ROCKET FUEL INC. (NASDAQ: FUEL)

03/28/2017 Focused Stock Trader Team

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Company Overview:

Rocket Fuel pioneered artificial intelligence in advertising. Predictive marketing is now here. Predictive marketing leverages real-time data and artificial intelligence to anticipate consumer needs. How does it all work? You finish binge watching your favorite series on Netflix and then you see thoughtful recommendations about what to watch next as you browse. You spend $500 on your Nordstrom store card and then start receiving sales promotions on items somehow they know you love. These situations are the beginning of a bright future in predictive marketing. Years ago, advertisers would run a television ad or a radio bit just hoping to get lucky enough to catch some portion of their target audience. Nowadays, Rocket Fuel is using artificial intelligence to process all the mountains of information out there into reliable signals about each individual consumer and their preferences. These signals have become the powerful foundation for how to build effective advertising campaigns. Today we are only at the forefront of a future evolution in predictive marketing based on artificial intelligence. Rocket Fuel is leading the way as the engine behind making these more magical advertising moments happen.

Investment Thesis:

Rocket Fuel is in the value bargain bin as badly busted IPO. The company raised $116 million in its IPO by selling stock at $29 a share back in 2013. The stock increased 93% in its first day of trading closing at $56. The shares proceeded to trade to the high $60s, but then the company conducted a surprise secondary at $61 and pre-IPO venture capital investors and other insiders exited some $175 million worth of their holdings. The surprise secondary kick-started a wave of negative momentum. The company started missing Street expectations that caused a vicious downward estimates cycle. Customer growth then stalled out. Then came a cost restructuring and a new efficiency program, but it was not enough to address the cash burn of unprofitability.

But here we are now in the value bargain bin. The current equity value of Rocket Fuel is just $230 million compared to the $2+ billion valuation hit back in 4Q 2013. The company has minimal net debt. We are not yet to the inflection point of profitability, but there is light at the end of the tunnel. If the turnaround is successful, we could see Rocket Fuel heading to 5x the current valuation, with even greater takeout potential.

See the supplemental pages of this report for more of the details about Rocket Fuel Inc that support our investment thesis.

Investment Highlights:

(i) The scale of Rocket Fuel’s computational infrastructure coupled with its predictive modeling and automated decision making create a disruptive force. While data is clearly the fundamental input for Rocket Fuel’s AI platform, we believe three critical components create the company’s competitive advantage.

The first component is Rocket Fuel’s predictive modeling, which estimates the probability of a consumer performing an advertisers’ desired action. Analyzing petabytes of data, Rocket Fuel’s AI technology calculates the probabilities from millions of simultaneous attributes derived from advertiser clients and third parties, as well as its own data collected from conducting thousands of campaigns. The automated decision making system translates these expected outcomes into a precise monetary value for each advertising impression.

The second component forming Rocket Fuel’s competitive advantage is its real-time optimization engine, which adapts these outcomes for market price fluctuations, consumer responses to ads, bids on impressions that were won and lost, and ad impressions served. These actions continuously refine each campaign to improve accuracy and achieve advertisers’ campaign goals. As shown in the graph below, the AI-platform continuously refines campaigns to achieve advertisers’ goals.

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The final component is Rocket Fuel’s proprietary computational infrastructure, which serves as the backbone of its real- time optimization engine in logging, processing, and acting on billions of events daily. The company has designed the infrastructure in such a way that it can respond to bid requests from real-time ad exchanges in approximately 100 milliseconds and deliver 36 billion impressions daily for over 1,000 campaigns. While competitors could become swamped by data overload, Rocket Fuel’s AI-driven platform will excel at determining the most receptive audiences for the advertisers’ campaigns given its scale.

(ii) We believe tremendous growth opportunities lie ahead for Rocket Fuel as real-time bidding (RTB) is widely adopted and social, mobile, and video advertising continue to grow rapidly. As the allocation of ad spending flowing to programmatic and real-time bidding increases, we expect more advertisers to turn to Rocket Fuel. We believe a fundamental aspect of Rocket Fuel’s success is the company’s ability to leverage the adoption of programmatic trading and real-time bidding.

With the rise of programmatic buying came the advent of RTB and exchanges. RTB is the real-time buying and selling of advertising inventory on an impression-by-impression basis on advertising exchanges. Real-time advertising exchanges reduce the transactional friction historically associated with the buying and selling of digital advertising inventory. RTB is expected to continue to rapidly grow and gain share of advertisers’ digital display advertising buying process. RTB represents only 15% of worldwide display advertising spend, but is estimated to increase at a rapid clip >25%.

