Thursday, November 28th, 2019
Earlier this year, PwC in Britain published a report estimating that Artificial Intelligence (AI) could contribute US$15.7 trillion to the global economy by 2030. One ASX listed company which is benefiting from the rapid growth of AI applications is Appen (APX).
Appen is a global leader in the provision of human sourced data to inform artificial intelligence algorithms. Appen’s customers include 8 out of the top 10 global IT companies, including Google and Facebook. The business has enjoyed rapid growth in recent years and the broader AI industry is set for strong growth into the medium and long term
Appen has a global crowd of over one million people which provide data sets to inform artificial intelligence algorithms for customers in its segments of Content Relevance and Language Resources. Content Relevance primarily services search results, social media platforms and ecommerce websites. Language Resources provides speech data for voice recognition on smart phones, automated call centres etc. A typical example of what is provided is the crowd ranking the relevance of search results e.g. the results for “Where is the next Rugby World Cup?”. https://appen.com/why-human-annotated-data-key/. This human sourced information is used to improve the rules built into the software to make the automated applications smarter.
Revenue is typically contracted over 12 months and is not strictly recurring, while relevance projects are generally continuous. Growing investment in AI globally is the key driver of increasing demand for Appen. In addition, advances in technology are driving adoption of “deep learning” algorithms, which typically achieve improved performance with larger data sets. This is a potentially material further driver of increased demand for Appen’s services over the medium and long term.
The old adage “garbage in, garbage out” is particularly relevant to Appen’s business and illustrates why customers are prepared to pay a premium to access data sets from leading providers such as Appen. Quality of data is the number one factor considered in training data procurement. APX ensures quality through initial testing of the crowd, providing extensive guidelines and managing output quality through technology overlays. Large customers have tended to ask for volume discounts as there demand grows. However, this has been offset by operating leverage, resulting in an increasing EBITDA margin over time.
Appen acquired Leapforce for $105m in November 2017, which increased scale in the Content Relevance segment and provided a more automated platform which management expects to assist cost reduction over time. In March 2019 Appen made a further software focused acquisition, buying Figure Eight, which is outlined below.
Figure Eight acquisition
In March 2019, Appen acquired complementary competitor Figure Eight for upfront consideration of US$175m and an expected earn-out of US$60-80m payable in March 2020. The acquisition price represented 5.7x historical revenue and the earn-out equates to 5.1-5.4x incremental revenue. The deal was funded by an institutional placement of A$285m (US$202m at the prevailing exchange rate), priced at A$21.50.
Figure Eight provides the business with a best in class machine learning software platform. This platform uses highly automated annotation tools that are combined with human annotation. This is used to add data to unstructured content for the purpose of informing customer AI algorithms i.e. as per Appen’s business but with a greater automated component. The acquisition increases the quality of Appen revenues, being more weighted to recurring subscriptions, as well as the breadth of the customer base. The business is not yet profitable but it is expected to be profitable in the second half of 2020 after realisation of cost synergies. Moreover, it is expected to increase the long term profitability of Appen’s business. Appen’s crowd will begin to use Figure Eight’s platform and Figure Eight customers will utilise Appen’s crowd, providing real cost benefits in addition to corporate cost savings.
Figure Eight revenue history
Source: APX acquisition presentation
Why the stock looks interesting today
APX’s stock price has reduced by 26% from $31.40 to $23.30 since the end of July 2019 as at the time of writing. Similarly, the forward PE of the stock has reduced from 56X to 36X. This is illustrated below.
APX share price and forward PE – two year charts
Source: IRESS, Factset
Contrary to the above price movements, consensus FY20 EPS forecasts have remained on a general upward trend, as illustrated below. This is despite FY19 dilution from the Figure Eight acquisition. Recall that Figure Eight is expected to be loss making this year, while the acquisition also resulted in increased shares on issue for Appen.
APX consensus FY20 EPS – two year chart
Current consensus expectations are for Appen to record 25% revenue growth in FY20 (to $664m) and 30% EPS growth. The EBITDA margin is expected to reduce from 19.6% in FY18 to 17.9% this year, following the acquisition of Figure Eight, but then to resume the longer term upward trend. Clime has a 12-month forward valuation for Appen of $26.00 and there could be upside to this valuation if the trend of earnings outperformance continues.