Motley Fool Money - Roblox Hits Roadblock

Episode Date: May 9, 2024

Wall Street thinks two growth stock prices have gotten a little too high. Plus, we feature a weed company with a lot of cash. (00:21) Kirsten Guerra and Ricky Mulvey break down earnings from Duolingo and Roblox. Then, (16:30) Nick Sciple takes a look at the legal pot business, and a legislative change that could have profound implications on the market. Companies discussed: DUOL, RBLX, GOOGL, GOOG, CRON Public.com disclosure: A High-Yield Cash Account is a secondary brokerage account with Public Investing. Funds from this account are automatically deposited into partner banks where they earn a variable interest and are eligible for FDIC insurance. Neither Public Investing nor any of its affiliates is a bank. US only. Learn more at https://public.com/disclosures/high-yield-account Host: Ricky Mulvey Guests: Kirsten Guerra, Nick Sciple Producer: Mary Long Engineers: Dan Boyd, Tim Sparks Learn more about your ad choices. Visit megaphone.fm/adchoices

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Wall Street might need some help translating this earnings report. You're listening to Motley Full Money. Ricky Mulvey, joined today by Kirsten Gera. Kirsten, thanks for being here. Hey, Ricky, happy to have me. Happy to have me. We are happy to have you. I appreciate you being here.

I love this start. We've got two high flyers that you follow pretty well, both experiencing a little bit of a fall, one more than the other. But Duolingo. Let's start with Duolingo, which is the app It helps you learn different languages. We'll talk about the earnings in a sec and why the street isn't happy that Duolingo grew revenue by 45% and daily active users by 54%.

But I loved this, Kirsten. The earnings call started with the announcement of Duolingo on Ice, which is a four-hour musical celebration with no intermission. They wanted to let the analysts know about it. What is your hype meter for Duolingo on Ice? Oh, it's high. If being bullied by a digital owl is this much fun on a regular day, it's got to just be more fun on ice, right? Absolutely.

I'll be buying my tickets. On the surface for Duolingo's quarter, it seemed like a lights out quarter beating every estimate for earnings and revenue and bookings. Also raised guidance. So what's going on with the drop? What's the street so worried about? I mean, the street is all about expectations. and this is a company with a lot of expectations built in. So every quarter for the last year, analysts have set expectations for Duolingo.

That's what the street does. And every quarter, Duolingo has beat them. So weirdly, it's almost like analysts are now expecting Duo to beat their expectations. And they did beat expectations yet again, but only narrowly this time. So here we are. I will say a 12% or maybe 16% drop now, I think, does seem rough until you realize that that's something like 20 days back in the market. We've just returned to the price where it was 20 days ago. And I realize that that's tough for someone who bought five days ago.

I don't mean to minimize that. But again, keeping perspective, this is still a stock that's up more than 50% in the last year. So I think the investor takeaway really from this share price movement is that the business is still performing well based on fundamentals. which it has earned at a lofty share price, but the expectations are high, and investors should just know that going in. So looking at the business, not just the share price, what are your headline takeaways then from Duolingo's quarter? I think one, one of the most important for Duolingo is that unit economics here remain

really strong. They are still pulling in a solid return from their marketing spend specifically. This is one of the more impressive companies I've ever studied in terms of marketing. So their revenue, just for this quarter, their revenue is up 10% sequentially, and their marketing spend is up less than 4%. So they're getting a substantial return in revenue more than they're having to spend to get that. Another big takeaway, one of the things I've been wondering about is related to the TikTok ban, the potential TikTok ban here in the U.S. Duolingo does a lot of advertising there. It is one of the big drivers of a lot of its popularity. and why its marketing spend is so efficient often.