RTB is typically associated with non-guaranteed advertising inventory, but over time the vast majority of premium advertising inventory should transition to programmatic buying and selling instead of direct sales. From a recent study, more than a third of media buyers indicated that they were at least somewhat likely to transition to programmatic buying. Another third was willing to replacing their direct relationship with publishers with programmatic buying, but wanted to see the success of the buying process first.

While mobile, social, and video alone represent multiple-billion-dollar opportunities, we expect programmatic and RTB media buying to gain traction in these three fast growing advertising channels, layering on additional revenue opportunities for Rocket Fuel. Below is a list of the great brands that already use the Rocket Fuels programmatic solutions.

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(iii) We believe Rocket Fuel remains the visionary leader in predictive marketing through artificial intelligence. A few recent events re-affirm our confidencethe IBM partnership and the Gartner study.

First, Rocket Fuel recently expanded its partnership with IBM embedding Watson Cognitive Capabilities into its prediciive marketing platform. Cognitive technology detects brand sentiment in online news content to inform digital advertising. Rocket Fuel announced a new capability called "Brand Moments" that embeds IBM Watson technology. Through this integration, Rocket Fuel, with IBM Watson Discovery, is informing consumer purchase decisions by using cognitive computing to identify keywords and brand sentiment signals in real-time. These keywords are then fed into Rocket Fuel AI to drive better performance, improved brand safety, and deeper intelligence for businesses. By facilitating AI to AI communications with IBM Watson Discovery, Rocket Fuel is applying AI in radically new ways to help solve digital 

marketers' toughest challenges. The next generation of digital marketers are realizing that access to data is not enough; real insight comes from applying AI powered decision making to various digital brand interactions. By using AI-powered tech, like Rocket Fuel's Moment Scoring Technology, predictive marketers can uncover value in data sets that previously meant nothing to them and translate these insights into marketing that is more meaningful for their customers. Rocket Fuel is testing the Brand Moments service with a few select customers. Upon completion, Brand Moments will be available to Rocket Fuel customers that advertise in the U.S. market.

Second, the widely-followed Gartner Study reveals Rocket Fuel as a top visionary in the space. This industry study looked at all the leaders and challengers in the space, who is a visionary, who is a niche player, and who has an ability to execute. Rocket Fuel scored very well.

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(iv) As always, it all comes down to the numbers, where we are excited about the turnaround story unfolding. Rocket Fuel most recently reported better-than-expected gross revenue, driven by 97% year-over-year growth in programmatic. The companys top 50 customers now represent 59% of revenue and the top 250 make up 87%, which highlights a broad and diversified base of customers underneath the revenue performance. As the company takes strategic steps to add incremental inventory like digital audio, we believe that Rocket Fuel has likely turned the corner and gross spend dollars per customer should see a trough this year that turns into a lift next year, putting the company on a path to profitability. A review of one investment banks earnings model is shown on the next page, which calls for the turn in 2021.

Near-term, we expect Rocket Fuel to need to continue to focus on strategically targeting its largest customers vis-à-vis its more streamlined salesforce, establishing new agency relationships, cross-selling its Data Management Platforms to existing Demand Side Platform customers, ramping its self-serve offerings, and potentially leveraging system integrators and resellers to service smaller advertisers. This executional challenges could result in some quarter to quarter volatility.

Importantly, we note that while the company has little current net debt, due to the operating losses there is a need for funding. Accordingly, in August 2016, management filed a controlled shelf registration allowing it to offer and sell up to $50 million of securities, however, only in strictly controlled way selling small doses every quarter. We believe these arrangements ensure that the shares are sold in a manner to minimize market impact while providing some capital flexibility to the company. A good thing given the context!

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(v) Valuation looks extremely compelling. Our longer-term investment thesis for Rocket Fuel lies on the belief that at its core, there is an underlying asset value in its technology and as it mends connections with agency holding companies and wins back ad budgets, that value will continue to be unlocked. Our base case is that Rocket Fuel is at least a double as the EV/Sales ratio normalizes from currently distressed levels. If the turnaround is very successful, we could see Rocket Fuel heading to at least 5x the current valuation, as publicly traded internet peers can go for EV/sales valuations of 2x, 5x, and even up to 10x. Then there is always the possibility for a take-out resulting in a M&A premium. Alliance Data Systems, which runs a private label credit card businesses connected to a leading digital marketing platform in Epsilon, has publicly commented on the attractiveness of Rocket Fuels technology. Dont miss out on buying into Rock Fuel at current levelsthis is the artificial intelligence marketing leader currently going for a bargain price!

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