Chit Chat Stocks - Duolingo (DUOL) | Deep Dive

Episode Date: July 11, 2021

Duolingo, a private company planning to go public, is an education platform for language learning. The company offers plenty of courses covering 40 different languages. Listen closely as Brad, Brett, and Ryan go through the history, financials, and future prospects of Duolingo. Enjoy the show! Our Sunday Deep Dives are sponsored by Potential Multibaggers. Multis are looking for stocks that have the potential to go up 10x in 10 years. Check-out the service here: https://seekingalpha.com/checkout?service_id=mp_1308 Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Interested in more of Brad’s work? Follow him on Twitter: https://twitter.com/StockMarketNerd?s=20 Rather watch us on video? Subscribe to our YouTube channel: https://www.youtube.com/channel/UCG5Ni-SI-jyrEsoNUhqftNQ Contact us: [e-mail] Timestamps Company Background | (3:33) Industry | (7:36) Management & Ownership | (9:49) Earnings | (13:57) Balance Sheet | (18:58) Valuation Game | (19:36) Our Analysis | (21:40) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, host Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now, please enjoy this episode. Welcome in. This is the Sunday Deep Dive episode. We have Brad Freeman on the show. I'm here with Ryan Henderson, as always, and we're going to be talking about Duolingo. It is a new pre-IPO stock,

so we have the S1. We're going to play the valuation guessing game, but this was Brad's choice. This is a company you've researched heavily, and you actually have them as your first stock you researched on your new substack, which we'll make sure to link in the show notes. We'll put it under. It is going to be another good resource for listeners out there. But Brad, how'd you find Duolingo and what inspired you to write that substack? Yeah. And thank you. Thank you so much for mentioning it. I had a lot of fun writing it. So hopefully people enjoy reading it and are interested. But for Duolingo, I mean, someone, honestly, I've used the app for a few years and I just saw someone post the S1 on

Twitter. And that kind of led me into my deep dive down the rabbit hole on Duolingo. To be candid with you all, as I say nice things about this throughout the episode, I do plan to buy shares of the IPO. I have applied on Robinhood for pre-IPO shares. I agree the valuation is going to look like a guessing game. So I have no clue how large my initial purchase is going to be. But regardless, I'm going to make, I'm going to buy some. It could be a symbolic 5% of a full position if it gets ridiculous like it could, but just so you know, I will own shares. All right. And that's good to know. And Ryan, we're going to talk about Duolingo. We'll let you kick things off. But first, we have to talk about our flagship sponsor for the Sunday episode,

Potential Multibaggers. Yeah. So Chris runs Potential Multibaggers, the friend of the show. He's been on here before. We got a sign up a while back and it's someone that says like, oh, I never do services or whatever, but I signed up for this one. It's totally worth it. So kind of, if you're looking for anecdotal evidence, maybe a little confirmation bias, that push to go sign up. This anonymous account said he did, so you should too. But the service itself, actually, we found a lot of value in it. And the goal of it is to find stocks that can 10X in 10 years. Do you kind of want to talk about some of his examples? Yeah. So he's got Shopify at 77, CloudFront at 39, plenty of other picks, Okta at 64. These

going to be high growth names sometimes and they might be a little bit riskier than your traditional you know s p 500 index fund but that's because they have tons of potential andy has a strong track record and you're not only getting the research app up front but you're getting updates from what he calls buy and verify he's constantly communicating to his members with him himself and then the team mark and strong that are under him as well and if you want to become a multi you can can go to Seeking Alpha and look for From Growth to Value. Google it or go to at From Value on Twitter. That is at F-R-O-M-V-A-L-U-E on Twitter. Check out the service. It'll help your research process. All right, Ryan, you want to introduce Duolingo? Yeah. So for anyone that hasn't

looked at the app before, Duolingo's mission is to develop the best education in the world and make it universally available. So basically, it's a mobile learning platform. And right now it's tailored specifically to learning new languages, although we'll get into some of the other parts of the business. So their flagship Duolingo app has more than 500 million total downloads and 40 million roughly monthly active users. So basically the way it works is you download the app, you make an account, you say what language you want to learn, you give them sort of your general skill level. So for me, I said, I went in, did it, said I want to learn Spanish instead of a beginner. And then whoever the user is, they go through various

lessons and the lessons include verbal and visual tools. And basically you just progress over time and it's done in bite-sized lessons. So the goal, you set your goal, let's say 10 minutes a day, and they'll give you a push notification to say like, hey, log in, get your 10 minutes, your one lesson whatever it is um and they just really break it down into easy digestible ways of learning uh and brad said he's been on it i've been on it i enjoyed it um and it's been fun to do it that way they have over 40 different languages and they operate a freemium model so learners that are using duolingo for free receive an ad at the end of each lesson and users who subscribe to Duolingo Plus get it ad-free, and they get access to some additional features.

