Advertising, Data Licensing and User Economy Could Be Enough to Drive Revenue Growth, If Successful

Key Takeaways

• Reddit’s key segment is advertising with a focus on U.S. male demographics.
• The target audience tends to be ad-resistant with low monetization potential.
• The company’s advertising platform needs a lot of work, which is also Reddit’s largest opportunity.
• Data licensing is a viable revenue stream, but may take away from Reddit’s proprietary value.
• Reddit’s CEO has majority voting power and a heavily skewed stock capital structure.
• I expect significant growth when Reddit improves advertisers’ ROI - after two years.

Catalysts

Reddit’s Is Beginning To Monetize Its Growth Verticals

Reddit boasts over 500 million monthly visitors and 73 million daily active users (p. 1), demonstrating a substantial and engaged user base. The company is expanding globally, with the U.S. contributing 81% of current revenue.

Reddit has a history of net losses, incurring -$90.8M in 2023. The company expects operating expenses to rise in the future due to planned investments in user acquisition, product development, marketing, and infrastructure. 

This means that investors shouldn’t expect Reddit to become profitable soon, rather, the value will be derived from growing their revenue baseline and attaching a profitability expectation based on their operating segments.

Prospectus: three key business verticals of Reddit (p. 7)

The company is pursuing three key verticals: advertising, a user economy, and data licensing. I will evaluate each of these opportunities separately.

Advertising Is The Core Revenue Stream

Advertising comprises 98% of Reddit’s revenue (p. 136). The company prides itself on providing a user base that advertisers can’t reach elsewhere: “Advertising is our first business, and advertisers of all sizes have discovered that Reddit is a great place to find high-intent customers that they aren’t able to reach elsewhere.” 

While it is attractive to provide a source of unique, frequently tech-savvy users, Reddit does not yet have the technology to directly capture high intent users, and currently uses subreddit (group) memberships as a means for advertisers to target audiences. The company also collects relatively (to other big tech firms) fewer personalized data points that can be used in constructing audience profiles. Anvaka: reddit audience matrix overlap

The uniqueness of Reddit users also extends to their approaches when surfing the web. Given the demographic mix (1, 2) of 67% to 74% males, 18 to 29 years old, 63% to 82% college educated, we can see that typical Reddit users tend to coincide with the population that uses ad blocking technology at a higher portion than the average 33% estimated for the U.S. This presents management with an additional hurdle that they need to address.

Prospectus: Reddit’s Quarterly ARPU (p. 101)

Reddit measures Average Revenue Per User (ARPU) relative to daily active users, where most of the monetization comes from their logged in users (p. 100). Its main geo-segment is the U.S. where the company produced $5.51 ARPU, and $3.42 worldwide ARPU in Q4 '23.

• Comparatively, Meta made $68.4 ARPU in the U.S. in Q4 - I emphasize Q4 because of the end of the year upwards seasonality for the advertising business. 
• Pinterest’s ARPU is not quite comparable because it uses monthly active (instead of daily as the two other peers) to derive ARPU. Nonetheless, for reference, Pinterest’s global Q4 ARPU is $2, and $8.07 in the U.S. 

While Reddit reaches unique users, the advertising platform has mixed reviews from customers, with customers pointing out bot clicks and a high bounce rate, while others are reporting a very good experience with reach and conversions (1, 2, 3, 4). One service measured the amount of Reddit bots impacting ads to be 50%, but that’s an improvement from 80% (1, 2, 3) in the past.

We can see that Reddit is the least monetized ad platform, which can also be interpreted that the company has a lot of potential to improve. Conversely, while there is room for improvement, we must take into account the fact that Reddit has been operating for some time and finds itself in an unprofitable state. Historically, investors have been known to put pressure to improve on public companies, however, Reddit’s share structure isolates management from such pressures - as I will discuss below. 

Advertising TAM Indicates High Growth 

Regarding the addressable market, Reddit’s prospectus stated (p. 9) “…By 2027, we estimate our total addressable market globally from advertising, excluding China and Russia, to be $1.4 trillion.” While global advertising may indeed become a more than a trillion dollar industry, this has little to do with Reddit and is not a serious reference to its business potential.

A better proxy to Reddit’s addressable market is the U.S. interactive (social) media market valued at $503B. From here, we can see that players like Meta take $142.7B (28%) of the share, while Pinterest takes some $3B (0.6%). Instead of estimating the market share that Reddit can capture from the industry, I opt to compare the company relatively to its peers Meta and Pinterest.

