2023-08-08 12:50:09 ET
Summary
- Chegg's stock jumped over 20% after hours after reporting second quarter earnings (but traded weakly in early morning trading), showing a surprising turnaround.
- The company's revenue declined 6.2% YoY, but management cited a recovery in customer acquisition trends and outlined a path for Chegg to become a generative AI application.
- While there are risks from generative AI, there is potential for Chegg to become a consumer-facing application built on generative AI capabilities.
- With a solid balance sheet and valuation of under 10x earnings, Chegg looks like a buy.
Chegg ( CHGG ) jumped after reporting second quarter earnings, a surprising turnaround after seeing its stock cut in half the last time the company reported. While the company continued to show struggling growth rates and profit margins, management cited a recovery in customer acquisition trends and outlined a path for Chegg to become a generative AI application. While there remains the risk that generative AI eventually renders the company obsolete, I can see a path for CHGG to become a consumer-facing application built on generative AI capabilities. Investors might not see revenue growth until next year when the comparables become easier, but the stock is looking cheap at under 10x this year’s earnings estimates. I reiterate my buy rating for the stock.
CHGG Stock Price
CHGG soared over 20% after hours on Monday after reporting earnings but showed only muted gains in Tuesday morning trading.
I last covered CHGG in May 2022 where I rated the stock a buy. The stock is down heavily since then - at the time, the company was facing tough pots-pandemic comparables but generative AI has since emerged to be a greater villain. The valuation is as attractive as ever, but Wall Street remains unconvinced that the company can overcome generative AI threats.
CHGG Stock Key Metrics
In this most recent quarter, CHGG saw revenue decline 6.2% YOY to $183 million (ahead of guidance for $178 million), largely due to a 9% decrease in subscription service subscribers.
CHGG also saw pressure to profit margins, with adjusted EBITDA margin declining to 33%. Free cash flow was stronger YOY, but that was mainly due to lower content purchases.
CHGG ended the quarter with a solid balance sheet position of roughly neutral leverage. The company repurchased $427 million of its convertible notes at a discount and used the net savings to repurchase $35 million of stock.
Looking forward, CHGG expects continued pressure to growth, with revenues expected to decline 6.7% to $153 million.
On the conference call , management noted that they saw customer acquisition and retention rates improve as the second quarter progressed, though I doubt that this was the driver for investor optimism given the modest guidance for the third quarter.
Instead, Wall Street likely focused on management’s commentary for their generative AI transformation. ChatGPT previously was blamed for the company’s sudden drop-off in growth rates, but management appeared optimistic that it could integrate ChatGPT functionality into its platform to create competitive advantages given its wide breadth of data. Management questioned the competitive threats from ChatGPT itself, stating that it is “overwhelmingly for writing and not for learning,” but I think many investors might ask the same questions about Chegg (whether or not it is good for learning). One thing stands out, though. ChatGPT as it stands might not be so easy to use for the masses, and CHGG has a narrow window of opportunity to offer ChatGPT capabilities with an easier consumer-facing interface. Given the wide selection of large language models (‘LLMs’), I expect the bulk of generative AI profits to come from the applications built with generative AI as well as the cost to host those applications. While CHGG has previously been seen as ChatGPT roadkill, it just might have a chance to be a generative AI winner.
Is CHGG Stock A Buy, Sell, or Hold?
Heading into the pandemic, CHGG was a strong growth compounder, showing over 30% CAGR in free cash flow since 2016.
Between tough comparables and ChatGPT threats, those growth days are gone, at least in the near term. Consensus estimates have CHGG returning to double-digit growth next year.
That isn’t so hard to believe, as CHGG would then be lapping essentially a whole year of ChatGPT competition. CHGG has rolled out generative AI capabilities in beta versions with some success.
The idea is that generative AI can help make CHGG’s existing offering more interactive, not dissimilar with the appeal of ChatGPT.
After trying ChatGPT myself, I can acknowledge the long term threats that the application poses to CHGG. However, I can also see the value in having applications built on top of ChatGPT interfaces in order to make it easier to work with (not everyone is born as a master of “prompt engineering”). There are no guarantees, but generative AI may be able to help CHGG increase its value proposition to students and further its lead over the competition.
At under 10x this year’s earnings, the stock can do well if the company can really return to double-digit growth next year. The solid balance sheet means that the company may be able to aggressively repurchase stock instead of pay down debt upon a financial recovery, adding an obvious catalyst for multiple expansion upside. On the flipside, if fundamentals continue to deteriorate, then the lack of a net cash balance sheet means that CHGG will likely have to seek means to pay down debt. I could see CHGG trading down to 5x earnings in the downside, and 12x earnings to the upside. I have limited the upside potential due to the possibility that generative AI remains a valuation overhang even if the company sees generative AI tailwinds. Valuation is not offering much of a margin of safety here as operating leverage can quickly work the other direction. Despite what looks to be a poor risk-reward proposition, I reiterate my buy rating for the stock as the solid balance sheet and modest valuation offer enough hope for the company to turn things around. But this is definitely a name that requires close monitoring as I suspect we will know sooner rather than later whether or not their efforts to harness generative AI are successful.
For further details see:
Surprise Surprise! Chegg Becomes A Generative AI Play