About 5% of their monthly active users were paid subscribers. Other elements of the business, they also offer something called the Duolingo English Test, which is just an assessment of people's English proficiency. And so it costs $49 to take, and this is not like a subscription service. It's on demand. And so I believe these are done over the desktop, not over your mobile phone. reason they provide this is because because a lot of people well the management team is they had to learn english at one point and so they kind of i think they had this in the back

of their minds when they started i imagine but a lot of people need to be proficient in english because the opportunities it can afford so university admissions work visas job applications things like that kind of require a proficiency exam an english proficiency exam maybe it helps I believe it's required. And right now the existing ones are terrible and they're costly. And especially in developing countries, there's some where not every city has a test center. And so you have to travel. So you'll not only have to pay $200 to take the test, you got to travel to get to the test center to take the test. And it can just be a real pain. So Duolingo has done this all online and Duolingo's test results are accepted by over 3000 higher ed institutions.

There was a 1500% increase in Duolingo's English tests taken this year because test centers were closed down. So that's kind of just another element. And then they state in their S1 that they want to become more of a diverse learning platform. So going beyond just languages to other subjects like reading, writing, math. And then I'll dive into the history a bit. It was founded by Luis Von Ahn and Severn Hacker. So they were both engineers prior to starting Duolingo. And Luis Von Ahn was a CS professor at Carnegie Mellon. Severn Hacker was one of his PhD students. and a MacArthur Fellow. I believe it was Luis Von Ahn that was the MacArthur Fellow. If you don't know what that is, it's basically, it's slang term is the genius grant. So it's where

recipients get a $625,000 stipend paid out over five years. So sounds like a smart guy. And then I believe Luis Von Ahn grew up in Guatemala and was fortunate enough to receive a good education. So that was kind of the reason or where the idea was conceived out of. He thought everyone could have access to that. So together they tried to build an intelligent learning system and the company was founded in 2011 where it looks like a $3.3M Series A to help them get started. And then since then they've raised another $180M in total. Sorry, that was long-winded, but a little bit of background and history there. Yeah, I'll hit industry and competition. Digital learning market is expected to be about $160B in 2019. Now these are third-party

estimates. And you should also remember there that that was pre-COVID. So some more estimates have it growing at a rapid rate over the next few years, something like 20% compound annual growth rate. Some people were estimating it would hit a trillion dollars by like 2030, but I think those are just clickbait headlines. Either way, it's a very large market growing rapidly. With Duolingo's unique product though, they're not only trying to take market share, but kind of build out their own um since they're not going after the i mean they are going after them the traditional learning centers and traditional school in general but it is through kind of a bank and almost a trojan horse type of deal and then within the app-based language market

so for stuff that is very similar to duolingo's product they have many many small competitors so one that gets good reviews online is called babble it is the 13th ranked on google play store versus number two for duolingo in the education category and then when i was scrolling through there it seemed like something called cake tango or other competitors this is something that's pretty easy to spin up you'd expect to just get maybe a few courses or something on there it doesn't seem like you'd have a giant need for a giant developer team but to get something as um diverse as duolingo with all the type of things on there you know it's almost you hate to use the netflix comparison but it's like there's a bit of an economies of scale where there's so many

different things that people want to learn that if you get an all-in-one platform then you'd maybe get some advantage over that so um it also competes with the traditional language learning and certification markets like schools and universities but again that is not direct and it's more adjacent and right now they may not compete with them directly but from that language they have in the s1 it seems like they're going to get closer and closer to competing with them in the future yeah they said they were 20 times larger than their next closest competitor yeah so no one's close but there are competitors out there rosetta stone or those are some older ones yeah but i mean that we joke that people kind of just know that as kind of a cliche but

