Duolingo & Roblox: Did Investors Get It Right?

In this podcast, Motley Fool host Ricky Mulvey talks with Motley Fool analyst Kirsten Guerra about earnings reports from Duolingo and Roblox, and with Motley Fool analyst Nick Sciple about the legal pot business and a legislative change that could have profound implications on the market.

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This video was recorded on May 9, 2024.

Ricky Mulvey: Wall Street might need some help translating this earnings report. You’re listening to Motley Fool Money. I’m Ricky Mulvey joined today by Kirsten Guerra. Kirsten, thanks for being here.

Kirsten Guerra: Hey, Ricky. Happy to have me.

Ricky Mulvey: We’re happy to have you. I appreciate you being here.

Kirsten Guerra: I love this start.

Ricky Mulvey: We’ve got two high fliers that you follow pretty well, both experiencing a little bit of a fall one more than the other. But Duolingo. Let’s start with Duolingo, which is the app that helps you learn different languages. We’ll talk about their earnings in a sec and why the street isn’t happy that Duolingo grew revenue by 45% and daily active users by 54%. But I loved this Kirsten, the earnings calls started with the announcement of Duolingo on Ice, which is a four-hour musical celebration with no intermission. They wanted to let the analysts know about it. What is your hype meter for Duolingo on Ice?

Kirsten Guerra: It’s high. If being bullied by a digital owl is this much fun on a regular day. It’s got to just be more fun on ice.

Ricky Mulvey: Absolutely. I’ll be buying my tickets. On the surface for Duolingo’s quarter, it seemed like a lights-out quarter. Beating every estimate for earnings in revenue and bookings, also raised guidance. What’s going on with the drop? What’s the street so worried about?

Kirsten Guerra: The street is all about expectations. This is a company with a lot of expectations built in. Every quarter for the last year, analysts have set expectations for Duolingo. That’s what the street does and every quarter Duolingo has beat them. Weirdly, it’s almost analysts are now expecting Duo to beat their expectations. They did beat expectations yet again, but only narrowly this time, so here we are. I will say a 12% or maybe 16% drop now I think does seem rough until you realize that’s something like 20 days back in the market. We’ve just returned to the price where it was 20 days ago. I realized that’s tough for someone who bought five days ago. I don’t mean to minimize that, but again, keeping perspective, this is still a stock that’s up more than 50% in the last year. I think the investor takeaway really from this share price movement is that the business is still performing well based on fundamentals, which it has earned. It has earned at a lofty share price, but the expectations are high and investors should just know that going in.

Ricky Mulvey: Looking at the business, not just the share price, what are your headline takeaways then from Duolingo’s quarter?

Kirsten Guerra: I think one of the most important for Duolingo is that unit economics here remain really strong. They are still pulling in a solid return from their marketing spend. Specifically, this is one of the more impressive companies I’ve ever studied in terms of marketing. Just for this quarter, their revenue was up 10% sequentially and their marketing spend is up less than 4%. They’re getting a substantial return in revenue more than they’re having to spend to get that. Another big takeaway. One of the things I’ve been wondering about is related to the potential TikTok ban here in the US. Duolingo does a lot of advertising there. It is one of the big drivers of a lot of its popularity and why it’s marketing spend is so efficient often. Management has said it’s not worried here that more than half of Duolingo’s social impressions actually come from outside the US. But half is a lot and US subscribers tend to be the most valuable in terms of average revenue per user. They tend to spend more on things like this. I’m not sure I actually believe that TikTok will be banned or that this is a huge risk, but it is certainly something to watch out for. Even though management has said it’s not a big deal, I think it might be a little bit understated there.

Ricky Mulvey: Duolingo is very much a marketing story and they’ve known how to create those viral moments starting off their earnings call with the musical celebration. Where one of the reactions to their musical celebration is an audience member saying, they took my son, where’s my son? If you look at just the earnings transcripts for Duolingo’s quarter, you will see a very odd sentence with how the quarter kicks off beyond something about forward-looking statements. The growth story for Duolingo though, is that it’s going to rapidly take share in this language learning market of which it has a very small percentage of. CEO Luis von Ahn saying that this is a $115 billion-a-year industry. That seems extraordinarily large. Kirsten, where are they getting that market number?

