2023-04-12 02:42:06 ET
Summary
- Chegg prioritizes shareholders over customers, neglecting to build a strong competitive advantage.
- Short-term acquisition strategy fails to contribute to long-term growth.
- Emerging AI competitors may pose a significant threat, yet the company focuses on buybacks instead of investing in future growth.
- The claim of revenue decline due to macroeconomic factors contradicts the statement that the market is still in its early growth stage.
- The company's vision and strategy are unconvincing.
Investment Thesis
We think Chegg, Inc. (NYSE:CHGG) has been enjoying its early success for too long and was too focused on shareholders than its customers. The company's acquisition growth strategy only provides short-term benefits to the company and has limited help to build the moat.
Also, the company attributed the decline in revenues to macro impact. This argument contradicts its statement that the market was still in the early growth stage.
Moreover, the company may face severe competition from emerging AI rivals in the future but the company spent the bullets on buybacks.
Overall, we found that the company's vision and strategy are not convincing.
There are a couple of catalysts for the stock but we think the upside is limited. We rated the stock as Neutral.
Company Profile
The company was founded in 2005. It provides digital and physical textbook rentals, online tutoring, and other student services.
The company provides the following services and products:
- Subscription Services: Chegg Study Pack, Chegg Study, Chegg Writing, Chegg Math, and Busuu.
- Skills and Other: Skills, advertising services, print textbooks, and eTextbooks offerings.
It generated $766 million in revenues in 2022 and an operating income of 8.9 million in 2022.
Key Takeaways from Q42022 Earnings :
- In Q4 2022, its revenues decreased by 1% to $205 million, from $207 million, accelerating from -4.1% in Q3 2022.
- Its Subscription increased by 4% and Skills and Others declined by 37%.
- In Q4 2022, its gross margin increased by 170 bps to 74.6%, from 72.9%.
- In Q4 2022, its SG&A% increased by 1080 bps to 71.2%, from 60.4%.
- In 2022, its subscriber grew by 5 % to 8.2 million. The company provided the following outlook for Q1 2023 and FY2023:
- Its revenues will decline by 8.5% in Q1 2023.
- Its subscription revenues will decline by 3.5% in Q1 2023.
- Its gross margin remains flat at 72%-73%.
- In 2023, its revenue will decline by 3%.
- Its subscription revenues will decline by 1.7%.
- Its gross margin will decline by approximately 100bps
We have the following comments:
In 2022, the company's revenue growth lagged behind its subscriber growth. It indicated a drop in revenue generated per subscriber, a sign of declining customer loyalty.
The company saw a decline in new subscribers growth in 2022 and attributed it to the macro headwind. The key indicator to monitor for a subscription business is subscriber growth. A decline in subscribers is a red flag for the company.
New subscriber and new revenue growth (Company's presentation)
Company Fundamentals
The company may already face competition
The company believed it has the highest unaided brand awareness among its peers. However, the Google trend result suggests the opposite result.
Company's brand awareness (Company's presentation)
The Google Trend search comparison not only reveals that Grammarly is more widely searched among users, but it also reveals that searches for Chegg have declined over the past five years.
Google search trend (Google Trend)
The company believes the industry is still in the early growth stage. According to Google Trends, it seems that ChatGPT attracted attention far faster than the company. In our opinion, ChatGPT fits the definition of a growing company more than Chegg.
Google trend search (Google Trend)
During the Q4 2022 earning calls , the management replied to analysts that they think ChatGPT was not a threat and that the company's strategy to react to ChatGPT was to use it.
Our ability to partner with these companies also validates how valuable our audience is to some of the biggest brands. The hot topic right now is AI and machine learning. We've all seen that large language models, such as ChatGPT, have captured the attention of many people. We believe AI will have a significant effect on human capabilities and humanity overall.
But AI and machine learning models are not new to Chegg. We have been leveraging these technologies within our platform for years, and we believe these continued advancements will benefit Chegg as a student. As an example, we've been using GPT 2 inside of our writing products, improving our ability to provide support with grammar, paraphrasing, and set structure.
We think that if ChatGPT becomes a threat to the company, it could be challenging for the company to defend its position in the market due to its limited resources. In the below section, we discuss that the company has invested heavily in acquisitions and buybacks, which may have strained its financial capabilities to respond to competition.
The company chose to spend on acquisitions and buybacks
The company raised $984 from convertible bonds in 2020 and $1091 million from equity offerings in 2021. Instead of spending on its research team, the company decided to use the fund to make acquisitions and purchase its stock. The company believed acquisition is a way to grow and we can find its acquisition footprint in its 10k . The company made a couple of acquisitions since 2010.
Beginning in 2010, we made a series of strategic acquisitions to expand our service offerings, including Cramster in 2010 to add Chegg Study, internships.com in 2014 to add to Chegg Internships, Imagine Easy Solutions in 2016 to add Chegg Writing and programmatic advertising, Cogeon GmbH in 2017 to add Chegg Math, WriteLab in 2018 to add enhanced features to Chegg Writing, StudyBlue in 2018 to add our flashcards offering, Thinkful in 2019 to add our skills-based learning platform, Mathway in 2020 to strengthen our Chegg Math offering, and Busuu in 2022 to add a language learning service. We completed our initial public offering ((IPO)) in November 2013, a follow-on offering in August 2017, issued convertible senior notes in April 2018, March/April 2019, and August 2020, and completed an equity offering in February 2021.
