AI Cost Pressures Will Challenge Efficiency As Learning Courses Expand

Key Takeaways

• AI-related cost pressures could shrink net margins as efficiency decreases and gross margins decline.
  
• New learning subjects face tough competition, possibly hindering substantial revenue contributions and affecting bookings growth.
  
• Diversifying into new subjects and leveraging AI innovations position Duolingo for enhanced user engagement, retention, and profitability through increased subscription revenue and reduced costs.

Catalysts

Operates as a mobile learning platform in the United States, the United Kingdom, and internationally.

• Duolingo anticipates a 150 basis point decline in gross margins year-over-year, despite initial outperformance, as ongoing cost pressures from AI-related features impact their overall efficiency, potentially affecting net margins.
  
• The roll-out of new language content, such as the 148 new courses which are not entirely new languages but extensions for existing ones, is expected to provide diminishing marginal returns on revenue growth as these efforts primarily serve smaller user bases.
  
• While new features such as Video Call with Lily and 3D call updates aim to increase engagement, the incremental revenue from these innovations may take time to materialize, delaying potential revenue growth and impacting short-term earnings.
  
• Expansion into new learning subjects like chess, math, and music could face significant competition from established players in those fields, possibly limiting substantial revenue contribution and affecting overall bookings growth.
  
• Relying heavily on viral marketing and social media presence without substantive paid advertising campaigns may limit the scalability of user acquisition strategies, challenging Duolingo's future revenue growth potential.
  

Duolingo Future Earnings and Revenue Growth

Assumptions

• This narrative explores a more pessimistic perspective on Duolingo compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming Duolingo's revenue will grow by 22.3% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from 11.9% today to 16.4% in 3 years time.
• The bearish analysts expect earnings to reach $244.0 million (and earnings per share of $5.39) by about May 2028, up from $96.8 million today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 88.2x on those 2028 earnings, down from 230.5x today. This future PE is greater than the current PE for the US Consumer Services industry at 19.0x.
• Analysts expect the number of shares outstanding to grow by 5.41% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 6.42%, as per the Simply Wall St company report.

Duolingo Future Earnings Per Share Growth

Risks

• Duolingo is expanding its offerings by adding new subjects like chess, math, and music, which have the potential to increase user engagement and ultimately boost subscription revenue.
  
• The company is effectively leveraging AI to rapidly develop new language courses and content, which could enhance both user retention and acquisition, positively impacting revenue growth.
  
• Duolingo reports strong growth in daily active users across mature regions, indicating significant market demand and the potential to maintain or increase revenue streams from their existing user base.
  
• Investment in generative AI is expected to create efficiencies and reduce content creation costs, likely leading to improvements in profit margins over time.
  
• As seen with the promising adoption of Duolingo Max, higher-tier subscription models with value-added features could drive higher average revenue per user and increased gross profit dollars.

Valuation

• The assumed bearish price target for Duolingo is $337.13, which represents two standard deviations below the consensus price target of $447.86. This valuation is based on what can be assumed as the expectations of Duolingo's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $515.0, and the most bearish reporting a price target of just $315.12.
• In order for you to agree with the bearish analysts, you'd need to believe that by 2028, revenues will be $1.5 billion, earnings will come to $244.0 million, and it would be trading on a PE ratio of 88.2x, assuming you use a discount rate of 6.4%.
• Given the current share price of $490.55, the bearish analyst price target of $337.13 is 45.5% lower. Despite analysts expecting the underlying buisness to improve, they seem to believe the market's expectations are too high.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.