2023-07-25 12:04:09 ET
Summary
- Duolingo's share price has more than doubled this year, driven by strong user trends and the incorporation of AI technology into its products.
- Despite strong performance, we should be mindful of Duolingo's hefty valuation as well as the very real risk of growth deceleration in the back half of the year.
- As international travel demand passes the summer season, fewer people may be motivated to learn foreign languages.
- Especially with tough macro conditions, more consumers may be reviewing their monthly subscription expenses (especially as streaming companies raise prices).
With the broader equity markets teetering at year-to-date highs, investors have to be more careful than ever to deploy careful portfolio reviews and stock-picking. Especially with stocks that have seen massive YTD gains, we have to ask ourselves: do fundamentals justify these advances, and does valuation still make sense?
Duolingo (DUOL) is a stock that merits careful review. This language-learning app has seen its share price more than double year to date, bolstered by strong active user trends plus the company's incorporation of AI technology into its products.
Especially at a higher stock price, there's more risk than reward in Duolingo stock
I'll acknowledge the strength here first. As regards Duolingo's fundamental performance, there can be no doubt that ~40% y/y bookings growth is quite impressive. This is likely due, in no small part, to voracious travel demand as airlines continue to report record profits and hotels enjoy high occupancy rates. Consumers continue to pick up on the "revenge travel" demand, especially to overseas locations - a heavy stimulant for the desire to learn a foreign language.
Second, Duolingo's increased adoption of big data and AI is compelling. The company's Explain My Answer and Roleplay features within its Duolingo Max subscription tier help app users understand their mistakes and simulate the function of an actual language tutor. These advanced capabilities, in my view, make Duolingo a favorite among language learners (I myself am a regular user of the app).
However, we have to ask ourselves two key questions:
- Is Duolingo's valuation sustainable after its meteoric rise this year?
- What is the risk of user/bookings trends falling off?
First, on valuation: at current share prices near $148, Duolingo trades at a market cap of $6.06 billion. After we net off the $641.1 million of cash on Duolingo's most recent balance sheet, the company's resulting enterprise value is $5.42 billion.
For the current fiscal year, Duolingo has updated its outlook to $500-$509 million in revenue, representing 35-38% y/y growth - up from a prior outlook of 32-35% y/y; as well as an adjusted EBITDA margin range of 11-12% (one point higher on the low end versus a prior view of 10-11%).
This puts the stock's valuation at:
- 10.7x EV/FY23 revenue
- 93x EV/FY23 adjusted EBITDA
A double-digit revenue multiple, especially in this market climate, is difficult to justify. We have to also be wary of macro-related risks to churn here. Duolingo may be a subscription software company, but it's not an enterprise software company - cancelling a Duolingo subscription is as easy as clicking a button. Once the summer travel season dries up, and a key motivation for language learning gets taken away - it wouldn't be surprising to see a lot of Duolingo users peel off in Q2 and Q3, especially if many consumers are feeling wallet-pinched and reviewing their monthly subscription expenses.
All in all, while I acknowledge the fact that Duolingo has achieved incredible performance so far, I find it difficult to justify the stock's doubling since January. If you're holding onto a Duolingo position now, it's not a bad time to lock in gains. Though previously bullish then neutral on the stock, I'm now downgrading Duolingo to bearish owing primarily to the risks embedded in its bloated valuation and the fact that fundamentals are unlikely to live up to heightened expectations.
Steer clear and move to the sidelines for now.
Q1 download
It's worth reviewing, however, Duolingo's strong results year to date. The results of its Q1 print are shown below:
Revenue grew at a 42% y/y clip to $115.7 million, beating Wall Street's slightly more modest expectations of $112.7 million (+39% y/y) by a three point margin. Underlying bookings, meanwhile, grew 37% y/y to $140.1 million, which represents sequential growth over $126.4 million in Q4 but a deceleration from Q4's 46% y/y growth pace as Duolingo starts to lap tougher comps.
As shown in the chart above, monthly active users grew 47% y/y while daily active users grew 62% y/y, indicating high engagement levels for the app - and at similar y/y growth rates to Q4.
Dissecting the performance in its Q1 shareholder letter , Duolingo management wrote:
Our results were strong mainly because we continue to improve the Duolingo language learning app along three dimensions: teaching efficacy, user engagement, and monetization. On top of that, we believe that our marketing through organic social media, influencers, and paid user acquisition keeps getting more effective."
It is important to highlight the heightened marketing efficiency portion of the statement above. As a percentage of revenue, Duolingo has been able to reduce sales and marketing spend to just 13% of revenue, five points lower than 18% in the year-ago Q1. On top of a 3-point reduction in general and administrative expenses for the quarter, this has allowed Duolingo to dramatically expand its adjusted EBITDA to $15.1 million (up nearly 4x y/y), representing a 13.1% margin - 820bps of improvement on a year-over-year basis.
While this progress is worth calling out, we should remember that at a near-100x adjusted EBITDA multiple, Duolingo's profitability is still not sufficient to justify its $6 billion market cap. And if top-line growth starts to moderate on higher-than-expected user churn, Duolingo's ability to dramatically boost its margins will also stagnate.
Key takeaways
I've enjoyed some year-to-date gains on Duolingo, but I'm wary to continue holding onto this name especially as it runs the risk of revenue deceleration in the back half of the year - driven both by lapping stronger comps and the potential for macro impacts to drive heightened churn. I prefer to play it safe and rotate out of this stock for now.
For further details see:
Duolingo: Why You Should Sell This Stock Now