Duolingo: With the TikTok refugee wave cooling down, can Green Bird still fly?

$Duolingo(DUOL.US) released its Q4 2024 performance after the market close on February 27th, Eastern Time. Due to higher expectations from buyers, the actual performance was not significantly above expectations. However, the metrics that funds are clearly more concerned about, the guidance for Q1 2025 and the full year, performed poorly—with no surprises on the revenue side, the pace of profit improvement is clearly lagging behind expectations.

This may disappoint some funds; is the gross margin under more pressure due to the incremental costs from Max? Or is there an intention this year to penetrate more into low-price regions? What are the reasons behind the accelerated growth in sales and R&D expenses excluding SBC? It is recommended to pay attention to the management's explanations and medium to long-term profit margin targets during the conference call.

Core performance highlights:

1. Biggest disappointment: Poor guidance

First, let's talk about the guidance issue. For high-valuation growth stocks, guidance is clearly more critical at this time. Although previous previews from institutions hinted at profit pressure, the short-term profit seems to be under more pressure than expected.

(1) Looking at the guidance for Q1 and the full year 2025, the median growth rates are 28%/25%, which are higher than investment bank expectations. However, buyers with pricing power have more optimistic expectations, so this guidance can only be considered basically inline and acceptable.

(2) But the profit guidance is clearly lagging behind expectations. The company guided an adjusted EBITDA for Q1 in the range of $54 million to $57 million, while the market expected $61.4 million, with the expectation gap mainly in profit margins (actual 25% vs expected 27.5%).

In addition to the increased short-term costs or reduced monetization efficiency due to the penetration of MAX and family plans, Dolphin Research also noted signs of accelerated growth in operating expenses excluding SBC in Q4. According to the current guidance, this indicates that the growth rate has not temporarily slowed down.

2. Subscription business: Revenue performance is the brightest. Q4 revenue grew by 50%, driven by both volume and price.

(1) From the perspective of user operation metrics, the platform's high growth remains stable and continuous. In Q4, the total user scale MAU grew by 32% year-on-year, with a net increase of 3.6 million quarter-on-quarter, approaching 117 million, while user stickiness DAU/MAU further improved to 34.7%. In terms of willingness to pay, the net increase in paying users at the end of the year was 900,000, with an overall slight increase in the payment rate, slightly exceeding market expectations.

According to Sensor Tower's monthly download and MAU data, there was a significant acceleration in December, likely stimulated by the marketing campaign to learn Korean in conjunction with "Squid Game 2." However, the TikTok refugee event in January, while temporarily boosting the peak of U.S. user downloads and activity, did not create a sustained increase far exceeding expectations. (2) Per capita subscription fees finally returned to growth in Q4. Previously, the penetration of the Family plan (with 5 people in the family plan, the per capita payment is only 30% of the Super individual plan) and the faster expansion of users in low-price regions led to a continuous decline in per capita payment.

The return to positive growth in Q4 is mainly attributed to the faster increase in the payment rate of the higher-priced MAX plan, or more users purchasing the video call feature separately. According to the financial report, MAX subscribers accounted for 5% of total subscribers, which is 450,000 people, a penetration rate that clearly exceeds institutional expectations.

2. Advertising and other: Slow growth, not a "second curve."

Other income in Q4 only grew by 5% year-on-year, further down from 10% in the third quarter. Other income is mainly composed of advertising, English testing, and in-app purchases, with the revenue scale of the three segments roughly in a 4:3:3 ratio.

The performance of the segmented businesses in Q4 still needs to wait for the annual report disclosure. Dolphin Research roughly estimates that both English testing and IAP purchases are still in single-digit growth, with in-app purchases slightly higher. Advertising still has about 10% growth, but has clearly slowed compared to Q3.

Historically, apart from in-app purchases, which may have a continuous expansion trend with user growth, advertising and English testing have many interfering factors besides user scale, making the growth trend uncertain. Overall, the current other businesses are still unlikely to provide much support for future performance. The company's growth story can only rely on subscriptions.

3. Profit: Short-term improvement pace slows down

Adjusted EBITDA in Q4 also only met buyer expectations, with gross margin under pressure due to the incremental costs from Gen-AI brought by MAX (in Q4, MAX users accounted for 5% of total subscribers), as well as the low per capita payment of the Family plan and the expansion in low-price international regions, further declining to below 72% in Q4.

At the same time, operating expenses, particularly R&D and sales expenses, accelerated growth this quarter. R&D expenses may be driven by a "low base + sustained R&D investment," while sales expenses may be related to the Super Bowl advertising in November and the marketing collaboration with "Squid Game 2" in December.