In 2022, the company spent $421 million buying Busuu. Busuu operated at a loss and had only $21 million cash and $16 million deferred revenue. Chegg incurred $368 million in goodwill from the acquisition. Chegg's actual 2022 revenue was $766 million, which was 7% less than the projected $820 million in proforma revenues. This indicated either Chegg or Busuu underperformed in 2022. Moreover, the company forecasted a flat to declining revenue in 2023. The company's acquisition strategy seemed not to work very well.
In addition, the company spent $623 million in buybacks in the past 2 years.
Cash flow statement in 2022 (Company's filing)
Despite this substantial buyback, the stock was still trading close to its 52-week low. For investors, this is a worrying sign as well.
Industry Trend Suggests Opposite to What The Company Think
The company attributed its decline in revenues to the decrease in U.S. college enrollment in 2022.
According to the National Student Clearinghouse, total undergraduate college enrollment in the United States has decreased by over 7%, or a loss of over 1 million students, since the beginning of the COVID-19 pandemic. Chegg derives a significant portion of its revenue from students attending U.S. colleges; and as such, a continued decrease in the number of students enrolled in U.S. colleges could materially negatively impact our business, growth, results of operations, and financial condition.
However, according to the National Student Clearinghouse, an educational nonprofit that has a nationwide network of 3,600 colleges, representing 97 percent of the postsecondary enrollment, the enrollment has stabilized in 2022 and started to grow in spring 2023. The management's pessimistic 2023 outlook does not align with this trend.
Fall undergraduate enrollment has begun to stabilize in 2022, contracting only by 0.6 percent or about 94,000 students, compared to fall 2021.
Community college enrollment is starting to grow in spring 2023 (+2.1%), fueled by strong growth among dual enrollees (age 17 and under) and freshmen. Community college growth is occurring across all campus settings while undergraduate enrollment is increasing only at suburban campuses for four-year institutions. Overall undergraduate enrollment was steady this spring (+0.2%), with only the public four-year sector experiencing undergraduate enrollment declines. Total enrollment (graduate and undergraduate enrollment combined) has remained unchanged compared to spring 2022.
Valuation and Catalysts
We make the following assumptions based on the company's financials and current market conditions:
- The company revenue remains flat in 2023.
- 20% WACC
- 3% terminal growth rate
- 20% free cash flow margin (2022)
- Net debt -84 million (Q4 2022)
- Outstanding shares 127 million (Q4 2022)
Applying the DCF method, we can arrive at an equity value of $1,005 million ($7.9 per share), which implies a 52% decline from the current stock price.
With the sensitivity test below, we can see that the stock is undervalued only if its free cash flow margin increases above 30% and WACC drops below 15% or just WACC drops below 10%.
Sensitivity Test (LEL Investment)
For the above scenarios, catalysts can be:
- The company improves its profitability through restructuring or raising product prices. The company improved its gross margin to 74% from 67% through the sale of its print textbooks library. The company has the opportunity to increase its gross margin by taking steps like working with ChatGPT and selling its redundant software. In 2022, the company had a high operating expense, which amounted to 73% of its revenues. However, there is a potential opportunity for the company to improve its margins by integrating the recently acquired software and staff into its core Chegg platform. This could result in cost savings for the company, which in turn could lead to increased profitability.
Income Statement (Company's filing)
- A rate cut by the Fed or a drop in the treasury yield as a result of a recession can potentially cause the WACC to decrease. In several of our analyses using the discounted cash flow ((DCF)) model, such as our report on Warby Parker Progresses At A Consistent Pace , we have found that certain stocks can benefit from economic recessions. In particular, companies that have shown resilience to economic downturns or are in the early stages of growth may experience a boost in their stock prices, as long as they can sustain their operations. This is because a lower WACC means the costs of capital for these companies are lower. If the company can sustain its operation, the market is comfortable to support the company with funding. We believe that the education industry could potentially benefit from a recession, as individuals who have lost their jobs are often more inclined to further their education and acquire new skills to remain competitive in the job market. Hence, recession or rate cuts can be catalysts for the stock.
Risks
Recession risks
As we discussed in the catalyst section, we think that the education industry has the potential to thrive during times of recession.
Moreover, the government often allocates more funding towards education during economic downturns, creating more opportunities for the company to grow.
However, the company's performance didn't seem to follow the general trend of the education sector recently. Therefore, it may not be a foregone conclusion that the recession will necessarily lead to increased revenue for the company.
Summary
We think the company has been enjoying its early success for too long and was too focused on shareholders than its customers. The company's acquisition growth strategy only provides short-term benefits to the company and has limited help to build the moat.
Also, the company attributed the decline in revenues to macro impact. This argument contradicts its statement that the market was still in the early growth stage.
Moreover, the company may face severe competition from emerging AI rivals in the future but the company spent the bullets on buybacks.
Overall, we found that the company's vision and strategy are not convincing.
There are a couple of catalysts for the stock but we think the upside is limited. We rated the stock as Neutral.
For further details see:
Chegg's Early Success Doesn't Seem Sustainable In The Long Run