Management has said it's not worried here, that more than half of Duolingo's social impressions actually come from outside the U.S. But half is a lot, and U.S. subscribers tend to be the most valuable in terms of average revenue per user. They tend to spend more on things like this. So I'm not sure I actually believe that TikTok will be banned or that this is a huge risk,

But it is certainly something to watch out for. Even though management has said it's not a big deal, I think it might be a little bit understated there. Dualingo is very much a marketing story, and they've known how to create those viral moments, starting off their earnings call with it, with the musical celebration, where one of the reactions to their musical celebration

is an audience member saying, they took my son, where is my son? So if you look at just the earnings transcript for Duolingo's quarter, you'll see a very odd sentence with how the quarter kicks off beyond, what is it, something about forward-looking statements, yada, yada, yada. The growth story for Duolingo, though, is that it's going to rapidly take share in this

language learning market, of which it has a very small percentage of CEO Luis von An saying that this is a $115 billion a year industry. That seems extraordinarily large. Kirsten, where are they getting that market number? Frankly, I don't think that the market is that big. I'm really glad you've asked this question because when I started looking at this, if we take them at their word and assume, okay, it is a $115 billion market, what does that mean? With 8 billion people on the planet, that would be roughly $15 per person.

And maybe that sounds reasonable, right? But every person in the world cannot afford to fork over $15 U.S. dollars. But let's make it more reasonable and say that there are an estimated 1.2 billion people who are actually actively learning a language at any time. And if you consider just that population, then you're talking closer to $100 per person. But part of the beauty of Duolingo is that it's a freemium platform. Not everyone pays. And so actually, their premium penetration, which is like the percentage of people of all of their users that are actually paying for a subscription, that's about 8%.

So if we say that that percentage holds and Duolingo does go on to serve 1.2 billion people and 8% of them, pay up for a subscription. That's almost $1,200 per person per year. And I believe that language learning is valuable, but I don't believe it's that valuable. And by the way, to contrast that, Duolingo's current super plan, they charge $60 per year. So if that's the value they think they're giving, what an incredible deal they've offered. I don't know how to make that make sense. I will say this though to kind of wrap it up. I don't think that that particular total addressable market number needs to be true for Duolingo to still have a solid runway ahead of it. I guess maybe it really just sounds nice to say that you have only 1% of the market. But I modeled them as having

almost 7% of the market close to a year ago, and they've done just fine. So don't listen to this number in particular, but I also wouldn't write them off for this alone. This is a fast-growing company. Traditional valuation metrics are tough to use. And I think the stock is about what, 71 times earnings, 20 times sales. What metrics are you using as you follow Duolingo story? It is really tough. You cited earnings, but this is only Duolingo's second straight profitable quarter. When you have a rapidly evolving number in the denominator like that, the numbers will look outlandish. And if you don't know what I mean by that, you can go check out Duolingo math. But even forward PE ratios that take into account near-term growth will look a little wild.

So what I did was I actually modeled out what I believe are reasonable growth rates to expect in two numbers specifically, just monthly active users and also that premium penetration that I mentioned. So those are the two main elements that are really going to drive revenue. And I think of those two, it's the premium penetration percentage that will really be the biggest lever for how much they can grow earnings. Right now, over the past year, it's stalled out around 8% of total users paying for subscriptions. but that's been due to some softness in the economy. So it's unclear if that's all that is. So going forward, the question is, will that shrink as Duo as Duolingo expands into a broader user base

that's maybe less likely to upgrade into a subscription? Or will it actually recover back to the steady growth rate it had before and will it surprise us with how high it can climb? How many people are willing to purchase subscriptions ultimately? I think that will be a major driver for how well the company ends up performing in shareholders' eyes. Let's move on to Roblox, the online game platform and game creation system. It's down more than 20% this morning at the time of this recording.

Real quick, Kirsten, because I don't think there's a lot of crossover between the Roblox playing audience and the Motley Full Money listening audience. It's a free video game platform. Quickly, how does this company make money? First of all, I can't believe that's true. Surely tons of our listeners play Roblox, no? Maybe. I don't know. If you are, podcasts at Fool.com, that's a lot.

the email address. There you go. But it is a great question. I think people could get confused because there's been a lot of talk in the news about advertising, developing on Roblox. And to be clear, that's actually, it's negligible today in terms of revenue. And management says it won't be material by the end of this year either. So really, where Roblox makes its money is directly from users. People pay to buy things on the platform. So Roblox uses a model common to gaming, this freemium model where they get tons of people in the door, kind of build up the network effect. And then those who find it valuable can pay up for certain things. So Roblox their virtual currency. That's the first step is you translate your money into that. And

then you spend them on things like upgrades to your avatar, which is like your digital representation inside Roblox, or you can buy speed boost to kind of progress a game faster. For certain games, if you're playing a racing game, maybe you want to pay up for a really nice car. And Roblox has also recently added subscriptions as a monetization tactic. So some create a if they decide it's best for their experience, they can make that experience exclusive and require an ongoing subscription to it. It's really up to the creators of any individual experience, how they choose to monetize, if at all. Many are still completely free, but those are some of the monetization mechanisms that Roblox provides. Yeah, I was playing the racing game this morning on Roblox.

