FVRR - Chegg's Cheap Valuation Is Deceiving

2023-11-01 12:51:17 ET

Summary

• ChatGPT and the rise of generative AI have made life difficult for some companies. I am, however, a strong believer that some of these companies have what it takes to survive.
• Chegg, Inc. is one such company that has been facing a direct impact from the rise of ChatGPT, and management has made no attempt to hide this from investors.
• An evaluation of Chegg's recent strategic decisions suggests Chegg is moving in the right direction, but this alone is not a good enough reason to invest in its stock.
• Chegg seems very cheaply valued in the market, but as I highlight in this analysis, looks can be deceiving.

ChatGPT and the rise of generative artificial intelligence, or AI, have made life difficult for some companies. I am, however, a strong believer that some companies have what it takes to come out stronger when they are backed into a corner. Fiverr International Ltd. ( FVRR ) is a good example of a company that in my view is making the most of what ChatGPT has to offer, alleviating the initial concerns many investors raised about the company's ability to survive and thrive as a freelancing marketplace during a time when artificial intelligence technology is expected to automate many of the gigs taken on by freelancers offering services on Fiverr's marketplace.

Not every company can make lemonade out of lemons, however. Chegg, Inc. ( CHGG ), an American education technology company that offers various services to students, such as homework help, digital and physical textbook rentals, and online tutoring, is one company that has found it difficult to deal with the blow dealt by generative AI. The company is far from done, though, and is implementing new strategies to overcome the threat posed by advanced technologies. After digesting these new developments, I feel Chegg is moving in the right direction, but I need more concrete data supporting Chegg's potential for long-term growth before I jump on board. Long-term-oriented investors, in my opinion, should monitor new developments from the sidelines for now as the risk-reward profile is not in favor of investors for the time being.

How Did The Launch Of ChatGPT Impact Chegg, Inc.?

Chegg was founded in 2006 and went public in 2013 under the symbol CHGG. When Covid-19 wreaked havoc in 2020, Chegg emerged as a reliable education solutions provider for American students who were confined indoors due to mobility restrictions. Consequently, Chegg stock reached an all-time high of over $100 in early 2021, but the going has been tough ever since. The launch of ChatGPT almost a year ago added salt to Chegg's wounds as the company was already suffering from a deterioration in investor sentiment - and its financial performance - on the back of the return-to-school policies.

The launch of ChatGPT has posed a formidable challenge to Chegg. ChatGPT, with its diverse array of capabilities ranging from generating original and plagiarism-free content to providing constructive feedback and suggestions, answering queries comprehensively, and even offering emotional support, has gained substantial popularity among students of various academic levels and disciplines. This transformative tool has been instrumental in assisting students in homework assignments, test preparation, essay writing, and academic research since its launch.

A survey conducted by Study.com, involving more than 100 educators and 1,000 students, has yielded a multifaceted perspective on ChatGPT's impact. It is evident that ChatGPT has found widespread usage, with over 89% of students availing of its services for homework support. A significant number, 48%, have utilized the chatbot for test and quiz preparation, while 53% have harnessed its capabilities to aid in essay composition and 22% for the creation of paper outlines.

The repercussions of ChatGPT's success have not been insubstantial for Chegg. The company witnessed a discernible decline in its revenue, user base, and market share, leading to a staggering 70% decline in its market value this year. Chegg CEO Dan Rosensweig acknowledged the impact of ChatGPT last May, particularly noting the spike in student interest in ChatGPT since March. As a result, Chegg refrained from providing a full-year outlook, citing the uncertainties surrounding the ramifications of ChatGPT on its financial performance. Chegg's CFO, Andy Brown, also said that the chatbot caused about 100,000 potential subscribers to not sign up for their main subscription services, which make up most of the company's sales.

In response to this formidable challenge, Chegg introduced CheggMate, an AI-powered study aide tailored to students' specific needs. This strategic move aims to counteract the threat posed by ChatGPT and uphold Chegg's standing as an industry leader. However, the efficacy of CheggMate in mitigating the slowdown in the company's core business remains uncertain. The future of Chegg hinges on its ability to adapt to the evolving educational landscape and effectively compete with the massive threat posed by not just ChatGPT but other new-age EdTech solutions that are being built around generative AI technology.

Third-Quarter Earnings

In the third quarter of 2023 , Chegg's financial performance was mixed, with results surpassing some analysts' expectations but still falling short of desired outcomes. The company reported a net loss of $18.3 million, equivalent to a loss of 16 cents per share in stark contrast to the net income of $251.6 million , translating to 21 cents per share, recorded in the same quarter of the previous year. This loss was primarily attributed to a one-time expense of $41.8 million related to content and associated assets, but there is running away from the fact that generative AI is killing new business opportunities for Chegg and many of its peers in the EdTech sector.

Exhibit 1: Quarterly earnings per share (GAAP and non-GAAP)

Chegg's total net revenues experienced a 4% decline compared to the previous year, reaching $157.9 million. This decline was driven by a 4% reduction in revenues from subscription services, which amounted to $139.9 million. Chegg's subscription services encompass offerings such as Chegg Study Pack, Chegg Study, Chegg Writing, Chegg Math, and Chegg Prep.