Kirsten Guerra: Frankly, I don’t think that the market is that big. I’m really glad you’ve asked this question because when I started looking at this. If we take them at their word and assume it a $115 billion market. What does that mean? With eight billion people on the planet, that would be roughly $15 per person. Maybe that sounds reasonable, but every person in the world cannot afford to fork over $15. But let’s make it more reasonable and say that there are an estimated 1.2 billion people who are actually actively learning a language at any time. If you consider just that population then you’re talking closer to $100 per person. But part of the beauty of Duolingo is that it’s a freemium platform. Not everyone pays. Actually, their premium penetration, which is the percentage of people of all of their users that are actually paying for a subscription, that’s about 8%. If we say that percentage holds and Duolingo does go on to serve 1.2 billion people and 8% of them pay up for a subscription that’s almost $1,200 per person per year. I believe that language learning is valuable, but I don’t believe it’s that valuable. By the way, to contrast that Duolingo’s current super plan, they charge $60 per year. If that’s the value they think they’re giving, what an incredible deal they’ve offered. I don’t know how to make that makes sense. I will say this though to wrap it up. I don’t think that particular total addressable market number needs to be true for Duolingo to still have a solid runway ahead of it. Maybe it really just sounds nice to say that you have only 1% of the market. But I modeled them as having almost 7% of the market close to a year ago and they’ve done just fine. Don’t listen to this number in particular, but I also wouldn’t write them off for this alone.

Ricky Mulvey: This is a fast-growing company. Traditional valuation metrics are tough to use. I think the stock is at about what? 71 times earnings, 20 times sales. What metrics are you using as you follow Duolingo story?

Kirsten Guerra: It is really tough. You cited earnings, but this is only Duolingo’s second straight profitable quarter. So when you have a rapidly evolving number in the denominator like that, the numbers will look outlandish. If you don’t know what I mean by that, you can go check out Duolingo math, but even forward PE ratios that take into account near-term growth will look a little wild. What I did was I actually modeled out what I believe are reasonable growth rates to expect in two numbers, specifically just monthly active users, and also that premium penetration that I mentioned. Those are the two main elements that are really going to drive revenue. I think of those two, it’s the premium penetration percentage that will really be the biggest lever for how much they can grow earnings. Right now over the past year it’s stalled out around 8% of total users paying for subscriptions, but that’s been due to some softness in the economy. It’s unclear if that’s all that is. Going forward the question is, will that shrink as Duolingo expands into a broader user base, that’s may be less likely to upgrade into a subscription? Or will it actually recover back to the steady growth rate it had before, and will it surprise us with how high it can climb? How many people are willing to purchase subscriptions ultimately? I think that will be a major driver for how well the company ends up performing in shareholders’ eyes.

Ricky Mulvey: Let’s move on to Roblox, the online game platform and game creation system. It’s down more than 20% this morning at the time of this recording. Real quick, Kirsten, because I don’t think there’s a lot of crossover between the Roblox playing audience and the Motley Fool Money listening audience. It’s a free video game platform. Quickly, how does this company make money?

Kirsten Guerra: I can’t believe that’s true. Surely tons of our listeners play Roblox, no?

Ricky Mulvey: Maybe. I don’t know. If you aren’t on podcasts it’s fool.com, that’s the email address.

Kirsten Guerra: There you go. But it is a great question. I think people could get confused because there’s been a lot of talk in the news about advertising developing on Roblox. To be clear, it’s negligible today in terms of revenue, and management says it won’t be material by the end of this year either. So really where Roblox makes its money is directly from users. People pay to buy things on the platform. Roblox uses a model common to gaming, this freemium model where they get tons of people in the door, build up the network effect. Then those who find it valuable can pay up for certain things. So Roblox sells Roblox, their virtual currency. That’s the first step is you translate your money into that. Then you spend them on things like upgrades to your avatar, which is like your digital representation inside Roblox, or you can buy speed boost to progress again faster. For certain games they are like if you’re playing a racing game, maybe you want to pay up for a really nice car. Roblox has also recently added subscriptions as a monetization tactic. Some creators, if they decide it’s best for their experience, they can make that experience exclusive and require an ongoing subscription to it. It’s really up to the creators of any individual experience, how they choose to monetize, if at all many are still completely free, but those are some of the monetization mechanisms that Roblox provides.

