Today, we will look at why we still like Appen Limited (ASX APX).
Appen has plunged more than 16% in a week, due to a downgraded FY20 EBITDA guidance released on 10 December 2020.
Slowing digital ad spending and an appreciation in the AUD/USD exchange rate during Q4 contributed to lower-than-expected revenue growth from its major clients, and hence the downgrade.
The concentration of revenue from major clients and exchange rate risk were not a surprise to us as they were covered comprehensively in our 2019 report.
However, we are still confident in the long-term prospect of artificial intelligence and AI adoption as the technology landscape remains relatively intact under COVID-19.
About Appen (ASX APX)
Appen is a global leader in the provision of human-annotated data for training artificial intelligence and machine learning algorithms.
The relationship between Appen and its technology clients (Google and Microsoft, for example) is like that between a junior cook and a real chef.
Junior cook deals with food, who chops vegetables, meat into eatable pieces, just like Appen prepares the data for Google to process.
Then the chef (Google) puts magic (algorithms) to tomatoes, onions, spice, and herbs to turn them into cuisines (better products).
Appen provides annotated data in the Relevance and Speech & Image segments that are mostly used for improving internet search accuracy, virtual assistants, and autopilot, among other scenarios. (For a more comprehensive review, please refer to our 2019 report).
Trading Update
On 10/12/2020, APX unexpectedly announced a downgrade to its FY 2020 Underlying EBITDA guidance by 15% from $125M-$130M to $106M-$109M.
This is a drastic decline from its guidance issued on 27 Aug 2020.
As estimated, 77.4% of the fall (AUD$15.48M) in EBITDA guidance is due to slowing growth from top five clients, such as Google and Microsoft who were hit the hardest by COVID-19 restrictions in California.
A stronger AUD /USD exchange rate in Q4 and other factors contribute 10% (AUD$2M) and 12.6% (AUD$2.52M) to the shortfall, respectively.
APX – FY20 – Q3 to Q4 Underlying EBITDA Guidance Shortfall Estimate
Source: MF & Co Asset Management Research Estimate
Downgrade Drivers
More concentrated Revenue from online advertising data. APX’s Relevance segment which provides annotated data for clients to target ads has increased its share of the revenue from 61% to 87% FY15-19, and to 89% in H1 2020.
This indicates APX’s greater dependence on the Relevance segment and it also reflects the global trend of data demand in AI and machine learning.
APX – FY20 – FY15-19 Segment Operating Revenue Composition
Source: APX Annual Reports, MF & Co Asset Management Research
Decline in Digital Ad Spending. Due to COVID-19, digital advertising spending globally experienced a decline thus affecting revenues of Appen’s major clients such as Google and Facebook, who subsequently spent less on advertising data sourced from Appen.
As illustrated below, global digital advertising spending has seen a much slower growth in 2020 than in 2019, 2.4% compared to 15.9%.
However, digital ad spending is expected to grow at 17%, reaching $389.29 billion in 2021.
Forecasted growth in digital ad expenditure in 2021 is indicative of a recovery in Appen’s Relevance revenue.
APX – FY20 – FY19-24E Global Digital Advertising Spending
Source: Emarketer
High concentration of customer base. As APX stopped disclosing their top clients in 2017, we pick Facebook, Google, and Microsoft and compare their online advertising revenue growth to APX’s relevant revenue growth.
As illustrated, there is a strong correlation between Tech giants’ digital ad revenue & APX’s Relevance revenue.
Therefore, apart from a high concentration in the types of projects (90% revenue from Relevance in 2020 H1), Appen still has a high concentration of customer base like three years ago.
Source: APX Annual Reports, 10Q reports of Facebook, Alphabet and Microsoft, MF & Co Asset Management Research
COVID-19 Impacts
The resurgence of COVID-19 in the U.S, where 87% of its revenue was generated in FY19 has negatively impacted APX’s revenue growth.
Furthermore, as California sees the highest total number of cases and the strictest restrictions on business activities, it is not surprising that Google, Microsoft, and other tech giants who contribute an estimate of 88% to revenue are reallocating resources and reducing expenditure and hence a lower revenue growth for APX.
Moreover, given that Appen’s revenue is generated from the individual case-by-case projects rather than long-term contracts, an impact on face-to-face sales and customer engagement practices especially in California where major customers are located would have a significant impact on revenues for Q4 2020.
However, the recent emergency authorisation of the Pfizer COVID-19 vaccine could result in the loosening of lockdown laws in the U.S which would directly improve Appen’s operating conditions.
APX – FY20 – FY16-19 Revenue by Geography
Source: APX Annual Reports
Increased USD Proportion of Income, Appreciation of the AUD in H1 2020, and Underhedged Position Led to Negative Currency Impact.
As illustrated, US’s contribution to APX’s total revenue increased from 67% to 87.5% FY15-19, while the Australian income proportion declined from 33% to 11% in the same period.
AUD has strengthened against USD, from the trough of 0.5743 on 13 March 2020 to around 0.75 in December 2020.
Moreover, the hedged USD position (measured by notional value of APX’s foreign exchange instruments) as a percentage of US revenue and of total revenue, have declined from 12.8% to 2.4%, and from 8.5% to 2.1%, respectively, as represented by the blue line and orange line below.
Uncertain AUD/USD Prospect Hinges on US-China Trade war and AU-CN Relationship. Iron ore composes of 65% of Australian export to China, our biggest trade partner, and improving economic conditions in China may increase Australian iron ore export in 2021, whose price has increased 48% in the last six months due to the vaccine news.
However, the deteriorating diplomatic relationship, substantiated by the recently placed trade restrictions on Australia by China may add uncertainty to the long term export landscape and the AUD exchange rate with USD.
APX – FY15-19 – Revenue Distribution and Hedging Strategies
Source: MF & Co Asset Management Research
APX – FY19-20 – AUD/USD Spot Rate
Source: Yahoo Finance
Conclusion
The recent 15% fall of APX share price was a direct result of downgraded guidance, underpinned by unresolved concentrated customer risk and exchange rate risk.
However, we are still confident in the long-term prospect of artificial intelligence and AI adoption as the technology landscape remains relatively intact under COVID-19.
Moreover, the forecasted industry trend of spending on Digital Advertising and current analyst forecast on APX’s key customers are all pointing to a strong rebound in FY21.
APX continues to show strong potential upside for its high market share in AI data annotation and the long-term growth of the AI market.