it is a competitor uh for sure brad you want to hit management and ownership then if you have anything else on industry or history let us know uh yeah and i would just so in terms of of competition i'm reaching a little bit here and i'm stretching it out a little bit but also going back to reed hastings and how he sort of talked about everyone competing for eyeballs and screen time with us we see as competition so i'm thinking about like youtube and in places like that that are offering content um even curiosity stream which is a startup streaming service that i own um it's all competition it's intense and the opportunity is incredible so of course it's going to be intense but moving on to management and ownership um louis von ahn serves as the ceo

as we kind of talked about it's a really young team he's just he's just 42 years old at this point i'm skipping ahead through all the accolades that we mentioned before the founding he did lead recaptcha which is a fraud detection company purchased by google we don't have a ton of glassdoor ratings on him but what we do have is pretty positive with a 96 approval rating and just a quote that i pulled from a shareholder letter that that really um i guess hints at his passion for the project um this is him i plan to dedicate my life to building a future and with through technology every person can access the best education i love seeing things like dedicate my life when a founder is talking about his project um i know he has to talk up his book i

know i know he has every incentive to make the stock in the company seem incredible but i i do enjoy seeing that now was it uh was it too you know sometimes you know we saw that with peloton too i forget what their mission was but it seemed a bit audacious uh i don't know this is it's it's obviously pretty nice but it seems a bit broad to me it well yeah i mean i think they're going to progress kind of subject by subject and audience by audience i do it slowly but maybe i just get I have Elizabeth Holmes syndrome. I see stuff like that and I just get worried that someone's a bit crazy, but he seems incredibly smart. Yeah. I mean, it's there. Everything this company is doing is incredibly ambitious. It's worked so far, but I mean, as you hear everybody

say, past results are not a predictor of future success. So they're going to have to continue being successfully ambitious. But moving on to the second founder, Severn Hacker, he's just 36 years old. He founded this company and built the software for this company when he was 26. Pretty crazy. So he doesn't have I mean, his name is hacker. So yeah, so it's perfect. So he doesn't have a ton of experience outside of Duolingo, just because he basically got his doctorate and then moved on to Duolingo immediately, but he was an intern at Microsoft. So yeah, I guess that's some experience to mention. But so we talked about reCAPTCHA being purchased by Google. And kind of intuitively, there are several more higher ups from the executive board

that came from game development, product development, and engineering at Google. Also, one of the, or I guess moving on to ownership, one of the firms involved is Capital G. That's another word for Google Capital. So Google is a shareholder of this company. They are involved with their venture capital arm. Institutions own about 54.8% of the voting power,

and then Luis and Severin together each own 14.6% of the voting power for 29.2% combined. Interestingly, Ashton Kutcher and Tim Ferriss are also invested. I thought that was pretty cool. And then just a side note on share structure, it is, all this ownership is in class B right now and in class A is kind of what they're going to be offering the public. Class B comes with 20 times the voting power of class A shares. All right.

Yeah, that was a great overview. I'll say Tim Ferriss is nice. I like his podcast, but Ashton Kutcher, you know, he invested in WeWork. We might be, you know, I don't know, but no, I mean, he's invested in every company. companies. So I can't really, yeah. He's like, I'm going to put $10,000 in every single Silicon Valley company so we can go on CNBC together. But I will hit valuation, but I think we should probably go into the earnings first because we're going to do the valuation guessing game. I guess what people should know is the ticker is going to be D-U-O-L,

probably not on any of those things like Koi Fin or whatever, Yahoo Finance yet. But Ryan, you want to go through earnings first and then after that, actually we'll go through earnings and then balance it and then we can play that valuation guess again. Yeah. And I just took the 2020 numbers because it was going to get a little tough to trailing 12 months. So they did grow this quarter a little bit. It wasn't a huge, it's not a huge discrepancy between that and the 2020 numbers I imagine. So they had 162 million in revenue in 2020. I didn't jot bookings down here, but bookings tend to just barely exceed revenue in this case because it's the subscription nature and that's how they

have to account for it. And then 72% or revenue grew 129% year over year in 2020. They had 72% gross margins that ticked up about 1% from 2019. Negative 16 million in operating income. They are spending, they're investing through the income statement heavily. They spend about 40% of their operating expenses on research and development. And that's of a percentage of operating expenses? Yeah. Okay. And then they had about 14 million in free cashflow, but they're spending roughly 10% of revenue on stock-based compensation. So if you pull that back out, they're basically break even cashflow wise. And then monthly active users was

39.9 million as the most recent quarter. That was up 19% year over year. Although it's worth noting, we talked about this before the show for a while. There was a boost. We're pretty confident there was a boost right as COVID hit because everyone was talking about like, oh, you got to learn a language while you're locked down and something like that. I think that was a slight temporary boost and dropped quickly, and then it's come back up gradually. So if you go look at the video, there's like a Duocon video on YouTube. They might be a little small for Duocon. Let's get to a million in revenue. But they have a chart that shows they eclipsed 40 million users last year. So that's kind of why that happened was right after COVID.

