AppLovin Stock Looks Way Too Cheap

Recent focus on Apple policy changes ignores the long-term earnings power of AppLovin's business.

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At the moment, AppLovin (APP) presents an interesting profile. 2022 guidance — revenue up 27% to 38%, Adjusted EBITDA growth at a faster rate — suggests APP remains a growth stock. Yet the broad risk here essentially is that AppLovin stock is a value trap.

It's a real risk, and in this market environment it's not the only risk. But investors shouldn't focus on those risks to the exclusion of the potential rewards. AppLovin is an exceptionally well-managed company with an attractive business model, a history of growth and enormous success in M&A. There is a path to significant value creation going forward — even if that path is likely to have a few bumps along the way.

Introducing AppLovin

AppLovin was founded in 2011 as a platform designed to help publishers monetize and market their apps. That business runs through its AppDiscovery product, and the need is somewhat obvious: between the respective 'stores' from Alphabet (GOOG) (GOOGL) and Apple (AAPL), there are 4.8 million mobile apps, according to figures cited in the AppLovin S-1 (the company went public just under a year ago). That need drove AppLovin’s original mission: to provide a way for app publishers in the gaming space to break out of the massive crowd.

In 2018, AppLovin made two key decisions. First, it became a game publisher itself by acquiring a pair of studios. The investments in first-party gaming have continued: after M&A now totaling well past $1 billion, per the most recent 10-K AppLovin has 19 studios offering over 350 games across five genres.

Second, AppLovin acquired a startup called MAX, which was just four months out of beta. That moved the company into mediation — connecting to multiple networks to best monetize advertising real estate — with MAX offering programmatic bidding for in-app advertising. MAX was the first step in the M&A strategy on the software side, which combined with the organic development of a machine learning engine referred to as AXON, aimed to significantly broaden AppLovin’s reach. Last year, AppLovin paid almost $1 billion for attribution (tracking a user from ad to install) provider Adjust, and so far in 2022 acquired MoPub from Twitter (TWTR) in January for ~$1 billion and announced the $430 million acquisition of connected TV player Wurl at the end of February.

The strategies driven by the 2018 decisions admittedly seem almost contradictory. On one hand, AppLovin has spent over $2 billion to build out a suite of marketing and monetization offerings for mobile game publishers. On the other, it’s spent another $1 billion-plus to compete with those very same publishers. 

Why both? AppLovin could have chosen to give those publishers better tools for marketing and monetization, and enjoy the 'sticky', high-margin software revenue that public and private market investors spent a decade falling in love with. Conversely, it could have kept those better tools for itself, using them to crush independent competition and to become the king of mobile gaming (or, at least, something close).

AppLovin’s own history seems to support the latter path. The company already is a force in mobile gaming. In 2022, just its fourth full year as a publisher, the company is guiding for $2.2-$2.35 billion in revenue from the Apps business, per its Q4 release. Analysts on average expect Zynga (ZNGA) to generate $3.12 billion in revenue (that company hasn't given guidance owing to its pending acquisition by Take-Two (TTWO)). 

The Flywheel

But there is a logic to the seemingly contradictory goals of growing first-party games and serving competitive publishers. The games and software businesses work wonderfully well together, as shown by a slide from multiple AppLovin presentations: 

source: AppLovin December 2021 presentation

Now, this slide might make a number of readers groan (or curse), as seemingly every software/platform/app developer and/or SPAC in the world has talked up its own "flywheel" (a description which usually merits sarcastic quotes). 

But for AppLovin, the flywheel effect is real. The company's financials prove it. As impressive as overall revenue growth has been — almost 8x between 2018 and 2022 — a good chunk of that growth has been driven by the nearly $4 billion in acquisitions, particularly on the game side. But the entire strategy serves to drive what the company calls Business Software Platform revenue — and that figure has exploded. In 2021, BSP revenue more than tripled, including organic growth of 188%. 2022 guidance contemplates another doubling or so, with organic growth likely in the 80% range, given discussion around MoPub's 2021 revenue.

And it's the BSP revenue that really matters. It's generally consistent, as nearly all of that revenue comes from enterprise clients (now defined as trailing twelve-month spend over $125K). And it's enormously high-margin. AppLovin has been cash flow positive since 2013, and is guiding EBITDA margins to the high 20s in 2022. 

That high-20 figure comes despite an enormous drag from the gaming business. Adjusted EBITDA margins in 2018, when the gaming business was in its infancy, were a staggering 53% (once again per the S-1). The compression has come because Apps revenue has gone from zero to $2 billion-plus, and because the Apps business is not particularly profitable.

