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Appen (ASX:APX) FY 2019 Results Analysis

2019-09-01T23:24:49+00:00

Appen Ltd (ASX:APX) FY 2019 Half Year Results Analysis

On Thursday Appen (ASX: APX) reported its results for the first half of FY19 (the company has a December reporting year-end). The stock price moved violently in response, initially soaring 10% within the first hour of trading to almost $30 (within sight of the $32 all-time high set in late July), but from that point plunged 20% to below $24 and ended the day down 11% from its previous close. On Friday the share price rebounded 7% as the market digested the key takeaways, and the APX share price managed to record a 2% gain for the week despite the nausea-inducing rollercoaster ride. In fairness, there was quite a bit to digest, but also readers should remember that over the past couple of months the markets have been particularly jittery amidst the ongoing trade/tariff wars, inversion of the yield curve and other macro concerns.

Figure Eight

A key focus of the result and accompanying commentary was Figure Eight (“F8”) which Appen acquired in March for upfront consideration of US$175M plus an expected earn-out of US$60-80M. This acquisition was announced only a couple of weeks after our initiation report on the company (see here for background on the company and the evolving Artificial Intelligence (“AI”) landscape).

The acquisition was met with a degree of puzzlement in some quarters but made sense strategically. Appen had planned to invest significant funds in developing an annotation platform to drive efficiencies amongst its crowd-sourced human workforce. F8 had spent more than a decade developing a high quality SAAS machine learning annotation platform to transform unstructured text, image, audio and video data into customised AI datasets. F8’s datasets have been used for autonomous vehicles, consumer product identification, natural language processing, search relevance and intelligent chatbots.

The strategic rationale for the acquisition is summarised below left, but essentially management believe that the combination of Appen and F8 will transform APX into the preeminent provider of high quality datasets for the Machine Learning (“ML”) market).

By acquiring the F8 platform – instead of investing capital into developing its own annotation tools over 2019/2020 – management argue that Appen has gotten the jump over its rivals (named in the graphic above right), and at the current super-fast pace of growth as the industry ramps, this time saving (presumably 12+ months) may prove to be a canny strategic decision indeed.

The acquisition of F8 also delivered to Appen a new high quality customer base with little overlap with the company’s existing tech giant customers, and recurring high-margin SAAS revenues:

New technology customers including eBay, Adobe, LinkedIn, Yahoo, Twitter, and Spotify (as well as some volumes with existing Appen clients Microsoft, Facebook and Google); and
Contracts with US government departments (representing Appen’s first meaningful foray into this market segment), including the US department of Defence.

This new Government segment appears to be an important future growth driver for the company, with growing US government interest in AI (no doubt stimulated by what it views as the AI threat from China – more on that later) and the potential for large-scale projects given the size and nature of these customers. The government sector will no doubt have high barriers to entry in the form of accreditation and extremely high security clearances – so given F8’s experience with working with the US government, I would hope that Appen is be well placed to win future lucrative contracts in this space.

Appen quoted Annualised Recurring Revenue (“ARR”) for F8 of A$27M for FY18 and management iterated its expectations for continued strong ARR growth for F8 over the medium term. Indeed, the US$60-80M (A$81-108M) Earn Out included in the transaction price was predicated upon strong growth in FY19, and the 5.1x to 5.4x incremental revenue multiple underpinning the Earn Out range (calculating to A$16-20M of incremental revenue) suggested that Appen expected FY19 ARR for F8 of A$43-47M.

F8 is currently still operating on a standalone basis and integration with Appen won’t commence until January 2020 (management have been focused on finalising the integration of late 2017 acquisition Leapforce). At the time of acquisition, Appen management forecast that F8 will generate positive EBITDA by the December 2020 half-year (prior to estimated post integration synergies of ~$10.5M).

