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AppLovin (NASDAQ:APP) has demonstrated impressive stock performance throughout the year, boasting a remarkable 256% growth, as illustrated in Figure 1. The substantial growth largely mirrors the significant opportunity the company is seeking to capitalize on. While some analysts believe that all the growth is already priced in, others anticipate further upside. My perspective differs as I emphasize the risks and immaturity inherent in the business model.

I advocate maintaining a ‘hold’ position in the company. I believe the company is pursuing a substantial market opportunity with a sound strategy for accelerating customer acquisition. However, they have not yet achieved sufficient scale, and this high-risk, leveraged strategy presents significant challenges.

I prefer to wait until the company realizes further scale benefits and consolidates its business model. While the current stock price may not be high, the uncertainties I observe in the company make it a less appealing opportunity when considering a well-adjusted risk-return profile.

Pursuing a great market opportunity

The digital advertising industry boasts a staggering market value of $667 billion, with Google and Meta reigning supreme at $283 billion and $117 billion, respectively as shown in Figure 2. The remaining players collectively contribute $267 billion to this dynamic landscape. Notably, digital banner ads claim a significant share, amounting to $155 billion, representing approximately 60% of the remaining market segment.

The industry within which AppLovin operates is the mobile app advertising spend, constituting 60.8% of the total market and predominantly programmatic at 81.8%. Thus, AppLovin is targeting a substantial $77 billion market for ad spending. Assuming a fee structure akin to TTD (as specific information for AppLovin is unavailable), where the fee for every ad dollar spent is 20%, the market that AppLovin is actively pursuing equates to a $16 billion market.

In practical terms, AppLovin has a reach extending to 3.5 million apps, actually overseeing an ecosystem that includes the management of 140,000 apps. Notably, gaming apps constitute 12.5% of the total market, amounting to 455,000 apps. AppLovin presence accounts for 4% of the entire App market and holds a significant 30% share in the gaming market. This estimation is based on my assumption that 90% of the apps managed by AppLovin are related to gaming.

The digital marketing spending is experiencing a robust growth rate of 21% annually. Additionally, there is a notable shift towards increased programmatic ad placement, with an additional 2 percentage points observed.

A correct strategy to accelerate customer acquisition

Drawing insights from the latest 10-K, 10-Q SEC forms, and earnings call transcripts, I have developed a model outlining how I see AppLovin’s strategic approach.

The company’s strategy revolves around three key pillars, as shown in Figure 3:

1. Building Brand Awareness: AppLovin aims to establish a presence within the developer community, positioning itself as a partner for business growth.
2. Gaming App Portfolio: AppLovin places emphasis on a curated set of apps tailored for the gaming community, treating these apps as key customers and a source of first-party data.
3. Utilizing Machine Learning (Axon): AppLovin leverages its machine learning system, Axon, to execute marketing campaigns.

The process unfolds as I interpret it: through app ownership, they acquire valuable insights into the tools for monetizing these apps, thereby enhancing their system with first-party data and direct experience. This iterative process leads to the development of a robust platform, which AppLovin then offers as services to other apps in the market. As they onboard more clients, they expand their dataset by incorporating third-party data, refining the system, and simultaneously enhancing brand awareness within the developer community.

AppLovin specializes in crafting tools that empower app developers to increase revenue streams from both users and advertisers (usually other apps). This outcome holds significant importance within app developer’s business model, positioning AppLovin as a pivotal player. As AppLovin gains recognition within the app developers’ community, trust is established, further solidifying its role as a trusted partner for app developers.

In my opinion, when a developer becomes part of the AppLovin ecosystem, they contribute to expanding not only as an advertising client but also as advertising inventory. This dynamic sets AppLovin apart from “Digital Ad Traders” (TTD, PERI…), where the entry of a new advertising agency typically only expands the network on one side in a two-side network. AppLovin benefits from substantial network effects in a one-sided network model. As each new app joins the network, the collective value for other developers increases: the former benefit 1) because they have available more ad inventory, and the capability to get more clients, 2) they have more prospective advertising clients enhancing the value of its own inventory.

Also, AppLovin distinguishes itself from major Ad Traders by catering to a different clientele, according to my interpretation. While Ad Traders primarily serve advertising agencies, AppLovin’s clients are app developers. This distinction allows AppLovin to concentrate specifically on mobile technology, avoiding the need to manage web technology. Their unique advantage lies in their in-depth knowledge of apps, derived from directly operating and running apps, a level of expertise that sets them apart in the industry.

