Duolingo, Inc. Q1 FY2023 Earnings Call

Good afternoon and welcome to Duolingo’s first quarter earnings webcast. My name is Debbie Belevan, Head of IR. Today after market close, we released our quarter-end shareholder letter with our Q1 results and commentary, which you can find on our IR website at investors.duolingo.com. On today's call, we'll have Luis von Ahn, our Co-Founder and CEO; and Matt Skaruppa, our CFO. They'll begin with some brief remarks before opening the call to questions. Please note that this event is being recorded. Just a reminder that we'll make forward-looking statements regarding future events and financial performance, which are subject to material risks and uncertainties. Some of these risks have been set forth in the risk factors of our filings with the SEC. These forward-looking statements are based on assumptions that we believe to be reasonable as of today, and we have no obligation to update these statements as a result of new information or future events. Additionally, we'll present both GAAP and non-GAAP financial measures on today's call. These non-GAAP measures are not intended to be considered in isolation from, a substitute for or superior to our GAAP results. And we encourage you to consider all measures when analyzing our performance. And with that, I'll turn it over to Luis.

Hello, everyone. Thank you, Debbie, and welcome. I'm proud to report that we kicked off this year with another great quarter. We had strong user growth, top line results, profitability and free cash flow. In the first quarter, our user growth exceeded our expectations. DAUs increased 62% year-over-year to 20.3 million, with all major markets growing nicely. Our strong user growth, of course, helps us deliver on our mission to create the best education in the world and make it universally available. But it also helps us increase paying subscribers, which are up 63% year-over-year to 4.8 million or 8% of MAUs at quarter end. This user and subscriber growth led to bookings and revenue climbing 37% and 42% year-over-year, respectively. And thanks to our continued financial discipline, this quarter saw us post our highest profitability ever. As a result of this outperformance, we're raising our top line and profitability guidance for this year. Matt is going to walk you through our updated outlook shortly. I've said many times before that the hardest thing about learning a language is staying motivated. That's why I'm proud that our engagement numbers continue to improve, with our DAU to MAU ratio reaching an all-time high of 28% compared to about 25% a year ago. And the number of DAUs with a streak longer than 7 days grew to nearly 14 million. Our goal is to keep learners coming back to our products every day, and we mainly do that by continually innovating and improving them so that they are fun and effective. This quarter's shareholder letter focuses on how well the recent advances in generative AI complement our existing competitive advantages like our data moat, our beloved brand and our unique way of teaching. As a former Computer Science professor, I've always believed that humans and computers working together can accomplish incredible things, and applying this synergy to benefit the greater good has long been my passion. I also feel very fortunate to be among the companies with the best chances of taking advantage of the rapid advances in AI. As you'll recall, last quarter, we announced our new higher-tier subscription offering, Duolingo Max, which is powered by GPT-4. We are proud that we are one of the few companies that have launched a live consumer-facing product with this technology. That we did this so quickly speaks to the talent of our team. Also last quarter, my shareholder letter reminded everyone that our freemium business model enables us to grow organically, keeps competitors at bay and provides us with enormous amounts of data that we use to make our products better. Because of our large user base, we're able to test Max features on small fractions of users and iterate rapidly. This is a great example of how our model works in general and how we'll use generative AI in particular. As you can tell, I'm very excited about all the possibilities I see with AI and Duolingo Max, but I should emphasize that we're still in the early stages of rolling Max out. We'll continue to update you about the progress we're making over time. And with that, I'll turn it over to Matt.

