2023-09-18 05:56:42 ET
Summary
- Duolingo continues to exhibit strong execution in its language learning business.
- The Company's profitability has shown significant improvement, with its GAAP EBIT margin narrowing from -10+% to -4% in 2Q23.
- DUOL's success spans across geographical regions, indicating its ability to tap into a global pool of learners.
Summary
Duolingo ( DUOL ) develops and offers its signature Duolingo mobile app to users to learn languages. I am recommending a buy rating for DUOL as I see the business continuing its strong execution, supporting the current valuation. While I did not model this in, I believe the stock sentiment will flip to super bullish when the business starts generating meaningful GAAP EBIT.
Company overview
DUOL went public in early 2021 at an IPO share price of $140 and was considered a broken IPO as the stock dipped to a low of $60, likely due to the fact that it IPO'd at a forward revenue multiple of 30. The stock has since derated to a forward revenue multiple of 10x.
The DUOL mobile app has both a free and paid version, for which users will pay a recurring fee (either monthly or annually) for the paid version. DUOL offers this service to both consumers and enterprises. This main business represents 74% of total revenue, while other smaller parts of the business include advertising (12% of revenue) and Duolingo English Test (9% of revenue). The business has continued to grow strongly, with revenue in the north of 40% and an improving profit margin status. Notably, the business has continued to grow at this level while maintaining a net cash status, which is commendable. The business, however, has improved significantly not only from a financial point of view (discussed below) but also from a qualitative perspective. For instance, DUOL launched the Duolingo ABC app, which is aimed at teaching young children how to read.
As for the current state of the business, it is on the brink of turning profitable (GAAP EBIT basis), which I see as an inflection point that will drive the DUOL share price into the next level as it leaves the camp of "growth-only" stocks.
Financials/Valuation
DUOL had a prosperous quarter, reporting an increase of 43.5% in total revenues year over year. Particularly robust were subscription revenues, with a total of 5.2 million subscriptions for the quarter thanks to robust average revenue per subscriber and paid subscriber additions. This is a continuation of DUOL's historically strong growth trend.
Based on author's own math
The combination of lower payment processing fees and price hikes in both subscriptions and DET led to a 40 basis point y/y increase in gross margins, bringing the total to 73.4%. Again, gross margin performance has improved over time as well, from 70.7% in FY19 to 73% over the LTM. Adjusted EBITDA increased to $20.9 million, up from $16.7 million, thanks to robust growth and strong gross margin performance. On the balance sheet, DUOL continues to operate with a sound balance sheet that has a net cash balance of $678.7 million (no debt). DUOL's ability to print this level of growth is highly commendable as it means that the business could have possibly grown more if they decided to supercharge their R&D or S&M reinvestments via the debt market.
Based on author's own math
Based on my view of the business, DUOL should continue to grow at high rates, albeit at a decelerating rate as the business becomes larger. My price target is $208.
Model assumptions: Sales to grow by 39.1% in FY23, 26.9% in FY24, 22.5% in FY25, bringing the revenue figure to $514 million in FY23, $652 million in FY24, and $799 million in FY25. These figures are based on consensus estimates which I used as a benchmark. The reason I believe a decelerating growth is likely is because a same trend can be seen in the total bookings growth over the past 10 quarters.
Based on author's own math
The business is currently trading at its historical average multiple of 10x, and I believe it should trade at 10x for the near term as it continues to grow the business and could see further upside rerating once it starts generating positive GAAP EBIT in the coming periods. The multiple is also justifiable when compared to two of DUOL's popular comps (albeit they offer much more than just languages): Coursera and Udemy. Historically, DUOL has always traded at a premium vs. these 2 peers due to the major difference in growth rates. DUOL has ~6x its revenue since FY19 to LTM, while the other two have 2.5x to 3x their revenue since FY19. Given all of them have no meaningful profits, comparing them based on expected growth is the best way to compare. Using consensus estimates, DUOL is expected to continue at a much higher than the 2 peers (60+% vs 20+%), hence, I expect this premium to continue.