1H19 results

Appen’s first few months of ownership of F8 don’t appear to have gone completely to script. The company provided an FY19 ARR range for F8 of A$30-35M, well below the range above, and admitted that F8 was “behind plan” due to distractions resulting from the acquisition and missing out on some key new customer contracts that it had expected to win. Appen believes it has remedied this initial disappointment with a new sales leader and stated that F8 is still expected to meet budgeted EBITDA for FY19 (based on a more profitable 1H19 than expected but a slower start to 2H19 based on contract delays and lost momentum). This speed bump with F8 is likely to result in a significantly lower Earn Out paid to the vendors of this business – now expected to be in the range of US$26-37M, less than half of the originally expected payment. This material saving is of course positive to APX shareholders in the long run (provided of course that F8 delivers expected longer term benefits and earnings).

The underperformance of F8 appears to be one of two key reasons for the (delayed, once the market had gotten through the shiny headline pages) negative share price reaction. The other driver I believe is the lack of an earnings upgrade – which we’ll get to later.

The results themselves were impressive at a headline level and demonstrated the strong revenue and earnings growth currently being generated by the company (half-year numbers ONLY below, refer to our previous Appen note for full-year historical numbers):

The company generated an 81% increase in underlying EBITDA from the comparable 1H18 period on a 60% lift in revenue – although the notes to the 1H19 results reveal that approximately $2M of the ~$21M EBITDA boost relates to the adoption of AASB 16 (Leases) which moved these costs below the line into D&A and Interest expense. The numbers are impressive nonetheless.

The Relevance division (which provides data sets for ML algorithms designed to improve content relevance (accuracy of search results) in online search grew revenue by ~$74M (+56%), $11M of which was contributed by F8. Margin increased by ~3% to 21.5% with management noting improved operational efficiencies following the integration of Leapforce, however excluding the $2.7M drag from F8 on this division, margin actually increased by 5.5% to 24%.

The Speech & Image division (which provides speech data collection and annotation services for use in voice recognition and voice synthesis – such as for AI assistants like Apple’s Siri, Amazon’s Alexa) increased revenue by ~$18M (+85%) with margins improving by 200bps to ~37%. With the Leapforce acquisition finally integrated, we would hope that margins will recover back to FY16 levels (i.e. north of 40%) for this division.

What may have been overlooked by some market observers is that the company significantly increased its investment in R&D over 1H19 , in order to “future proof” the company, according to management. R&D investment increased nearly-10-fold from $1.4M in 1H18 to $13.3M, and clearly the un-capitalized component of this additional investment will have impacted 1H19 earnings. This sacrificing of near term earnings in order to bolster the longer term revenue and earnings potential of the business is eminently sensible in my view, especially considering the vast potential of the fast-growing ML/AI market and what we should assume are increasing competitive pressures. No doubt a primary aim of this additional investment will be to improve internal efficiencies and enhance/protect margin (i.e. in the event that competition leads to future pricing pressure).

FY19 guidance vs. Appen’s earnings upgrade history

As mentioned earlier, the second reason for the negative share price response to the 1H19 results appears to have been the lack of a “hard” upgrade to FY19 guidance previously provided by the company (which was US$85-90M initially provided in February, and then reiterated at the AGM in May). This previous guidance had been pegged at an AUD F/X rate of $0.74 against the USD, and again the company reiterated this EBITDA range at the same F/X rate.

As we noted in our initiation piece on the company, Appen has a long history of earnings upgrades (versus consensus expectations) – 13 of them in fact – and this continuous cycle of upgrades has driven a material inflation in the company’s forward P/E multiple since 2015 (chart below updated from our previous APX report).

As noted previously, for most of FY15, FY16 and FY18, actual forward P/E was below broker consensus P/E – meaning that even after brokers upgraded forecasts to account for APX’s new guidance, the company still ended up outperforming broker forecasts. This resulted in an inflation of the forward P/E multiple from 20x to above 40x over the last year or so as the market began to automatically assume future earnings upgrades. The share price soared by 70% following the release of the FY18 results (and accompanying broker upgrades) in February this year – up until the late July 2019 peak, at which time the company was trading on a forward FY19E P/E multiple of over 55x (“HA, CHILD’S PLAY!” snorted Pro Medicus and Nanosonics from above the clouds).

