A New Way To View 10-K Risks: Rubicon Project Example

The risks section of a company’s 10-k is normally thought of as a mundane, unchanging part of the filing, at least to me. I have found it rare that they bring up an issue that was otherwise not common sense. Recently I have began to approach the risks section in a different way, especially in companies that are going through significant changes.

The new approach involves analyzing both the current and previous 10-k for changes in the risks outlined by the company; especially additions of new risks. This methodology was first brought to me attention while listening to The Investor’s Podcast. A quantitative momentum investor spoke of algorithms, which scan through annual reports looking specifically for changes in the risks section. The idea is that if there is an addition to the risk section it is because the lawyers told management that there is a new potential issue that they need to cover themselves on.

I recently applied this methodology to the Rubicon Project (ticker: RUBI), a company which I have written about in a previous post. RUBI is going through a huge shift in their business model, with several shake-ups in their executive leadership. The new model focuses on mobile and header bidding specifically. Their previous focus had been on general desktop-based ads, however slow downs in revenue and increased competition caused them to refocus. The extent to which RUBI was being pushed out of the market was veiled by the enthusiasm on the new direction outlined in the latest Q4 conference call, however the change in risks from 2015 to 2016 in their annual reports truly highlight the turbulence to come.

One of the most important aspects of RUBI’s business model is their take rate. Take rate is measured by net revenue divided by total ad-spend. The take has been decreasing for RUBI due to increased competition. Based on the new risks placed in the 2016 10-k, it seems there will be no slow-down of the fall,

“…the expansion of header bidding exposes more inventory to competitive bidding, thereby potentially resulting in increased volatility of our operating results…”

The very thing that they are targeting for growth will increase their competition and drive down their take rate. Further evidence of the decreasing take rate comes from another new risk,

“Client demands for transparency and pricing concessions have increased significantly, and more quickly than we previously expected, making it difficult for us to increase our business with some clients, causing others to reduce their spending, reducing our take rate in some transactions with demand sources, requiring us to provide less expensive self-service offerings and more transparent pricing alternatives.”

While RUBI’s net income has been both negative and positive over the past several years, their free cash flow has remained positive over the same few years. The pressure on their take rate in conjunction with their decrease in revenue is going to squeeze their margins, making it difficult to be FCF positive.

The shift in their business model also requires significant investments and new expenses, which will further contribute to the reduction in margins, as identified by the following new risk,

“we expect our expenses to continue to increase over time as we pursue expansion of our business, including hiring…investing in technology and infrastructure…and developing additional media platforms”

It is clear that this shift in business focus is going to bring unprecedentedly low take rates and drastically increased expenses, leading to all time low margins.

The final nail in the coffin is that the online advertising industry is shifting against independent players like RUBI. RUBI's results are highly dependent on the advertising inventory they are able to buy. The quality of inventory that RUBI can buy and the price are dependent on the basics of supply and demand. The industry trends are making supply and quality of inventory limited and more expensive for RUBI. The following new risk outlines how the shift in the industry will negatively impact RUBI,

“…the amount of inventory available to independent platforms like us could be reduced as a result of decisions by Facebook to emphasize content viewable through its site… or decisions by Google to utilize its ad server advantages to outbid us… Similarly, decisions by buyers and sellers to transact directly rather than through us would tend to reduce both spending and inventory on our platform.”

This new risk is especially meaningful because it very specifically mentions Facebook and Google. It also just so happens that Facebook is in fact pushing content viewable through their platform with their video implementation along with Facebook live.

Rubicon's new risks read as an obituary. There are significant headwinds facing the Rubicon Project even in the new refocused direction they are taking. Problems that were glazed over in the conference call are clearly more burdensome than management would want investors to believe. Although they guided lower than expected for the next quarter, it seems that even in the long term the turnaround they are pursuing is unlikely. They are late to header bidding technology, late to the mobile ad technology, competition is crushing their take rate, expenses are increasing and middlemen as a whole are being cut out of the industry by giants like Facebook and Google.  Even though RUBI is trading below book value, any value left is more likely to be eroded than realized.