AppLovin’s AI Tailwinds Are Still Not Getting The Love They Should (NASDAQ:APP)

Investment Thesis

In my view, AppLovin (NASDAQ:APP) is the poster child of ‘having struck a pot of gold’. The company has seen phenomenal growth in its business once again as it used its backend technology to pivot to the faster growing digital ad business in general, allowing it some exposure to the rapidly expanding CTV ad market and diversifying away from its volatile mobile ad market.

Management made all the right moves a couple of years ago and infused their growth outlook with the right ingredients to turn their business around and navigate the company through a pivotal 2023.

The stock is already up 88% for the year, but I still believe there is upside remaining for the year since I believe the catalysts for its FY24 growth are growing. Hence, I rate this as a Buy.

Summarizing AppLovin’s Business Updates

Note: I have added more detail in this section for a couple of reasons. One, I believe this is required because of the monumental transition the company has gone through since FY22. Two, the digital ad market may not be understood well enough, so I believe some of my explanations below will benefit users on SA.

AppLovin has undergone a significant evolution in its business since the company went public in early 2021. The company started off as an app growth and monetization platform to help app developers grow their apps in the mobile ecosystem.

However, with the general slump in ad spending a year later, the company evolved into a broad-based marketing technology platform, driving monetization across digital channels. Now, the company mainly operates under two main segments, with its Software Platform business driving over half of the company’s total revenue while its Apps Monetization business, which used to be the breadwinner, three years ago, is now plateaued.

Its Software Platform operates via four key products:

• AppDiscovery: The cornerstone of AppLovin’s Software Platform which provides advertisers with performance-based ad tools. This product is powered by the company’s in-house Axon 2.0 AI algorithms, which I will elaborate on further later.

• Max: AppLovin’s in-house bidding algorithms are provided for free to publishers, but the company charges a ~5% take rate from advertisers who bid through Max.

• Adjust: the company’s measurement and analytics marketing platform for advertisers & marketers

• Wurl: the namesake acquisition by AppLovin, which is the company’s Connected TV (CTV) ad product, allowing advertisers to advertise on streaming video channels.

I have added a chart below that explains how AppLovin’s products fit in the overall digital ad space. This is important because many companies in this space tend to work with one another, forging partnerships while also competing with one another at the same time.

In AppLovin’s case, the company competes with Google (GOOG) and Facebook (META) as an ad network while also using the Google Cloud Platform for its backend products and having ad partnerships with Google. The digital ad ecosystem I have added here can be implied across most other channels, such as mobile, web, social media, CTV, etc.

AppLovin is also focused on increasing their exposure to channels other than mobile, etc. They acquired Wurl in FY22 to enter the CTV ad space and are in the process of expanding product testing this year on CTV.

How AI is a game changer for AppLovin’s Revenue Growth

As part of their transition plan announced in the fatal Q1 FY22 earnings call, management announced the transition to the Software Platform business by leveraging their Axon ad-tech engine. The company transitioned their entire Axon platform onto Google Cloud in 2022 and further upgraded the backend technology early last year, with Google Cloud’s AI capabilities rechristening it Axon 2.0. I believe this is possibly one of the reasons why the company saw a boost in its revenue performance in the Q2 quarter last year, when revenue rose 21.2% in that quarter. The tailwinds initiated by the backend technology upgrade and transition into its Software Platform business continued to propel AppLovin through the year, as the company recorded stellar top-line and bottom-line numbers for the year.

As can be seen in the chart above, AppLovin’s revenue has grown at a compounded growth rate of 31% since FY20. Much of that growth has come from its Software Platform revenue which has grown at breakneck speed, growing 107% on a compounded basis. On a y/y basis, Software Platform revenue grew a massive 76% since FY22. Management attributed the reasons for success mainly to the company’s AppDiscovery product, which is powered by the AI-enabled Axon 2.0 that I had touched upon earlier. While reviewing AppLovin’s 10-K, I found that improved AppDiscovery ad performance led to app installations rising 17% y/y and net revenue per installation rising 35% y/y. While these numbers have slightly receded from the previous year’s growth performance, they are very strong numbers for advertising performance metrics, which would incentivize advertisers to spend more on AppLovin’s platforms.

