Duolingo’s AI Magic: Driving Record User Growth and Profits

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In the last Visual Brunch, we explored a fascinating visual on the performance of one of the world’s most successful apps, Duolingo ($DUOL). In Q2, the company crossed 100 million Monthly Active Users (MAUs), a major milestone for an app-based business.

DUOL shares jumped 13% post-earnings as investors were thrilled with the company’s stellar performance, even in a challenging consumer environment.

Duolingo has mastered the art of user engagement, retention, and conversion, driving continued hyper-growth and increasing profitability. By effectively utilizing AI and adding social features to the app, this language learning platform continues to grow in popularity more than a decade after its launch.

The recent earnings report confirmed that Duolingo is likely one of the most interesting AI plays that few investors are talking about. Here’s why its AI-powered decision-making is a game-changer for its growth strategy and long-term success.

AI-Powered Decision Making

While everyone is talking about AI these days, few companies are successfully using this technology to enhance their operations, and Duolingo is one of them. The language learning app boasts millions of monthly and daily active users, allowing the company to track behavior and optimize the app accordingly. AI thrives on vast amounts of data to generate valuable insights, and Duolingo’s large user base enables the company to train its AI models and optimize the app for maximum user engagement and retention.

In Q2, user growth accelerated again—MAUs grew 59% y/y to 103.6 million, up from 54% y/y growth in Q1. Similarly, DAUs grew 40% to 34.1 million, up from 35% growth in Q1. This impressive performance for an app with an established user base is largely due to the company’s use of AI for decision-making and app optimization.

Thanks to the vast amount of data collected, Duolingo’s algorithms suggest new features that are highly likely to resonate with users and keep them engaged. For example, the company introduced the Friend Streak in Q2, a feature that allows you to invite up to five friends to share a streak with you. If your friend hasn't completed their lesson, you can send a nudge reminding them to extend their streak. The company reported that early results have been excellent, as users are now accountable not only to themselves but also to their friends.

Features like Friend Streaks and Leaderboards not only encourage learners to return more frequently but also turn learning into a shared experience. Now, over half of DAUs follow at least one friend, proving that Duolingo’s AI models are highly effective in identifying new trendy features.

Duolingo is now leveraging its proven social-first marketing approach from mature markets to expand globally into other large, high-income markets. The results in Japan, for example, have been impressive. In Q2, Japan DAUs jumped 93% y/y, and bookings grew 58%. The company has also recently added country marketing managers in France and Korea, two other promising markets where they could replicate their success in the U.S. Creating localized content for different markets will help Duolingo sustain its rapid growth rates, and the early success in Japan is a very encouraging sign.

Sustained Momentum On The Top & Bottom Lines

Duolingo has managed to sustain impressive, multi-year growth momentum, despite the inflationary environment. This highlights the stickiness of the app and the success of the company’s conversion strategy. As of Q2, one in five DAUs had a streak longer than 365 days. The hundreds of AI-powered A/B tests conducted on hundreds of thousands, or even millions of users have made the app extremely engaging.

In Q2, revenue grew 41% y/y to $178 million, making Duolingo one of the fastest-growing subscription-based businesses on the market. Subscription revenue, which accounts for 95% of the total, jumped 51% y/y during the quarter, accelerating from 46% growth in the same quarter last year. This acceleration underscores the impressive growth momentum in Duolingo’s key revenue stream, driven by its focus on growing premium subscriptions.

Bookings growth confirms that this momentum will remain strong. Bookings grew 38% y/y to $190 million in Q2, or 41% on a constant currency basis, while subscription bookings grew 50% y/y on a constant currency basis.

Duolingo is not only growing rapidly but also very profitably, thanks to its smart and cost-efficient marketing strategy. In Q2, the company spent only 11% of its revenue on sales and marketing, down from 14% a year ago—an extremely low marketing spend for a digital company. This shows that Duolingo has mastered viral, social-first growth strategies that allow it to grow efficiently. As you can see below, the growth momentum is so strong that all expenses are decreasing as a percentage of revenue over time, resulting in higher profits.

The significant operating efficiencies gained in Q2 resulted in an adjusted profit of $48 million, up 130% y/y, while free cash flow also increased 60% to $54.9 million. This translates to a world-class free cash flow margin of 30.8%, up from 27.1% a year ago.

What About Valuation

Despite its continued stellar fundamental performance, Duolingo stock has lagged behind the market this year. Shares are down 16% YTD, creating a very attractive buying opportunity for long-term investors. The company’s valuation is also appealing. At current prices of $190 per share, DUOL trades at a PS ratio of 13 and an all-time low Price/Free Cash Flow ratio of 37—neither metric reflects the company’s world-class fundamental performance.

Assuming DUOL’s PS ratio rises to 15 and full-year revenues increase 39%, the stock could rise 34% from current prices to $255 by the end of the year.

What Else

Duolingo’s consistent growth in various economic environments shows that the language learning app is here to stay, potentially becoming a staple subscription service for millions around the world. Despite inflationary pressures, macroeconomic challenges, and other issues, Duolingo consistently over-delivers, making it one of the most resilient software names on the market. It’s a founder-led company with an experienced CEO who previously sold a company to Google, and it offers a great product. Even after a 16% post-earnings rally, $DUOL stock is still too attractive to ignore.

DUOLINGO RATING

Short Term: Buy

Long Term: Buy

🎯 FY2024 Price Target: $255

I’m long DUOL.

The boring Disclosures: Newsletters express the opinion of the authors. Nothing in this email is a buy or sell recommendation. I'm not a financial advisor; make your own decisions.