AppLovin: Back On Track For Growth, But Advise Buying On Dips (NASDAQ:APP)

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Thesis

AppLovin Corporation (NASDAQ:APP) is a mobile mediation company, providing software solutions to assist app developers market to potential customers and optimize their monetization efforts through encouraging in-app purchases or conducting in-app advertising. Moreover, via its Apps business segment, AppLovin sells ad inventories and game items across its wide range of game studios. The company’s successful transition to a software-based business model, coupled with increased profitability and a positive outlook for the mobile advertising market, reinforces AppLovin’s long-term growth prospects. Therefore, despite the stock’s rally following the 2Q earnings, I recommend that long-term investors consider utilizing any market corrections to either initiate new positions in AppLovin or augment existing holdings. Other analysts on Seeking Alpha also give a Buy rating and Seeking Alpha’s Quant model assigns the company a Strong Buy.

Overview of the business

AppLovin’s revenue is generated by two business segments. During the COVID-19 pandemic, the company’s revenue growth came primarily from the Apps segment. People had to stay at home due to lockdowns, so many chose to play mobile games. From 2020 to 2021, Apps revenue increased by 70%. With the easing of pandemic restrictions, the influx of game users in AppLovin’s games decreased, leading the company to change its strategy to place more emphasis on the software segment.

As the company is now focusing more on the software segment, with a series of acquisitions including MoPub and Wurl, the share of total revenue from software has increased. In 2020, software platform revenue accounted for roughly 25% of the total revenue, while it reached 51% of the total revenue in the second quarter of 2023. Based on my research, I believe the software segment will continue to be the primary growth engine for AppLovin

● Software Platform Revenue

– AppLovin provides software solutions that help app developers market to potential customers and optimize their monetization efforts.

AppDiscovery: With Axon machine learning recommendation program, it markets apps to potential customers who are most likely to use the apps.

Max: AppLovin’s Max helps app developers to sell their ad inventories in a way that can maximize their profits.

Adjust: Adjust in an analytical solution that marketers use to monitor their marketing efforts.

Wurl: Wurl can be explained as a solution that combines AppLovin’s AppDiscovery, Max and Adjust specifically designed for the CTV market. It assists in attracting new customers, maximizing inventory values and providing software solutions such as a turnkey solution to open new CTV channels.

● Apps Revenue

– AppLovin has a wide range of mobile game studios which focus on casual games with roughly 350 games in its game portfolio. Approximately 20% of Apps revenue comes from three games: Project Makeover, Matchington Mansion and Wordscapes. In-app purchase revenue (IAP) is generated when app users buy products within the company’s apps while in-App advertising revenue (IAA) is created when advertisers purchase ad inventories from the apps.

● Competitiveness

I believe the competitiveness of the Apps segment is not very strong, mainly because the game portfolio is predominantly comprised of casual games. Users can easily switch to other games, leading advertisers to post their ads where there is a higher influx of game users. However, AppLovin’s major games have received good ratings (e.g., Project Makeover: 4.4, Matchington Mansion: 4.4, Wordscapes: 4.5 on Google), and they are likely to maintain a certain level of users.

In my view, the competitiveness of the software platform is derived from its technology, Axon2, and the company’s mobile ad networks. Axon software is AppLovin’s ad tech platform designed to predict potential app users and target them. This benefits customers, primarily game developers, as it leads to higher ad efficiency. With ongoing upgrades to the platform using A.I. technology, further improvements are anticipated. Moreover, AppLovin boasts one of the largest mobile ad networks, thanks to the acquisition of MoPub. To maximize ad revenue for your app, connecting to one of the best ad networks is essential.

Although there are not many metrics to judge the growth of the software platform customers, SPECs (third-party clients from whom we have collected greater than $125,000 of Software Platform Revenue in the trailing twelve months to a given date) have substantially increased from 2020 to 2022.

Financials

Even though the growth rate has plateaued since 2021, the CAGR of the revenue growth rate from 2018 to 2022 was roughly 42%. After the Corona bubble burst and people began spending more time outside rather than playing mobile casual games, AppLovin’s App business was significantly affected by these changes. According to the recent second quarter earnings release, Apps revenue declined by 25% yoy. But with ongoing restructuring, the adjusted EBITDA margin recorded 18% in the second quarter, higher than 16% recorded in the first quarter of 2023. I believe Apps revenue would continue to decrease further but at a slower rate with current margin level as the effects of the COVID-19 bubble burst have subsided.