And I'm thinking they had that video out, they chopped it off right in Q1 when they could have had one month of just amazing growth. But I mean, it seems like they've gone back to their long-term trend of this. Yeah. And they had 1.8 million paying subscribers. So that's up 64% year over year. And then subscribers as a percentage of monthly active users has gone from 3% to 4.5%. That's good.

And you obviously want to see that and you want to see more and more users start to convert. And then I just put this down here, but it's pretty standard earnings for a digital business where you're just investing heavily through the income statement and just powering up and try to grab market share fast by R&D. Yeah, we've hit free cash flow positive, but, you know, it's all from stock based comp. Not that that's a bad thing, but you can just dress it up. It's I don't think if they got lean, I don't think this is a business that would struggle to be profitable. No, no. It's not very costly. Yeah. And I think they only have 400 employees. So, and that can scale up rather quickly. 170 of them are engineers.

Not as good as robots. They have 79% of the whole company's engineers. But let's carry on. Balance sheet, Brad, do you want to hit that? That will play the valuation against the game. And before moving on to balance sheet and liquidity, kind of elaborating more on this whole concept of lean and profitability, they called out, which this was one of my favorite parts of their s1 that because of this massive scale that they've enjoyed they've they've achieved or they achieved in 2020 90 of their growth via organic means and that's not saying not via m a that's saying via word of mouth so they're they're only spending for 10 of their growth on external marketing as of right now that changed and new year's over 2020 they spent about

um a half of all the marketing dollars they've spent since inception on a new marketing campaign which boosted brand awareness but but they really have i mean they they've done this very efficiently yeah and i'll also add like i mean just think about the business model these languages aren't changing so as long as you have the you put in the upfront hours to build the catalog full of languages those costs shouldn't like scale with the business those should be really up front and so ideally there's a lot of operating leverage here yeah and then one oh gosh what can i say say there's one other note about that. Oh, they only started monetizing in 2017, I believe. So they've started in 2011, but they were basically funded by VCs until 2017. Is that correct, Brad,

do you think? Yeah. And then I'll head over to the balance sheet before we forget that. But they take a few years to monetize their products. So just as an example, the Duolingo ABC product, which we might get into later. It is a literacy program for kids aged three to six. They debuted it in 2020, and they are not planning on monetizing it for a few years. So they really like to collect this user data to run what they call these A-B tests, which is essentially just testing two different user interfaces and seeing how the users react. They like to do that for a long time for monetizing, and it's worked for them so far. So moving now into balance sheet liquidity and know that these numbers are going to change when

company ipos but as of right now it has 117 million in cash and equivalents this is almost all held in money market funds it has another 18 million in net receivables but but again this upcoming ipo is definitely going to bolster the cash position a lot since inception it's raised 183 million it says in debt and equity financing but it has zero interest expense so they have at least they have no current debt on the balance sheet um so pretty pristine i'd call it all right But yeah, quick balance sheet, really simple one, like a lot of these VC funding companies. But let's wrap things up here. What are guesses for what the valuation is going to come out at?

Brad, what are your thoughts? Yeah, I'm cringing here because I am the advisor to the IPO and I do think it's going to get crazy. But so I think General Atlantic, they raised funds at $2.4 billion last year or the year before that. It was pretty recent. And I think $5 billion is kind of a number that makes my jaw drop a little bit, but also a number that I could really see happening at the IPO. It's raised at that $2.4 billion price tag about

17 times gross profit. So you could double that and it would become one of the most expensive companies on the stock market. Yeah. Ryan, what are you? Yeah. I don't know because IPOs have been so wild lately. Well, it's called the guessing game. It's just a guess. You got to make a guess. Yeah. I think it's going to get a premium based on the numbers that I'm seeing on the S1.

I think it's an opportune time for them to go public. I think they did it intentionally before they hit these quarterly comps. So I'm going to guess, based on the S1 numbers, somewhere between $2 and $4 billion. $2 and $4? It's a wide range. I think that's low. I'm going to go closer to Brad's. I'm going to go $4.5 billion.