I was having a good time until I ran the car into this like wedge point between like a barrier and the off-road thing and then I couldn't continue. you playing and then realized I should probably get back to work. Anyway, Kirsten, I think the problem at Roblox came down to what the CEO said, quote, we saw less growth than we expected. That said, we exceeded our margins on cash flow targets, end quote. Looking at, does Roblox have a business problem or an expectations problem? Management says that they're trying to get bookings, daily active users, hours engaged back to 20% growth rates, right?

I think they, for daily active users, they reported something like 17. So what's so special about 20% specifically? Well, Roblox is a lot of things, but at its core, it's a social network. And it's a social network that was first popular with kids and is really aging up from there. So about a year ago, I looked at how Roblox's growth has compared to Facebook's early growth. And once I normalize them by kind of the year they went public, the growth rates are very similar from there. And so looking ahead for 2024, I kind of tried to extend that curve out by both 20%, which is what they say they're they want to be at in the 17% they were actually at for this quarter.

And they don't really look that different, right? They're still right on track for following kind of in something like Facebook's footsteps. So for a single year or a single quarter, a slowdown from 20% to 17% is not that huge in the overall story. But there will be always some vacillation around kind of an average growth. But certainly if that growth rate continues to trend downward, that would be a different story. So maybe it is an expectations problem for the moment, but it could be a business problem down the line. And I'm glad that you clarified that's actually a quote directly for management. I thought maybe it was just your quote.

But yeah, that's wild. You mentioned the or you mentioned that the CEO mentioned the exceeding the cash flow targets there. And they did technically increase their cash flow from operations year over year. But they started with a lower net income and they just juiced it with more. non-cash stock-based compensation. So I certainly wouldn't point to that as some silver lining, and I'm maybe a little disappointed that the CEO did. Yeah, this is a company with a lot of stock-based compensation. I think they spent about a third of their revenue on stock-based comp over the past 12 months. And when you have CEO,

David Bazuki, saying, hey, look over here at our cash flow numbers. They're adjusting out something significant. Not bad for a company to have stock-based comp, but for forgiveness becomes a little lower when you're not meeting your growth estimates. Speaking of the CEO, David Bazuki blamed the slowdown, basically on shipping out a bunch of new technology that low-end Android devices just can't handle. Are you buying that explanation? What do you think of that? Sure, somewhat. I mean, about 80% of users do access Roblox through mobile devices,

and many of those are Android's. And it is true that they have recently introduced features like dynamic heads that use a lot of local processing power by design. And I'm sure that that does suffer on a lower-end device, and it makes for a less-than-ideal user experience. So maybe some of those users turn away from the platform. That said, those devices exist, and they will continue to exist. So if you want to grow to serve 1 billion daily active users, as they've said,

they will have to contend with that. The platform, in some capacity, will have to be able to serve users that don't just have top-of-the-line phones. And I will actually mention, if it's okay, one other thing that I think is huge that the CEO pointed to. And that is that the way they highlight all of their new content bubbling up on the platform is, quote, not optimal. I'd say that's understating it. I think this is one of the biggest things that they really have to solve, especially if they want to retain the older, more mature users with higher expectations in games. They need a much better recommendation engine.

There are 15 million plus experiences. And yes, there's a little bit of fun in the treasure hunt element of kind of clicking through and seeing what you'll get. But really, I need them to find some of that TikTok level greatness in knowing what games I will love before I know what I want and just serving them to me. I don't have time to go dig them up. Just give them to me, Roblox. We've talked about two high growth stories.

And we're long-term investors here at the full 25. plus stocks holding on for three to five years minimum. But Roblox, Duolingo, you follow both of these. Are any of these more appealing for an entry point for investors taking a look at these companies? Yeah, I mean, both of them you could say have dipped, but dips are all relative, right? I think before these earnings releases, Duolingo was already sorting at what I see as a pretty steep premium valuation.

