Duolingo, Inc. Q3 FY2023 Earnings Call

Good evening, everyone. If you haven't accidentally tuned into a replay of Duocon, this is actually Duolingo's Third Quarter Earnings Webcast. Today after market closed we released this quarter's shareholder letter, a copy of which you can find on our IR website at investor.duolingo.com. On today's call we 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 and all attendees are in a listen-only mode. And just a reminder we will 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 in 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 will 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 now, I will turn over to Luis.

Thank you, Debbie, and welcome, everyone. We had another fantastic quarter. We surpassed our expectations and had impressive user bookings and revenue growth. It was a fun quarter with the Barbie campaign and also preparing for our Best Duocon. We also feel very good about the coming quarter, which is why we're raising our full year guidance to now reflect 40% year-over-year bookings growth. We're also materially raising our full year adjusted EBITDA margin. Matt will share more details on our results and outlook shortly. Every year we run thousands of experiments to make our product more fun, engaging, and effective. A lot of these experiments result in small wins that add up over time. If you look back at the past two years, you can see evidence of this in action. In Q3, 2021, we had about 10 million DAUs. This past quarter we had over 24 million. In Q3 of 2021, we had 2.2 million subscribers. In this past quarter, we had nearly 6 million. We’ve also hit some exceptional home runs. Our partnership with HBO's House of the Dragon and most recently our Barbie social campaign built around the inclusion of our trademark Bing in the Barbie movie generated 140 million organic social impressions, which is a record for us. To create opportunities for both incremental improvement and home runs, we occasionally make bolder moves that open up entirely new areas for experimentation. For instance, last year we redesigned the home screen of the app to give us more room to experiment with engagement, efficacy, and monetization. Earlier this year we set out to create a multi-subject app experience by integrating our existing math course and a new music course into our flagship app. This change is intended to give our users an even more engaging experience. By adding new subjects into the main app, we believe we can more rapidly scale these new subjects with our gamification mechanics like streaks, leaderboards, and quests that have been so effective in the language learning app. As more users access these new courses, we believe it will increase the commitment to our platform and that they'll be more likely to recommend us, which will further drive organic user growth. Our strategy is clearly resonating, as demonstrated by our exceptional growth. While we can't expect to accelerate forever, it’s gratifying to see that our product improvements and creative marketing efforts resonate with our learners. I'm excited about our ongoing innovation and look forward to all the energy that the new year brings. Now I'll turn it over to Matt.