If you look at their bookings run rate, which if they have that bookings kind of trailing stuff, that could be great because I feel like a lot of people look at revenue numbers for gaming companies and that can really screw up. It weirdly is a simple opportunity for investors when the bookings are a lot different than the actual revenue. And just to say bookings is the cash they're actually bringing in. So a company that has to defer revenue like this, bookings is the real revenue number. And they're at about a $200 million bookings run rate. So at about $4.5 billion, growing this quickly, that seems about right for the IPOs out there. But you can see an inch up to $5, $6 billion. And then we saw globally way higher, UiPath way higher as well.

Depends how excited people get. But that's going to be the first half. Let's take a break. I'll get back to the second half of the show. Pluralsight, a tech workforce development company, provides the solutions high-performing engineering teams need to tackle today's biggest challenges. Whether it's building the skills individuals and teams need

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or when your kid downloads a song from a shady link and now all your computer can play is red color red color where are you all blocked thanks to advanced security included with cox panoramic wi-fi advanced security must be enabled in the panoramic wi-fi app restrictions apply Okay, welcome back. We're going to have anecdotal evidence up first. Brad, kick things off. Yeah, this is why I saw the Duolingo S1 and got so excited. I really like the product. I've used it for a while. I don't think I'm a monthly active user. I use it pretty sporadically, but I do get into it occasionally. I'm learning Spanish on it currently, and I was a Spanish student in high school. They did a pretty good job of figuring out how far along I was, and I

I think it's like five minutes. The experience really does feel gamified and that's what they're really going for. Trying to get people to enjoy education just a little bit more to get them motivated and excited about learning. We see Robinhood gamifying options trading and people yelling at them for that and rightfully so. But gamifying education seems a little more palatable to me. So I like the product. I like what they're doing and I'll probably continue to use it what would they have to do to get you to become a paying subscriber yeah honestly um this is one of one of the uh i guess big hesitations i have with the company and again i am buying shares so it's a it's a it's a big hesitation um comparatively but not all that big uh there's not

a ton of compelling features that that they offer for these subscribers uh it lets you skip through content but i don't really care about that personally um it lets you not see an ad every few minutes i don't care about that all that much personally so i think one of the big things going forward is them building out these unique features for subscribers to get them to continue driving growth i think they've gone from like four percent penetration last year to five percent this year so long long way to go um but yeah all right ryan anecdotal i completed my first lesson this morning so I am fluent in Spanish now but I like the approach

the app really is good it's well configured to teach and it does make it fun it makes me kind of want to go back and you can go ahead like on that Duocon video I went into the comments on YouTube and everyone had the exact same response

they all loved the app they all liked they all felt motivated again to learn and it's one of the only YouTube videos I've seen recently where it wasn't just troll comments like people genuinely liked the product so as far as customers go I think everyone kind of loves it yeah for all the things you hate about Robinhood for gamifying investing and personal finance you kind of invert it for Duolingo it seems like the best way to go about it using those tactics I'll just say I'm definitely going to try it out haven't used it yet enticed by that product

description seemed good for anyone but that the conversion to ping is definitely anecdotally kind of one of the red flags that came up in my mind uh future growth opportunities though brad what are your thoughts here yep and this this surprised me a little bit there they really i mean maybe not surprised but wouldn't have expected that they really focused on north america early on um and so that that international expansion is in the very early innings and very strong they didn't give us a number on the asian maus but it's up 130 year over here and i think and the company said this and i agree with them but the international value proposition is even stronger um than it is in the united states with over half of their maus learning english

in some other language and they call out how english learning is um powers economic mobility and in all these really deep connections and and i think i think it's safe to say that that's a more frequent ambition when when you have other countries that don't have english as their national language yeah north america you got that spanish influence where a lot of people are trying to learn english to get that proficiency test like we've talked about before but internationally there's a ton of people that are trying to learn english as their second language or for whatever reason as you know as americans we gotta say you guys gotta learn our language we're not learning anything else uh but no that's just joking uh ryan what is your future uh so duolingo abc this

