AppLovin Dips on S&P 500 Snub, Morgan Stanley Lifts Target Anyway

Key Points

• AppLovin just missed out on an opportunity to join the S&P 500, sending shares into a tailspin.
• However, given the company's massive valuation, inclusion in the index remains a strong future possibility.
• Analysts at Morgan Stanley upgraded the stock despite this news, supporting the company's sale of a lagging business segment.

AppLovin NASDAQ: APP was one of two much-loved stocks over the recent past that markets dumped on June 9. This was in reaction to news coming from S&P Global NYSE: SPGI. The financial services company operates the market’s most important benchmark, the S&P 500 Index.

For AppLovin and Robinhood Markets NASDAQ: HOOD, investor disappointment was palpable when they learned that the index would not add these names to its constituents. AppLovin ended the day down over 8%, while Robinhood dropped 2%.

These stocks have been absolutely red-hot over the past two years, up around 1,840% and 697%, respectively, as of the June 9 close.

In an interesting twist, AppLovin dropped significantly on the same day it got a big price target upgrade. This upgrade came from Morgan Stanley, which raised its target from $420 to $460.

This new target implies 20% upside from the stock’s June 9 closing price. So, what negative ramifications does AppLovin face due to its exclusion from the S&P 500? Additionally, why did Morgan Stanley raise expectations despite this situation?

AppLovin Fails to Gain S&P 500 Benefits, But Eventual Inclusion is Likely

When it comes to joining the S&P 500 Index, the main benefit comes down to one thing: exposure. Given the index's importance, inclusion in it means that investors are more likely to learn about, and thus invest in, a company. This can substantially increase awareness among retail investors, leading to more retail buying and boosting shares.

However, the far more important benefit is increased exposure to institutional buying. This is particularly true among companies like BlackRock NYSE: BLK, State Street NYSE: STT, and Vanguard, which operate the world’s largest S&P 500-linked funds.

When new companies get included in the S&P 500, these firms must buy shares so that their funds properly track the index. The fact that AppLovin will not gain these exposure benefits, when many thought it would, led to the big drop in shares. However, this doesn’t indicate weakness in AppLovin’s business.

Still, the S&P 500 will likely include the company at some point. Among the nearly 100 U.S. stocks with a market cap of over $100 billion, AppLovin is one of only two that are not in the S&P 500. The only other company that can say the same is Strategy NASDAQ: MSTR.

Its Bitcoin-driven business likely isn’t doing it any favors with index-makers. AppLovin’s strong advertising tech segment generated over $3.7 billion in sales over the last 12 months. This stands in sharp contrast to Strategy's business. Still, given the stock’s incredible rise over a short period, it makes some sense why S&P is being cautious in its approach.

Morgan Stanley Sees AppLovin’s Value Rising After Gaming Segment Sale

Not all the news surrounding AppLovin on June 9 was bad. Morgan Stanley's price target increase may have helped somewhat cushion the blow that the stock took. The target boost stems from bullishness related to the company’s sale of its gaming business.

AppLovin’s advertising technology focuses on mobile gaming. It assists game developers in boosting downloads for their games. However, AppLovin also operates its own first-party (1P) mobile game studios.

This part of the business has been declining, while its advertising technology business is soaring. AppLovin announced a deal to sell its 1P business in May. It expects the sale to close in Q2, pending regulatory approval.

Morgan Stanley believes selling this part of the business will increase AppLovin's overall value. This is largely because AppLovin’s 1P studios also use its advertising platform.

They are essentially paying the company that owns them. Even after the sale of these studios, they will likely continue to use AppLovin’s ad-tech platform. This will allow AppLovin to keep generating high-margin ad revenue from these games, but it won’t have to cover the costs of operating them.

This should benefit margins. Morgan Stanley cut its earnings before interest, taxes, depreciation, and amortization (EBITDA) estimates on the stock. However, they predict a higher EBITDA multiple, which they believe will give AppLovin a higher overall valuation.

AppLovin’s S&P Tailwind Remains Likely; Morgan Stanley Adds to Bullish Views

AppLovin can still gain membership in the S&P 500. Given the data around U.S. stocks with over $100 billion market caps, it is statistically likely that it eventually will. Morgan Stanley is adding fuel to the fire of bulls, predicting notable benefits from the company’s 1P business sale.