You can see from the chart above that Appen had delivered “hard” earnings upgrades at the release of each of its 1H15, 1H16, 1H17, and 1H18 results (i.e. for 4 Augusts in a row), and so unsurprisingly the market had already presumptuously factored in yet another. When this did not eventuate, the share price uncoiled accordingly. Following the recent decrease in share price, Appen is back trading at ~45x forward P/E – a level it first breached about a year ago.

But note: the $0.74 AUD/USD F/X rate assumed by the company is ~10% less favourable than the current spot rate ($0.67) and ~5% less favourable than the average over CY2019YTD ($0.70). As such, there is likely to be a strong currency tailwind in 2H19 – as there was in 1H19 – and therefore a very real possibility that Appen outperforms this guidance range (indeed management expressed its confidence that it would hit the top end of the range – which was already a “soft upgrade” without factoring in potential F/X upside).

Readers should note that the company has in prior years upgraded guidance late in the year – October 2015, November 2017 (via the Leapforce acquisition) and November 2018. I have a feeling there may be another upgrade around November this year - at which point management will have good visibility on likely CY19 numbers including the benefits of currency tailwinds. We shall see.

China’s increasing importance in AI

At Appen’s AGM in May, management for the first time called out China as potential new market for the company. This makes a lot of sense strategically – as China is the second largest AI market in the world (behind the US where Appen is focused heavily), and in mid-2017 China announced its ambitions to become the global leader in AI by 2030. This included a vision for the country to develop a “new generation” of AI theory and technology (both software and devices) by the end of 2020, and then a “major breakthrough” in AI technology by 2025 in order to facilitate “industrial upgrading and economic transformation” in areas such as smart cities and also its military (cue global AI arms race).

The chart below left from Appen’s investor presentation from last week includes forecasts from German online statistics portal Statista that the Chinese AI market will reach $14BN of value by 2020, representing a CAGR of 55% since 2015 (albeit off a low base).

According to the Nikkei Asian Review, China filed more than 8,000 AI patents between 2009 and 2014 – significantly closing the gap on the US – and since 2015 has been the largest filer of patents in the world (and largest publisher of AI-related publications) (see middle chart above). As at June 2018, China had the second largest number of AI start-ups in the world (behind the US) and this is expected to accelerate in response to the Chinese government’s AI policies and funding packages (which have included science parks, incubators and development zones). Cynical observers might note that China’s comparatively lax data privacy regulations may prove to be a highly valuable (and potentially unlimited) source of data for AI algorithms

Appen entered China in 2017 with the establishment of an office in Beijing, and has since expanded to other cities such as Shanghai and Wuxi. While initially the focus was on providing Chinese language data to US customers, presumably the company has its eye on securing contracts with Chinese AI leaders such as Baidu, Tencent, Didi Chuxing and Alibaba. Contracts won with any major Chinese AI players could potentially move the needle for Appen, so we will be watching that space with interest.

Ethical Equities readers should note that Alibaba has backed a couple of Chinese AI start-ups which are focused heavily on facial recognition technology and which are providers of these AI products to the Chinese government (including in suppressing the Muslim-majority Uighurs in Xinjiang province in China’s West): near-term IPO aspirant Megvii Technology, and SenseTime (also backed by Softbank and valued at US$7B during its 2018 funding round). At this stage, we don’t know if Appen will be working with these companies.

Closing thoughts

Over the past few months there had been murmurs in the market that Appen might be impacted by the ongoing privacy issues of its huge technology customers (i.e. revelations of AI assistants recording private conversations and much pearl clutching over the potential use of this information etc). Appen management did not comment on this however (particularly amidst commentary on the outlook for future demand), so this may have been overblown.

At the release of 1H19 results last week, management reiterated its “strong conviction” on the F8 acquisition and the benefits from combining the companies, in particular the acceleration of Appen’s technological capabilities resulting from F8’s best in class platform and the diversification of its customer base (including into the lucrative US government market). I am a believer, personally. If the company can land some large contracts for the US government – as it races against China in the perceived battle for global AI supremacy, I would see that as the start of a new growth engine for the company. And if the company could demonstrate serious traction in the Chinese market, that would also represent a potential step change in Appen’s revenue and earnings base.