Not getting enough scale yet

To assess whether the company is gaining a distinct competitive advantage, we examine the presence of economies of scale in both its App and Software Platform businesses, as shown in Figure 4. Neither segment shows a clear indication of enjoying economies of scale. In the App segment, there is a slight downward trend, going from $227 cost per App to $209. Conversely, in the Software Platform, which is expected to benefit more from economies of scale, we observe an upward trend from $647k per SPEC to $772k. But I expect higher Sales & Marketing expenses to acquire more clients, so the overall scale efficiencies remain a nuanced aspect for further consideration.

High risk strategy that poses huge challenges

I see two main areas of concern that create uncertainty in the prospects of the business: a growth strategy based on acquisitions and the financing of the growth through debt.

Similar to Unity (U), AppLovin is driving its growth through acquisitions (Figure 5). While this strategy is beneficial, especially in a business landscape with significant network effects and ‘winner-take-all’ dynamics, it introduces an additional layer of risk because integration is not obvious and can create additional costs with no clear benefit.

To finance this growth, AppLovin has loaded itself with debt. Assessing the credit risk, the company exhibits a less robust debt structure compared to industry standards, with Net Debt over Assets standing at 40%, as shown in Figure 6. This is primarily a result of the company’s aggressive acquisition strategy. Additionally, the EBITDA/Interest expense ratio at 3 is below our comfort threshold, raising concerns about the company’s ability to comfortably manage its interest obligations, especially in this scenario of high-interest rates.

Debt is having adverse effects on the ability to generate cash, as depicted in Figure 7:

Recently, we have observed certain corporate events that may indicate a less favorable outlook for the company. While these events alone may not decisively determine the fate of the company, they underscore the importance of exercising caution in this inherently risky business environment. Notably, there has been a change in the Chief Financial Officer (CFO), and Herald Chen is set to depart from the company by the end of 2023. Additionally, CEO Arash Adam Foroughi sold 653,619 shares of the company worth $25.6 million, CTO Vasily Shikin sold 300,000 shares worth $11.6 million and CMO Katie Jansen has sold 52.2K shares for $2.1 million. This insider sell is noteworthy and warrants further consideration.

AppLovin business valuation

I employ the Discounted Cash Flow Method in my analysis (Figure 9), and the assumptions incorporated into the model are as follows, as you can see in Figure 8.

Revenue growth starts conservatively at 20%. I recognize that while the Software Platform is experiencing robust growth of over 50%, the Apps segment might undergo a revenue decline due to optimization efforts. Conservatively, I cap the revenue growth at a maximum of 20%, with a gradual decline to 3% by year 10.

I consider EBITDA/Revenue commencing with the mean of the last 5 years. This conservative stance accounts for potential margin growth with the expansion of the Software Platform and the optimization of the Apps segment. Despite these considerations, I express doubts within this conservative viewpoint due to the high-risk nature of this business.

I state Amortization + SBC/Revenue as the average over the 10-year period is set at 21%, with a variability of 10%. The change in Net Working Capital/Revenues factors in the impact of a growing business on net receivables; I set the average over the 10-year period at -8%, with a variability of 10%. The average CAPEX/Revenues over the 10-year period is set at 0.4%, with a variation of 0.4%.

These assumptions collectively shape the model, incorporating both conservative estimates and considerations for potential risks and uncertainties in the company’s growth trajectory.

After running the model, it’s evident that there’s a 70% probability of the value exceeding the actual price of $38, as indicated in Figure 10. Upon analyzing the variables, it’s clear that the most influential factors affecting value variation are the Change in Net Working Capital/Revenues and EBITDA margin (Figure 11). In simpler terms, effective management of growth is paramount. If the company experiences growth with a lower margin or faces challenges in managing receivables, it poses a significant risk, potentially impacting the overall value adversely.

In the short-term, Q3 2023 witnessed a robust 21% year-over-year surge in total revenue, reaching $864 million, and a slightly above net income against market expectations, totaling $109 million with a net margin of 13%. The Software Platform exhibited substantial growth, generating $504 million, marking a remarkable 65% increase year-over-year. Conversely, Apps revenue amounted to $360 million, reflecting a decline of 11% compared to the previous year. The actual Earnings Per Share (EPS) GAAP in Q3 2023 stood at $0.3 per share.

As we look ahead to Q4 2023, our projections indicate that revenue is expected to be within the range of $900 million to $910 million, slightly below the company’s initial prospects. Regarding EPS in Q4 2023, my estimations aim to maintain $0.3 per share EPS GAAP, which is also below consensus expectations.

Conclusion

I acknowledge the substantial potential within the market and the company’s performance. The ‘winner-take-all’ prospect of the market in a one-sided network presents a particularly explosive opportunity. Despite the immense potential, there are notable execution challenges ahead. While this company seems poised to excel in capturing the market, my current recommendation leans towards a ‘HOLD’ strategy. It would be prudent to monitor how both the market dynamics and the company’s strategies unfold before making further decisions.

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