Appen (OTCPK:APPEF) was an Australian tech darling until recently, when tough times hit the global tech industry. The company was experiencing high rates of revenue growth as large technology clients (ie FAANG of the world) accelerated their investment in AI products; However, the dependency on these same clients has led to a decline in revenue in the current year. While the general recession environment has had a negative impact, the rapid adoption of AI has resulted in new competition entering the market with peers focusing on technology solutions (vs. Appen), which has further deteriorated Appen’s prospects. This has led to the need for additional investment in new capabilities (both organically and through mergers and acquisitions), resulting in lower profitability in the short term. While overall risk remains elevated and the drop in share price is warranted, shares are now trading at less than 4x EBITDA and present an opportunity for long-term investors to establish a position. We discuss various catalysts that could lead to change and generate outsized returns for patient investors.
Appen is the world leader in developing high-quality data sets that are used to build and continually improve artificial intelligence (AI) systems. In fact, there is only one other known competitor that provides this type of service at scale (Lionbridge AI – acquired by TELUS International in 2020). To bring AI systems to a level that enables autonomous decision-making, these systems must be “trained” using large amounts of data. Think of an autonomous vehicle that needs to be “taught” how to react in different situations (eg, lane change, pedestrians, road signs, weather changes, etc.). This requires large amounts of video and image data. However, for this data to be useful to a machine, it must be annotated (i.e. tagged), which usually requires human input. While tools have been developed to make the annotation process faster, a large number of people are required to judge the raw data to eliminate bias. Ultimately, the quality of the data determines how well the AI system performs.
Appen employs a large base (over 1 million) of temporary/on-demand workers known as the crowd, who are spread across the globe (over 170 countries) and annotate data remotely. Although the company is based in Australia, it serves global technology clients around the world. The company has also entered other parts of the AI value chain by developing/acquiring tools that enable efficiency in the annotation process. While the company’s customer base has historically been large tech companies, the company is branching out into other enterprise customers as AI adoption accelerates outside of the big tech players.
Why has the stock underperformed of late?
High dependency on global technology customers
Approximately 80% or more of the company’s revenue is generated by its top 5 customers, which are large technology companies. These companies provide their own software platform for data annotation work, however they employ Appen to provide their multitude, which performs the data labeling. Historically, these companies have represented the vast majority of the AI market and have invested heavily in this area. Some examples of products that require data annotation services include Alexa (Amazon), Siri (Apple), Maps (Google), Marketplace (Facebook), etc. While this investment in AI has benefited Appen in recent years, the current macro environment has put a damper on this spending, which has impacted the company’s recent performance.
Given the accelerated adoption of AI, many new competitors have entered the space. These include companies like AI scale Y cloud factory. These competitors are well funded and have raised money in high valuations. These companies have also focused on developing tools that enable faster automation rather than focusing on employing humans to get the job done.
While new competitors may enter the market, it is important to note that the incumbency advantage that Appen enjoys is not insignificant. It’s a challenge to replicate the scale of having over 1 million crowd members in 170 countries. Having this scale allows Appen to access deals offered by big tech companies that prefer to work with established players versus more nascent-stage peers.
Evolving business model that requires initial investment in new tools
Given the evolution in the AI data annotation market, Appen has had to invest funds in R&D to keep up with new competitors. This is also important to cater to the enterprise segment, which, unlike the big tech players, does not have its own annotation tools. These investments have led to lower returns as these clients generally seek short-term contracts that are less profitable than the work Appen does for large tech clients.
Why should long-term investors consider a position in the stock?
Increased adoption of AI
As discussed above, while major technology companies have accounted for the vast majority of AI investments in recent years, adoption is increasing in other industries. Use cases include autonomous vehicles, administrative digital transformation, medical imaging, etc. The overall market for these services will continue to grow rapidly despite the current economic environment. Also, since Appen’s services are needed to serve all kinds of use cases, the company is well positioned to take advantage of the overall growth of the AI market (ie, its use case agnostic).
solid balance sheet
Despite recent poor financial results, the company has ~$40 million of cash on the balance sheet, is in a net cash flow positive position (despite R&D investments), and has no debt . These are all positive signs and could mean that Appen survives the current environment against many smaller competitors and can take advantage of any vendor consolidation into big tech clients.
Multiple potential increase as software business expands
Given the investment in software tools, as this part of Appen’s business expands, it could lead to the multi-pronged improvement typically enjoyed by SaaS companies over general service providers that don’t have their own IP.
Potential for a purchase
Appen received a buy offer for AUD $9.5 per share earlier this year. While that deal ultimately fell through, it shows the value that a well-established competitor placed on the company. Given the current share price (AUD$2.5), we believe private equity buyers may be eyeing the company with an eye to taking it off the public markets. Private equity players have raised a significant amount of cash in recent years and, despite higher interest rates, they need to invest this cash in profitable assets where value can be created.
- Client Concentration – As discussed above, the vast majority of Appen’s revenue is generated by its top 5 clients (big tech players) that have been affected by the macro environment.
- Liquidity: The company is listed on the Australian Stock Exchange. US investors may need to invest in the over-the-counter market, where the company’s shares are rarely traded.
- Low Revenue Visibility: Appen does project-based work, which leads to lower revenue visibility and is less recurring in nature.
- Investment in technology: Appen needs continuous investment in R&D to keep up with its investors. The company may also seek to participate in mergers and acquisitions, which carries integration risk.
While there will be some short-term pain, Appen could present patient investors with a discounted opportunity to ride the AI wave. The company’s balance sheet looks strong and we believe the prevailing macroeconomic conditions affecting spending by the big tech players will change going forward. It is not inconceivable that a company like Appen, even with expected lower than normal revenue growth going forward, could trade at 8-10x EBITDA, which would represent >100% improvement over current levels.