And I think Roblox has really been suffering with a stagnant stock price for somewhere around a year that was maybe undeserved. For me, my own personal expectations are more at odds with the market on Roblox's story. So I think that's where I see the larger price dislocation and maybe the greater opportunity. But that's just me. I think if you agree with the market punishing either of these stocks today for whatever reason, then it might not be the company that's easiest for you to hold in the long time. term because certainly they're both growing and they're both going to experience a lot of volatility.

These dips aren't nothing for a growth investor. Kirsten Gera, appreciate you coming on for the A segment. Thank you for your time and your insight. Thanks for having me, Ricky. If you're early in your career and looking for insight, inspiration, and honest advice, listen to the Capital Ideas podcast, hear from Capital Group professionals about leaning into the differences that make you unique, making decisions that last, and what it means to lead with purpose.

The Capital Ideas podcast from Capital Group. available wherever you listen, published by Capital Client Group, Inc. The excitement about investing in the legal weed space died down over the past few years significantly. But there's a big change coming in its classification is a federally illegal drug in the United States. I know this sounds technical, but it could have profound changes for the industry. My colleague Nick Seiple joined me for a look at the legal market and a publicly traded weed company that's high on cash. Nick, we're a few years past sort of this weed investing boom, and it's an extraordinarily difficult business where there's not a lot of tax incentives. You have to basically deal in all

cash. The drug is still federally illegal. But before we get to this sort of state of play today, I think it's worth looking back on that investment boom. Why was there so much hype? Sure. I think the short answer to that is marijuana, pot, weed is a product. A lot of people use. There's a big community around it. Folks saw a potential opportunity to own the next great consumer goods product. We'd also had lots of movements towards opening up sales of the product. 2014, you'd seen recreational legalization take place in Colorado. I believe it was in 2016. You saw recreational legalization take place in Canada. You had a product that had kind of an existing constituency, some belief among folks, so this could be a big consumer product, and you

had a legalization trend taking place. In some ways, this really did become a really big, big, important consumer product. California, one of those states that legalized recreational sales in 2023 last year, did $5 billion in recreational marijuana sales. You look at Canada, it's been legal again. Going back to 2016, did $5 billion Canadian dollars. I mean, sales in 2023 has been quite a big consumer product market that's generated lots of revenues for the tax authorities in those jurisdictions. But this is a commodity market where you saw lots of cash an excitement rush into that business bound to lead to oversupply and push prices down, which we've seen in really all these developed jurisdictions over the past several years.

You add in a really substantial tax burden in a lot of these markets. And if you look at the stocks in the industry, really all down about 90% from their peak. And there's been a washout among even some of the smaller players, folks totally exiting the industry. Now there's something new going on, though, which is that it sounds technical, but weed is going from a Schedule 1 drug to a Schedule 3 drug. Glad we have a lawyer on. Why is this a big deal? Yeah. So this has been something that's been going on for quite a while, was first recommended by the Biden administration back in August of last year. And here on about a week ago, April 30th,

the Department of Justice announced its intent to follow through the rulemaking process to read Schedule marijuana from Schedule 1 to Schedule 3 under the Controlled Substances Act. Under Schedule 1 drug, Those are drugs that are viewed as having no medical use and a high likelihood of dependents. Think about things like heroin. A Schedule 3 drug, much lower classification, substances with moderate to low abuse potential, a currently accepted medical use, and a low potential for psychological dependence. This new rescheduling puts marijuana in a class of drugs with things like testosterone, anabolic steroids, Tylenol with codeine.

So for one, just means the level of federal regulation will reduce. Again, this isn't a final rule in place to last to go through the federal rulemaking process won't really be at the earliest until the fall, that we see this rule go into place. But in addition to changing the regulatory environment for the operators in this space, potentially allowing more investment in research of marijuana as a drug, also significantly changes the tax environment. These companies operate in up to, and still today, again, because this rule hasn't been enacted, companies selling marijuana have been subject to Section 280E of the Internal Revenue Code, which essentially prohibits companies, operators, selling Schedule