Reddit’s advertising platform still needs a lot of work, which will give the company’s revenues a slow initial growth. However, as customers notice an increased ROI on advertising, I expect them to increase the budget portion allocated to Reddit. Going forward, I expect mid-teens revenue growth in the first three years, but accelerating between 20% to 30% in the remaining 2 years of my forecast period. Starting from a base of $878M in the last 12-months, my estimated 15% growth rate yields about $1.220B revenue in three years, and the 25% midpoint rate grows revenues to $1.9B in year 5.

At maturity, i.e. whenever revenue growth stabilizes, typically after 10 years; I expect Reddit to be able to maintain 25% (500M MAUs) of Meta’s user base, but monetize them at 15% the rate of Meta’s U.S. ARPUs. This works out to $5.1B as 500m*($68.4*0.15). This is because execution, tech sophistication, affordable ads pricing, male demographics and adblock usage are all headwinds to the monetization potential of Reddit. Rounding up to account for other geo-segments, I estimate the advertising revenue at maturity to come up to $5.5B. 

Data Licensing: The Google To Reddit Flywheel

Google and Reddit are expanding their partnership, including a new Cloud agreement and access to Reddit's Data API. Google will use this data to train their AI models, in return according to the announcement, “Google will make it easier for people to find, discover, and engage in content” from Reddit. We can already see this playing out, as some reports indicate an increase in Google’s organic traffic directed to Reddit.

Medium: Reddit’s increase in organic traffic from Google

This is likely baked-in the usage statistics of Reddit, and may explain some of the Q3 & Q4 usage growth. However, if the user growth does not reflect an increase in quality of the platform or a trend that stimulates long-term demand, we can expect a slowdown in subsequent quarters as Reddit seems to be borrowing from the future in order to post growth around its IPO.

Prospectus: Reddit’s weekly active users (WAUs) (p. 99)

Conversely, the Federal Trade Commission (FTC) took notice of the deal and advised Reddit that it is conducting a non-public inquiry into the deal. This is likely novel territory for the FTC and it may be too early to come out with a strong interpretation of the deal.

The company also announced a new user data partnership with Cision, which is a service that monitors social media and helps companies manage their brand image on multiple platforms.

It is my impression that user data will be a valid revenue stream for Reddit in the future.  While a $60M deal is not enough to move the valuation, new customers may show interest, subsequent deals may increase in price, and Reddit may find ways to offer data products, instead of just the unstructured user data API.

Because of this, I estimate that this vertical can contribute $300M to $500M revenue in five years.

Reddit Doesn’t Have A Clear Approach For Its Political Segment

In 2016 Reddit elected to ban (1, 2) r/The_Donald, essentially limiting parts of its market opportunity. This opens up a substantial user base to competitors such as X (formerly Twitter) that attempts to pursue the political discussion market. In 2020, Reddit decided to allow republican advertisements. Reddit’s policy decisions caused an internal conflict, which culminated in 2021 when the CEO Hoffamn refused to censor discussions, leading to the departure of Reddit’s co-founder Ohanian, who was replaced by Michael Seibel, managing director of startup incubator Y Combinator and longtime friend of the cofounders.

Reddit shouldn’t disregard its political community, especially while selling away data that can be used to train AI models which may be used by competitors to provide instant answers to technical questions. Regardless, it is important for investors that Reddit has a clear direction when it comes to its approach to social discourse, which may still be a large user segment with monetization potential.

Reddit’s User Economy Is Not Playing Out Yet

To diversify revenue streams, Reddit is exploring alternative avenues such as user contributions, where people use Reddit Gold to pay redditors for their content/service. This is not a revenue sharing program from Reddit’s ad revenue, but more of a marketplace program for redditors that make valuable contributions.

Reddit is partially designed as a user-anonymous platform, where people can register with a pseudonym and discuss topics in a way that would be difficult elsewhere. However, this conflicts with building a user economy as paying out users has to be done in compliance with know your customer (KYC) regulation. Reddit is experimenting with moving in a direction of increased ID validation even for read-only browsing via VPN, and some users find this approach antithetical to their image of Reddit. I opened Reddit with a VPN both on the day of the tweet, then again shortly after, and the feature seems to have been rolled back.

In its current state, the system is heavily circumvented as users link to their personal accounts such as paypal in order to get tips and avoid KYC regulation. Reddit’s prospectus mentioned r/PhotoshopRequest, but there are currently plenty of examples where people are working around the system instead of with it.

Reddit’s user economy is in its very early stages and does not constitute a motivational factor where users can create sustainable revenue. The lack of such an incentive makes Reddit a place where people share experiences and vent out, not a place where quality content is produced regularly. 

Until management sets a clear direction on how the user economy is going to function, and executes on this promise I will not be integrating the segment into my valuation. However, should this segment take off, I would assign a value of $450M, roughly equivalent to 20% of the combined market cap of Upwork and Fiverr.