Ricky Mulvey: Yeah, it was playing the racing game this morning on on Roblox. I was having a good time until I ran the car into this like wedge point between a barrier in the off-road thing. Then I couldn’t continue playing, and then realized I should probably get back to work anyway. Kirsten, I think the problem at Roblox came down to what the CEO said, “We saw less growth than we expected. That said, we exceeded our margins on cash flow targets.” Does Roblox have a business problem or an expectations problem?

Kirsten Guerra: Management says that they’re trying to get bookings daily active users, hours engaged back to 20% growth rates. I think for daily active users, they reported something like 17%. What’s so special about 20% specifically? Roblox is a lot of things, but at its core it’s a social network. It’s a social network that was first popular with kids and it’s really aging up from there. About a year ago I looked at how Roblox’s growth has compared to Facebook’s early growth. Once I normalize them by the year they went public, the growth rates are very similar from there. Looking ahead for 2024, I tried to extend that curve out by both 20%, which is what they say they want to be at in the 17% they were actually at for this quarter. They don’t really look that different. They are still right on track for following in something like Facebook’s footsteps. For a single-year or single-quarter a slowdown from 20%-17% is not that huge in the overall story, but there will be always some vacillation around an average growth. But certainly if that growth rate continues to trend downward, that would be a different story. So maybe it isn’t expectations problem for the moment, but it could be a business problem down the line. I’m glad that you clarified that’s actually a quote directly from management. I thought maybe it was just your quote, but yeah, that’s wild. You mentioned that the CEO mentioned exceeding the cash-flow targets there. They did technically increase their cash flow from operations year-over-year. But they started with a lower net income and they just juiced it with more non-cash stock-based compensation. I certainly wouldn’t point to that as some silver lining. I’m maybe a little disappointed that the CEO did.

Ricky Mulvey: This is a company with a lot of stock-based compensation. I think they spent about a third of their revenue on stock-based comp over the past 12 months. When you have CEO David Baszucki saying, hey, look over here at our cash flow numbers. They’re adjusting out something significant. Not bad for a company to have stock-based comp, but forgiveness becomes a little lower when you’re not meeting your growth estimates. Speaking of the CEO, David Baszucki blamed the slowdown basically on shipping out a bunch of new technology that low-end Android devices just can’t handle. Are you buying that explanation? What do you think of that?

Kirsten Guerra: Sure, somewhat. I mean, about 80% of users do access Roblox through mobile devices, and many of those are Androids. It is true that they have recently introduced features like dynamic heads that use a lot of local processing power by design. I’m sure that that does suffer on a lower end device and it makes for a less than ideal user experience. Maybe some of those users turn away from the platform. That said, those devices exist and they will continue to exist. If you want to grow to serve one billion daily active users, as they’ve said, they will have to contend with that. The platform in some capacity will have to be able to serve users that don’t just have top of the line phones. I will actually mention, if it’s OK, one other thing that I think is huge that the CEO pointed to, and that is that the way they highlight all of their new content bubbling up on the platform is “not optimal.” I’d say that’s understating it. I think this is one of the biggest things that they really have to solve. Especially if they want to retain the older, more mature users with higher expectations in games. They need a much better recommendation engine. There are 15 million plus experiences. Yes, there’s a little bit of fun in the treasure hunt element of kind of clicking through and seeing what you’ll get. But really I need them to find some of that TikTok level greatness in knowing what games I will love before I know what I want and just serving them to me. I don’t have time to go dig them up. Just get them to me Roblox.

Ricky Mulvey: We’ve talked about two high-growth stories, and we’re long-term investors here at the Fool, 25 plus stocks holding on for 3-5 years minimum. But Roblox, Duolingo, you follow both of these, are any of these more appealing for an entry point for investors taking a look at these companies?