is their app that's designed to teach early uh early literacy skills to children ages six or three to six um and it was launched in early 2020 and it shares the same tech infrastructure as their flagship app this is something they talk about a lot having the shared infrastructure between the english test the abc and then the flagship app allows them to innovate faster because there's less redundancies in the code and they can just go ahead and build out the more exciting parts and then this just feels like a really logical market to go after and if they're going to they aren't they haven't monetized this yet at all but i imagine it's the kind of thing where parents and this is kind of a hunch on my board on my part but parents want their kids

spending if they're spending time on a mobile phone this is what they want them doing and this is where gamification is useful really helpful um and so i imagine a freemium model would have a higher subscription rate as a percentage of users for kids um than maybe one for adults where it's language learning yeah definitely a safer environment than youtube there's always those issues with kids getting on youtube stuff like that the recommended videos what all happens there um i'll hit mine uh this is more of a tailwind i think they talk about it a bit but But with COVID-19, all the stuff that's happened with remote work, stuff like that, everyone knows about that stuff. But people moving around more and then the rise of Airbnb, people moving to places for a month at a time.

Now, that could just be a short-term bet, but stuff like that will definitely benefit them. If people are moving around the world and, say, borders are breaking down more because there's these distributed workforces around the globe and that slowly grows over this next decade, the likelihood of people wanting to learn another language seems higher because right now they say there's 1.8 billion people i believe that want to learn another language and that becomes slowly over time three four billion and then everyone around the globe that's uh you know we're talking a bit tan insanity there uh but i think it makes sense it could get more enticed more people to use the product um let's go to highlights and lowlights brad what do you like what do you not like about this company i'm gonna do two highlights and one

low light so they they called out this study on efficacy and the s1 um keep in mind this was all data it all the data was internally sourced not from an independent third party duolingo did this survey on their own so if you'd like to roll your eyes and take it with a grain of salt that's your prerogative and i understand i mean that's that's powerful stuff if it's real i'm gonna give them the benefit of the doubt because luis and severin have given nobody any reason to doubt them but uh but yeah internal data so keep that in mind also it's rapidly shifting from this monthly subscription plan that it has to annual um they've gone from 40 something percent to 70 something i don't have the numbers in front of me but really meaningful um a really meaningful shift and the

vast majority of their input costs are this there is this 30 fee they pay to both apple and google and that's for the first 12 months and after the first 12 months it goes down to 15 so if they can get these annual subscribers to keep picking the annual plan which which means they renew at a 4x rate and they produce ltv at a 2x rate this is a really powerful margin to win and they're showing that that it's something that we should expect going forward uh lowline oh sorry oh sorry low light is uh so 2019 they called out uh issues in their in their accounting controls they hadn't they hadn't hired the appropriate people to audit and report um so there were issues in the reporting um when you're a four or five billion dollar public company this is completely

unacceptable so this can't happen again um so duolingo please don't let this happen again but but yeah it's a it's a concern whenever even a company with a two billion dollar valuation is struggling with accounting um standards that's a concern they have since remedied the issue and and hire new people. But yeah, that's definitely a low light. Yeah, it's fairly normal for that to happen in an S1, especially for a company that may have done that three, four years ago when they were a lot smaller. But I remember when we had Francie McKenna on, the financial journalist and forensic, yeah, investigative journalist, forensic accountant, and she said the easiest thing to do is just control F on the S1, material weakness, check if they have any. It's really easy

you'll see that in the risk factors. And one thing I note on your highlights is with the 72% gross margin, if they're paying these app store fees, that means they could be X app store fees, 92% gross margin, which seems really strong and they could get a benefit sort of like Match Group and some of the video game companies if those app store fees get legislated down. But I'll let Ryan hit his low lights and highlights. Should I actually add something really quick to that? Go ahead. We're also seeing Microsoft come out with their own app store and really undercut Apple

and Google just to say, we're with creators and we're not going to take a cut. So it'll be interesting to see if a $2 trillion company like that can put pressure on these gigantic walled gardens to lower their fees over time. I'm purely speculating there. It's not super likely, but maybe it could happen. Yeah, don't bank on it, but it could be a benefit. Yeah. Yeah. All right. For me, highlights, I think the app is effective. I like the way the courses are

taught. And I think this could really work really well for younger kids. And then also maybe even use it as like a supplement to the classroom. Let's say if they branched out into literacy type stuff in your writing, and you've got... I think they're in a lot of classrooms, like 40%. Yeah, they're in a ton of classrooms. Yeah, that seems like a logical kind of market for them to be in, kind of almost like a kahoot, I guess. what is good that's like the quizzes and type stuff that teachers use it's like a software tool it's a public company that's like two billion dollars but then lowlights for me i'm just not sure duolingo plus is that compelling of an offering yet and i don't necessarily like the