Comments
I believe the management team at DUOL deserves a round of applause for their strong streak of execution so far over the past 12 quarters. The business has continuously grown at very high rates even in the current macro environment (2Q23 growth rate was still >40%), while profitability has taken a big step forward from -10+% to -4% GAAP EBIT margin in 2Q23, and I expect it to turn profitable over the next few quarters. Importantly, FCF growth has grown dramatically as well, reaching >$30 million in 2Q23.
Aside from the reported P&L, the underlying metrics are still very strong, and this gives me confidence in DUOL's ability to sustain its rapid growth. Total bookings were robust, increasing by 41.1% year-over-year to $137.5 million. Notably, if not for FX headwinds during the quarter, bookings growth would have been 42%. It was encouraging to see that an increase in the number of paying subscribers was a major factor in the growth. Keep in mind that DUOL runs on a freemium model, so the willingness of users to convert from free to paid subscribers is the primary factor in the growth of the service. That this conversion is so robust gives me confidence that the DUOL product is finding favor with its target audience. Some might argue that DUOL is heavily discounting and promoting; my counterargument is that this does not tie up with the increasing profit margin of the business. In fact, if DUOL is actually offering a lot of promotions to drive conversion and is improving its profitability, I think it is a bullish point overall.
With a healthy potential pipeline for incremental free-to-paid conversion, I anticipate the growth trend to continue. With an increase of 1.5 million MAUs (monthly active users) in 2Q, DUOL ended the quarter with 74.1 million MAUs and a year-over-year growth rate of 49.7%. The increase in DAUs was also relatively stable, coming in at 62.1% Y/Y, or 21.4 million. Lastly, I think the fact that DUOL saw strength across all geographical regions is a very strong indicator of DUOL's success, as it is able to tap into the global pool of learners, which significantly expands its TAM. This also reduces DUOL's reliance on developed markets like the US and Europe over time. While there are pricing differences between regions, I think the long-term benefit is worth it, as the education system in developing regions is much poorer than in richer countries. As such, the value that DUOL brings to the table is much greater, which also means there is a longer growth runway. Let's also not forget that of the top 10 most populated countries, 8 out of 10 are outside of the US and Europe, so there are definitely a lot more potential learners.
In the long run, I expect DUOL to dominate the international market for language study, with far more users, higher engagement, and more lucrative opportunities than any of its main rivals. Given that the TAM is huge and has the potential to be worth more than $100 billion , I think the growth runway is a lot longer than one might imagine.
I believe the 2Q23 results put to rest any concerns that DUOL will be unable to maintain its users growth metrics, and the business has continued to execute very well. I think the only question left to be answered is how long it will take for DUOL to turn a profit. Over the next few quarters, I anticipate this issue to be resolved, as management has expressed enough confidence in the incremental margin outlook to raise its EBITDA guidance for FY23. If we look at the GAAP EBIT trend so far, DUOL has been gradually reducing its losses, and the incremental margin (sequentially) has picked up from negative to positive. Assuming the similar incremental margin for the coming quarters, DUOL should turn GAAP EBIT profitable. I expect a strong multiple re-rating upward once DUOL begins to generate meaningful GAAP EBIT.
Risk & conclusion
Competition in the market for online language learning is fierce because so many companies are constantly releasing new products. A simple search on Google suggests at least 10 different other alternatives. As a market leader, DUOL needs to avoid the innovator's dilemma by continuously adding new features to its platform.
Google
That said, DUOL leads by a huge margin so far based on apps downloaded. I believe this gives them a big lead in terms of user behaviour and data collection, which feeds into their flywheel circle of improving the app at a faster pace than competitors. Also, DUOL has the option to tap into the equity and debt market to supercharge its growth if necessary, which could further extend its lead against peers, if it needs to.
Overall, DUOL's strong execution and impressive financial performance underscore its potential for continued growth. The company's robust revenue growth, expanding subscriber base, and improving profitability are commendable achievements. Management's ability to navigate the challenging macro environment while maintaining high growth rates is noteworthy. The outlook for Duolingo remains positive, with a sound balance sheet and a growing user base. The potential for further growth, particularly as the company moves towards generating positive GAAP EBIT, suggests a promising future.
For further details see:
Duolingo: Strong Execution Continues To Support High Growth Rates