking Prevention to further weigh on net revenue growth. In addition, the process through which Criteo is trying to broaden its portfolio of products and enhance the technology behind them is likely to further pressure top-line growth in the near term. We note that management did raise its 2018 adjusted EBITDA margin guidance a bit. We lowered our net revenue estimates, the impact of which was partially offset by a slightly lower effective tax rate assumption per management’s guidance. Our adjustments resulted in a fair value estimate of $35 per share, down from $37. In reaction to management’s guidance, the shares were trading 20% lower on Aug. 1, which may have created an attractive entry point for this no-moat and very-high-uncertainty name, as it is now in 4-star territory.

While Criteo is beginning to implement various strategies to broaden its offering and maintain or increase client retention rates, we think it will take time before the firm recognizes returns on these strategies. Apple’s ITP move is forcing Criteo to invest further in development or purchase of additional products and technology in order not to remain solely dependent on net revenue from retargeting. In addition, the company is now focusing more on attracting small and midsize businesses to its retargeting offering, which will probably be automated, possibly resulting in higher-margin revenue. Plus, to make its offerings stickier and maintain its high client retention rate, the firm is also now positioning itself as more of a technology provider for enhancements of product development, marketing, and customer relationship management, rather than just an ad-tech company. To do so, Criteo is likely to increase head count mainly in engineering and sales during the next 6-12 months. In addition, management said it will be focusing on helping retailers to more effectively monetize their online properties, such as by selling more ad inventories to brands and other advertisers, from which Criteo can generate additional ad revenue.

While we are confident that demand for online advertising will remain strong during the next five years, we are cautious regarding Criteo’s ability to broaden its portfolio of products and effectively cross-sell the various offerings to current or new clients. For this reason, we expect a mere 5% net revenue compound annual growth rate for the firm through 2022, down from our prior 7% assumption.

In the second quarter, net revenue came in at $230 million, up 5% from last year. Growth was driven primarily by strength in retargeting revenue stemming from the addition of net 500 clients, albeit at a 16% year-over-year decline in gross revenue per client. In addition, while Criteo’s client retention rate declined a bit, its impact was not material during the quarter as the rate did remain around 90%. Apple’s ITP, which we believe is curtailing Criteo’s ability to capture enough user data--possibly lowering the effectiveness of ad load purchased and ads placed for its clients--lowered top-line growth by 14 percentage points during the quarter. According to management, GDPR did not materially affect Criteo’s revenue growth nor is it expected to do so during second half 2018. However, we remain convinced that Apple’s ITP and some hesitancy brought forth by the GDPR in Europe will pressure Criteo’s monetization of clients, or gross revenue per client.

During the quarter, Criteo performed well in all regions with 4%, 4%, and 7% year-over-year growth in the Americas, EMEA, and Asia-Pacific, respectively. Online advertising, more specifically retargeting, appears to be strengthening in the most consumer-driven economy, the United States, as Criteo’s U.S. net revenue grew 8% from last year.

On the margin front, the slower-than-expected growth in head count, along with a slightly higher take rate of 42.9% (up 230 basis points from 2017), helped push operating margin higher by 2 percentage points from last year. While we expect the take rate to return to normal levels of 41%-42% and for the firm to continue investing in research and development for further product development, we do believe growth in the higher-margin and more automated midmarket retargeting along with continuing general and administrative cost control will create some operating leverage in the next five years. We have not changed our margin assumptions, and our projected five-year average operating margin remains at nearly 9%, compared with the firm’s 6% in 2017.