Appen: falling knife or window of opportunity?

Since hitting its all-time high of $43 in August, data giant Appen has run into difficulty after difficulty. After a slump in Q4 2020 earnings and a rising Aussie dollar, investors hoped to have their fears quelled and their pockets filled going into the February reporting season. But the stock is down near 30% from January. And today's result may have just added fuel to the fire.

True, Appen, which was your ninth-most tipped large-cap list for 2021 Livewire's annual reader survey did highlight exciting growth in China and a strong uptick in recurring revenue. But it was the uncertain outlook and what could be construed as an exchange-rate bungle that took the attention of the market.

To make sense of this news, I sat down with Ausbil Investment Management's Mason Willoughby-Thomas to discuss the key highlights from today, what attracts him to Appen, and why he believes now might be a window of opportunity. The Q&A below is an extract of our discussion.

Can you provide some background as to the functions of Appen?

Appen provides annotated data which is essential for machine learning processes that produce artificial intelligence applications.

The data is used to train or ‘tune’ machine learning algorithms whose goal is to make accurate predictions based on a set of data inputs. Machine learning algorithms require vast volumes of accurately annotated data. Appen has emerged as a global leader in the supply of annotated data to many of the world’s largest technology companies because of its ability to deliver the data at scale, on a timely basis with relatively few annotation errors and at low cost.

What attracts you to the company?

The sheer scale of the opportunity to develop innovative AI applications implies a very large addressable market for Appen which should support healthy levels of organic growth for Appen for many years yet. Data has become an extremely valuable intangible asset for a growing number of commercial organisations, but it takes innovative data science to monetise the asset and Appen is a key contributor to that process.

Appen generates good margins in the high teens %, capital requirements are light and incremental return on invested capital is high (noting that headline ROIC is diluted by growth in goodwill from acquisitions).

What were the key points of this result?

The key points today were:

• Uncertain outlook for the near term
• A downgrade relative to consensus 2021 EBITDA expectations
• Growth in new customers
• Strong growth of recurring or committed revenue vs project growth
• Attractive growth in China. A small percentage of revenues but may become a real opportunity in the future.
• Their debts have been repaid and have an excess of cash

In December, Appen updated the market with a downgrade to their 2020 full-year guidance and their results today were largely consistent with that. Overall, the result was consistent with the December guidance with underlying EBITDA coming in at $108.6m which was towards the upper end of the $106m-$109m.

There were a number of notable positives in the release: 

• an increase in customer numbers; 
• solid growth in project wins with existing customers; 
• a rise in the level of recurring or committed revenue as a proportion of total revenue;
• continued growth in China (off a small base); 
• strong balance sheet reporting a healthy net cash position after borrowings were repaid during the year; and 
• strong cash generation supported by seasonal working capital unwind.

Can you give some colour to the situation that caused the earnings slowdown?

Guidance provided in early December last year indicated, amongst other things, that the usual fourth-quarter surge in customer demand had not materialised. With the final quarter of the year typically accounting for 30% of full-year revenue, the impact on the full year was material.

In addition, COVID disruptions over the course of the year meant that customers reprioritised new project areas over existing core relevance products, sales and marketing activities were restricted by an inability to conduct face-to-face meetings and the growing currency headwind brought by a rising Australian dollar compounded Appen’s troubles.  

Were these results within your expectations?

The result itself was consistent with expectations for the 2020 year, as discussed before, however, the outlook did little to soothe the bears or give confidence that the business is turning the corner after a COVID disrupted year in 2020. The challenging operating environment experienced in 2020 is expected to persist into the first half of 2021. If we do see a recovery in earnings it is likely to occur in the latter half of the year.

Quantitative guidance was provided which is admirable in such an uncertain operating environment, however it fell well short of consensus expectations. Guidance for 2021 EBITDA of between $120 million and $130 million was made on a currency assumption of an Australian dollar value of 69 cents US.

The current local spot rate of 78 cents against the US-dollar translates to guidance of between $106 million and $115 million, or $110 million at the midpoint. This divergence of figures results in an implied downgrade of approximately 20% relative to FY21 consensus expectations, providing ample fodder for the naysayers. That said, if we ignore the currency headwind that is largely outside of the company’s control, Appen is still looking to grow its EBITDA 17%-27% in constant currency terms in a challenging operating environment

Appen's share price was down around 11% today; what sentiment is causing the sell-off?

It's all in the outlook. I don't think the outlook did anything to soothe the company. The two main reasons would be:

• Downgrade to FY21 consensus expectations exacerbated by a rising A$, and

• The persistence of challenging operating conditions in the first half of 2021 with any recovery in 2021 likely to be back-ended.

Management flagged an 11% dividend rise on last year. Is that something you like to see or would you prefer earnings are reinvested in the company?

Appen is a growth company with a high return on invested capital so where ever possible I would prefer as much capital to go into the growth opportunities before it. In saying that, cash generation in 2020 was strong with the remaining debt repaid from cash reserves, so as long as the growth opportunities in front of them are fully addressed and funded I would prefer to see those earnings paid out rather than sitting on the balance sheet.

Has your position on the stock changed post result?

The shares have undergone a significant derating since reaching a peak of $43.50 in August last year. Concerns have been raised about the risks to Appen’s business from changing customer priorities, new market entrants and new technologies competing with APX’s largely human-focused approach to data annotation. Today’s result will probably only intensify those concerns.

From our perspective, we remain of the view that the opportunity set available to Appen remains large, that demand for human-annotated data (noting that Appen also has machine annotation capabilities) will remain robust, that Appen remains nimble enough to adapt to changing customer needs or technological evolution and that it’s proven abilities to deliver accurate data, at low cost and at large scale will hold it in good stead as the future of artificial intelligence unfolds. The company continues to grow at a healthy pace (in US$ terms) in a challenging operating environment so after a heavy derating and some of the heat removed from consensus expectations (no longer a consensus long) – now might be a window of opportunity!

How would you wrap up today's results in one sentence?

Appen delivers results in line with expectations, but their outlook remains uncertain with guidance disappointing.

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