Thanks, Luis. I'll walk through how we did this quarter in more detail and then I'll provide our Q4 and updated full year guidance. As Luis shared, we are extremely pleased with this quarter's performance, which exceeded our expectations, thanks to continued strong execution. Our DAUs increased 63% year-over-year to 24.2 million, and MAUs increased 47% to 83.1 million. This growth continues to be not only rapid but also high quality and broad-based, with strong growth from around the world and improving free-to-pay conversion as well. Our total paid subscribers increased by 60% to 5.8 million. This continued strength in user and subscriber growth drove bookings and revenue growth of 49% and 43% year-over-year respectively or 48% and 42%, on a constant currency basis. Turning to profitability, we've made tremendous progress in expanding the bottom line, as we continue to see a very strong top line growth coupled with cost discipline. Our net income totaled $2.8 million compared to a net loss of $18.4 million in the year-ago quarter. We also posted an adjusted EBITDA of $22.5 million, or a 16.3% adjusted EBITDA margin, which is a roughly 14-point expansion year-over-year. This quarter, we capitalized additional R&D expenditures compared to Q3 last year, as we continue to innovate on Math and Music. Excluding this would have led to an adjusted EBITDA margin expansion of about 12 points year-over-year. Based on our strong results and the trends we're seeing so far, we feel confident about raising our full year outlook, issuing the following Q4 guidance. For Q4 2023, we are guiding to $167 million to $170 million in total bookings, $145 million to $148 million in revenue, and an adjusted EBITDA margin of 19.8% to 20.8%. For the full year 2023, we are raising our guidance to $598 million to $601 million in total bookings, $525 million to $528 million in revenue, and we are updating our adjusted EBITDA margin range to 16.6% to 16.9%. Our full year guidance calls for 40% and 42% year-over-year bookings and revenue growth, respectively at the midpoint. As a reminder, at the end of every December, we start a promotion that discounts our annual subscription. Since we offer this promotion only once a year, Q4 bookings performance has more seasonal variance than other quarters. Note that our guidance assumes current prevailing foreign exchange rates as well. Because we've achieved significant operating leverage this year across the business, we feel good about raising our full year adjusted EBITDA margin guidance by about 225 basis points at the midpoint versus our last call. Now I'll provide some color on average revenue per subscriber, OpEx, and share count. Our average revenue per subscriber has declined by about 7% to 8% for each of the past three quarters driven by a combination of foreign exchange impacts and regional mix shifts. Q3 saw higher-than-expected conversions in non-US countries, which kept the year-over-year change in that same range. We expect the year-over-year change in ARPU to improve in the coming quarters. As to OpEx compared to Q3 of this year in Q4, we expect non-GAAP R&D as a percentage of revenue to decrease by two points and non-GAAP sales and marketing to decrease by almost 2.5 points. We expect non-GAAP G&A to be roughly flat as a percentage of revenue in Q4. We ended the quarter with approximately 48.8 million fully diluted shares outstanding using the quarter end closing price, and we expect to end the year with about 1% to 1.5% dilution from equity issued to employees. Finally, as Luis mentioned, the last years have been extraordinary for our business. Our user growth has benefited from compounding continuous product improvements, including home run improvements like we've seen with our street mechanic. We have unlocked social-first marketing and have had some big brand moments like the Barbie movie, and we've also seen large increases in conversion from free to paid versions. Looking ahead, we feel very good about next year. However, as Luis has already reminded you, our user growth is unlikely to accelerate forever, and it may be hard to repeat some of the one-time events that have happened this year. Even so, we feel good about our ability to continue our strong top line growth and make progress towards our long-term margin. Now I'll turn it back to Luis.

Thanks, Matt. Just want to thank the team for all their hard work and dedication. We know we've only made a tiny dent in the massive market opportunity ahead of us and we're just getting started. We would be happy to take your questions. I'll turn it back to Debbie to manage the queue.

Thanks, Luis. Your first question comes from Ralph Schackart at William Blair.

Good afternoon. Thanks for taking my question. Maybe let me start with you. I've been public for a couple of years now and you've seen some extraordinary growth. Some of this has been based on conservatism and the outperformance, and the business is obviously doing really well. Maybe just taking a step back, if you isolate maybe the top one, two or three things that have really driven this significant outperformance, that would be really helpful I think for investors and then I have a follow-up after that.

Well, thank you for the great question. Yes, we've had really good growth, and honestly, it's exceeded our expectations. The main two things that have made us grow so fast are first, product improvements. We run hundreds of A/B tests every quarter and they compound. Our product is significantly better than it was two years ago. The second biggest factor is we've greatly improved our marketing. The combination of these improvements has allowed Duolingo to strike a chord globally. It's worth noting that part of the reason we've exceeded our expectations are events we couldn't have predicted, like Duolingo being featured in the Barbie movie or appearing in SNL skits. It’s a combination of these factors that has contributed to our success.

Great. And then maybe Matt, in the prepared remarks you talked about potential ARPU improvement. As you’re approaching two years since making some price adjustments in Europe, can you give some color on how ARPU may improve going forward? Thank you.

Yes, thanks Ralph. ARPU has been impacted by foreign currency, which is hard to predict. The price adjustments we made were in Q2 of 2022, and this impacted bookings in that quarter and flowed through to revenue. This quarter, some effective experiments we ran drove free-to-pay conversion outside the US and kept ARPU range bound for now. We remain optimistic about improvements, especially as we start to lap those pricing changes and continue experimenting with pricing while adding value to the product.

Next question comes from Justin Patterson of KeyBanc.