The growth rate started to recover thanks to the Software segment, reaching a 28% revenue growth rate on the second quarter of 2023. The adjusted EBITDA margin in the second quarter was 67%, which is comparable to 62% recorded in the second quarter of 2022. As software segment constitutes a large portion of the revenue, the EBITDA margin of total revenue has also improved. On TTM basis, the EBITDA margin increased to 28%, which is comparable to 20% in 2020. With the launch of Axon2, I anticipate further growth in the software platform revenue.

The above chart shows Price FCF/Share. With a higher margin, AppLovin’s cash generating ability has improved. The company is conducting share buybacks with cash flow.

However, AppLovin’s growth came at a cost as the company focused on M&A, rather than organic growth. Through a series of acquisitions, total debt recorded on the balance sheet has exceeded $3 billion. With improved cash generation, Debt/EBITDA indicator decreased from 6.0 to 4.1 on a TTM basis. Even though the company is not expected to face liquidity difficulties, $3 billion of debt would be a burden for future M&A.

Based on the third quarter guidance, the revenue is expected to grow quarter on quarter between 4% and 6% while the adjusted EBITDA margin is anticipated to be 44%-45%. The low growth rate would be a result of ongoing restructuring of the Apps segment but the positive point is that AppLovin is back on growth. Axon2 is expected to contribute to the software platform and depending on its success, I believe AppLovin revenue would record higher growth.

Stock Performance History

Despite the recent rally since the start of the year, AppLovin’s stock price dropped more than 60% from its peak. In my opinion, there are three main reasons why investors were bearish about the company. Firstly, after the corona pandemic, people spent less time on mobile games. The chart below shows a decline in global game revenue after enormous growth during 2020. Secondly, high interest rates and concerns about a recession have led to stock corrections, given that in-app advertising and app development are closely tied to overall economic situation. Lastly, Apple’s (AAPL) privacy changes to protect personal information have made it difficult for advertisers to analyze the effectiveness of their advertisements and to conduct personalized ads.

Thesis Enablers

Firstly, I believe most of the bad news about AppLovin is likely to be reflected in the stock price.

Source: AppFigures, Sensor Tower (App Download Data (2023))

As it is stated in the chart above, app and game downloads are recovering from the decline in 2022. Even though there would be ups and downs in the short term, when it comes to the long term, app and game downloads are expected to gradually increase. Moreover, even though Apple’s change in personal privacy remains as a risk for AppLovin, the company and other peers are finding ways to navigate their business.

One way is to participate in the UID2 ecosystem. UID2 is a deterministic ID that is based on identifying information such as email address or phone number. As UID2 does not contain sensitive personal information, participants across the advertising ecosystem can track users for programmatic advertisements. UID2 is just one example, and AppLovin would upgrade its platform to adapt to changes in the market environment.

Secondly, mobile app advertisement spending is expected to increase over the next few years and AppLovin would benefit from this long-term trend. Over the past decade, the penetration rate of smartphone has increased significantly, and more people are spending their time on their devices.

Source: Zippia (25+ Incredible US Smartphone Industry Statistics [2023]: How Many Americans Have Smartphones – Zippia)

It is estimated that there are 307 million smartphone users in the United States as of 2022. The growth rate of users would definitely slow down, but based on the huge number of users, I believe the mobile application market would continue to develop further.

Source: Mobile ad spend worldwide 2024 | Statista

People live on their mobile devices, so that’s where the money goes. According to Statista, mobile advertising spending is expected to exceed roughly $400 billion on 2024. As new services such as AR/VR, AI technologies are going to be introduced over the next few years and attract more users, it is likely that advertisers would put more ads on mobile applications.

With this trend, AppLovin, the all-in-one solution mediation company, is poised to get back on track for growth. AppLovin’s competitiveness as a one-solution mobile mediation company is strong. Alongside big tech companies such as Google (GOOG) and Meta (META), AppLovin stands out as one of the market leaders in in-app advertisement, along with IronSource. AppLovin assists app owners in user acquisition (AppDiscovery), monetization through ad display (Max), and analyzing the effectiveness of advertisements (Adjust). The launch of Axon2 will further enhance its ability in user discovery with A.I. technologies. With ownership of one of the world’s leading in-app ad exchanges, AppLovin offers attractive monetization models to app owners, enabling them to gain exposure to numerous ad publishers by simply connecting to the AppLovin platform

Thirdly, I believe the current valuation offers a favorable entry point. I would explain further on the valuation part.

Valuation

In my opinion, the purpose of doing valuation of a company is not to calculate the exact future stock price, but to check whether the probability to earn money is higher than losing when investing in the stock.

