Appen's risk is to the upside, not downside

We recently identified Appen (ASX:APX) as an attractive opportunity after coming to the conclusion that the shares, while appearing pricey, still offered value. This was given that: i) The fundamentals remain strong, and ii) There was more upside than downside risk to earnings guidance.

Since our charting commentary on 14 April, the shares have rallied over 30%, and since our most recent fundamental analysis on 5 May, they have returned over 16%.

So with these sorts of moves in the share price, do we think there is scope for further upside?

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About Appen

Appen is a global leader in the development of high-quality, human-annotated datasets for machine learning and artificial intelligence. The Company’s human-annotated datasets are used by customers ranging from search engines and speech recognition systems to social media platforms and autonomous vehicles. APX helps organisations and businesses to improve the user experience for their customers, accelerate their time to market, and drive efficiency.

A key strength and differentiating aspect of the business model is the skilled global crowd of over one million contractors across over 130 countries. These contractors mainly work from home and are engaged, typically on a part-time flexible basis, to collect and label data that is used by APX’s customers to train artificial intelligence applications.

There are two operating divisions:

i. Relevance: Formerly ‘Content Relevance’, this division provides annotated data used in search technology for improving relevance and accuracy of search engines, social media applications and e-commerce; and

ii. Speech & Image: Formerly ‘Language Resources’, this division provides annotated speech and image data used in speech and image recognisers, machine translation, speech synthesisers, and other machine-learning technologies.

APX’s earnings are positively leveraged to a weaker Australian Dollar (vs the US Dollar), given that most of the Company’s revenue (and the majority of cost base) is derived offshore and is denominated mostly in US$.

Why We Consider Risk to Guidance is Skewed to the Upside

1. Demand Remains Strong

APX has high customer concentration (top five customers are 88% of revenue), which are predominately global technology/digital advertising companies. The Company’s scale and speed to market have solidified its position as a leading data annotation provider for artificial intelligence applications.

The demand outlook is robust and industry growth is healthy (i.e. double-digits). Importantly, APX has not faced pricing pressures from major customers to date. It also recently updated a multi-year agreement with one of its largest Relevance customers at flat pricing (vs FY19) for five years.

2. Potential for Expansion into Other Sectors

While APX’s historical growth has been driven by a few major technology customers, future growth from sectors such as Government and Automotive are likely to be significant. In the Government sector, artificial intelligence budget in the US and UK are significant (an estimated US$5b in the US and an estimated £2.3b in the UK), with a new government customer win secured in FY19.

The opportunity in the Automotive sector for APX lies in autonomous vehicle capability via a LIDAR annotation solution. This is where pilot projects have commenced. Investment in autonomous vehicles is estimated to be growing at 35% per annum. LIDAR-based technologies are expected to grow to US$10b by 2025.

3. Scope for Margin Expansion Remains

While group margin in the recent half-year period (1H20) were impact by increased sales & marketing spend, there are several factors that underpin the potential for a strong rebound in group margin. These include:

i. Continued strong revenue growth in Relevance, primarily driven by existing customers and growth in non-traditional sectors (as outlined above).

ii. The loss-making Figure Eight business (acquired by Appen in in March 2019) is expected to make a positive earnings contribution. This will be driven by revenue growth, improving gross margins as a result of leveraging APX’s crowd, and further synergies from the integration of the acquisition.

iii. Improved margin for Speech & Image division – Margin for this division in 1H20 was impacted by a change in work mix as well as a decline in revenue after project activity peaked in the prior corresponding period. However, gross profit margin for Speech & Image are expected to benefit from the use of Figure Eight’s platform and annotation tools.

iv. Greater Efficiencies – Internal productivity (effectively managing the crowd workforce) helps margins and meet demand while crowd productivity (i.e. using artificial intelligence in the data labelling process) is still in early days.

Balance Sheet is in Excellent Health

APX has no debt on its balance sheet after recently repaying all borrowings. The Company currently has cash resources in excess of $100m. The strong balance sheet, supported by impressive operating cashflow and cash conversion, provides APX with optionality to continue to invest in product development and sales & marketing, as well as pursue further technology-related bolt-on acquisitions.

Fundamental View

The re-rating in the shares since our recent review now places APX on a 1-year forward multiple of ~42x. While this multiple is lower than the peak of >50x reached in mid-2019, the shares are well above the long-term average of ~28x.

In addition, the current multiple is starting to look a little stretched in comparison to the EPS growth profile of +25% from FY20 to FY22 on a CAGR basis. The share price is starting to factor in market expectations of an upgrade to guidance.

Charting View

Although Appen has had a great run in the last several weeks, when we look at it from a long-term weekly chart, we can see that it could potentially head higher. In the last year, it has been consolidating the rally that preceded it. This consolidation has taken the form of a flag (diagonal blue lines). With APX now breaking free of that flag, it should be able to continue rallying higher from here. The only negative at the moment is that it is hitting its old high which could lead to some weakness in the short-term. A break of the 2019 high would be the next buy signal for APX.