Great. Thank you very much, and good afternoon. I appreciate the call out on experiments in the letter. Luis, as you've expanded the range of products in the core app to include music and now math, how should we think about the pace of experiments and A/B testing ramping up to optimize these new elements within the app? And for Matt, the incrementals in the business remain attractive north of 50% margins within the Q4 guide. As you're considering 2024 budgets, what are the key investment areas you’re focusing on to keep driving this healthy growth going forward? Thank you.

Thank you, Justin, and excellent question. Regarding math and music, we decided the best strategy was to integrate both into our main app. This gives us the opportunity to leverage positive changes made to the main app for engagement and monetization immediately. That’s why we believe we can grow these courses much faster than if they were independent apps. I should caution that our short-term focus is on ensuring the math and music courses are comprehensive and effective. They haven’t been launched yet, but they will be available to all our iOS users starting tomorrow. Once launched, we will concentrate on those courses. In the long term, we aim for Duolingo to be known not just for language learning but also for math and music learning.

To follow up on budgeting for 2024, the amazing aspect of our business remains that we are still early in the opportunity for the core app. The majority of our investment will be focused there. We invest primarily in three areas: growth, monetization, and learning improvement. These will continue to be our focus, just like this year. We will layer in investments for math and music, but the core business remains our primary focus for investment.

Thanks, Justin. Next question comes from Ryan MacDonald of Needham.

Thanks for taking my question. Congrats on the positive quarters. Luis, with the integration of math and music into the core app, how do you see the experience for learners changing based on their subscription status? How does the engagement of MAU to DAU develop over time?

Thank you for the question, Ryan. In terms of monetization for math and music, think of them as if they were another language course. Everything that applies to language courses applies here. A free user will see ads at the end of a lesson just as with a language. We plan to enhance premium subscriptions with additional features for math and music similar to our language offerings. However, it’s vital to remember that while math and music are exciting, the majority of our business still focuses on language learning, where we have ample room for growth.

That's helpful. A follow-up for either Matt or Luis. In the shareholder letter, you mentioned about your paid advertising experiments that led to a notable increase in users on the platform. Can you provide more detail on what you did differently this year? Thanks.

Certainly, there are several factors at play. We’ve become better at crafting our messaging in ads. Moreover, being in a position where we have users across nearly every country allows us to shift budgets effectively between regions based on conversion rates. This flexibility has increased our effectiveness. However, it's crucial to underline that the majority of our users come in organically, and our marketing budgets remain relatively small.

Thanks, Ryan. Your next question comes from Zach Morrissey of Wolfe Research.

Great. I wanted to dive deeper into user growth. You've mentioned improvements in retention effects in previous years specifically concerning the current user retention rate. Do you believe that the growth this year stems mainly from retention improvements? Looking ahead, what is the potential for further enhancements in retention to sustain growth? On the competitive landscape, especially considering Google’s recent developments, how do you perceive Duolingo's competitive advantages standing against larger platforms?

Great question. For user growth, we believe that improvements in free user retention are the primary drivers, comprising more than 50%. Other marketing factors play a role, but retention improvements are crucial. We expect to continue identifying areas for enhancement in retention. Regarding competition, especially with Google's recent entries, we admire their work but don’t see them as a direct competitor. Instead, we're focused on delivering motivation to our learners, which is something we excel at that others struggle to replicate. Our product remains engaging, which we believe is our strongest market differentiator alongside our growing brand recognition.

Very helpful. Thank you.

Next question comes from Alex Sklar, Raymond James.

Great. Thank you. Luis, this is a bit of a follow-up to Justin's question regarding your product catalog. I want to understand if there's an ideal number of subjects that you target within the main app. And how you plan for future content expansions, organic or inorganic. Do you plan to keep it all in one primary app, or is there potential for multiple apps?

I understand your question. Regarding expansion, we will not be adding more subjects other than math and music for now. We are committed to ensuring their success in the main app first. We believe in providing subjects where repetition is essential for learning. Therefore, for the time being, we've decided to focus on math and music. As for future considerations, we're prioritizing making these options fruitful before exploring more subjects.

Next question comes from Andrew Boone at JMP.