That’s not because AppLovin can’t generate profits from that business. Rather, as chief executive officer Adam Foroughi detailed on the Q1 conference call, it’s chosen not to:

Our objective with the content business is not to generate cash flow or material cash flow from the content business yet. The objective from the Content business is to grow the games to as large as possible to get as much transactional data that we can get from the customers playing our games and use that data in a behavioral and privacy safe manner in our ad algorithm, which accelerates our business and has exceptionally high software margins.

Here’s Foroughi again after Q4: 

We've been talking about for the last year, like, the games business may grow, it may not grow, it doesn't really matter, because it's scaled enough where it's fueling the massive growth in the Software business...Being at a scale that we're at today with the technologies and the data platform and machine learning and algorithms that we've built, you're obviously seeing a software platform that's growing much, much faster than any other platform in the industry. 

Thanks to the 1P games business, AppLovin has generated massive amounts of data on app installation and usage. And its AXON machine learning software can predict "lookalikes," as Foroughi put it after Q4, to that data at a roughly 10x multiple, adding to the data advantage over software rivals in the space. 

That data, and that strategy, drive the value here. They are what is driving software revenue to the ~$1.5 billion range in 2022. And, again, given history and consolidated high-20s margins guided for 2022, it's likely that $1.5 billion is coming at margins in the range of 50%, at least. For investors like Charlie Munger who believe that EBITDA is a synonym for "bullsh-- earnings," bear in mind that AppLovin's capex (including capitalized software) totaled $5.5 million in 2021. The BSP business is a cash flow machine already.

It's not close to done, either. AppLovin is starting the process of expanding beyond the gaming vertical. Given the success of its Project Makeover game — one of 3 that drove 29% (~$800 million total) of consolidated revenue last year, per the K — shopping and recommendation apps are a logical next step. International markets drove 40% of 2021 revenue, but AppLovin sees more room for growth overseas as well. One of the benefits of the Adjust acquisition, beyond expanding the product suite into attribution, was to bring on a salesforce that can drive AppLovin's expansion into new verticals and new countries. Wurl provides a foothold into connected TV as well.

APP Stock Looks WAY Too Cheap

Fundamentally, the BSP business looks like one of the best in the market. ~80% organic growth at ~50% margin (at least), along with new market opportunities, is not a combination on offer for a cheap price, if at all.

Yet, by the fundamentals, APP stock looks rather cheap. With a fully diluted share count just shy of 400 million, net debt at year-end of ~$1.7B, and ~$1.5B in 2022 spend on MoPub and Wurl, enterprise value at the moment stands at about $24.5 billion. 

Using the midpoint of 2022 guidance, then, on a consolidated basis APP trades at about 6.6x revenue and (assuming a 28% consolidated EBITDA margin) something like 24x EBITDA. Moving to more concrete figures, the current price offers a 35x-40x multiple to 2022 free cash flow (excluding working capital movements). (EPS performance and estimates don't look nearly as attractive, but that's in large part to non-cash depreciation and amortization.) 

Obviously, the games business is driving those valuations to at least some degree (notably in terms of EV/revenue). And, just as obviously, the two sides of the business shouldn't receive the same valuation. Some Street analysts and no doubt some investors have used a sum of the parts method, comparing the games business to gaming peers and the software business to Unity Software (U) and other names. 

There should be some caution toward that method. In fact, it seems wisest to value only the software business. There's some value in the games, no doubt, but assigning, even a 2-3x revenue multiple (Zynga is being taken out at ~4x 2022 consensus) seems questionable when AppLovin's own CEO literally said the games business "may grow, it may not grow, it doesn't really matter." The games business isn’t being run for profit, so investors shouldn’t model in those profits going forward, at least from a margin of safety standpoint. It seems preferable to position the games business as providing a ‘free’ option if AppLovin either can wring some unexpected free cash flow out and/or can catalyze some kind of value from the portfolio. 

Focusing solely on BSP, APP stock perhaps doesn't look quite that cheap, at ~17x 2022 revenue. But given margins, profit-based valuations no doubt are far more attractive.

AppLovin management does not appear to have publicly given any color on margins in software (though commentary around incremental margins in that business has remained exceptionally positive). But it seems likely that software accounts for the overwhelming majority of consolidated EBITDA — and potentially all of it.

Software even drives at least a chunk of whatever profit comes from games, because AppLovin doesn't book revenue from the use of its platform by its first-party games. The usage of the platform by 1P games is significant. AppLovin discloses Total Software Transaction Value, which measures software platform revenue as if the games business was a separate entity. The gap in Q4 between revenue and TSTV was $93 million.