Kirsten Guerra: Both of them, you could say have dipped but dips are all relative. I think before these earnings releases, Duolingo was already soaring at what I see as a pretty steep premium valuation. I think Roblox has really been suffering for with a stagnant stock price for somewhere around a year, that was maybe undeserved. For me, my own personal expectations are more at odds with the market on Roblox’s story. I think that’s where I see the larger price dislocation and maybe the greater opportunity. But that’s just me. If you agree with the market punishing either of these stocks today for whatever reason then it might not be the company that’s easiest for you to hold in the long-term because certainly they’re both growing and they’re both going to experience a lot of volatility.

Ricky Mulvey: These dips aren’t nothing for a growth investor. Kirsten Guerra, appreciate you coming on for the a segment. Thank you for your time and your insight.

Kirsten Guerra: Thanks for having me, Ricky

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Ricky Mulvey: The excitement about investing in the legal we’d space died down over the past few years significantly. But there’s a big change coming in. It’s classification is a federally illegal drug in the United States. I know this sounds technical, but it could have profound changes for the industry. My colleague Nick Sciple joined me for a look at the legal market and a publicly traded weed company that’s high on cash. Nick, we’re a few years past this weed-investing boom and it’s an extraordinarily difficult business where there’s not a lot of tax incentives. You have to basically deal in all cash. The drug is still federally illegal. But before we get to the state of play today, it’s I think it’s worth looking back on that investment boom. Why was there so much hype?

Nick Sciple: Sure. I think the short answer to that is marijuana, pot, weed as a product a lot of people use. There’s a big community around it. Folks saw a potential opportunity to own the next great consumer goods product. We also had lots of movements toward opening up sales of the product. Twenty-fourteen, you’d seen recreational legalization take place in Colorado? I believe it was in 2016, you saw recreational legalization take place in Canada. It’s yet a product that had an existing constituencies and belief among folks. This could be a big consumer product and you had a legalization trend taking place in some ways it’s really did become a really big, important consumer product. California, one of those states that legalized recreational sales in 2023 last year did $5 billion in recreational marijuana sales. You look at Canada, it’s been legal again, going back to 2016, did 5 billion sales in 2023. Has been quite a big consumer product market that’s generated lots of revenues for the tax authorities in those jurisdictions, but this is a commodity market where you saw lots of cash and excitement rush into that business bound to lead to oversupply and push prices down, which we’ve seen in really all of these developed jurisdictions over the past several years, you add in a really substantial tax burden and a lot of these markets. If you look at the stocks and the industry really all down about 90% from their peak. There has been a wash-out among even some of the smaller players, folks totally exiting the industry.

Ricky Mulvey: Now there’s something new going on though, which is that it sounds technical, but weed is going from a Schedule 1 drug to a Schedule 3 drug. Glad we have a lawyer on. Why is this a big deal?

Nick Sciple: This has been something that’s been going on for quite a while. Was first recommended by the Biden administration back in August of last year. Here on about a week ago, April 30, the Department of Justice announced its intent to follow through the rule-making process to reach scheduled marijuana from Schedule 1 to Schedule 3 under the Controlled Substances Act. Under a Schedule 1 drug those are drugs that are viewed as having new medical use in a high likelihood of dependents thinking about things like heroin. A Scheduled 3 drug, much lower classification substances with moderate to low abuse potential are currently accepted medical use and a low potential psychological dependence to this new rescheduling puts marijuana in a class of drugs with things like testosterone, anabolic steroids, Tylenol, with codeine. For one just means that the level of federal regulation will reduce. Again, this isn’t a final rule in place last to go through the federal rulemaking process. We won’t really be at the earliest until the fall that we see this rule go into place. But in addition to changing the regulatory environment for the operators in this space, potentially allowing more investment in research of marijuana as a drug also significantly changes the tax environment these companies operate in up to and still today again, because this rule hasn’t been enacted, companies selling marijuana have been subject to Section 280 E of the Internal Revenue Code, which essentially prohibits companies, operators selling scheduled 1 and 2 drugs from exempting ordinary business expenses, the types of tax deductions that most businesses would get things for, your rent, payroll, things like that. Historically, they’ve only been allowed to deduct their cost of goods sold on their taxes if. Comes down to what these companies report can be tens of millions of dollars in cash flow that is now going to drop to the bottom lines of these companies that was previously required to be paid back in taxes to the federal government. However, doesn’t change everything for the industry. A recreational marijuana still remains federally illegal. There is continued push by some members of Congress to allow marijuana banking entities to be treated in the same way as traditional businesses that would require further action from a legislative point of view. But if that takes place again, would reduce costs of the industry has had to bear that normal operating businesses don’t. Big takeaway is produces the regulatory barriers to entry, perhaps in the marijuana business, and also going to significantly change the tax regime, which should be a windfall for the folks currently operating.

