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The problem with Adgorithms' prospectus

IC TIP: Ignore

Sometimes companies can be hit by truly unexpected events, and sometimes companies are just not ready for public life. The question for Adgorithms is whether it fully informed the public of its readiness.

The ad tech firm's initial promise was heady. Prior to listing, Adgorithms had developed a sophisticated piece of software called Albert which could efficiently handle the labour-intensive task of managing clients' online advertising campaigns. An example of 'programmatic advertising', the self-learning software identifies and bids for the most appropriate impressions available on advertising exchanges. These exchanges are essentially brokerages which help advertisers and publishers buy and sell ads in real-time auctions.

A classic disruptive story, Adgorithms is backed by technology which can do human work more effectively, efficiently and cheaply. Such stocks often play well with investors.

Once sold as a service, Adgorithms believes Albert is highly scalable, in addition to the revenues it receives from the exchanges. Judging by the pre-IPO numbers, it was clearly growing the latter revenue stream. Between 2013 and 2014, sales rocketed from $4m to $20.2m, while earnings before interest, tax, depreciation and amortisation - once adjusted for non-cash share-based payments - went from $200,000 to $6.9m. Demand for Albert was apparently strong: in June, management said the software was handling 20,000 campaigns.

Despite that impressive rate of headline growth, Adgorithms' management opted for rapid international expansion over short-term profitability. In April - with the IPO apparently a dead cert - management effectively paid itself the $2.1m cash on its balance sheet in dividends. It then went to the market to fund a massive US sales push and a war chest for acquiring online advertising agencies, primarily for their client relationships and sales teams.

With that investment case, the Tel Aviv-based firm successfully tapped institutional investors to the tune of £27m, (which dropped to £19.6m after listing costs and a £5m payment to management). Overnight, chief executive Or Eliezer Shani's stake was marked at £39m. Those shares are now worth £7.4m.

So what went wrong? This is what the company said in its first profit warning, on 9 October, explaining a "significant" and indefinite impact on revenue:

"In recent weeks, the online advertising market has experienced severe disruption, resulting in a loss of supply for major online advertising exchanges and a drop in demand from major media buyers."

In fact, this disruption had begun several months before, even prior to Adgorithms' listing. In April, media trading platform news site reported that AppNexus - which, together with fellow ad exchange Adap.TV related to the majority of Adgorithms' 2014 revenues - had started screening out unverifiable media inventory. AppNexus' chief executive, who followed several other ad exchanges when he launched the clean-up in November 2014, later acknowledged that more than half of the impressions flowing through his platform were failing the test. This has had the dual effect of suppressing Adgorithms' revenues and - according to Peel Hunt analyst Alex DeGroote - increasing the cost of digital media.

Adgorithms certainly should have known about AppNexus' clean-up plans before listing, and was aware that at least one of its peers had been hit by the broader changes. In April, fellow Israeli ad tech group Matomy Media (MTMY) issued a profit warning, citing the "implementation by one of the leading media trading platforms [this was AppNexus] of a new media verification and screening tool that resulted in an immediate decrease in the amount of digital media available for purchase".

Given these critical changes to ad exchanges were occurring before Adgorithms' float, and clearly contributed to its later profit warnings, how was this reflected in presentations to investors?

The admission document touched on several related risks. First, the company acknowledged its dependence on the exchanges and the broader architecture of the digital advertising world. For a middle man like Adgorithms, that's a given. The prospectus then explains that ad exchanges like AppNexus and Rubicon "are in a position to exert significant influence on advertising media", adding:

"Failure... to successfully cope with unexpected or unanticipated changes to the industry's current set of basic playing rules may materially affect the company's revenue and profit projections as well as creating direct losses."

Were these "current set of basic playing rules" not in severe flux? How "unexpected and unanticipated" were the changes, given the long-trailed clean up on AppNexus? And crucially, when did it dawn on Adgorithms that this would cause serious disruption to the business?

The company declined to comment on when it first became aware of AppNexus' clean-up and how it reacted. Short of these facts, there is no evidence that Adgorithms papered over the risks to the "basic playing rules" at the IPO, or in the months before October. One shareholder who spoke to the Investors Chronicle believes the changes which affected Adgorithms only became apparent in September, long after AppNexus implemented its clean up, though no specific evidence was offered to support this assertion.

There is another notable omission in the listing prospectus. Nowhere in the 102 page document is there a mention of the threat ad blocking software poses to all parts of the industry. This is despite a 41 per cent growth in the use of ad blockers in the year to July 2015, according to industry consultancy PageFair. Its report also estimated ad blocking would render worthless $22bn of last year's $171bn predicted global online ad spend. Investors have told the Investors Chronicle that concerns around ad blocking were raised at the time of the IPO, but their due diligence and Adgorithms' view was that ad blocking presented an insubstantial risk to the business. The company declined to comment on the omission.

With so much turmoil in the online advertising sector, it is difficult to feel too much sympathy for shareholders. Blue-sky technology stocks are inherently risky businesses, and it is up to investors - major fund managers such as Schroder Investment Management, Standard Life and Rathbone Investments - to carry out their own due diligence. Nonetheless, if I were a shareholder I would have wanted the prospectus to include more detail and assurance on the looming and existing changes to advertising exchange policy.