Description

AppLovin was written as a short a year ago.But the company has since undergone significant transformation, warranting another fresh look. While the stock is up more than 100% YTD,I see more gains ahead due to its healthy and sustained revenue growth and FCF growth for years to come.

AppLovin is a mobile technology company in the gaming industry. The company's business model can be broken down into two main segments:

Software Platform

AppLovin's software platform is the core of its business, accounting for approximately 70% of revenue and 85% of EBITDA. 

Its comprehensive, end-to-end Software Platform, powered by AXON, its AI-based recommendation engine, enables advertisers to automate their marketing, engagement, and monetization efforts in three core ways. First, it provides marketing technology that allows advertisers to reach more of the most suitable users with personalized content in order to increase the number of users who download and engage with their content. Second, it provides advertisers with monetization and analytics technology to maximize the value of their advertising inventory by obtaining a high price for each impression. Third, it provides developers a set of capabilities to optimize their apps and help streamline their businesses. 

The software platform also enables publishers to leverage real-time auctions that optimize the value for each impression, while simultaneously enabling them to attain an attractive value for each of the impressions from their advertising inventory. It creates a robust and successful marketing and monetization engine that both sells attractive advertising inventory to advertisers while monetizing it for publishers.

Apps

The apps business consists of a globally diversified portfolio of over 200 free-to-play mobile games across five genres, run by eleven studios. The studios have developed and published games across a number of genres including: casual, match-three, card/casino, midcore, and hyper-casual. A large portion of its portfolio are casual, match-three and card/casino games that have a lower risk of development and generally have more predictable revenue streams and return. These games can be played a few minutes at a time and appeal to a wide range of users across many highly attractive demographics. The studios leverage live ops to quickly iterate and increase in-game monetization by optimizing app economies and improving in-game conversion on items and offers. The studios also leverage the company’s software platform to market, scale, and monetize.

A key critique from the short article was the conflict between AppLovin’s two businesses: third-party game advertisers were reluctant to use the platform, fearing it would benefit competing studios owned by the parent company. To address this issue, AppLovin shifted focus to its advertising software business. It also publicly stated that its apps division is now managed for profit, not growth, and is open to divestiture. This strategic shift, coupled with AppLovin’s superior user acquisition software, has led previously hesitant game studios to adopt its ad services.

Apple’s ATT(AppTrackingTransparency) created a massive shift in game advertising

Before Apple’s ATT update, game companies were able to precisely target whales - gamers with high spending power - on Instagram or Snapchat with direct response game ads that enticed users to install a game. Some of the hardcore games could be viable if they could acquire enough whales, who make up even just a sliver of the entire player base. But Apple’s ATT changed this: it is now cost prohibitive to find such players. As a result, the number of mobile games that solely rely on selling virtual goods to high spenders declined dramatically. More and more newly launched mobile games aim to monetize the entire player base by advertising. This shift created a perfect situation for AppLovin: there are now more ads supply available and game advertisers are looking for a cost effective replacement to top-funnel direct-response ads on social media. AppLovin’s offering is exactly what game advertisers are looking for: native in-game ads,for example the ads that get played between levels, at the bottom of the funnel marketed to gamers with strong intent to explore new games.

AppLovin’s AI engine is in the league of its own

Amid this market dynamic shift, AppLovin developed its new proprietary matching engine based on the latest AI technology that maximizes the chance of app installs.  Management noted that prior to this, AppLovin’s offering was on par with its biggest competitor IronSource, which was acquired by Unity. However,since the introduction of AppLovin’s new AI engine, the advertising business of AppLovin has been on an absolute tear while Unity’s ads revenue has remained flat. 

While investors and analysts are desperate to know what makes this new engine so powerful, the company keeps a tight lip on its secret weapon. Management noted the step change between the new and the old engine is like the difference in performance between ChatGPT 3 and 4. The new engine is self-learning and self-improving constantly as it digests billions of data points. Furthermore, the company’s nimble and entrepreneurial AI team is continuously adding new improvements to the system.  

How long can AppLovin keep its technological lead on its main competitor Unity/Ironsource? I believe it’s a long way before Unity comes up with a viable competitor.

Here are some excerpts from Unity’s recent earnings calls. It’s clear to see that after promising a quick catch-up to AppLovin’s capabilities by Unity’s previous CEO, management under the new CEO admitted that it will take quite some time before seeing tangible improvement on Unity’s ad tech in the latest call.

Promising a quick catch-up to AppLovin

23 Q4:”Yeah, I mean, on the Grow side, we're just seeing a more intense competitive environment, right? And you've all seen some of our competitors' report numbers, some of them have been better than ours, so it's just been more intense. And some of the innovation they brought to the market has been strong. And as Jim said, we were busy doing integration work, and now we have very -- we know what our gaps are and we have aggressive plans to close those in the very short period of time. So, we're working towards. So that's what we referred to in the notes. “

24 Q1:”And finally, we talked a lot about interventions we're doing on the data and analytics side of the monetization business. Obviously, those have not manifested in the numbers yet. We've done a lot of the work. We're starting to get the results of the testing. It looks very encouraging.