Ricky Mulvey: It’s a step but not an all-out win. One problem for a lot of these businesses is that it’s hard to sell across state lines. There’s no interstate commerce. What is this change in the scheduling mean for interstate commerce? Because I think that would be a significant factor for these companies.

Nick Sciple: A to-be-determined right now, but potentially could open up a lot more competition across state lines. We’ve said previously, as you alluded to, currently medical marijuana operators, folks that are even selling these recreational States are locked within the states they operate in. However, with these changes, perhaps you could see some new entrants. The early easy one is maybe you see more activity among the pharma industry. It’s much easier to get a license to research a Schedule 3 substance than a Schedule 1 substance. Maybe you see some marijuana-based pharmaceuticals and products out there in the market that could be sold under the existing regulatory regime for pharmaceutical products, which would again add more competition in the industry. Or interesting California for a number of years has been dipping their toe in the water of exploring interstate sales via partnerships with other states operating out there to be determined whether this change in scheduling allows that to take place. But there were, that’d be a quite a, quite a lot of attitude among, among operators in particularly places like California and Oregon that because of their more mature market, have their wholesale prices 20% below the U.S. average could potentially open up opportunities for some of these lower price states to undercut operators in these other states if those regulations allow interstate sales. Could it also offer the opportunities for more developed companies in the Canadian market and elsewhere to enter the US That’s something they’ve been sniffing around that for quite a while, to-be-determined. But we do know for sure that if we allow new entrants into this market going to increase competition or if it’s anything like what we’ve seen previously more capital pouring into this space should push prices down. These near-term tax windfall these companies the current operators are going to capture with this tax change won’t necessarily stick around for the long term if we see higher competitive intensity come about.

Ricky Mulvey: I think the reclassification in research is going to be significant just because there’s not a ton of research on weed about the long-term implications just because it’s so difficult to study a schedule on substance if you’re a researcher. I’m a little optimistic about that just to get the science. One of the big investment thesis about weed sales was that is more states are going to open up more federal legalization and that means more sales. But with this news did your investment thesis around these weed businesses change at all?

Nick Sciple: I wouldn’t say the investment thesis changed at all. I would just say this is one of those buy-the-rumor, sell-the-news events so that I would say. You’ve seen that in the activity in the marijuana stocks. I say that just because this promise of rescheduling that’s been out there for a long time, the potential windfall on these tax changes. Yes. You’ve seen a lot of these stocks moved quite a bit this year and they moved quite a bit leading into the announcement. But on the back end now that we’ve got this information out there and the market is starting to digest it we’re thinking about who are these winners long-term. I still think it’s hard to say what the end state of the market is going to be today. I think there’s maybe an opportunity to trade around the news. Short-term, longer-term I think you’re going to still need to see a little bit more of a shakeout before we know the clear winners and losers in this market. I have some ideas which I know you’re going to ask you about here in a little bit. But I do think for many folks that the reaction in the market to rescheduling taking place, you think, wow man, these stocks are going to go go straight up. But I think we’re learning there’s a little bit more uncertainty now than the many folks had hoped for and I think that’s why it was potentially one of those buy-the-rumor, sell-the-news events.

Ricky Mulvey: Well, it’s an industry that even with this reclassification still has a really strong illicit market as a competitor. Even in the legal states where people can buy weed from a store there’s still a lot of black market weed going on.

Nick Sciple: That’s right. The short answer to that is just the big tax burden that many of these legal operators face. If you just look at Canada as an example, a mature nationwide marijuana market about 30% of the selling price that you see at the market is comes from excise taxes which obviously gives an opportunity for elicit folks to undercut on price. Over five years post-legalization in Canada estimates have 25-50% of the marijuana still remaining in the illicit market. From the bullish side of things you could say that’s an opportunity to squeeze out some of those elicit sales opportunity for the legal operators to come in. But I think that the real explanation is high taxes and also inertia. Where were folks getting these products before legalization? These products haven’t just teleported onto the market over the past five years.

