AI-Driven Advertising And Diversification Fuel Revenue And Margin Surge

Key Takeaways

• Continuous software improvements and diversification into new verticals like e-commerce indicate potential for revenue growth and market expansion.
  
• Strategic capital allocation and high adjusted EBITDA margins highlight efficient operations and confidence in future growth.
  
• Reliance on AI, diversification into e-commerce, and optimistic growth projections are challenged by potential market realities and strategic financial decisions.

Catalysts

Engages in building a software-based platform for advertisers to enhance the marketing and monetization of their content in the United States and internationally.

• Continuous improvement of AppLovin’s software models due to additional data, leading to more accurate user targeting and increased advertiser spend. This is likely to boost revenue growth as the platform becomes more effective in matching advertisers with profitable users.
  
• Expansion into new verticals beyond mobile gaming, such as e-commerce, with the launch of web advertising campaigns. This diversification could significantly increase the addressable market for AppLovin, potentially impacting revenue and net margins positively.
  
• Technological advancements, specifically in AI-driven marketing platforms, which create new growth opportunities by making sophisticated advertising possible. This could lead to higher earnings as AppLovin leverages technology to capture more market share.
  
• High adjusted EBITDA margins demonstrating efficient cost control and operational leverage. The company’s ability to grow revenue while maintaining lean operations could further improve net margins.
  
• Strategic capital allocation towards organic growth initiatives and share repurchases, aimed at enhancing shareholder value and supporting EPS growth. This suggests confidence in the company’s future growth prospects and financial health.

Assumptions

• Analysts are assuming AppLovin's revenue will grow by 14.5% annually over the next 3 years.
• Analysts assume that profit margins will increase from 20.8% today to 34.3% in 3 years time.
• Analysts expect earnings to reach $2.0 billion (and earnings per share of $5.79) by about September 2027, up from $823.8 million today. However, there is a considerable amount of disagreement amongst the analysts with the most bullish expecting $2.8 billion in earnings, and the most bearish expecting $1.6 billion.
• In order for the above numbers to justify the analysts price target, the company would need to trade at a PE ratio of 19.1x on those 2027 earnings, down from 51.8x today. This future PE is lower than the current PE for the US Software industry at 38.7x.
• Analysts expect the number of shares outstanding to decline by 3.9% per year for the next 3 years.
• To value all of this in today's dollars, we will use a discount rate of 6.81%, as per the Simply Wall St company report.

Risks

• The reliance on continued improvement of their AI models for growth could result in lower-than-expected performance if these improvements do not materialize or deliver diminishing returns, potentially impacting revenue growth and market share expansion.
  
• Expansion into non-gaming verticals like e-commerce is still in early stages and unproven. Failure to capture significant market share in these new verticals could limit growth opportunities, potentially affecting revenue diversification and long-term growth.
  
• The mobile gaming market's low single-digit growth rate may not provide a strong enough base for AppLovin's projected growth, especially if mobile gaming advertising does not accelerate as expected, possibly impacting overall revenue growth.
  
• Significant investment in share repurchase programs might limit the company's ability to invest in other growth initiatives or could impact financial flexibility if market conditions change, potentially affecting liquidity and capital allocation efficiency.
  
• The optimistic long-term growth projection of 20% to 30% for the software business may not account for potential market saturation or increased competition, which could lead to slower growth rates, affecting profitability and market expectations.

Valuation

• The analysts have a consensus price target of $107.54 for AppLovin based on their expectations of its future earnings growth, profit margins and other risk factors. However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $155.0, and the most bearish reporting a price target of just $57.0.
• In order for you to agree with the analyst's consensus, you'd need to believe that by 2027, revenues will be $5.9 billion, earnings will come to $2.0 billion, and it would be trading on a PE ratio of 19.1x, assuming you use a discount rate of 6.8%.
• Given the current share price of $127.75, the analyst's price target of $107.54 is 18.8% 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.