Those will roll out through the quarter and you'll start to see that in Q3. So you put all that together, I'm highly confident in our plan for the remainder of the year. “

Capitulation

24 Q2“Complementing the great product work already underway, weʼve already begun a comprehensive rebuild of our machine learning stack and data infrastructure. ”

“For the full year, we are adjusting our guidance. New revenue guidance for our strategic portfolio is $1,680 to $1,690 million compared to $1,760 to $1,800 million previously. This represents a decrease of 2% to 3% year-over-year. The reduction in guidance represents a more cautious approach to the recovery in our Grow Solutions business, where investments in fundamental product enhancements will take some time to manifest in sustainable increased performance.”

AppLovin believes it is a multi-year effort for anyone to be able to replicate AXON’s success. By the time a copycat arrives, AppLovin will still be years ahead because it is continuously improving its own technology. Unity has hired the co-founder of MoPub, the in-app ad server and exchange acquired by Applovin, and the founder of MAX, the advertising systems acquired by Applovin in 2018 to rebuild its ads business. However, these hires do not help Unity close the gap with AppLovin on the most critical matter - the AI algorithm. Furthermore, since Unity right now has to also turn around its bread-and-butter game engine division after the run-time fee increase fiasco, I question how fast Unity’s ads team can innovate under the current situation. On the contrary, AppLovin is all-in on its software platform. 

Numbers easily show how dramatically differently these two companies’ ads businesses have fared since the introduction of AppLovin’s new engine AXON 2 :

Q by Q comparison between AppLovin’s ad business and Unity’s ad business:

Last quarter, AppLovin’s CEO and founder talked about a goal of growing the company’s software business 20% to 30% for the long term.  This quarter, he revealed that he usually doesn't communicate externally about his goals if he doesn’t have conviction. He further went on to explain how he thinks the company can achieve this goal even without expanding into new verticals: ”We don't think it's very dependent outside of gaming at all. You've got a mobile gaming category. It's got a few percentage points of growth a year now. So let's call that low-single digits. You've got a business that as these models continue to improve from gathering more data, we think that's an extra 3%, 4% a quarter as well. So, that sort of gets you to the low end.” 

But the company is expanding into new verticals, making it very likely that AppLovin will be growing nicely above its low end growth target. The company has expanded into web marketing, e-commerce, connect TV and OEM app install markets. The early results have been promising with growth rates faster than its more mature gaming market. Although insignificant at the moment, the company thinks some of the new markets could make meaningful contributions to revenue growth from 2025 on. 

Investment Thesis and Valuation

AppLovin, with its superior technologies and competitive position, will continuously improve monetization on its vast user base while consistently reducing its share count. As a result, FCF on a per share basis could grow 20% or more for an extended period of time. 

AppLovin’s ad business sits on top of over 1 billion daily active game players with roughly 170 million daily active users in the U.S. alone. Historically, in this channel, the modernization has been very low per 1,000 impressions, compared to what the social networks and the search engines and the video apps have gotten to. Part of the reason, besides having very engaging content, is that these companies have very sophisticated technology and a lot of data. Now, AppLovin’s tech has become effective enough to monetize its audience more effectively. 

Meta made about 40/DAU in the last 4 quarters while AppLovin made about 2.5/DAU during the same period. Although AppLovin is unlikely to get as much revenue per DAU as Meta does, the gap does show there’s tremendous potential for AppLovin to increase monetization if it can increase its advertising demand by reaching new verticals and improving conversion rate. 

The software business has about 70% ebitda margin and 50% FCF conversion. Using TTM revenue gets us about 1.25B FCF including SBC. Assuming the company grows revenue 30% in the next 12 months and FCF grows in line with revenue, we could see 1.6B FCF. (The 30% estimate is very conservative given that management is guiding roughly 50% growth for the software business next quarter.) This is roughly 6% FCF yield without factoring share repurchases. The company has been very consistently repurchasing its shares, reducing its share count by 10% in the last 10 quarters. 

For a company with such growth potential and shareholder friendly capital allocation policy, 3-4% FCF yield feels like a reasonable number, implying a 50-100% upside from the current level. Capital expenditure is minimal - the company had 4B rev but only spent 10m on capex in the last 4 quarters.

Although a remote possibility atm, there will be more upside for the stock if Apple and Google are forced to open up their ecosystem to third party app stores on a global scale. If game developers can save 15% or more on apple store fees, it is very likely that they will reinvest at least part of the savings to marketing and spur growth. AppLovin could be one of the biggest beneficiaries should that happen.

Catalyst

3rd party app stores become viable alternatives to Apple and Google’s first party app stores

ConnectTV business takes off

Non-gaming ads revenue becomes a significant portion of the company’s total revenue