Improving Macro Outlook for Ads has also helped. CTV is a bonus

The optimism in retail spending as well as enterprise spending last year has also aided the boost in spending on AppLovin’s platform, in my opinion. The strong show in ad revenue from Meta Platforms and Amazon can also be reflected in AppLovin’s revenue growth, as improving macro forces had some hand to play in the revenue growth for AppLovin, according to my observations. Moreover, these trends are expected to continue as the outlook gets better in FY24, as seen below.

As per a study by eMarketer, the overall ad spend dollar is expected to grow 9.7% in FY24, powered by a 13.2% projected increase in digital ad spending, while programmatic ad spend is also expected to increase 16% y/y. Moreover, ad spend for CTV is also expected to increase by 22.3%.

These are all areas where AppLovin has its products gradually being adopted and used, such as its AppDiscovery platform or its own ad-exchange platform for programmatic buying, including CTV ad inventory. I believe the significant improvement in the macro outlook is putting AppLovin in pole position to outperform for the year.

Valuation suggests upside

Before I move on to evaluating AppLovin’s target price, I do want to also make a mention of the significant impact the company’s Software Platform business is having on its overall performance. AppLovin’s Software Platform is a high-margin business with adjusted EBITDA growing significantly faster than the revenue segment’s top line growth at 119% CAGR since FY20. This has been one of the key drivers for the company to be profitable on a GAAP-basis and register $357 million in FY23, as can be seen below.

This has allowed the company to score a 45.8% adj. EBITDA margin in FY23, and management expects to sequentially improve this in Q1 FY24 by projecting adj. EBITDA margins of a mouth-watering 50.3% on the back of revenue to be growing 35% y/y to $965 million (all management projections are taken at the midpoint of their guidance range).

Now, the company does not have an official long-term operating plan, nor did they guide for the full fiscal year of FY24. So I will use consensus estimates for the next two years to value the company’s stock. I will also be factoring in a 10% discount rate based on these assumptions, which I believe are important when valuing AppLovin’s stock.

Despite management’s delightful guidance for Q1, their lack of full-year guidance makes me want to be cautious in my expectation of their adj. EBITDA growth, so I have actually assumed their EBITDA margins to be relatively flat for the next two years.

From the model above, I can see that both AppLovin’s revenue and adj. EBITDA are estimated to rise ~16% in line with one another. For these growth rates, I believe a forward PE of ~17 is absolutely fair here. My model implies 14% upside from current levels.

Risks & Other Factors to consider

Digital advertising has become increasingly complex and competitive at the same time over the years. The complexity arises from the rapid evolution of technologies underpinning the digital ad landscape and the privacy changes occurring on various platforms. Google’s cookie deprecation and Apple’s increased App Store crackdowns on privacy and ad fingerprinting have made it complex for some ad platforms to deliver higher ad performance. However, I believe the integration of AI is enabling AppLovin to empower advertisers with better ad targeting, and this can be seen in the lift in revenue.

Competition is a big risk here too, but as I mentioned earlier, AppLovin often enters partnerships with some of its competitors and peers. For example, the company had partnered with Trade Desk (TTD) on an ad-inventory buying deal a couple years ago. I also believe AppLovin’s innovative strategies and its embrace of AI should insulate the company from competitive pressure so long as it keeps on innovating.

So far, its Apps Revenue segment has stalled, growing only 5% on a compounded growth basis since FY20, as seen from an earlier chart. But with overall digital ad spend growth expected, this may add a further boost to AppLovin’s revenue, which I have not accounted for in my model yet for the purpose of being cautious.

Conclusion

In conclusion, AppLovin seems to have gotten itself back on the right track by scoring a huge win with its outperformance in its Software Performance revenue segment in FY23. I expect these tailwinds to continue in 2024, coupled with the improving macro outlook for general ad spending, which should act as catalysts to boost AppLovin’s prospects in FY24.

I rate this as a Buy.