Does Appen still appeal?

Artificial intelligence giant Appen notched up a miss on Thursday. But are the company’s lacklustre EBITDA results just a consequence of an unpredictable market and a rough few months? 

After acquiring tech company Figure 8 in March, the company’s growth prospects looked positive. Additionally, given the strong tailwinds to come out of COVID-19 for technology and AI, the market was eager for solid results and Appen’s share price ran hard. But CEO Mark Brayan told investors to be patient, as those tailwinds may pick up in the coming months. 

Regardless of anticipated growth for the company, management is looking for a stunning comeback in the second half of CY20 in order to hit guidance. Olivia Salmon of Lennox Capital Partners knows the road ahead is long, yet is confident in Appen's future prospects. Olivia reveals why investors shouldn’t fixate on just the result, but also consider the company’s bigger picture. 

How long have you held the stock?

We’ve held Appen since the beginning of 2018 – originally in both our microcap and our small cap funds. As the company grew larger and larger (unfortunately) we could no longer hold it in our microcap fund so now it is just in our small cap fund.

How big a position is the stock for you currently?

We’ve always liked Appen – it has consistently been one of our top 10 holdings.

What attracted you to Appen? 

As Mark Twain said, “During the gold rush, it’s a good time to be in the pick and shovel business.” For artificial intelligence and machine learning, you need good quality labelled data and algorithms. Appen provides the labelled data (or picks and shovels for the automation “gold rush”). As is the case with anything, if you put rubbish in, you get rubbish out – while Appen may not have as strong IP as other technology companies, the quality, speed, breadth and depth of labelled data it provides to tech firms is hard to replicate. So, it comes down to whether you believe artificial intelligence and machine learning is here to stay and if you believe Appen will still be able to provide the necessary data to technology firms.

It sounds silly but the realisation that machine learning was here to stay was when I saw children using Siri on their parents’ iPhones. My parents were always on to me about writing things out by hand rather than typing because “you wouldn’t have a computer in an exam”. Now, parents are encouraging typing because their children are so used to searching things by asking an artificial intelligence system. 

The growth of automation is huge and only accelerated post-pandemic as more things move online. Some argue that it is likely technology firms take the data labelling in house; the data labelling itself will be automated; or other companies will replicating what Appen, which will in turn depress Appen’s margins. While this could be the case, we believe the growth in the industry is so large that for the foreseeable future, Appen will be a great beneficiary of this growth even if competition increases. The acquisition of the Figure 8 platform which is an AI-assisted data annotation platform, further cements their position as an essential component in the AI industry.

What were the standouts of the recent result?

Group revenue for 1H20 was up 25% vs. 1H19, driven by a 34% increase in revenue in the relevance division but a 20% decline in the speech and image division revenue which is more ad hoc and cyclical in nature. Given Appen earns the majority of its revenue in the US, the depreciating AUD against the USD also helped its result. Underlying EBITDA of $49.1m was up 6% on 1H19 and included $13.4m of growth investment made in the business. Underlying figures exclude the earn-out adjustment, share-based payments and transaction costs for the Figure 8 acquisition but includes the currency benefit from the falling AUD.

How did the results compare with your expectations? And those of the broader market?

The results were in-line with our expectations but below the market’s expectations with a larger than anticipated 2H20 skew and weaker revenue growth. The share price increased nearly 21% over the last two weeks in anticipation that the company would upgrade CY20 guidance so the share price decline on the day was expected when the company only reiterated guidance.

Were there any surprises? 

In a reporting season dominated by companies boosting earnings through government stimulus and cost-cutting measures, it was refreshing to see a company reiterate pre-COVID-19 guidance without the help of government stimulus and while investing heavily for future growth. 

The key positive for us was the US$80m enterprise-wide annotation platform agreement with an existing major customer, highlighting the benefit of the Figure 8 acquisition, underpinning the growth in annual contract value and increasing the certainty of future revenue.

Has your position on the stock changed post results? Why / Why not?

We look at our investments on a medium-term view. Obviously, we don’t want to buy a stock just before it downgrades as we should be able to get a more attractive entry point, but we accept there will be short term fluctuations in any company’s growth profile and share price performance. 

As long as the investment thesis doesn’t fundamentally change, the industry tailwinds remain and the valuation stacks up, we are prepared to stick with an investment even if it disappoints in the short term. Appen’s share price ran hard into the result.

While the lack of upgrade disappointed and that was reflected in the share price movement on the day, there were some positives in the result that means the underlying story for Appen hasn’t changed. 

While COVID-19 has resulted in some negative impacts, the significant uplift in annual contract value and investment for future growth means the business’s momentum should remain strong and Appen is well-placed to benefit from the long term structural growth trends.

Invest in the leaders of tomorrow

Olivia and Lennox Capital Partners look to exploit inefficiencies in the small and microcap segment of the market by identifying at an early stage those smaller companies that are the beneficiaries of change. Stay up to date with her latest insights by clicking ‘follow’ here.