In our initiation report on the company in February we included the (then) latest (from August 2018) Gartner Hype Cycle for Emerging Technologies – a very helpful tool for understanding how close emerging technologies are to widespread adoption (following initial flurries of excitement). Fortunately for both of us, dear reader, Gartner released the updated 2019 version of its Hype Cycle last week and it is presented below.

When compared with the 2018 chart (refer to our previous APX report), we can see that AI has been split into multiple categories including AI Platform-as-a-Service and “Explainable AI” (where AI outputs can be understood by human experts), and “Augmented Intelligence” (the use of AI to improve human intelligence, not replace it). Further, we can see that Autonomous Driving Level 4 (no need for a human to monitor safety) has moved further down the curve, and that Autonomous Driving Level 5 (“steering wheel optional”) has appeared for the first time. As far as I’m concerned, investing in Appen offers direct exposure to these exciting emerging themes (alongside technologies that have already arrived within the last few years such as AI assistants and chatbots, and augmented reality – and which are becoming mainstream).

As we mentioned last time, APX has not been “cheap” by traditional value measures since 2015 and is unlikely to be any time in the near future while the broader market and Appen’s top and bottom line are growing so quickly. We continue to recommend that the company is only suitable for readers with a higher than normal risk appetite, and are prepared to weather some share price volatility along the way.

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Disclosure: I (the author) own shares in Appen and consider the company to be a cornerstone of my Growth portfolio. I aim to add to my position over the coming months during any bouts of share price weakness – though, as always, not for at least 2 days post publication of this article.

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Three Wise Monkeys Podcast: MNF Group (ASX:MNF), Pro Medicus (ASX:PME), Appen (ASX:APX), Nanosonics (ASX:NAN), A2 Milk (ASX:A2M) and Webjet (ASX:WEB)

2019-03-01T02:37:40+00:00

The latest episode of the Three Wise Monkeys Podcast is out now. The pint-size chimps cover MNF Group (ASX:MNF), Pro Medicus (ASX:PME), Appen (ASX:APX), Nanosonics (ASX:NAN), A2 Milk (ASX:A2M) and Webjet (ASX:WEB) in an action packed earnings season episode.

Listen to episode 15 on Soundcloud here.

Or, if you prefer, subscribe to the feed on iTunes by clicking here.

Please feel free to sign up to the forums and let us know what you think!

For early access to our content, join the Ethical Equities Newsletter.

Disclosure: The Author, Claude Walker, owns shares in all the above-mentioned companies, at the time of publication. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Appen Ltd (ASX:APX) Initiation Report and FY 2018 Full Year Results

2019-02-27T23:09:56+00:00

Appen (ASX: APX) listed in early January 2015 at a $0.50 per share IPO price. Since that time, the company has been one of the best performers on the ASX, becoming a ~47 bagger. This remarkable run has been fuelled by significant top and bottom line growth which has been supercharged by a couple of canny acquisitions and a long history of earnings upgrades.

On Monday Appen reported a stellar set of results for the FY18 financial year (December year-end) and the share price responded with a 22% increase to $22.90. It has climbed further to $23.40 over the last couple of days. But enough of that, let’s look at the business itself and the Artificial Intelligence (“AI”) market in which it operates.

Company background

Appen is a leading global provider of high quality training data sets for the Machine Learning (“ML”) market. Machine Learning is an iterative process in which computers receive datasets and information about that data, and are then trained to perform a task using an algorithm, without explicit instructions, instead relying on inference and recognising patterns, with corrections and adjustments made by humans as required to improve accuracy. This intersects with traditional computer programming where computers were fed data and a program and simply derived the answer. Machine Learning is a subset of AI and differs from Deep Learning (a further subset of ML), which involves the development of a deep artificial neural network with the end goal of the computer learning and making intelligent decisions on its own (hello, SkyNet).