1 and 2 drugs from exempting ordinary business expenses, the types of tax deductions that most businesses would get things for, like, your rent, payroll, things like that. Historically, they've only been allowed to deduct their cost of goods sold on their taxes. It comes down to what these companies report can be tens of millions of dollars in cash flow that is now going to drop to the bottom lines of these companies that was previously required to be paid back in taxes to the federal government. However, it doesn't change everything for the industry. Recreational marijuana still remains federally illegal. There is continued push by some members of Congress to allow marijuana banking entities to be treated in the same way as traditional

businesses. That would require further action from a legislative point of view. But if that takes place, again, would reduce costs that the industry has had to bear that normal operating businesses don't. So big takeaway is reduces the regulatory, kind of barriers to entry, perhaps, in the marijuana business, and also is going to significantly change the tax regime, which should be a windfall for the folks currently operating. It's a step, but not an all-out win. One problem for a lot of these weed businesses is that it's hard to sell across state lines. There's no interstate commerce. What is this change in the scheduling mean for interstate commerce? Because I think that that was,

would be a significant factor for these companies. Yeah, so to be determined right now, but potentially could open up a lot more competition across state lines than we've said previously. As you alluded to, currently medical marijuana operators, folks that are even selling these recreational states are kind of locked within the states they operate in. However, with these changes, perhaps you could see some new entrance. I mean, the early easy one is maybe you see more activity among the pharma industry. It's much easier to get a license to research a Schedule 3 substance than a Schedule 1 substance. So maybe you see some marijuana-based kind of pharmaceuticals and products out there in the market that could be sold under the kind of existing regulatory regime for pharmaceutical products, which would, again, add more competition in the industry.

We're interesting. California for a number of years has been dipping their toe in the water of exploring interstate sales via kind of partnerships with other states operating out there to be determined. whether this change in scheduling allows that to take place. But if there were, there'd be quite a lot of attitude among operators, in particular places like California and Oregon, because of their more mature market, have their wholesale prices 20% below the US average. Average could potentially open up opportunities for some of these lower price states to undercut operators in these other states if those regulations allow interstate sales. Could it also offer the opportunities for more developed companies in the Canadian

market and elsewhere to enter the U.S., that's something they've been sniffing around at for quite a while to be determined. But we do know for sure that if we allow new entrants into this market, going to increase competition, if it's anything like what we've seen, previously, more capital pouring into the space should push prices down. So these near-term tax windfall, these companies are the current operators are going to capture with this tax change. Won't necessarily stick around for the long term if we see higher competitive intensity come

about. think the reclassification in research is going to be significant, just because there's not, there's not a ton of research on weed about the long-term implications just because it's so difficult to study a Schedule 1 substance if you're a researcher. So I'm a little optimistic about that just to get the science. You know, one of the big investment thesis about weed sales was that is more like more states are going to open up, more federal like legalization, and that means more sales. But with this news, did your investment thesis around these weed businesses change at all? I wouldn't say the investment thesis changed at all. I would just say,

this is kind of one of those, kind of buy the rumor, sell the news events that I would say. And you've seen that in the kind of the activity in the marijuana stocks. I say that just because this promise of rescheduling that's been out there for a long time, the potential windfall and these tax changes, you've seen a lot of these stocks move quite a bit this year, and they moved quite a bit leading into the announcement. But on the back end, now that we've got this information out there, and the market's starting to digest it, we're thinking about, okay, who are these winners long-term? I still think it's hard to say what the in-state of the market is going to be today. So I think, you know, there's maybe an opportunity to trade around the news, short-term, longer-term.

I think you're going to still need to see a little bit more of a shakeout before we know the clear winners and losers in this market. I have some ideas, which I know you're going to ask you about here in a little bit. But I do think for many folks, the reaction in the market to rescheduling taking place, you think, well, man, these stocks are going to go straight up. But I think we're learning. There's a little bit more uncertainty now than the many folks had hoped for. And I think that's why I was potentially one of those buy the room or sell the news events. Well, it's an industry that even with this reclassification still has a really strong illicit market is a competitor. Even in the legal states where people can buy weed from a store,

there's still a lot of black market weed going on. Yeah, that's right. I mean, the short answer to that is just the big tax burden that many of these legal operators face. If you just look at Canada as an example, a mature nationwide marijuana market, about 30% of the selling price that you see at the market comes from excise taxes, which obviously gives an opportunity for illicit folks to undercut on price. Over five years post-legalization in Canada, I estimates have 25 to 50% of the marijuana sales still remaining in the illicit market. From the bullish side of things, you could say that's an opportunity to squeeze out some of those illicit sales, opportunity for the legal operators, you know, to come in. But I think that the real explanation is high taxes

