Language learning app Duolingo (DUOL -1.88%) went public in July with a huge initial public offering. According to Reuters, the original range for the pricing of Duolingo's IPO was $85 per share to $95 per share. However, there was so much demand that the IPO eventually priced at $102 per share and the stock has already traded over $150 per share in its short time on the public market.
It's clear there's a lot of optimism from Wall Street and Main Street alike regarding Duolingo's long-term prospects. And it's easy to understand why -- 2020 was a great year for its business. However, now that it's a public company, it's important to see if ongoing business results are trending in the right direction. Duolingo just reported its quarterly financial results for the first time as a public company. Here are three encouraging trends investors should know about.
Image source: Duolingo.
1. Paid subscriber growth
Duolingo has two sets of users: those who pay and those who don't. As of the second quarter of 2021, the company had 37.9 million monthly active users, of which just 1.9 million (5%) were paying subscribers. Non-paying users are monetized by ads. But even though most users aren't subscribers, subscription revenue accounted for 74% of total revenue in the second quarter, demonstrating the importance of this customer base.
If Duolingo stock is going to beat the market, it will need to grow its paying subscriber base substantially over time. Converting free users to paying users was explicitly mentioned as part of management's growth plan in its prospectus (the document it filed when becoming a public company). And prior to the Q2 report, Duolingo was accomplishing this goal. In 2020, the company grew its paying subscriber base 84% year over year to 1.6 million.
Duolingo's fantastic growth rate continued in Q2. The company ended the quarter with 1.9 million paying users, an increase of 46% from the same quarter in 2020. This was also the company's highest percentage of paying users compared to total users. In short, Duolingo made progress in this crucial area -- great news for shareholders.
One thing to monitor, however, is slowing growth. Duolingo's paying user base grew less than 6% from last quarter. And its overall user base declined year over year. Shareholders will hope both user bases can experience better growth in the coming quarters.
Image source: Getty Images.
2. Gross margin expansion
When profits grow faster than revenue, that's a good investment opportunity. This is why investors should generally keep an eye on profit margins. In the case of Duolingo, its gross profit margin was expanding prior to Q2 results. In 2019, its gross margin was 70.7%, which is quite good. In 2020, it was 71.6% -- even better.
In Q2, Duolingo's gross margin expanded again to 72.6%. This increase in gross profitability is directly correlated to the aforementioned paid subscriber growth. Consider the company has already built the Duolingo language-learning platform and many of those costs are fixed. Therefore, when it grows its paid subscriber base, it enjoys operating leverage. It's a classic case of "build once, sell twice."
3. Spending for the future
Non-discretionary expenses are reflected in the gross margin. After that comes discretionary spending. Included in these discretionary costs is spending for research and development. In Q2, Duolingo chose to increase its R&D spend by 81% year over year to almost $22 million.
Let's contextualize this R&D spend; Duolingo isn't just spending money willy nilly. As a percentage of revenue, general and administrative expenses barely increased while sales and advertising expenses actually decreased. By contrast, Duolingo spent 37% of revenue on R&D in Q2 compared to just 30% last year. This demonstrates clear intentionality to me.
In its prospectus, Duolingo's management talked about its long-term vision. Management said the goal is to "diversify the scope of our platform beyond language learning to a variety of subjects." It doesn't want to be a language-learning app. It wants to be an ed-tech platform. Considering the limited scope of the language acquisition market, I'm in favor of this broader vision. But Duolingo certainly needs to spend money on R&D to execute that vision, which is why the increased R&D spend is actually a good thing.
And yet, Duolingo's management is still showing some discipline regarding spending. Instead of reporting massive losses, its net loss in Q2 was just $176,000 compared to net income of just $40,000 last year. In other words, the company is operating near breakeven by choice but is still growing its platform at an impressive rate.
Investor takeaway
In summary, Duolingo's business is trending in the right direction for long-term investors. Though it still has a lot to prove, it's off to a great start.
