Digital Turbine: Valuation Improved But Headwinds Too Strong (NASDAQ:APPS)

Investment thesis

My first cautious thesis about Digital Turbine’s (NASDAQ:APPS) stock of early July aged well since the stock price almost halved over the last quarter. Such a massive stock price decrease made the company’s current market cap look attractive compared to my fair value estimations. However, the stock is still a “Hold” for me because the company experiences substantial headwinds as its revenue decreases rapidly and profitability is also shrinking. I cannot call the company’s financial position weak. Still, it is also not strong, meaning that APPS does not have a solid position to fuel growth or innovation in the current environment of rapidly deteriorating financial performance. Last but not least, the ongoing Q3 earnings season revealed massive fears in the stock market, and this sentiment does not favor young growth stocks like APPS. I expect the stock to continue underperforming the broad U.S. equities market.

Recent developments

The latest quarterly earnings were released on August 8, when the company topped consensus estimates. Revenue declined YoY by over 20% for the second straight quarter, reflecting the harsh macro environment. Weakness in revenue dragged down profitability metrics. While the gross margin demonstrated relative resilience with a modest below three percentage points decline, the operating margin crashed and even went below zero. The increased SG&A to revenue ratio by more than ten percentage points indicates that the management does not have solutions that would be efficient enough to address the revenue drop.

As a result of the significantly shrinking operating margin, the company generated almost no operating cash flow during the latest quarter, and the cash balance decreased by about $17 million during the quarter. This looks like a red flag because the macro environment is still harsh, and the company’s balance sheet does not look like a fortress with its substantial net debt position and relatively thin covered and liquidity ratios.

The company’s financial performance is poised to deteriorate in the near future. The upcoming quarter’s earnings are scheduled for November 8. Consensus estimates expect quarterly revenue at $146.5 million, which indicates a 16% YoY decline. The adjusted EPS is expected to follow the top line and narrow by more than twice from $0.34 to $0.15. There were four downward EPS revisions over the last 90 days, which is a bearish sign.

I think the recent weakness in the stock price was fair, mostly because I see little evidence that the management is doing enough to adapt to the current unfavorable environment. Not much focus on cost efficiency was emphasized during the latest earnings call, which looks disappointing and does not reflect the current environment. Therefore, it is unsurprising that consensus estimates forecast a massive 40% drop in EPS in FY 2024, significantly outpacing the modest expected revenue drop of below 9%.

When the EPS drop outpaces the top-line decrease, it suggests that the management is not ready to make unpopular decisions to improve shareholder value. I found no news regarding notable layoffs in APPS and it looks inadequate to rapidly shrinking revenue. There are ongoing massive layoffs in the technology industry after rapid headcount growth during the pandemic, with even much more financially strong companies cutting their workforce to sustain profitability. At the same time, APPS headcount shank by a narrow margin from its peak, according to the chart below.

I think that there is a solid potential to save profitability if the company’s headcount moderates to levels in line with revenue dynamics. Still, recent news gives almost no hits that the management plans new rounds of layoffs. News regarding notable headcount cuts is likely to be a solid positive catalyst for the stock, but the probability of such a scenario in the foreseeable future looks low to me, given the management’s soft rhetoric regarding efficiency measures.

Valuation update

The stock suffered a lot this year, with a 68% year-to-date decline, which is a much weaker performance than the broad U.S. market. Seeking Alpha Quant assigns APPS a decent “B+ valuation grade because current ratios are substantially lower than the sector median and the company’s historical averages across the board. From the valuation ratios perspective, the stock looks substantially undervalued.

Now, let me proceed with my analysis of the discounted cash flow [DCF] simulation. I use an elevated 13% WACC due to the recent hawkish Fed rhetoric and the company’s deteriorating financial performance in recent quarters. I use a TTM FCF margin of 5.7% and expect a 25 basis points yearly expansion. I have consensus revenue estimates available until FY 2027 and forecast a 5% long-term revenue CAGR for the years beyond.

According to my DCF valuation, the business’s fair value under the conservative assumptions above is close to $600 million, which is about 24% higher than the current market cap. That said, my target price for the APPS stock is $6.

Risks to my cautious thesis

The valuation of growth stock heavily depends on the Fed’s monetary policy. To be more concise, growth stock prices usually overreact even to rumors regarding upcoming interest rate hikes or cuts. That said, if investors see between the lines in Jerome Powell’s speeches that the pivot in the monetary policy is approaching, it might be a strong positive catalyst for growth stocks, especially oversold ones like APPS. On the other hand, the latest news suggesting that the U.S. economy still grows at an impressive pace makes this risk remote.

For a company operating in a promising niche that is oversold and attractively valued, there is also a potential to become an acquisition target from one of the technology behemoths. Any news or rumors about a potential acquisition by one of the American hyper scalers might also be a huge positive catalyst for APPS stock price.

Bottom line

To conclude, APPS is still a “Hold”. While my valuation analysis suggests that the stock currently trades with a notable discount compared to its intrinsic value, I have a high conviction that the current environment, both from the business and the stock market perspectives, is unfavorable for APPS. The revenue is declining at a rapid pace, and so does the profitability. The company’s balance sheet is not weak but not strong enough to provide APPS with good options to fuel revenue growth or innovation. There are a couple of significant risks to my cautious thesis, but I still think there will likely be much better entry points for potential investors.