The company operates 2 divisions, with a degree of overlap and certain capabilities leveraged across both units:

Content Relevance – this unit provides data sets for ML algorithms designed to improve content relevance (accuracy of search results) in online search. Data sets provided by this division link search engine users with relevant websites, products, videos, maps, social media content and advertisements – and can therefore be used for highly personalised marketing. The key customers for this business are therefore global search engines such as Google and Microsoft, who are keen to optimise their search algorithms to deliver the fastest and most relevant results with the least spam; and
Language Resources – this unit primarily provides speech data collection and annotation services. This segment enables voice recognition and voice synthesis (i.e. in AI assistants such as Apple’s Siri, Amazon’s Alexa etc, or in text-to-speech systems), but also includes the compilation of pronunciation and other custom dictionaries, language translation and various types of linguistic analysis. This data is used by government customers (as in government surveillance), automated call centres, and manufacturers of voice-activated speakers and other devices including in-car systems.

The company’s datasets are created by a crowd-sourced human workforce of more than 1 million people spread across the world – in 130 countries and covering 180 languages (all stats per APX’s FY18 results investor presentation released on Monday). This broad geographic spread suggests to me the ability for the company to access the resources required to expand into other markets if requested by existing or new customers, or should management see opportunities in adjacent verticals.

Revenue for both of these divisions is typically earned over 12-month contracts – but note that this work is typically project-driven and therefore lumpy, and not recurring per se – though Appen notes very little customer churn over the historical period and a high degree of follow-on projects per the chart below left. A meaningful proportion of this repeat revenue is generated from some customers’ need to continually refresh the data – as often as weekly in some cases (per the chart at bottom right).

The Content Relevance division was given a significant boost by the transformative acquisition of Leapforce in late 2017 for A$105M. This was funded primarily by debt but also a small ($30M) capital raising – the only time the company has raised additional capital since its IPO. Leapforce was a global leader in Content Relevance with a crowd-sourced workforce of >800,000 people – and the deal immediately established APX as the #1 global player.

The vendors received 20% of consideration in the form of APX shares (issued at $5.66 – so they will be ecstatic with the quadrupling of the share price since the transaction was completed) – escrowed for 3 years. I think this was a smart way to ensure alignment with the company and its shareholders. The transaction was priced at a comparatively cheap 5.9x forecast EBITDA. So it was hugely accretive (35% to EPS, before synergies).

The company said that the Leapforce integration has proceeded according to plan with some re-engineering of APX systems to optimise the combined platform. Management commented on the investor call that the acquisition has given the company “bulk scale” and positioned it well to take advantage of expected strong future growth. Management also estimated synergies of ~$6M in FY19 following the integration of Leapforce – funds which have been earmarked for reinvestment in R&D to further boost the earnings potential of the company.

In addition to Leapforce, Appen has made 3 other acquisitions since inception in 1996 (as a linguistic technology company):

2011: Merger with Butler Hill (US) – expansion into Content Relevance;
2012: Acquisition of Wikman Remer (US) – internal workforce management tools; and
2016: Acquisition of Mendip Media group – speech transcription services.

It wouldn’t surprise me to see another similarly transformative acquisition in order to gain new capabilities or enter adjacent markets. Management were keen on Monday’s investor call to hose down talk of any near term large acquisitions, but did state a couple of times that it is “keeping its eyes and ears open”. The company has recently expanded into China (with a beachhead established at Shanghai) – which is the next logical stage for large scale AI growth given that government’s stated intention to dominate the global AI market. The resulting logical question was asked around a potential acquisition in China to accelerate this expansion, however management were keen to stress that APX is taking its Chinese market entry slowly and that valuations of Chinese players have been “eye watering” – so shareholders should expect that growth in China is likely to be organic at this stage.

It also wouldn’t surprise to see Appen itself be a takeover target – there have been literally dozens of AI-related acquisitions by Google, Facebook, Microsoft, Baidu, Apple, Samsung, Tencent and other technology giants over the past 5 years. Even after the jump in the share price this week, APX’s market capitalisation is *still only* around $2.5 billion – certainly doable for these large tech giants with big cash holdings – though I’d imagine a high degree of dis-synergies from any tech giant acquiring Appen resulting from lost business from its rivals.