and also inertia. Where were folks getting these products before legalization? This isn't, these products haven't just teleported onto the market over the past five years. Yeah. I also got to take, I just want to bounce off off you. I think the vibe in Colorado, at least, has shifted around weed. There's just lower consumption post-pandemic. And I think there's a little bit more of a discussion about the health risks out here, as opposed to a lot of these states, early legalization, it's like, yippy, yippy, we have weed now. Yeah, yeah, I guess it's, you know, like the end of prohibition. People probably drank more than 10 years after the end of prohibition, what have you.

I think Colorado, being the most mature recreational marijuana states, we had legalization for over a decade. You've probably hit a maturation of the market that you're going to see in other markets over time as well, where the folks who want to partake in the products have, the folks who thought about trying the products and didn't try them until legalization, have done so, and you kind of reach a balanced level in the market. I will say nationwide, the issue is arguably as popular as it's ever been. If you look at Gallup polling, at the end of 2023, at 70 percent of Americans supporting marijuana legalization compared to just 51 percent

in 2014 when Colorado was enacting its legalization. You're still seeing more jurisdictions open up for recreational use. Florida, Big State is going to vote on opening recreational sales in November, and also, if you look internationally, Germany approved recreational use on April 1st. There's still a growth industry when it comes to more legislative dominoes falling around the world and around the U.S. A lot of the smoke has cleared. A lot of the hype has died down, and there's still our companies operating in this space. I know you've looked at a few of them, or any of them investable, in your opinion.

Yeah, I mean, lots of uncertainty in this market, a lot of ends, a lot of outs, a lot of what-have-eus. But if you had to dip your toe into this market, I did think there's one company that stands out to me That company is Kronos Group. Ticker is CRON. Canadian cannabis operator. Again, Canadian market's been legal since 2018, has had fewer of these regulatory issues that the companies in the U.S. have had, so have been able to build national distribution, invest in R&D and branding in Canada in a way that these U.S. operators haven't been able to do. Kronos has grown to become the number two brand by market share in Canada, and importantly, number one brand in edibles. I think a lot of folks think about marijuana consumption and have this vision of, you know, smokables being the

dominant kind of area of the market. I think in the same way that you're seeing nicotine go more towards things like vaping and nicotine pouches and that sort of thing, I think that's where you're going to see cannabis move over time. So having an advantage in those sorts of products and having established branding in those sorts of products, I think puts companies at an advantageous position. And I think Kronos is one of those companies. Second point I'll make, they have a great balance sheet. This is a company with a billion dollar market cap that has about $860 million in net cash, was trading for less than cash a few months ago here today, still trading at a pretty reasonable valuation. If you back out kind of a lumpy tax payment, last

year it's approaching cash flow break-even. You're continuing to see a washout in the Canadian market. This is going to be one of the companies that's standing at the end of that. Also, have some interesting opportunities in other legal cannabis markets. They're importing products into markets like Germany, the UK, and Israel. So I already have an established operation in Canada and an ability to export the operation into new markets. And then last but not least, I think, is very noteworthy for Kronos. They're backed by Altria, the big tobacco company, parent of Marlboro in the U.S.

Altria owns over 40% of the company's stock has rights to appoint four of the company's board members, has a global partnership agreement. with Altria gives the company access to Altria's distribution and regulatory expertise in the U.S., which I think will be very important to them if and when they come into that market. So, strong balance, street, strong competitive position in a mature market, opportunities in foreign markets, and then the partnership with Altriya, I think, positions them well with access to distribution, cost to capital, and perhaps gives them a foot in the door in the U.S. if and when that time comes.

So for those reasons, I think Kronos is a company to have on your radar, ticker CRON, also trades in the U.S. as well. Look at that. A weed company with a great balance sheet was not expecting that when we first started talking, Nick. Appreciate your time and your insight. Yeah, happy to do it. Happy to do it. I've got high hoax for this one. As always, people on the program may own stocks mentioned, and The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. I'm Ricky Mulvey. Thanks for listening. We'll be back tomorrow.