business just purely on the ad supported side so obviously if they can approve and they are improving that conversion that's good and i think honestly the best way to do that and this is how spotify did it to me is not just to upgrade the premium the plus version the subscription version but to basically make the experience on the ad supported terrible i know that sounds counter intuitive but if you just bog me down with ads and i can't leave the service or whatever like i'll just subscribe yeah yeah you have to make it a clear difference in the value proposition that seems like a bit of a weakness for them right now but i mean that's something they can easily fix it's not and they can kind of they could just hit their hurdle rate so let's say 100 million

users we're going to start bogging down the free service something like that yeah it's a bit risky it's kind of uh you're kind of balancing it's a balancing act uh but we'll see what they end up doing there um all of my highlights uh you know you're not worried about any sort of market saturation here i think there's almost an endless runway for growth that they execute and i seem a bit bullish um and but i think it's true the market is huge and there's an opportunity with you know we've all heard about it disrupting education uh from 2020 onward i do like how their founder led all those people seem to check out or uh the two guys there seem to check out but probably want to look more into them because you're really betting on them at this

point um and one thing i like is that all the stakeholders win if duolingo succeeds so unlike robin hood who from our point of view we think are exploiting you know users sometimes by gamifying uh finance and making it a casino which is a bad thing but a good thing for ramen hood if duolingo gamifies it everyone wins you know advertisers win uh teachers win people the people that use it win and then duolingo wins it's kind of a you know the net zero sum stuff uh or no non-zero sum excuse me um and then the unit economics are really strong you can see them getting to you know 20 30 percent cash flow profit margins over the long term but low lights here uh one that I don't think any of you guys did. I believe there might be a tail risk from someone

like Google Translate. There's always been people talking about how, and this may not occur for a long time or if ever, of making it so you don't have to learn another language where if you just speak with someone, you can almost instantaneously get translated for you. That could be a long ways away. You guys understand what I'm describing? Or other hardware providers. yeah i mean it's just google just insert anyone for google translate that just seems like the biggest candidate with their uh capabilities there but that is some sort of tail risk where learning a new language isn't necessary anymore uh seems a long way off it might never happen um i do worry about the one-time code boost uh did that you know artificially accelerate growth

and you know maybe they weren't actually on that good of a track it's kind of hard to tell i would love to look at inside the you know the 2016 2017 2018 numbers and then the conversion to paid subs seemed weak um that is something i worry about although it is getting better over time would love to see that number rise um all right bull case brad what are your thoughts on the bull case here yeah and i've accidentally taken a couple of ryan's points uh before he said them and i i'm reading that i'm going to take another so i'm going to pivot super quick um so i'll go go with, I'll go with that subscription conversion that they can, they can really make it more compelling. And that's a really interesting point of making the free version less compelling just to

make the subscription comparatively more compelling. But yeah, I mean, 5% isn't isn't a massive number. They've gone from 0% in 2017. And then 1% in 2018. And 4% last year and 5% this year. So it's ticking up. But it's really, it's a slow crawl. And getting that to accelerate, I really think is, is a would be, will obviously be a very powerful tailwind for the company's business. All right, Ryan. Both case for me, there is obviously a large market, they're able to branch into other areas, I do like the bite sized learning approach. And if they are sort of the dominant one in the market, which I think they can be. I think they already are. There's obviously going to be good returns

pending a fair evaluation. It's hard to make any decisions. Yeah. It's assuming they got a premium multiple like the rumors are saying with no market gap, so the bull case or the bear case, but I'm just going to put it on. I'll like, all right, if you expect them to get to $1 billion annual bookings, which would be 5X from here, I mean, the key driver is going to be paying subscribers, which is very simple. It is their over 80% of their booking. So it's going to drive the most of their financial growth. And then if I was invested in this company, I would be looking for how management is talking about how they can continue to increase free to paid conversion metric, which has grown from, it was 4% like

a year ago, and then now it's 5% conversion from MAU to paid. Growing that over time is going to be a big boost for them because if they have over 500 million downloads, I think a lot of people are aware of the product, but driving people to pay for it is going to be the big driver going forward. Bear case though, what kind of downsides are we seeing here, Brad? I don't think that the bear case is a catastrophe like with some other companies we've covered. I think the bear case is that this is just a language learning app. And I think the TAM is like $61 billion for language learning versus $6 trillion for educational spend. Take TAM with a grain of salt, but you get an idea that if they can move from a language company to a digital