From the guidance, the short-term pressure will continue, so the pace of profit margin improvement will slow down. The gross margin is still under pressure due to the aforementioned Gen-AI costs, but operating expenses seem to maintain high growth. Dolphin Research expects R&D investment to remain high, and marketing expenses may be related to the "Revive Duo Campaign" in February, leading to some incremental spending, which can be further clarified by management in the conference call.

4. Significant increase in free cash flow profit margin

Free cash flow in Q4 grew to 88 million, with the revenue ratio increasing to 42%, indicating that at least in Q4, the impressive subscription revenue is the absolute cornerstone for maintaining a strong free cash flow situation. Especially with a focus on more cost-effective annual memberships, the company has effectively pre-collected a considerable amount of revenue, thereby releasing more space for cash flow status 5. Overview of Key Financial Indicators

Dolphin Research's Viewpoint

Duolingo is an online education platform similar to "streaming + gaming," currently leading the user base in the general language learning market.

Game-like features can offset the inherent drawbacks of the education sector, which often goes against human nature, by providing a gaming experience akin to level challenges and PVP rankings, closely aligning with the addictive characteristics of games, resulting in higher user engagement and willingness to pay compared to traditional education platforms.

Streaming-like characteristics indicate that its business model is solid. Especially when the fixed content investment is not high, the advantages of scale effects and cash flow will become more apparent. Referring to Netflix and Spotify, when there is a clear competitive advantage, if paired with disguised price increases in packages, it can further amplify the benefits of the business model.

However, unlike streaming services, it features gamified and programmed teaching characteristics, which are actually code-driven teaching forms, with relatively low investment costs. As long as a user base can be formed, it becomes a reliable cash cow (the fact that free cash flow can account for 42% of revenue also indicates the advantages of the business model). Therefore, Dolphin Research has chosen to initiate long-term tracking of Duolingo.

In the short term, revenue growth is steady, but it does face profit pressure due to international expansion, Gen-AI costs, and the penetration of family plans.

(1) International expansion naturally lowers monetization efficiency. Over 40% of Duolingo's users are learning English, which is the most comprehensive course offered on the platform. However, the regions with the highest payment capacity, namely Europe and North America, are not primarily English users. Additionally, once Duolingo has developed countries and regions with decent payment capacity, subsequent user growth will clearly rely on penetrating countries and regions with weaker payment willingness, which inevitably leads to a reduction in gross margin due to low customer unit prices (to acquire customers, Duolingo offers discounts in areas with low payment willingness).

(2) Gen-AI costs are not a significant issue in the medium to long term. Of course, in the short term, this is mainly because the output is not yet sufficient, leading to profits being significantly impacted by high investments.

(3) Family plans are generally priced at 1.5-2 times that of individual plans but can accommodate 4-6 subscription accounts, making the per capita price equivalent to a 30% discount. Currently, family plan penetration is also quite rapid, which will also drag down profit margins.

From the company's perspective, it seems willing to sacrifice short-term profits to first increase penetration and user scale influence. If Duolingo were not profitable, the market would focus on the topline, but Duolingo has already achieved profitability, attracting some funds that look at profits. Therefore, investing in it now requires bearing the impact of profit pressure on stock prices In addition, the current valuation itself is also relatively high (with a 2026 EV/EBITDA greater than 40x, while the profit growth rate under the 2025 guidance is less than 40%, and the expected compound growth rate from 2025 to 2027 is only around 25%-30%. If Max progresses more smoothly, it might exceed 30%), the valuation fluctuations caused by short-term performance misses will also be greater.

So, how much growth potential does Duolingo have in the long term? Dolphin Research believes that calculating the scale of Duolingo's advantageous markets and offensive markets is very important for its long-term valuation. Dolphin Research will conduct a detailed discussion in the in-depth study of Duolingo, so please stay tuned.

The following is a detailed interpretation

1. Strong user growth and increased stickiness

In Q4, the total user scale MAU grew by 32% year-on-year, with a net increase of 3.6 million quarter-on-quarter, approaching 117 million, while user stickiness DAU/MAU further increased to 34.7%. According to Sensor Tower's monthly download and MAU data, there was a significant acceleration in December, likely stimulated by the marketing campaign to learn Korean in conjunction with "Squid Game 2." However, the TikTok refugee event in January, while it temporarily spiked user downloads and activity, did not result in an overly unexpected increase. On one hand, TikTok quickly paused its ban, and on the other hand, the learning threshold for Mandarin is indeed relatively high for users from Europe and the United States.