Thanks, Luis. To recap our impressive results, in the first quarter, we delivered 37% bookings growth year-over-year, which was about 42% on a constant currency basis. We had a net loss of $2.6 million compared to a net loss of $12.2 million in the year-ago quarter. And we posted our highest quarterly adjusted EBITDA of $15.1 million, which was a 13.1% adjusted EBITDA margin. We also had our highest quarterly free cash flow margin of about 25%. Based on the strong start to the year, we feel very good about our Q2 and full year outlook. For Q2 2023, we are issuing guidance of $128 million to $131 million in total bookings, $122 million to $125 million in revenue and an adjusted EBITDA margin of 11% to 12%. And for the full year 2023, we are raising our guidance to $552 million to $561 million in total bookings, $500 million to $509 million in total revenue, and we are updating our adjusted EBITDA margin range from 11% to 12%, which reflects an incremental margin of about 32%. Because of the strong trends we saw in Q1, we are guiding to continued strong top line growth, with bookings growing at 30% year-over-year at the midpoint and revenue growing at 37% at the midpoint. The combination of strong top line growth and continued discipline on operating expenses is why we feel good about raising our adjusted EBITDA margin guidance at the midpoint. In Q2, we expect each non-GAAP expense line item to show operating leverage year-over-year with R&D showing about 1 point of improvement as a percentage of revenue, G&A showing about 3 points of improvement and S&M showing about 1.5 points of improvement. I know that the S&M line would show about 2.5 points of improvement, but for the roughly $1.5 million of S&M spend, there was time shifted from Q1 of this year into Q2. As to the seasonality we expect for the rest of the year in adjusted EBITDA, we are guiding to an 11% to 12% adjusted EBITDA margin for Q2. Our Q3 margin will be lower than Q2, and that's the quarter in which the largest portion of our new hire start. And then in Q4, the margin will expand because that quarter is typically our strongest revenue quarter. We don't expect a material step-up in costs between Q3 and Q4. As Luis mentioned, we are excited about Duolingo Max, but we are still in the early days of rolling it out. We have not yet included any material amount of bookings or revenue in our guidance for this new higher tier. We will keep you posted on the progress in the coming months. Finally, we ended the year with approximately 48.3 million fully diluted shares outstanding using the quarter end close price. And as we mentioned on the last call, we expect to end the year with about 2% dilution from equity issued to employees. And with that, I'll turn it back to Luis.

Thank you, Matt. And I just want to take this opportunity to thank our amazing team whose collective passion and commitment to excellence helped us deliver another excellent quarter. And now we would be happy to take your questions as long as they're good. I'll turn it back to Debbie to manage the queue.

All right. Thanks, Luis. So our first question comes from Mark Mahaney of Evercore.

I hope this question is good. We haven't discussed one of my favorite topics, which is Math. Could you talk about the early interest you are seeing in that? Additionally, could you address the China market? It seems to have fluctuated, but it appears to be strengthening. How much has that contributed to your monthly active users and, if at all, your paid subscribers?

Well, thank you for the questions, Mark. Of course, Math is also one of my favorite topics. As you know, we launched a Math app to learn Math a few months ago. It's doing really well. It's growing entirely organically, and it's growing very nicely. I should mention, of course, this is still the very early days and it's still also a very small team. So we're just basically have a long list of features that we still need to add and we're working on doing that. I don't know if there's anything else to say other than I'm loving using it. And very soon, there's actually going to be more content in it, more advanced content. So we're very happy with that. In terms of China, we're also very happy with our progress in China. It's one of our fastest-growing countries. I should remind people, though, I mean, yes, China is one of our fastest-growing countries, and we seem to be doing well, but it is still a small market for us. It's probably 2% to 3% of our revenue, give or take, but it's growing very nicely, and we're very happy with it. Thank you, Mark.

Next question comes from Justin Patterson of KeyBanc.

Great. Two, if I can. First, just a big picture one. We've seen a lot of companies in gaming, in dating, about monetization and engagement. Could you talk a bit, Luis, about just some of the guardrails you have in building product in a way where monetization initiatives don't necessarily impede the monetization or impede the consumer experience? So that would be the first question. And then since you alluded to it in your prepared remarks, would love how you're thinking about just leveraging AI more over the future? Whether that's something that investors should think of as just broadening the set of educational apps that Duolingo can participate, so even moving beyond math over time. So even just building deeper, more immersive experiences and existing apps. So moving up from what might be a casual learning experience to really gaining mastery of a competency.

Thank you for your questions, Justin. Regarding monetization, I’d like to explain how we develop our products. We enhance our offerings by conducting numerous A/B tests—hundreds every quarter. Each test usually aims to improve specific aspects, such as monetization, engagement, or learning outcomes. We establish clear goals for each test. For instance, if a test intends to boost monetization, we might try making the subscribe button larger. However, we also monitor guardrail metrics, ensuring that any changes do not negatively affect user engagement or learning effectiveness. If having a larger subscribe button leads to users spending less time on the app, we would not proceed with that change. This approach has proven successful for years, allowing us to grow monetization without diminishing user engagement. We believe user engagement and growth are crucial as they lead to positive outcomes, including the potential to convert free users into paying subscribers over time. On the topic of AI, I am very excited about its potential. Since our launch, our goal has been to create a product that teaches as effectively as a human tutor but is more scalable and cost-effective. We have been employing AI since the beginning to enhance our teaching methods. We analyze the vast number of exercises our users complete—around 1 billion daily—to refine our teaching strategies, particularly ensuring that users receive the right exercises at the right moment, aided by our advanced model called Birdbrain. Recently, with the rise of generative AI, we have started to develop new features that leverage this technology, which acts like having a proficient writer available. For example, we introduced two new features within our Duolingo Max subscription: one that provides clear explanations when users make mistakes, and another that allows users to role-play real-life scenarios for conversational practice. We aim to use AI to closely replicate human-like teaching and will continue investing in enhancing our Math app and Duolingo ABC. The goal is to generate content more efficiently and affordably while improving our teaching and engagement levels.