Additionally, the company observed a 5% decline in skills revenues, amounting to $18 million. This decline was a result of the changes in the revenue model for required materials and some advertising challenges. Chegg's total subscriber count dropped by 8% year-over-year, amounting to 4.4 million. However, there were positive signs in terms of increased retention rates and take rates for the Chegg Study Pack, which bundles multiple services at an economical price.

Exhibit 2: Revenue and subscriber data as of Q3

In September, Chegg initiated the rollout of its AI-powered user experience, aiming to deliver faster and more relevant solutions to students by tapping into its proprietary database of over 150,000 subject matter experts and generative AI models. During the earnings call , CEO and President Dan Rosensweig expressed confidence in the company's capacity to create a potent AI-enabled personal learning assistant, poised to offer extensive benefits to a broader spectrum of students at a more cost-effective rate.

Market Opportunity And Outlook

Chegg is positioned within a substantial and dynamic global academic market, offering a plethora of growth prospects and an impressive outlook. The market's vast scale encompasses approximately 100 million potential users, presenting ample room for expansion and innovation.

Within this expansive landscape, Chegg has identified key segments that collectively represent a substantial market opportunity. These segments include 18 million students in Canada, Australia, and the UK pursuing secondary and tertiary education, as well as 34 million high school and university students in the United States. With 8.1 million Chegg Subscription Services subscribers recorded in 2022, the company has already established its presence in some of these key markets.

Exhibit 3: Market opportunity

Outside of the core markets in the U.S. and English-speaking countries of Canada, Australia, and the UK, there is a potential audience of 48 million English language instruction students. This global reach highlights the company's potential to impact students across borders.

Chegg's commitment to serving students from diverse backgrounds is a testament to its inclusive approach. The company caters to first-generation students (27%), those with family incomes below $20,000 (15%), minorities (56%), females (59%), individuals over 25 years old (25%), and those who work either full-time (11%) or part-time (32%).

The CEO's remarks during the recent earnings call emphasize the strength of Chegg's offerings in the education sector. The recognition that students are turning to Chegg not only for academic purposes but also for a range of other needs underscores the company's versatility. When compared to more general AI solutions, Chegg consistently outperforms, resulting in impressive retention rates and high customer satisfaction. Notably, 91% of students report improved grades, 89% find Chegg instrumental in understanding course materials, and 90% express increased efficiency in their coursework with Chegg's assistance.

Chegg's forward-looking strategy is characterized by the introduction of new AI capabilities and features. This expansion is expected to provide even greater value to students, further solidifying its position as a key player in the education technology sector. The company's plans to release a suite of AI training programs in the coming months through both B2B partnerships and direct-to-student initiatives signal its proactive approach to skills development. This strategic move aims to boost Chegg's skills division, which is anticipated to become a meaningful contributor to revenue in the years ahead.

Chegg's Valuation Is Not As Rosy As It Seems

When I got started as a young investor, I often made the mistake of jumping to conclusions prematurely based on seemingly attractive earnings and cash flow multiples. A few investing makes later, I realized stock picking is not as easy as screening for companies with attractive earnings multiples. Investing, if you ask me today, is more about understanding the story the market is telling, the story the valuation is telling, the story the company is telling, and then coming up with a reasonable intrinsic valuation estimate for a company.

Chegg wants to survive the threat posed by generative AI. The market, however, does not believe in that. For ease of comparison, I will use price-to-cash flow multiples as the company has been bringing in positive cash flows for much longer than it was profitable. Today, Chegg is valued at a P/CF of just 5.5 compared to its 5-year average of 33, which leaves me in no doubt that Mr. Market is not buying Chegg's story today.

A closer look at industry dynamics and Chegg's recent financial performance has forced me to conclude that Mr. Market is reasonable today. Although Chegg may not face a liquidity crunch in the foreseeable future, returning to growth will be extremely difficult from here on, if not impossible. For context, Chegg has reported YoY revenue losses in the last few quarters.

Source: Seeking Alpha .

Chegg, in my opinion, has hardly faced an existential threat similar to generative AI in the last decade, and therefore, it makes sense for the company to be valued at a substantially low P/CF multiple compared to its historical averages. Also of note is that 5-year averages got a boost in 2020 and 2021 as Chegg was flying high back then aided by the rise of at-home learning, which is no longer the case anymore.

As a long-term-oriented investor, I believe there is no valid reason to invest in Chegg today despite the company looking attractively valued. Looks can be deceiving, and I believe Chegg's valuation is deceiving today.

Takeaway

Within the changing EdTech landscape, Chegg is trying to take proactive steps to deal with the challenges posed by ChatGPT. As a premier student-centric connected learning platform serving a global audience, Chegg is leveraging its extensive experience to develop CheggMate, a chatbot aimed at surpassing the quality and reliability benchmarks set by ChatGPT. However, the successful rollout of CheggMate is not an immediate undertaking, and this transitional phase may potentially impact the company's business operations. I am not convinced Chegg will see the light at the end of the tunnel.

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