In other words, TSTV in 2022 is likely heading toward the $2 billion range (BSP revenue is guided to $1.35-$1.5 billion), while consolidated Adjusted EBITDA is guided to roughly $1 billion. And so it seems likely that software indeed is generating 50%-plus margins — not coincidentally, as it did before the games ramp began. In that rough model, a business posting 80%-plus organic growth is trading at 30-35x EBITDA and less than 60x free cash flow. 

The Apple Risk

Fundamentally, then, APP looks like an almost perfect GARP (growth at a reasonable price) play. But, again, the risk here is that the stock in fact is a value trap. It looks cheap based on 2022 numbers — because the numbers are set to deteriorate in 2023 and beyond.

That seems like a silly risk given growth, but there's a real threat to AppLovin: Apple. As summarized well (better than I can, truthfully) in this excellent Twitter thread from @Emilgold, Apple's move away from IDFA (Identifier for Advertisers) was actually a boon for AppLovin, and may have helped 2021 growth. (As Foroughi explained it after Q3, "IDFA changes decrease competition in the market," which is a boon to a company with the scale of AppLovin. Unity and rival IronSource (IS) have said much the same.)

One way around IDFA is through "fingerprinting," technically known as probabilistic attribution. But Apple is trying to shut that down as well, even rejecting apps with Adjust code last year (Adjust claimed the code was for anti-fraud, not attribution). With an estimated 80% of iOS users opting out from tracking (that rate seems to change depending on the source, and I haven’t seen updated figures; AppLovin's figures as of the Q2 call were much better), the iOS ecosystem (~50% of US customers) is at significant risk. Google is updating its policies as well, albeit not to the same level of restriction, but those challenges are on the way as well, likely 2024.

Essentially all of adtech has been built on user tracking, which is why Apple so often has been accused of trying to “blow up” the entire ecosystem. The broad problem here for AppLovin, across its software business, is that without user tracking, ads are far less targeted. And ads that are not as well targeted are not as effective — and thus not as valuable. That means plunging CPM prices, potentially lower revenue, and the same attractive incremental margins that drove growth on the way up becoming the anchor of decremental margins on the way down.

For the gaming vertical, the impact on AppDiscovery may not be quite as severe. Particularly for casual and hypercasual games, the need to target is not that high. But as Eric Seufert wrote back in 2020, the end of IDFA can crush in-app advertising revenue, a problem for MAX and for the games business: almost one-quarter of consolidated revenue last year came from in-app advertising ("Business Revenue - Apps" in the 10-K).

But, again, AppLovin is looking to expand beyond gaming. The end of targeting potentially creates problems outside the vertical, as well as potentially threatening the business models of some of AppLovin's enterprise customers. Google's changes and Apple's potential promotion of private relay more risks. We've already seen IDFA worries pressure Facebook (FB) stock (and shave off billions in revenue). Similar concerns no doubt have being at least partly responsible for APP's own pullback from $116 in November, and those concerns can dog the stock in 2022 as well.

The concerns are legitimate, and may be enough to keep some investors away from the stock for the time being. But from a long-term perspective, AppLovin should be reasonably well-protected. The massive amounts of first-party data garnered by the games business (in the past and going forward) will still give the company a competitive advantage. Both management and observers have argued that outside of Google and Facebook, there's no company better positioned. 

Ad demand isn't going to dry up. Gaming demand isn't going to dry up. The kneejerk consumer response against targeting may change over time (targeted ads have some value which might be more apparent once they’re limited). And Apple, whatever its motivations, seems unlikely to simply decimate the entire online ad ecosystem in the U.S., while its international share and impact is far lower.

The Case for APP Stock

Exactly how privacy and targeting changes play out is up for debate. Industry participants sharply disagree on the impacts, the winners, and the losers. Apple’s own motivations aren’t entirely clear.

But taking the long view, it’s difficult to see how both sides of the AppLovin business get crushed. If tracking truly goes away, AppLovin still has its first-party data, and it can change its focus relating the games business. If the industry simply adapts to a more reasonable Apple-led regime, then AppLovin will be fine at some point.

And, again, significant impact already seems priced in. The multiples assigned to APP stock are not simply more reasonable after the decline from last year’s highs. A good deal of disruption to post-2022 growth seems priced in at this point.

It may be too early to jump in ahead of likely volatility in the stock this year, whether because of developments surrounding Apple’s strategy or simply because of the market risks we highlighted last week. I’m happy to at least start a position here, and happy to dollar-cost average if the opportunity presents itself (assuming the story doesn’t deteriorate in 1H). Investors can also look at selling puts, though spreads and liquidity (somewhat surprisingly) aren’t great.

Whatever the strategy, from a long-term perspective APP does look attractive at $55. There are risks right now — but businesses like this aren’t available at a valuation like this without risks. Investors willing to take those risks seem likely to be rewarded at some point.

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Vince Martin is long shares of AppLovin.

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