2023-12-12 07:57:11 ET
Summary
- Duolingo's strong growth momentum should continue over the next 2 years, with the company projected to turn GAAP EBIT positive in FY24.
- The company reported impressive financials, with total revenues growing at a staggering pace of 43.3% year-over-year and strong margin performance.
- Duolingo's efforts to introduce new products, such as generative AI features and expansion into math and music, are expected to support further growth and user engagement.
Summary
Readers may find my previous coverage via this link . My previous rating was a buy, as I believed Duolingo (DUOL) execution was on point, and once DUOL starts generating positive GAAP EBIT, the stock valuation should re-rate higher. My previous target price was $208, and the share price today has surpassed that. Below, I discuss my updated view on DUOL. At a high level, I am reiterating my buy rating for DUOL as I see DUOL continuing its strong growth momentum over the next 2 years. Most importantly, I expect DUOL to turn GAAP EBIT positive in FY24, which should trigger valuations to rerate upwards.
Financials/Valuation
I think there is no debate that DUOL continues to execute at a very high level, as it reported another strong quarter (3Q23) . Total revenues grew at a staggering pace of 43.3% y/y, mainly driven by Subscription revenue growth of 46.7% to $105.8 million. Strong subscription revenue was driven by strong paid user growth, although ARPU was a minor headwind. Other aspects of the business, Duolingo English Test, also performed very strongly, growing 29.5% to $10.6 million. Importantly, margin performance was spectacular, with gross margin increasing 100bps to 73.7% and adj EBIT margin expanding 12.1 percentage points to 16.5%. GAAP EBIT margin also showed significant operating leverage, expanding from -21% to -3.4%.
Based on author's own math
Based on my view of the business, DUOL should continue to grow at 40% for FY24, followed by a slowdown in growth rate to 35%. The slowdown is to reflect management comments that they do not see accelerating growth forever. With my revised expectations, DUOL should generate close to a billion in revenue in FY25. Another adjustment I made to my model is that I now expect DUOL to trade at 1x above its historical average (10x forward revenue), as DUOL should turn GAAP EBIT margin positive in FY24. This is a major milestone that should trigger a re-rating in valuation. While growth is not as high as in the past, I think a premium to average is justified because DUOL is now a much bigger business and will be GAAP EBIT positive.
Comments
I expect growth to continue at this staggering pace, as total booking growth has remained very strong. In fact, booking growth accelerated to 49.5% Y/Y to $153.6mm. The acceleration in growth came at an incredible timing, as it indicates that total bookings growth can remain above 40% (2Q23 total bookings growth recovered by 400bps to 41% sequentially). Implicitly, this also suggests that revenue growth can be sustained at >40%. What's more important is the quality of the bookings growth. 3Q23 bookings growth was mostly organic, as it was driven by continued strength in free-to-pay conversion as paid subscribers. Leading indicators suggest that DUOL can continue this pace of conversion as MAU (monthly active users) growth remained strong (47.1% in 3Q23), with DUOL adding another 9 million MAUs, ending 3Q23 with 83.1 million. DAU (daily active users) growth also accelerated, growing 62.4% Y/Y to 24.2 million users. The growth in users and bookings was across all of DUOL's regions, which points to the sustainability of growth. In particular, management has pointed out that prices in developed countries like the US and Europe were stable, which suggests that the increase in paid users was not prompted by steep discounts.
Furthermore, DUOL's efforts to introduce new products that improve the app should continue to support growth. For example, management is actively working to incorporate generative AI features while simultaneously broadening the app's subject matter to include math and music.
For generative AI, I like how management is rolling this out gradually (as a part of a third and higher-priced tier, Duolingo Max). This allows management to gather data and reiterate the app to better meet learners' preferences. Through this process, they are also gathering data on pricing-how much are learners willing to pay for this? and also the best way to incorporate this into the learning plans. So far, initial uptake has been good, and management plans to continue experimenting with shuffling features across pricing tiers to drive usage. Personally, I think generative AI will significantly improve learners' experiences in learning, especially in speaking. As such, as DUOL rolls this out, I expect to see an increase in adoption of the app. For math and music, I think this is a very interesting development for DUOL. In hindsight, this appears to be a natural move as it penetrates into other subjects. Currently, monetization is not within the pipeline, as management is still integrating these two into the core learning app. If integrated and executed well, this should drive more user engagement and retention. That said, I do have my concerns about how successful this can be, as these are very different subjects and languages that likely require a completely different teaching approach. As such, I am not modeling any upside from this. But I would not be surprised that DUOL can pull this off given their execution track record.
As such, for growth, I don't see a reason for the growth momentum to stop. The fact that management raised FY23 revenue guidance is a clear testament. The new range is guided for $525 million to $528 million, from $510 million to $516 million, which represents Y/Y growth of 42.5% at the midpoint. Bookings guidance was also increased to a range of $598 million to $601 million from $569 million to $575 million, representing a year-over-year growth of 40%. In terms of profitability, the catalyst that I mentioned previously-DUOL generating positive GAAP EBIT-is going to materialize soon. In the 4Q23 guide, management is guiding revenue to a range of $145 million to $148 million, and adjusted EBITDA was guided to a range of $28.7 million to $30.7 million. This implies the adj EBITDA margin will come in at 20.2% in 4Q23. Historically, the delta between adj EBITDA margin and GAAP EBIT margin is around 20%. Assuming the same delta, this implies that 4Q23 GAAP EBIT could be in the positive region. While management did not provide an initial outlook for FY24, their comments suggest that GAAP EBIT is going to inflect into a positive region. Specifically, management noted that they feel good about strong topline growth in FY24 while still making progress towards long-term margin targets.
Risk & Conclusion
Worse-than-expected payer conversion dependence could impact growth momentum, especially if generative AI adoption was worse than expected and the rollout of math and music was not interested by consumers. Management venturing into the math and music vertical is positive as it expands the addressable market. However, this is outside of DUOL expertise, which means there is an elevated execution risk here. Overall, I recommend a buy rating for DUOL due to its sustained growth trajectory and potential to achieve positive GAAP EBIT in FY24. The company continues to exhibit exceptional execution, evident in its impressive financial performance with strong revenue growth and margin expansion. The introduction of generative AI features and expansion into math and music realms bodes well for improved user engagement and retention.
For further details see:
Duolingo: Continued Growth Momentum And Potential For Positive GAAP EBIT In FY24