Yes. And just to jump in there, Justin. I think the one additional point I would make that I think is our not-so-secret weapon is Luis on this. You can tell by his answer there how excited he is. I mean it's really been a dream of his to have this type of technology so you can teach in this way. I mean he really wrote his PhD thesis on how humans and computers could work better to learn better together. So it's just a moment in time. We're pretty lucky that he's leading us through this. That's great.

And your next question comes from Ralph Schackart of William Blair.

I'm just curious on DAU to MAU is strong yet again and saw further reacceleration in the quarter, which is really impressive. Just curious if there's anything you'd call out there driving that really strong growth once again. And then second question, I know you've been testing pricing in different international markets. Just curious what sort of trends you're seeing there and how users are responding to different pricing plans?

In regard to daily active users and monthly active users, our main product, the Duolingo language learning app, continues to become increasingly engaging. Our ratio of daily active users to monthly active users is improving, currently at 28%. This improvement is primarily due to the ongoing A/B testing that enhances user engagement. For instance, we have made our street feature more prominent and intuitive, and we have improved our social features to encourage users to invite their friends back. Overall, it’s a high-performing growth area that is enhancing our daily active users. We are focused on increasing daily active users because we believe daily engagement is essential for effective language learning. Simply put, you cannot learn a language by participating only once a month, and I anticipate this ratio will continue to improve. As for regional pricing, when we went public a couple of years ago, we had the same pricing model worldwide, which we realized was not the most effective approach. Over the past few years, we have experimented with pricing in various countries, and currently, our pricing aligns well with the GDP of most regions globally. The adjustments we made have positively impacted our bookings. While we appreciated the increase, it wasn't transformative. In wealthier areas like the U.S. and Europe, prices have generally remained similar, with only slight increases, whereas in less affluent countries, prices have dropped significantly, leading to a higher number of subscriptions. However, it's important to note that in these poorer countries, the digital subscription market is still developing, and many consumers may lack suitable payment methods. We view the price reductions in these markets as a crucial step toward monetization, but we recognize that more must be done over the coming years to achieve the same level of monetization as in wealthier countries.

Next question comes from Andrew Boone of JMP Securities.

One on Max. I would assume that Max is attracting a more advanced learner to the platform. Is that true? What are you seeing in terms of the type of learners that are actually adopting Max? And then secondly, just a broader question on LOMs more broadly. How do you think about this change in the competition for Duolingo? Are you at all concerned there? What comes top of mind as you think through that?

Thank you, Andrew. We're very pleased to have launched Max on the same day GPT-4 was announced. We moved quickly to release it, but initially, it was only made available to a small group of users. This is part of our product development process at Duolingo—we start with a limited user base, especially for complex features like Max, the home screen redesign, or the family plan. It typically takes us about a year to optimize these features with small groups before we roll them out to a broader audience. That’s the current status with Max. At this stage, we can't provide specific metrics for Max since we're still assessing its potential. However, there is significant interest in this higher tier, and we're pleased about that. As for whether it's attracting more advanced learners, we can't say for certain. Many people are purchasing it, but it's challenging to determine if they are more advanced learners. They might be more committed or have greater financial means rather than being more advanced, but that's hard to quantify. Additionally, I must note that we advise against including Max in forecasts since we ourselves are not incorporating it into our models at this time. It's simply too early to gauge its impact. Regarding language models and our competition, this is not a primary concern for us. We possess several advantages. Large language models are trained on vast amounts of generic information from the internet, but they lack specific insights into language learning that we have accumulated over time. Our data represents a substantial advantage—far larger than our competitors. Furthermore, even without modifying large language models, our distribution network is significantly more extensive than that of others. We also benefit from many other strengths, including an engaging product, a strong brand, and unique characters like our owl, which contribute to user retention. Therefore, competition in this area is not something we are particularly worried about. I hope that addresses your question.