2. Subscription revenue is the only bright spot, while other business growth continues to slow down

Q4 subscription revenue grew by 50%, driven by both volume and price.

1. At the end of the period, the number of paid subscription users reached 9.5 million, a year-on-year increase of 32%, with a net increase of 900,000 quarter-on-quarter, and the overall payment rate slightly increased to 8.4%, slightly exceeding market expectations.

2. The per capita subscription fee in Q4 finally returned to growth at 2.7%. Previously, the penetration of the Family plan (with a family plan calculated for 5 people, the per capita payment is only 30% of the Super individual plan) and the faster expansion of users in low-price regions led to a continuous decline in per capita payment.

The return to positive growth in Q4 is mainly attributed to the faster increase in the payment rate of the higher-priced MAX plan, or more users purchasing the video call feature separately. According to the financial report, MAX subscription users accounted for 5% of total subscription users, which is 450,000 people, and this penetration rate clearly exceeded institutional expectations.

In other businesses, growth further slowed to 5%. Other income mainly consists of advertising, English testing, and in-app purchases, with the revenue scale of the three sub-segments not differing significantly.

The performance of the sub-segments in Q4 still needs to wait for the annual report disclosure. Dolphin Research roughly estimates that both English testing and IAP purchases are still experiencing single-digit growth, with in-app purchases slightly higher. Advertising still has around 10% growth, but has clearly slowed compared to Q3.

Historically, except for in-app purchases, which may have a continuous expansion trend with user growth, advertising and English testing have many interfering factors beyond user scale, making the growth trend uncertain. Overall, the current other businesses are still unlikely to provide much support for future performance. The company's growth story can only rely on subscriptions.

3. Profit margins under pressure, healthy cash flow

The adjusted EBITDA in Q4 also only met buyer expectations, with gross margins under short-term pressure due to the incremental costs from Gen-AI brought by MAX (in Q4, MAX users already accounted for 5% of total subscription users), as well as the low per capita payment of the Family plan and the expansion into low-price international regions, which further declined to below 72% in Q4.

At the same time, operating expenses, particularly R&D and sales expenses, accelerated growth this quarter. R&D expenses may be driven by a "low base + increased R&D investment," while sales expenses may be related to the Super Bowl advertising in November and the marketing collaboration with "Squid Game 2" in December.

In addition, the company mentioned that the founding team has a previously agreed one-time incentive, which accounts for about 15% of the Q4 equity incentive expenses. However, for high-growth companies, we generally focus on the adjusted EBITDA after excluding the impacts of SBC, other income, interest expenses, etc., so the short-term impact of the founder's incentive does not require too much attention.

Overall, the proportion of SBC to revenue has slightly improved quarter-on-quarter. SBC is mainly composed of incentives for R&D and management personnel, primarily relying on official designed marketing activities, social media communication, and word-of-mouth channels for customer acquisition, without needing to rely heavily on the scale of the sales team.

From the guidance, the short-term pressure will continue, so the pace of profit margin improvement will continue to slow. The gross margin is still affected by the aforementioned Gen-AI costs, but operating expenses seem to maintain high growth. Dolphin Research expects R&D investment to remain high-speed, followed by marketing expenses, which may be related to the "Revive Duo Action" in February, leading to some incremental expenditures. Other reasons can be focused on the management's explanations during the conference call.

The prepaid business model of streaming media has always been favorable for the company's cash flow, and Duolingo is a platform that mainly consists of annual memberships (with significant discounts for annual payments), and it does not require frequent investments in new content production like long videos; otherwise, subscription users may fluctuate.

The question of whether users are loyal to content or the platform is not a major concern for Duolingo, as it is clear that users are primarily loyal to the platform. In this case, Duolingo's cash flow advantage will be more apparent, even though it has a natural disadvantage of low per capita payment and payment rate. As it gradually enters a mature stage of development, it can leverage its competitive advantages to incorporate more course content into paid rights, achieving a price increase effect indirectly.

Q4 free cash flow grew to $88 million, with the revenue ratio increasing to 42%, further highlighting the advantages of the business model. At the same time, it indicates that the impressive subscription business revenue is the absolute cornerstone for maintaining a strong free cash flow situation. Especially with a focus on more cost-effective annual paid memberships, it essentially means that the company has pre-collected a significant amount of revenue, thereby releasing more free space for cash flow.

Risk disclosure and statement of this article: Dolphin Research Disclaimer and General Disclosure