● Peer Analysis

Click to enlarge

Source: Seeking Alpha

The Trade Desk (TTD) seems to be the most expensive company based on the EV/EBITDA criterion, but TTD deserves to receive a premium as it is the leader of the DSP platform and has recorded impressive organic growth over the years. DoubleVerify Holdings (DV) and Integral Ad Science Holding (IAS) also have great business models, but I believe their valuation is expensive when considering their growth and the size of their revenue. Perion Network’s (PERI) numbers look positive, but its dependence on a partnership with Microsoft (MSFT) may pose a risk. AppLovin and Digital Turbine (APPS) have comparable business models, but AppLovin is the leader in its field, so the market gives it a premium for its competitiveness.

I also attempted to compare digital marketing companies using P/E and Price/Cash flow metrics. In my view, using the price-to-earnings ratio may not be a good tool to compare these tech companies, as a high P/E ratio does not necessarily mean it is overvalued (think of Amazon (AMZN), Tesla (TSLA), Nvidia (NVDA), and so on) and a low P/E ratio does not mean that the company is undervalued. Thus, I focused on the Price/Cash flow ratio because cash flow is often a better way to check cash generating ability of software companies, considering non-cash items in the income statement. With this metric, APP seems to generate better cash flow than TTD when considering market cap. In conclusion, although AppLovin is successfully transitioning its business toward software and significantly increasing its margin, its valuation would not be considered super undervalued. However, based on peer analysis, it is not overly expensive.

● Earnings*Price

In my view, market valuation is based on the formula of Earnings * Price. In the 2Q 2023 shareholder letter, AppLovin increased its third-quarter revenue guidance to $780-$800 million and its adjusted EBITDA to $340-$360 million. Therefore, the company is likely to record more than $1.2 billion in adjusted EBITDA for 2023.

To delve more deeply into the 2024 projections, I made three assumptions.

First: I will use an EV/EBITDA multiple of 10, rather than the current level of 12, which is a 20% discount. I believe the reason for conducting valuation is not to calculate the exact future market cap, but to assess whether there is a margin of safety. A 20% discount would likely reflect market corrections.

Secondly, I assumed a roughly 10% decline in quarterly revenue for the Apps segment, stabilizing around $300 million per quarter. I think the revenue is unlikely to drop further, as the effect of the Covid pandemic bubble burst has subsided. While there won’t be spectacular revenue growth, given the company’s ongoing restructuring, the EBITDA margin is expected to remain around 17~18%.

Thirdly, I considered QoQ growth rates of software segment revenue: 5% (worst scenario), 10% (typical scenario), 15% (best scenario), and assumed a 60% EBITDA margin. The reason why I’m lowering the growth rate and margin is similar to discounting the EV/EBITDA multiple. If the valuation is acceptable even with lower growth and margin, then there would be a margin of safety

Based on my assumptions, even in the worst-case scenario, AppLovin’s stock price is likely to be higher in 2024. Keep in mind that the software margin is higher than 60%, and the stock multiple is more than 10. Despite fluctuations in the stock price, long-term investment remains valid when considering the growth of the software segment.

Risks

AppLovin has a significant amount of debt on its balance sheet

The company underwent through a series of acquisitions as AppLovin’s strategy for business expansion was not based on organic growth but through M&A. Consequently, it holds over $3 billion in debt on its balance sheet. When considering the company’s assets at about $6 billion and market cap at around $12 billion, the debt load is not insignificant. However, according to a recent earnings release, it holds more than $800 million in cash and cash generation from the businesses is robust. Therefore, in my opinion, it is not likely to face significant credit events or liquidity problems in the near future.

Competition is intense

In mobile mediation and digital marketing industry, there are numerous competitors ranging from major players such as Google to small and mid-sized companies like IronSource. Despite the current outstanding software growth rate and EBITDA margin, the company may struggle to maintain its competitiveness. For example, both IronSource, which was acquired by Unity (U), and AppLovin similarly aim to become an all-in-one mobile mediation platform. However, Unity’s game engines are widely used by mobile game developers. Consequently, Unity may market its mediation service and game engine as a combined package at a discounted price. To sustain its growth, AppLovin needs to offer compelling features such as competitive pricing or cutting-edge technology.

Personal privacy information protection may hamper software segment growth

As governments and companies such as Apple and Google place greater importance on personal privacy information, the software segment may face negative impacts in the near future. If digital marketing companies are unable to utilize personal information, conducting personalized advertisements becomes challenging and analyzing the effectiveness of ads becomes more difficult for ad publishers. Since it remains uncertain how AppLovin would address this issue, investors should monitor how the situation unfolds.

Conclusion

Despite the recent rally, I believe long-term investors should enter or add to existing positions whenever there is a market correction. Considering mobile mediation market and AppLovin’s growth projections, the stock price is more likely to increase.