Ricky Mulvey: I also got to take I just want to bounce off you. I think the vibe in Colorado at least has shifted around weed. There’s just lower consumption post-pandemic and I think there’s a little bit more of a discussion about the health risks out here as opposed to a lot of these states, early legalization. It’s like yippee yippee, we have weed now.

Nick Sciple: I guess it’s like the end of prohibition people probably drank more than 10 years after the end of prohibition, what have you. I think Colorado being the most mature recreational marijuana states but had legalization for over a decade. You’ve probably hit a maturation of the market that you’re going to see in other markets overtime as well where the folks who want to partake in the products have the folks who thought about trying the products and didn’t try them until legalization have done so and you kind of reach a balanced level in the market. I will say nationwide the issue is arguably as popular as it’s ever been. If you look at Gallup polling at the end of 2023, at 70% of Americans supporting marijuana legalization fair to just 51% in 2014 when Colorado was enacting it’s legalization. You’re still seeing more jurisdictions open up for recreational use. Florida, big state is going to vote on opening recreational sales in November. Also if you look internationally Germany approved recreational use on April 1st. It’s still a growth industry when it comes to more legislative domino’s falling around the world and around the US.

Ricky Mulvey: A lot of the smoke has cleared, a lot of the hype has died down and there still are companies operating in this space. I know you’ve looked at a few of them. Are any of them investible in your opinion?

Nick Sciple: Lots of uncertainty in this market, a lot of ins, a lot outs, a lot of what have yous. But if you had to dip your toe into this market I do think there’s one company that stands out to me. That company is Cronos Group, ticker is CRON, Canadian cannabis operator. Again Canadian market’s been legal since 2018, has had fewer of these regulatory issues that the companies in the US have had so have been able to build national distribution, invest in R&D and branding in Canada in a way that these US operators haven’t been able to do. Cronos has grown to become the number 2 brand by market share in Canada. Importantly, the number 1 brand in edibles. I think a lot of folks think about marijuana consumption and have this vision of smokables being the dominant area of the market. I think in the same way that you’re seeing nicotine go more toward things like vaping and nicotine pouches and that sort of thing I think that’s where you’re going to see cannabis move over time. Having an advantage and those products having established branding and those sort of products I think puts companies at an advantageous position and I think Cronos is one of those companies.

Second point I’ll make they have a great balance sheet. This is a company with a billion-dollar market cap that has about $860 million in net cash, was trading for less than cash a few months ago. Here today still trading at a pretty reasonable valuation. If you back out a lumpy tax payment last year it’s approaching cash-flow break-even. You’re continuing to see a wash-out in the Canadian market. This is going to be one of the companies that standing at the end of that. Also have some interesting opportunities and other legal cannabis markets. They’re importing products into new markets like Germany, the UK, and Israel, so already have an established operation in Canada and an ability to export the operation into new markets. Then last but not least I think is very noteworthy for Cronos is they’re backed by Altria, the big tobacco company, the parent of Marlboro in the US. Altria owns over 40% of the company stock, has rights to a 0.4 of the company’s board members, has a global partnership agreement with Altria, gives the company access to Altria’s distribution and regulatory expertise in the US which I think will be very important to them if and when they come into that market. Strong balance sheet, strong competitive position in a mature market, opportunities in foreign markets and then the partnership with Altria I think positions them well with access to distribution, cost of capital, and perhaps gives them a foot in the door in the US if and when that time comes. For those reasons I think Cronos is a company to have on your radar ticker is CRON, also trades in the US as well.

Ricky Mulvey: Look at that. A weed company with a great balance sheet. Was not expecting that when we first started talking Nick, appreciate your time and your insight.

Nick Sciple: Happy to do it. I’ve got high hopes for this one.

Ricky Mulvey: As always people on the program may own stocks mentioned and the Motley Fool may have formal recommendations for or against so don’t buy or sell anything based solely on what you hear. I’m Ricky Mulvey, thanks for listening, we’ll be back tomorrow.