Talk of any takeover for APX is premature and probably just wishful thinking at this point. There is a significant growth opportunity open to the company (which as a shareholder I’d prefer management to execute on prior to any takeover) – so let’s take a quick look at the key industry drivers that have underwritten the company’s growth to date, and underpin its medium term future.

Growth of AI

The chart below left comes from Appen’s August 2018 investor presentation and describes the large market opportunity as different industries begin to embrace AI (with AI still comparatively nascent). The slide below right from the FY18 results investor presentation frames APX’s Total Addressable Market (“TAM”) – being the $17 - $19 billion (by 2025) Data Labelling segment of the total global AI market.

AI is expected to transform the majority of industries over coming decades and significantly boost profitability – but AI is not some far off distant technology, we are already enjoying the early benefits of AI in our everyday lives:

Smart phones – digital assistants such as Siri, adaptive camera effects, apps and games with mixed/virtual reality;
Smart cars – such as the Tesla models (connected to the Tesla network to share learnings);
Social media feeds – personalised news, ads and notifications (all curated by AI);
Music and media streaming – with personalised recommendations and curated playlists;
Navigation & travel – pretty much any activity that relies on location-based services;
Video games – powering the non-human (bot) players in the game and adapting for human skill levels;
Banking & finance – used to track potential fraudulent transactions etc
Smart home devices – such as those used to set lighting, regulate temperature and manage appliances; and
Security and surveillance – using facial and object recognition in deciphering videos and images.

In its 2017 report “Artificial Intelligence – The Next Digital Frontier?”, renowned consulting group McKinsey estimated that global AI spend in 2016 was US$26 - $39 billion. The technology giants (likely to primarily comprise cashed-up major players Google, Amazon, Microsoft, Facebook and Apple) are estimated to comprise US$20 - $30 billion of this total.

While Appen typically does not disclose the identity of its clients, it has revealed that it works with 8 of the top 10 global technology companies, plus we know that Facebook and Google generated the vast majority of Leapforce’s revenue, and that Microsoft was APX’s largest customer prior to the acquisition of Leapforce. Based on the customer relationships graphic from earlier, these would still seem to be large APX customers.

McKinsey estimates that Machine Learning accounted for ~60% of the 2016 total AI spend – primarily due to it being an enabler for the other technologies and applications below – which includes speech recognition, autonomous vehicles and computer vision (both video and images).

A key current driver of demand for APX’s services is in the AI assistant space (i.e. Google’s Siri and Amazon’s Alexa, as noted earlier) – which combines both of Appen’s divisions:

Language Resources: speech data collection for customer voice recognition, as well as voice synthesis (the assistant conversing with the customer); and
Content Relevance: the need to precisely understand what the customer wants, and then have high accuracy internet search abilities to find that good/service exactly, and continue learning to incorporate new contexts and meaning in order to better deal with future customer wants.

Smart phone AI assistants have been a “thing” since Siri’s launch in 2011 and the use of Voice in searches continues to increase due to its convenience and the difficulty in using keyboards on some devices. The game-changing widespread adoption of AI assistants is likely to be in the home – especially following the advancements made in speech recognition accuracy in the past couple of years.

Professor Scott Galloway of NYU Stern believes Voice is the next battleground for the tech giants and describes Alexa and Siri as beachheads into the home – from which Amazon and Google respectively aim to have their products involved in every retail decision made – in a future where all households will have an Amazon Prime account (100 million US households as of April 2018) and all retail purchases will be delivered to the home. Sales of AI assistant speakers (including Amazon Echo and Google Home using the above examples) were predicted to reach 100 million units globally for 2018. Last month Recode reported that ~52 million units were sold in the US alone in 2018 – increasing the number of installed US speakers to 118.5 million (an increase of 78%).

Impressive history of revenue and earnings growth

Appen reports according to the calendar year, and the 2018 numbers were eye-catching. FY18 revenue increased by 119% to $364M – reflecting the first full year contribution from the Leapforce business acquired in late 2017. Appen’s revenue grew at an impressive pace prior to this acquisition (48% CAGR between FY14 and FY17), but Leapforce has certainly supercharged the top line growth potential of the business.

