Language learning app Duolingo (DUOL 2.84%) provides investors with a lot to like. The company's revenue was up 129% year over year in 2020. Its gross margin is expanding, increasing from almost 71% in 2019 to almost 72% in 2020. And it's already free-cash-flow positive.
It's rare for a young company to combine high growth with profitability as Duolingo does, so it's easy to understand why investors are excited about this stock. But there's a big problem I see with businesses that profit from language learning, and it's why I won't be investing in Duolingo anytime soon.
Image source: Getty Images.
The 500-million-plus download problem
Duolingo shares an impressive stat in many of its filings: Since the app launched in 2012, it's been downloaded over 500 million times. The company shares this to signal the strength of its brand. However, in sharing this statistic, it's accidentally acknowledging its greatest weakness: customer churn.
Consider that Duolingo has less than 40 million active users. This means that of the people who've downloaded the app at some point, more than 90% (!) are no longer active users.
Don't misunderstand, this isn't Duolingo's fault. It's simply the nature of a language-learning business. Duolingo competitor Babbel ran a survey of its users and found that 56% were learning a language so they could travel the world. Among international users, 19% said they were learning a language to further their careers (English was the top language choice for this).
People have diverse reasons to learn another language, but a common thread that runs throughout is a goal or purpose. Few people study language just for the fun of it.
Now consider what happens if there's a personal goal in view. Either the person is going to learn the language to desired fluency or they're not. In either case, they're eventually going to stop studying. In the case of Duolingo, if it's great language-learning software, users will learn the language and be satisfied -- but they'll still be done.
I believe Duolingo's implied customer churn bears this out. Potentially 500 million-plus people have already given it a try. But over 450 million people aren't using it now. Perhaps all 450 million are satisfied with Duolingo's product and are grateful to have learned a new language. But don't expect them to keep using and subscribing to Duolingo's services for a third and fourth language; there are relatively few compulsive polyglots in the world.
Using the Duolingo app. Image source: Duolingo.
Why it matters
Duolingo has four ways of generating revenue, the biggest of which is subscription revenue from its Duolingo Plus service. Subscription revenue is attractive for most companies if customer retention is high. In those cases, the company spends heavily on sales and marketing initially, but eventually, it can scale back as it retains customers, leading to operating leverage.
In 2020, Duolingo spent 22% of its revenue on sales and marketing. In the most recent quarter, that scaled back to just 16% of revenue. But consider that its user base also declined 3% year over year. Since this is inherently a high-churn business, I don't expect Duolingo will ever be able to cut back on spending much more and still maintain the current size of its business. Especially not with competitors like Babbel and Busuu spending to acquire users as well.
How things could get better
I believe Duolingo's management recognizes the need to be more than just a language-learning platform. Its stated vision when going public was to "diversify the scope of our platform beyond language learning to a variety of subjects, using the same product-focused, mobile-first, gamified approach to education."
Duolingo is putting its money where its mouth is. Its biggest expense is not sales and marketing but rather research and development (R&D). In the most recent quarter, it spent 37% of its revenue on R&D, and it has spent roughly $44.5 million on R&D so far this year.
Assuming Duolingo's language learning software is effective, then it stands to reason the team can apply its insights to new products. And given what it's spending, it's also reasonable to believe the company will be able to launch new educational-technology (ed-tech) apps that can be monetized. Some would point out that it's already done this with the recent launch of its literacy app Duolingo ABC.
But the transformation from language-learning app to complete ed-tech platform is still very much aspirational and speculative. In time, Duolingo can demonstrate the effectiveness of the strategy, at which point I'd reconsider buying the stock. But as it stands now, the customer churn inherent to this business keeps me on the sidelines.