Hi, guys. Thanks for taking my question. Luis, can you provide an update on Max? After watching the developments related to OpenAI, how do you view text-to-speech integration? What prevents that from being implemented in Duolingo? How do you envision Max evolving with these advancements?

Thank you for the question about Max. We announced Max earlier this year, which is a higher-tier subscription. In Max, we included features like role play and explain my answer based on generative AI. We're currently rolling them out to a broader user base, and we're pleased with their effectiveness. Costs for AI features have also decreased, and over the next few months, we'll likely shuffle features between the tiers to maximize user value and revenue without isolating AI features to just the highest tier. Regarding text-to-speech, we have our own system that we use for character voices and for now, we plan to continue with it unless we find OpenAI’s offerings to be significantly better.

Just a follow-up regarding conversational tools, how are you thinking about evolving the user experience to feel more like one-on-one tutoring in Duolingo?

We are indeed working on features to create a more conversational experience in the app. While I can’t disclose specifics, you’ll see us rolling out features that make the learning experience feel more interactive and reflective of one-on-one tutoring in the near future.

Thanks, Andrew. Next question comes from Arvind Ramnani at Piper.

Thanks. I had to compete with Justin for the best Zoom background, so here I am. I wanted to ask about your product development roadmap. You have options in enhancing your core language and adding skills like math or music on the side. How do you prioritize product enhancements versus expansion?

The majority of our efforts are focused on core language learning. We are the leaders in this category and believe there’s significant growth potential left to explore. While math and music are important, the majority of our focus is on improving our language offerings. Integrating these new subjects improves the overall app and allows for faster growth.

Are there any gating factors for investing? Is it balancing profitability against opportunities and resources?

Our primary gating factor remains the timeline to develop quality products rather than resources. It generally takes time to develop a product effectively, and adding more people does not significantly accelerate the process. Timing is critical.

Next question comes from Mark Mahaney at Evercore.

Thanks. Two questions please. First, any thoughts on expanding into skill-game categories like chess? And second, could you give us insight into the sources of MAUs and subs, specifically geographic trends?

Regarding skill-based games, such as chess: while interesting, we're focused primarily on education. Our interest lies in pure educational content. Regarding the sources of our growth, we've experienced broad-based growth internationally. The high level of MAUs is consistent across different regions and remains robust.

Our growth across MAUs and subs has been geographically diverse, maintaining high quality. While user growth varies, there are no fundamental changes from a few quarters ago regarding our subscriber demographics.

On the balance of profitability and growth investments moving forward, are there risks in lack of investment opportunities?

We are successfully balancing profitability with necessary investments. Historically, tech companies show a significant jump in profit margin in their first year of profitability, which is what we're aiming for. We're hiring and investing in product development even while increasing profitability.

We consistently prioritize growth and investment opportunities in our R&D without constraints due to resources. We have not limited projects because of hiring constraints or profitability desires.

Your next question comes from Curtis Nagle at BofA.

Thank you for taking my question. Luis, you spoke about the free-to-pay conversion trends across different regions. Could you elaborate on that success this quarter?

Our success stems from multiple experiments around the world, optimizing how we convert free users to pay. We refined our messaging and the internal hooks to entice users, which enabled significant growth this quarter.

Just a quick follow-up on dilution. You mentioned a 1% to 1.5% dilution rate. How will that differ from previous estimates?

The changes in dilution stem from hiring plans and better-than-expected stock performance and its impact on treasury stock method calculations.

Your next question comes from Chris Kuntarich at UBS.

Regarding payer penetration, how much is urban and repeat in terms of market behavior compared to experimentation with unknown factors?

While there are regional differences in payer penetration, most improvements come from optimizing our broader strategies. Adjustments made can benefit all markets in some ways. However, different tactics resonate more strongly in wealthier versus less affluent markets.

The follow-up: on ARPU trends, may we venture an estimate of low single-digit decline for revenue per subscriber?

The trend remains consistent with prior indications. While we anticipated some improvement, our current circumstances—particularly our recent experiments—drove ARPU to remain steady for now.

I’m not showing any further questions. I will now turn it back to you, Luis, to wrap up.

Thank you, everyone, for your great questions. We look forward to seeing you next quarter.