Next question comes from Ryan MacDonald of Needham.

Congratulations on a fantastic quarter. Luis, building on that topic, as you consider the development of Max and its growth, one reason ChatGPT experienced such rapid adoption is that it was not only powerful but also free, allowing learners to experiment with it. As you plan to introduce features more widely with Max, how do you find the right balance between functionality and pricing, especially since Max represents a significant price increase compared to the core Super Duolingo?

Yes, that's a great question. Over time, we will determine which features belong in which tier. Right now, we're pleased with our standard free tier and the Super Duolingo paid tier that we've maintained for the last five years. We recognized that introducing a higher tier would benefit the business, and GPT-4 provided a good opportunity to do that. We now have three tiers and, moving forward, it will take us quite a while to decide where each feature fits best. While revenue is important, our primary focus is on growing our free user base, as that leads to wider benefits. If we find that certain features are better suited for the free tier, we will place them there. However, it’s worth noting that providing live access to large language models comes with significant costs. For instance, we partner with OpenAI and must pay for GPT-4. Therefore, we currently keep these features in the highest paid tiers to cover those expenses. In the future, we anticipate that the costs associated with accessing large language models will decrease, potentially allowing us to offer more features in the free tier. This is an evolving process, and it’s still too early to predict where these features will ultimately be positioned.

I appreciate the additional context. That was a good question. I apologize if I overlooked this, but what really caught my attention in the metrics was the significant increase in paid subscribers from one quarter to the next. If I missed it, I'm sorry, but was there a particular region or feature you believe contributed to that notable rise in paid subscriptions from the fourth quarter to the first quarter?

Our paid subscriptions have been steadily increasing since we launched them. This growth isn't due to a single factor; it's a result of becoming more effective at converting our users. We enhance the subscription by adding or improving features, and we also improve our marketing strategies to better understand when and how to promote the subscription effectively. Through various A/B tests, we continuously increase our subscriber numbers. This trend has been consistent every quarter, with noticeable growth each time since we became public.

Yes. Since we've been public, we've seen a nice trend up in conversion basically every quarter. So I think this recent quarter was just kind of continued strength in our conversion trends based on what Luis said.

Next question comes from Mario Lu at Barclays.

The first one is why is Love Language not a real TV show?

Listen, a lot of people have asked us for it, but we're focused on our main business right now. I believe if we had a vote, half the employees would want to make it a real show or even more.

Got it. You had my vote as well. The first one is on DAUs. You said it's a very important metric that you guys track. It accelerated in the first quarter. I guess any main drivers for this acceleration? I know you guys talked about compounding. But is this social media like TikTok, like newest promotion, anything to call out? And how should we think about DAUs for 2Q and rest of the year?

The primary reason our daily active users continue to grow is that our product keeps improving. We can track this progress, and it creates a compounding effect that makes it increasingly engaging. While that’s the main factor, there are additional elements to consider, like our marketing efforts. Our marketing team has really hit its stride by identifying which strategies work effectively. For instance, organic social media has proven to be very beneficial for us. TikTok is one example, but we also perform well on Twitter and Instagram. Overall, our brand aligns well with social media, and we focus on organic reach rather than paid advertising. We've also seen positive results from paid influencers, especially in certain regions, particularly in Asia and Latin America. Additionally, a small amount of performance marketing in lower-cost markets also proves effective. Together, these strategies have contributed to the acceleration of our daily active users. As for what to expect in the second quarter, I’ll let Matt address that. However, it’s encouraging to see our user growth accelerating over multiple quarters. Of course, it’s important to note that this trend won’t last indefinitely; we can’t expect to have sustained growth forever. At some point, we will reach our saturation point.

That was going to be my point is we feel really good about those 7 quarters since we've been public. It can't go on forever, and we can still have really strong user growth, even if it doesn't accelerate. So it's not a requirement that things accelerate, just we want that to stay strong, and we like the trends so far in this year.

Great. And then just one more on gross margins. If we look at COGS, I assume a big portion of it is app store fees. There's this new ruling from the Apple vs Android court case where apps can now go direct to consumer, if you will. I guess what is Duolingo's strategy in terms of potentially going to direct-to-consumer and kind of expanding gross margins out of it?

