On occasion, I become curious about stocks whose prices wildly fluctuated over a very short period of time. Digital Turbine Inc. (APPS) is one of the more recent ones. The stock quadrupled over the course of a year, but still only has a $500 million market cap.
Overall, the company does not fit into my philosophy of buying good businesses at reasonable prices and the stock is not cheap based on my assessment of the business. Digital Turbine is indeed in a high-growth period, is cash flow positive and has no debt. The valuation multiple may still be tolerable in context of its growth and in today’s market, but this looks to be another Criteo (CRTO, Financial) rather than the next Trade Desk (TTD, Financial).
The following chart shows the stock price of Criteo. Sales more than quadrupled, but the stock didn’t follow.
Background
Digital Turbine works with mobile operators and original equipment manufacturers to get apps automatically loaded onto new mobile devices. When you buy a new Andriod phone and finish setting it up, you will notice several apps have already been loaded. Some of these apps are standard, such as the web browser, maps and app store, which are defaults set by either the carrier or the OEM. Others you may have never heard of. Digital Turbine is responsible for getting those apps based on a user's personal information, such as age, gender, location, etc.
Digital Turbine makes money from advertisers (i.e., app developers) and shares this revenue with its partners, which include Verizon (VZ, Financial) and Samsung (XKRX:005930, Financial). The U.S. accounts for 70% of revenue. The revenue shared with its partners is considered cost of goods sold. Therefore, the normalized gross margin is around 40%, unless the revenue model changes. This is illustrated in the following diagram.
Source: Company presentation.
As of Wednesday, the pre-loading app business accounted for 90% of Digital Turbine’s revenue. The remaining sales come from other products. For example, the company can install an app with one click when a mobile user is attracted to an ad or notification sent by Digital Turbine to the device. These ads and notifications are essentially the mobile version of the now-ancient banner ads and junk emails I am used to seeing on PCs.
From 2012 to 2016, Digital Turbine made money primarily from its content and mobile ad agency businesses. Its fortunes started to change after it signed an agreement in 2014 with Verizon to pre-install apps on its phones. Subsequently, it gained additional partners, including AT&T (T) (Cricket), in March 2016. So the majority of the company's progress has occurred over the past three years.
It recently signed an agreement with Samsung, a big win for the company as the high growth is likely to sustain it for a while. But it also makes me wonder whether the good news is nearing an end.
The company was under the control of a few owners and changed its name a few times. Currently, it is owned by several hedge funds and private equity funds, each with a 5% to 7% stake. Executives collectively hold about 6% of the company. CEO Bill Stone has been at the helm since 2014.
The bull story
Digital Turbine can be described as a broker of the tiny “real estate” space on a mobile phone. It helps the apps fight for a spot on devices' tiny screens. The demand comes from numerous app developers. There are over 200,000 such developers in the U.S. alone, whio each want to have a slight advantage of being exposed to customers who are drowning in a sea of apps. Being able to be pre-load its app onto a new mobile phone is very appealing, so it's no wonder Digital Turbine enjoyed fast revenue growth over the last three years.
From the summer of 2016, the time when Digital Turbine started working with Verizon, its U.S. and Canada revenue grew from close to nothing to $73 million. The growth came from both volume and pricing. Average revenue per device doubled or even tripled.
Not surprisingly, management has great ideas for the next several years.
Source: Analyst data June 2018.
Valuation
If management’s goals are achieved by 2022, then apply a price-sales ratio of 3 and the company could be worth $900 million, up 60% or a compounded annual growth rate of 17%.
Why use 3 times sales? From a 40% gross margin, subtract 10% for sales and marketing and 10% for research and development (low by norm) and the net margin is 15%. A price-sales ratio of 3 would translate to 20 times earnings. Not crazy, but it is not cheap either.
As a reference, the price-sales ratio has been anywhere from 1 to 20. Digital Turbine is a speculative stock to start with.