education company, they can 100X their already massive market. And I think that's the path forward. We talked about they're going into language arts and they're going into mathematics and all of these new subjects. And if they can pull it off, I really think there's a lot of outside there all right ryan yeah for me the bear case is that this gets priced like they have a successful expansion guaranteed um into other markets because that part will be hard um and then there's also as good as the financials seem right now whenever there's like language learning stuff like this or even like or talk about for sarah too kind of yeah it's just like the risk of trendiness like like how i know it doesn't seem like it when you have 40 million maus but

could it be a bit of a fad like is there the possibility that someone comes along and can do the same thing that there is that risk uh right now it seems like they're the leader and it seems like they're the best product i like the app but there's always that risk yeah and that's the whole you have to believe in the and they say it explicitly the gamification of learning If that's just way better value proposition from people from three years old up to 80 years old, then that could change. But there is that worry of that ceiling. And that's my number one bear case or potential bear case is the number of paying subscribers hits a ceiling. I would worry that it can't get much past 5 million.

I'm just unsure of how many people are willing to pay for a product like this. and then like i mentioned the google translate type thing if that becomes the it gets the ai capabilities like a lot of people speculate again not guaranteed to happen but there is tail risk there for a product that would render a second language learning unnecessary now duolingo could come up with that but i think there's no way it would be a lot harder for them to do that versus someone like google uh but the bear case i don't know can we sum it up as subscribers stall yeah that's kind of the sum up here brad anything else on that yeah in and in terms of the the google risk i kind of see it not the exact same thing but but in terms of a really

great calculator that does all this math and work for us um i think that it will dampen demand but i don't think it will eliminate demand for people wanting to to learn a new language but regardless good point will dampen demand for sure it is yeah it's it's kind of interesting because if you could just plug in Google Translate to like AirPods, and it could immediately translate what someone says in your… Now it sounds like VCs. Like how do you do it the other way, though? I mean, I guess maybe it's possible. Yeah, no, the thing about that is you worry about people sounding robotic, lost in translation,

stuff like that, which you can't get, you know, you can't get a full immersion unless you learn that second language legitimately. But yeah, that's kind of the downsides there. simple model. So pretty easy to see what the upside and the downside is. But let's wrap things up more or less interested. Brad, we know that you're more interested, but maybe just give a few reasons why. Yeah, more interested. Really appreciate this conversation as always. Good to consider things in a more cautious light than I often consider things when I'm excited about a company like I'm excited about this one. But more interested, I'm going to own shares of the IPO. Again, maybe a small little nibble if it's ridiculous, but I'm very excited to own this company.

And as long as there's no abrupt change to my thesis, which is always a possibility, I'm excited to own it for the long term. All right, Ryan. I'm more interested and I'm cautiously optimistic about the business. Yeah, it kind of depends on price. Obviously, price matters, but I like the business. I like management. I like where they can go. yeah it's I'll go more interested yeah I'm more interested too numbers look great there are those

worries that we talked about I worry about the moat I'm a little bit unsure about the moat a bit you know it seems like they have the best product but this is an industry which and I'm saying like digital learning where there's been a lot of upstarts I guess there's been a lot of people trying things out and then afterwards they may just seem trendy like a few years so that's kind worries for me but i'm definitely more interested this company is probably going to go on my watch list and i'll be tracking you know how they're doing uh seems like a great business and we got the stock for next week it is my turn uh and we got this one as a recommendation uh we're going to do matterport it is a spac uh so we're landing back into spac land i think they're about to merge

and go public under their new name but the um the spac is called oh gosh gores yeah the sponsored gore's holding the sixth uh so is there six back they're pretty gosh we'll fund it that's perfect capital yeah lux capital was one of their investors it's one of these high-tech ones um they talk a lot about a giant tam too so it should be should be similar but really really fun it's gonna be really fun i want to talk about this one was fun as well glad to talk about duolingo but let's hit the outro remember we are not financial advisors anything we say on this show is not formal advice or recommendation. Ryan and I are general partners at Arch Capital. Arch Capital clients may hold securities discussed in this podcast. Thank you all for listening. We'll see

you next time.