Duolingo Stock: Overvalued; Growth Will Eventually Hit Wall (DUOL)

Investment Thesis

Duolingo (NASDAQ:DUOL), a leading language learning platform, has many things going for it: the company improves its margins, has plenty of cash, and is close to profitability. However, I believe the company is now clearly overvalued, and the increase in outstanding shares, stock-based compensation (SBC), and insider trading is hurting shareholders. Furthermore, the business model is not endlessly scalable but operates in a competitive market environment against many options, which sometimes are even free. Overall, such an app is not something that users will pay for their entire lives but only as long as they want to learn a language. After that, there is no reason to pay for it anymore. Therefore, I have doubts about the scalability in the long run.

Short company overview

Duolingo was co-founded in 2011 by Luis von Ahn and Severin Hacker. Today, the U.S.-based company is one of the best-known language-learning apps in the world. It targets a wide range of learners, from those who want to master widely spoken languages such as English and Spanish to those interested in less common languages such as Thai or Swahili. In total, it offers courses for 40 languages. The company operates on the freemium model and offers a premium service without advertising and with additional features. To date, the platform has more than 500 million registered learners. However, most are inactive.

Monthly active users (MAUs) grew 47% to 72.6 million from the prior year quarter and Daily active users (DAUs) grew 62% to 20.3 million from the prior year quarter.

Q1 2023

Industry overview

The global language learning market, where Duolingo competes, exhibits robust growth potential. Valued at $40.22B in 2021, the market is projected to expand at a CAGR of 10.6% from 2023 to 2028. This is fuelled by several factors, including the ongoing process of globalization, the burgeoning e-learning industry, rising investments in education, and increasing demand for multilingual employees among multinational corporations.

Moreover, rapid technological advancements have enabled language learning applications to offer a rich multimedia educational experience, integrating texts, images, animation, audio, and video. This has significantly enhanced the learning experience, leading to heightened student engagement. Among different regions, the Asia Pacific stands out as the fastest-growing market segment, driven by factors such as strong government support for education, rapid adoption of digital technology in educational facilities, fast-growing economies, initiatives to promote digital education, rising disposable incomes, and increasing internet penetration.

Financial Progress & Trends

First, a short overview over a longer period for revenues, expenses, and net income.

I have created this overview of the income statement of the last quarter compared to the previous year, showing where money is spent and how the revenue and cost development is in general.

The gross profit margin is strong, and the net income looks about to turn positive. The net income looks much better than the operating income because the company generates interest income due to its high cash position. According to the Income statement, this interest income was $5.6M in the last quarter. But even without that, margins have been improving for more than a year, as expected from a software-based asset-light business model.

Valuation & Outlook

The company is currently valued at an enterprise value of $5.78B. The market cap is $6.40B, and the remaining cash is about $640M. In the trailing twelve months, the loss was $50M, so the company is more than adequately supplied with cash. Nevertheless, the valuation is anything but cheap. The EV/Sales (TTM) ratio is a very high 14X, according to Seeking Alpha.

The P/S ratio is not a very good valuation measure overall, but the company is still unprofitable, so we cannot use a price-earnings ratio. A very high P/S valuation would be justified if the margins were excellent. The market seems to be already pricing in this prospect as it is a scalable business model. However, margins are improving but are still far from the level that would justify this P/S ratio. In particular, the stock has almost doubled again since January. The company has delivered good quarterly results but not so phenomenally good that it would justify doubling the valuation. In my view, the company is severely overvalued.

Risks

A risk at such a high valuation is if a quarter disappoints unexpectedly. We have seen this pattern quite a few times in 2022: when results meet or exceed expectations, the stock tends to stay flat or rise slightly. When there are negative surprises, and the outlook is lowered, shares plummet 20% or 30%.

Another risk is that the company operates in a competitive market where numerous competitors may even offer apps for free. I have learned two languages outside of school and think there is so much learning material out there that you can do it entirely for free and on your own.

Furthermore, the current 72M MAUs will no longer be customers in a few years because they are no longer interested in learning the language or see no need for it because they are already good enough. Language learning software is not where you stay a subscriber forever, but only as long as you want to learn a specific language. The massive discrepancy between registered users (500M) and daily active users (20M) shows this effect. It is not an app like Spotify or Netflix that people stick with for years.

Another danger is the impact of artificial intelligence, which is difficult to assess. In a few years, there may be the possibility for very precise real-time translations, possibly linked to some technical devices in wearables. In the worst case for Duolingo, this would decrease the importance of learning other languages. After all, it’s also a significant time commitment that many people would like to avoid, especially when spending limited time in a country or learning a language for business purposes.

Share dilution, insider trades & Stock-Based Compensation

For me, these three things are standard checks I make in every article, as excessive stock dilution and stock-based compensation can put us, shareholders, at a disadvantage. In addition, insider trades sometimes contain valuable info about the confidence of management itself.

We can see that in the last 12 months the outstanding shares have increased by about 10%. The SBCs represent about 17% of the total annual sales, which is huge. Also, compared to other companies, this is a lot (I look at this in each of my company analyses).

Furthermore, there were several insider sales. These are all insider sales and purchases in the last three months. However, there were no purchases, and numerous senior employees have partially sold shares in the context of the recent strong share price growth.

Conclusion

The company definitely shows positive developments: growing monthly active users, improving margins, a lot of cash, and will probably reach profitability soon. On the other hand, the valuation is very high, and there is substantial share dilution, SBCs, and insider selling. Furthermore, I believe scalable growth in this area is not possible forever. If the company already has 72M monthly active users, then sooner or later, it will hit a saturated market; keep in mind that 72M is almost 1% of the entire worldwide population. It is unrealistic that the company can reach something like 500M monthly active users. The world population is just 8B, and not everyone is interested in learning another language or can afford it.

For all these reasons, it is not an attractive long position for me. On the contrary, I think a possible short opportunity exists in a generally falling market. At the moment, the stock is still in an uptrend and should not be shorted here, but sooner or later, a return to more reasonable valuation levels will take place, and I may trade this as a short position.

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