Reddit’s Share Structure: Investors Are Last In Line, But Don’t Have The Last Word

Steve Huffman, the CEO, sold a significant portion of his stock during the IPO, which could paint the IPO as a cash out event, rather than an event to raise funds and expand the business. 

Simply Wall St: recent insider transitions in Reddit

The former scenario means that management is less beholden to shareholders and may not see the need to push for creating value. 

Further, the company has a share structure that puts management above shareholders as their B class shares have 10 to 1 voting rights compared to the A class. As per the prospectus, “The holders of our outstanding Class B common stock will hold approximately 97.1% of the voting power”, with the CEO owning 46.3% of the voting power after the IPO (p. 193, last column).

Markets got a taste of this game when Mark Zuckerberg - Meta’s CEO went on his metaverse expedition spending tens of billions in capex. It took a large market reaction and protest from the board (including the resignation of Peter Thiel) in order for Meta to revert, however Mr. Zuckerberg could have ignored the market for a few more quarters and investors still wouldn’t be able to replace him.

Reddit’s B class 10 to 1 voting structure is highly favorable to management and means that shareholders will be in a position to rely on Mr. Huffman’s morality and Reddit’s potential need for liquidity in order to motivate them to create value.

Prospectus: Reddit’s unvested, potentially dilutive shares (F-16, appendix)

The company has reserved close to 73M preferred shares which can be issued by the board (effectively the CEO) without stockholder approval. The preferred stock is undefined, but the board may determine “the rights, preferences, privileges, and restrictions, including voting rights…” essentially giving the CEO a brush to design Reddit as he wishes.

In summary, Reddit seems to be a cash out IPO with a share structure that minimizes pressures from investors where the CEO holds a majority of the voting rights.

Assumptions

Revenue: I assume that advertising will be the key revenue contributor, driving 75% of the revenues in year 5. Using my forecasts from the segment analysis, I estimate that advertising revenue will grow 15% in the first three years, followed by an acceleration of 25% per year for the remaining two forecast years. A key assumption here is that it will take a bit more time before Reddit attracts large advertising customers. This results in around $1.9B advertising revenue in 2029. I also estimate that data licensing and future data products will contribute around $400M in 2029. This brings my 2029 final top-line forecast around $2.3B.

Profitability: Compared to two competitors in the advertising space, Reddit scales its headcount expenses the highest (best) with 250k users to 1 employee, while Pinterest scales 125k users to 1 employee, and finally meta has the lowest with 57.5k users to 1 employee. Looking at the expenses side of the analysis it seems that Reddit is in a good position to scale its business. During the forecast period I expect the company to grow total expenses at a 15% rate, converging on $1.9B. The resulting net income in 2029 is around $400M.

Multiple: I assume that growth will continue after year 5 and assign Reddit a 5x price to forward sales multiple, resulting in a valuation of $11.5B. Conversely, given my $400M net income estimate, this corresponds to a 29x forward PE.

Dilution: Reddit makes use of stock-based compensation and stock options in order to compensate and provide employee incentives. The company has around 162M shares outstanding, however, management has authorized stock capital of 2.34B shares. I expect that Reddit continues diluting investors in order to fund growth, resulting in a 5% annual rise in outstanding shares, leading to 206M outstanding shares in 2029. Reddit’s options are assigned a fair value of $500M in the prospectus (F-29) which will be accounted for in the valuation below.

Risks

• Social media is still evolving: Reddit faces intense competition from platforms such as Meta, X, Pinterest, Snap, for user engagement and advertising dollars. These platforms and the fierce competition in this space could limit the growth prospects for Reddit if it isn’t able to keep up or even outpace them for user engagement. If Reddit fails to drive user engagement in the face of competition, advertiser demand and thus cost per ad will decline, hurting Reddit’s top line.
• Data licensing isn’t free money: To the extent that people use Reddit to find factual and technical answers, the user-base may be challenged by new AI powered platforms that are trained on Reddit's own data to provide answers. This may take away part of Reddit’s information value, and reduce the platform to sharing experiences and discussions. 
• Redditors use adblock: Their reliance on ad revenue makes them susceptible to changes in user behavior and ad-blocking technology. Reddit may want to consider permission marketing instead of growth hacking in order to build loyalty and increase ad impressions.
• The new verticals may not take off: The success of alternative revenue streams like data licensing and user tipping is uncertain. The FTC is investigating Reddit's data licensing practices, which could potentially restrict this revenue source.
• Another tech monarchy: The company’s share structure yields a majority voting power to the CEO Mr. Huffman, who, despite being highly talented, does not need to answer to market forces.