EBITDA increased by 147% in FY18 – demonstrating the scalability of the business, while underlying NPAT increased by 114% (with a significant increase in depreciation following the Leapforce acquisition, and higher effective tax rate), and adjusted EPS rising by 97% (including shares issued to the Leapforce vendors). Cash conversion was strong at 92% of EBITDA.

Gross margins declined in FY18 primarily due to a less favourable project mix in Language Resources (lower volumes of complex higher margin government work). Following the acquisition of Leapforce, Language Resources comprised just 14% of full year revenue in FY18 (compared with 44% in FY14).

Margins in the Content Relevance business increased in FY18 to a high watermark of ~24% – per management reflecting the increased scale of this division following the integration of Leapforce and also increased automation. As mentioned earlier, management plan to reinvest the estimated $6M of synergies back into the business in the form of increased use of AI within the business – i.e. using ML to take the first crack at datasets with humans taking over from there. This could lead to a material improvement in internal efficiencies and margins – and could drive Return on Invested Capital back closer to the very attractive historical levels (north of 50% and growing prior to the acquisition of Leapforce and associated increases in debt and equity).

With almost all revenue derived outside Australia (mainly in USD), Appen is also likely to be the beneficiary of any further depreciation in the AUD – but earnings would naturally be impacted if the AUD moves in the other direction.

FY19 guidance

In terms of forward outlook, management guided towards FY19 EBITDA of $85M-90M assuming an AUD F/X rate of $0.74 against the USD (note currently around $0.715 – so upside for APX if exchange rates averaged at these levels throughout the year – but always wise to give a buffer when quoting F/X for forecasting purposes). This reflects EBITDA growth from FY18 of 22-29%. Factoring in similar depreciation & amortisation and effective tax rate in FY19 as just recorded in FY18, and a degree of continued debt pay-down – and FY19 EPS could be 30-40% higher than FY18. Given the 24% increase in the share price since FY18 results were released however, that still equates to a forward P/E in the vicinity of ~40x FY19 earnings.

The total value of sales generated to mid-February and the forward order book at that time was $165M – already 45% of total FY18 sales.

One analyst on the investor call – no doubt bearing in mind the string of earnings upgrades since listing (see next section) tried to get management to admit that this FY19 guidance might be conservative based on the strong second half of FY18 – which management disclosed contained some unusually large projects which are not expected to repeat this year. I’m more inclined to believe that this guidance is probably a little conservative – note APX has never delivered an earnings downgrade versus 13 upgrades if you include this week. Time will tell however and we won’t have a feel for how FY19 is tracking until the company either releases half-year results in August – or issues yet another earnings upgrade.

Continual earnings upgrades = enormous share price momentum

As referred to at the start of this article, APX has been a stunning performer since listing just over 4 years – as borne out by the chart below. This chart includes the company’s share price as well as its forward P/E multiple – both the consensus (research analyst) forward multiple, and also the company’s actual forward P/E multiple in hindsight. Note that (A) the forward EPS estimates are always for the financial year in progress, and (B) Appen has a December year, and so on 1^st January the EPS estimate used rolls forward to the new financial year; and (C) the distortion of a falling P/E in late 2017 is due to the amount of new equity issued for the Leapforce acquisition, as well as the resulting significant EPS upgrades for FY18 including Leapforce.

Apologies for the many flavours of everything that is going on in the chart above but you can see that:

APX has a long history of earnings upgrades – I counted 12 between June 2015 and November 2018 (or 13 including this week). This included upgraded guidance at all four of the company’s half-year result reporting dates, one upgrade on the release of full year results (12 months ago, but also again this week) and the remainder during the normal trading year (including at the time of the material Leapforce acquisition);
For most of FY15, FY16 and FY18, actual forward P/E was below broker consensus P/E – meaning that even after brokers upgraded forecasts to account for APX’s new guidance, the company ended up outperforming broker forecasts.
In response to the growing earnings profile combined with the string of upgrades, the company’s forward P/E has inflated considerably from ~20x in 2016 to between 30x and 40x ever since (and around ~40x currently for 2019F – though I’m writing this before seeing updated broker estimates).