Concerns for the company
First, it appears to be a business that people can go without. It has competition from Google Play, which is more widely known. In addition, good apps don’t need to be forced onto people’s screens, but can be bought from app stores. Therefore, Digital Turbine is similar to a telemarketer in that it sends out junk mail (and emails). The apps being marketed the most have the tendency to be either newer or harder to sell. I am not sure whether end users appreciate businesses like this. In fact, the name for these pre-installed apps is “bloatware.”
Second, the company is at the mercy of its partners that are much larger. Verizon accounts for 46% of Digital Turbine’s total revenue and AT&T accounts for 39%. If either of these mobile carriers choose another partner or decide to bring the business in-house, it will be a devastating blow.
Digital Turbine’s total research and development is about $10 million, or less than 10% of sales for such a tiny company in the technology sector. It has only 161 employees. I estimate Verizon pays Digital Turbine over $20 million a year to do this work for it through revenue sharing. If Verizon really wants to take this business in house, it does not seem to be very bad economics.
Third, it does not look like a long-term growth story. I do not see sustainable growth beyond management’s three to five-year plan, Simply put, the space on phones is limited and the price advertisers can put up has a cap.
Based on my estimates, management’s aspirations for penetration of 75 million devices in the U.S. is as high as it can be. International growth sounds good, but the company has a checkered history and also likely faces far more fierce competition. Revenue per app installed is likely close to its potential.
Finally, the company has a checkered history. Digital Turbine was reborn from a public shell company after 2008. It went through a series of acquisitions then divested a majority of them. The most noticeable acquisition is Appia, a mobile ad agency, in March 2015. To acquire Appia, Digital Turbine diluted its share base by 50% and suffered a stock price decline of 75% within a year. At the time of the acquisition, Appia was a loss-making company, just lost a big customer and saw its revenue decline 40% year over year. In April 2018, Digital Turbine divested the Appia business as it was still posting losses.
Growth assessment of Digital Turbine
Number of devices in the U.S.
There are about 270 million smart phone users in the U.S., of which about 40% are Apple (AAPL, Financial) users. Assuming Apple is able to hold its market share steady, that means the number of Android users is about 160 million. Assuming the average user buys a new phone every two years (which is likely an aggressive assumption), that is about 80 million new Android devices each year. As a result, the management’s penetration target of 75 million devices is close to full penetration by one company. It is possible, but could prove to be a difficult task.
Revenue per device in the U.S.
Revenue per device equals the price per pre-installed app times the number of apps pre-installed. The former is determined by the app’s profitability, which is hard to change. The latter is capped by the individual phone user.
From fourth-quarter 2018 to second-quarter 2019, Digital Turbine grew revenue per device in the U.S. by 83%, which is very impressive progress. The current revenue per device is $2.75, of which about 85% is from installs. In other words, Digital Turbines makes about $2.34 per device from installing customized apps.
To add some perspective, Venturebeat reported in January that Candy Crush Saga, the insanely successful mobile game, has a user base of 270 million worldwide and generated $1.5 billion in revenue in 2018. That is $5.6 per user. Assuming marginal cost is 0 and the conversion rate is very high at 15%, Candy Crush may be willing to spend 84 cents to acquire a customer.
For an average app, the amount is probably a quarter of that or less due to a smaller margin profile and lower conversion rate. Let’s say 20 cents is a good number to start with. For Digital Turbine to earn $2.34 in revenue, it needs to push 10 apps on to the phone screen. I personally think 10 apps from advertisers is quite a few already given that 20 to 30 icons fit on the first screen and default apps from the OEM and operators probably already account for half of these.
Based on these estimates, revenue per device growth is limited.
International growth looks erratic
Unlike the U.S., revenue growth in other regions has been erratic. The company has historically said little about the international segment. In addition, the revenue per device is simply too low to make a difference.
Conclusion
In brief, Digital Turbine's short-term outlook is bright, but it does not appear to be a stock worth owning.
Disclose: I do not own the stock.
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