Yes. Historically, we've clearly recognized the app stores as valuable partners. As Luis pointed out earlier, one of our advantages is our extensive distribution, which is partly due to the app stores. Our margins on subscription products have increased because more users are remaining on our platform for over a year, which lowers our app store fees. This is our main approach to boosting subscription gross margins over time. Regarding exploring different avenues, while we have tried it in the past, it hasn't been a priority, and I don't anticipate it becoming one in the near future.

And the next question comes from Arvind Ramnani of Piper Sandler.

Thank you, Debbie. I see that all the important questions have been asked, so I’ll ask some less significant ones. I'm curious about the Duolingo English test. I realize it's not a major part of the overall narrative, but I believe it offers a good amount of potential if certain events align. What is the current status regarding acceptance from universities? You mentioned the British or Canadian government; are they significant factors that could help advance this?

Thank you for the question. We are very excited about the Duolingo English test. Personally, I'm thrilled about it as it offers significant optionality and complements the Duolingo language learning app. If we succeed with this test, it could help establish a standard score for language proficiency. Our goal is for people to identify their language skills by saying something like 'I'm a Duolingo 65' instead of just noting their years of study in a language. Although achieving this will take time, the Duolingo English test is a key component in giving that score credibility. Its growth is promising, currently accounting for about 10% of our revenue. However, its growth trajectory won't be as steady as that of our language learning app, which has a more predictable growth pattern. The English test is influenced by external factors such as its acceptance by governments and universities. We are making good progress with institutions in the U.S., Canada, Australia, and the U.K., and we're increasing the number of accepting organizations. Regarding government acceptance, we are working on getting the test recognized by the U.K., Canadian, and Australian governments, with the U.K. being the most significant. However, this process will take time, as they still need to issue a call for proposals for tests, which has yet to happen, and we cannot predict when it will be. This situation is beyond our control.

Yes, that's great. Can you share any metrics on usage or progress you've made regarding Math?

Yes. We're not sharing exact metrics yet, but we are very happy with the growth is what I can tell you. I mean it's growing very nicely. You can probably look at there's ways to track metrics external, and you can see that it's growing very nicely.

Next question comes from Nat Schindler of BofA.

I believe I'm the last one here, but Luis, as a computer scientist and language learning expert, you are the ideal person to address this question that I've been asked frequently lately. I've heard that this will happen, and I genuinely want to understand how the search box will enable me to learn French.

How can a search box like ChatGPT teach you French? Well, I believe there might be some individuals who could learn French just by asking questions in something like ChatGPT. For years, people have learned French by reading books. While some individuals can learn a language this way, the average person usually lacks the motivation or ability to effectively learn just by reading books. Most students don't even know what questions to ask when using a search box. Another significant challenge is staying motivated. We think this is the hardest part of learning, which distinguishes us from many educational companies. The technology to learn has existed for thousands of years, in the form of books. You can learn nearly anything, even complex topics like quantum mechanics, by reading. However, most people chose not to because it can be boring. Therefore, maintaining motivation is crucial. With Duolingo, we aim to use tools like GPT-4 but combine them with methods to keep you engaged and guided. Learning without guidance is very challenging, similar to trying to learn math on your own, which most people tend to avoid.

I have a more serious question. How do I determine the size of your market? I understand that there are 1 billion people globally who are actively learning a foreign language. I would estimate that half of your current subscribers are in the U.S., most of whom are adults, and I'm confident that at least all of these individuals were not actively learning a language before using Duolingo. What would be the best approach to assess your market penetration? I'm observing the increase in daily and monthly active users and am curious about the potential trajectory of this growth.

It's a really good question to which the most honest answer is that we don't really know. I'll share what we do know. There are about 2 billion people in the world learning a foreign language, spending around $60 billion a year. We understand that a significant portion of our users in the U.S. were not previously engaged in language learning before Duolingo; 80% of them were not in the market. This shows that we are expanding the market. We make language learning easy and user-friendly, which keeps people engaged and feeling good about learning. It's challenging to predict where this will end, and while I wish I knew, what we do know is that there is plenty of room for growth. Currently, we have around 73 million monthly active users, while there are billions of people actively seeking to learn a language. So, even without market growth, there is still more potential. Again, we are indeed growing the market, and I wish I could provide a clearer answer.

And we have no more questions. So I'll turn it back to Luis.

Thank you for all the great questions. It is our aspiration to create applications that teach as effectively as humans can. This has been our focus, and we will continue to work towards it. This is the vision I have and the vision of the company. However, the most important takeaway I want to leave you with is a heartfelt reminder to please complete your language lessons today.