Valuation considerations

Make no mistake: the current ~40x forward multiple is a premium multiple which very few ASX companies enjoy – which means a lot of earnings expectation is baked into Appen’s share price and that any material underachievement versus market expectations could trigger a savage decrease in the share price.

High growth, relatively expensive companies like APX are also likely to be sold off during the market’s “Risk Off” phases – as occurred when Appex’s share price declined by 35% between the end of August and the end of October last year; and these high growth companies are generally considerably more volatile than more stable Blue Chip companies (though try telling that to long-suffering shareholders of AMP, Telstra and the big four banks).

It must be noted, however, that not all companies are cut from the same cloth. It’s easy to compare APX’s forward P/E multiple to other (especially more mature and non-growth) stocks and conclude that Appen is very expensive. While true prima facie (in the context that APX commands a higher multiple), this exercise ignores comparative growth rates between the companies. It is useful to use a PEG Ratio (which incorporates future growth rates) to make comparisons like this more meaningful, and personally I’d rather own a company with a 40x forward P/E and a 20% EPS growth rate (PEG Ratio = 2) than a company on a 15 forward P/E and a 5% EPS growth rate (PEG Ratio = 3).

Closing thoughts

It’s worth recalling Appen’s total addressable market (the Data Labelling segment of the total global AI market) of $17 - $19 billion, by 2025, and the concept of the company being the global #1 player (though I would expect the number of competitors (in China in particular) is growing weekly). A 10% share of that market would translate into nearly $2 billion of sales. That’s a 400% increase on FY18 revenue just reported. This is a very easy and *obvious* calculation to make – and one which is not necessarily going to come true of course – but it demonstrates the size of the opportunity in front of the company.

Management’s excitement over the size of this opportunity was palpable on the investor call. The CEO expressed his confidence in the extremely high growth prospects for the Data Labelling market and made it clear that the management team are keen to execute. The CEO sees demand for data sets growing substantially over the medium term – and in order to meet this demand APX is investing in technology to make its global crowdsourcing workforce more efficient. A key question will be whether the company can continue to grow its crowd to meet forecast demand, and whether there will be margin pressure if Appen is forced to “fight for talent” against emerging rivals. As the market grows, management will need to continue to execute as it has done admirably to date. But at a ~40x forward P/E there is little margin for error.

There is little question that the growth potential of the business is enormous – we haven’t really touched on Autonomous Vehicles or Augmented/Virtual Reality in this article. Both are expected to be significant opportunities in their own right over the next few years, having passed the “Peak of Inflated Expectations” and working their way through the “Trough of Disillusionment” in the Garner Hype Cycle. (The August 2018 version is below; I find it a great tool for understanding how close previously hyped technologies are to actual widespread adoption):

APX has not been “cheap” by traditional value measures since 2015 – and many readers will not be comfortable with paying such a premium multiple. We therefore suggest that Appen would only ever be suitable for investors with a higher than normal risk appetite, and are able to endure a higher degree of volatility than exhibited by more mature companies.

In addition, the share price has doubled since the depths of December – so I would expect a degree of profit taking over the next couple of weeks. I will not be one of them personally – I am happily strapped in and curious to see where this ride takes me.

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Disclosure: I (the author) own shares in Appen – although it took me a long while to commit and this has significantly reduced my returns from owning the company. After stalking it around $2.80 (being too “cute” in waiting for it to fall to $2.60) pre earnings upgrade, then being thwarted by my Anchoring Bias above $4.00 (pre-acquisition of Leapforce), I eventually gritted my teeth about the valuation and bought some above $7.00 in late 2017. I personally consider APX a longer-term portfolio cornerstone, and may purchase more shares (though I know I will continue to grapple with the valuation) – but not for at least 2 days after the publication of this article.

Claude Walker also owns shares in Appen (and will not trade within 2 business days of publishing this article).

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This article does not take into account your individual circumstances and contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.