Is Chegg’s initial success sustainable in the long run? (NYSE:CHGG)

The investment thesis

We think Chegg, Inc.NYSE: CHGG) enjoyed its early success for a long time and was more focused on shareholders than on its customers. A company’s acquisition growth strategy only provides short-term benefits to the company and There is limited support to build the ditch.

Also, the company attributed the decline in revenue to macro effects. This argument contradicts the statement that the market was still in the early growth stage.

Moreover, the company may face stiff competition from emerging AI rivals in the future but the company spent the bullets on buybacks.

Overall, we find that the company’s outlook and strategy are not convincing.

There are some catalysts for the stock but we think the upside is limited. We rate the stock as Neutral.

Company Profile

The company was established in 2005. It provides digital and Physical textbook rentals, online tutoring, and other student services.

The company offers 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 offers.

It generated revenue of $766 million in 2022 and operating income of $8.9 million in 2022.

• In Q4 2022, its revenue fell by 1% to $205 million, from $207 million, accelerating from -4.1% in Q3 2022.
• Its membership increased by 4% and skills and others decreased by 37%.
• In Q4 2022, its gross margin increased 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 subscribers will grow 5% to 8.2 million. The company provided the following outlook for Q1 2023 and FY2023:
• Its revenue will decline by 8.5% in Q1 2023.
• Its subscription revenue will decline by 3.5% in Q1 2023.
• Its gross margin remains flat at 72%-73%.
• In 2023, its revenue will decrease by 3%.
• Its subscription revenue will decline by 1.7%.
• Its gross margin will decline by around 100bps

We have the following comments:

In 2022, the company’s revenue growth lagged behind its customer growth. This indicates a decrease in revenue per subscriber, which is a sign of decreased customer loyalty.

The company sees a decline in new customer growth in 2022 and attributes this to macro headwinds. A key indicator to monitor for a subscription business is subscriber growth. A decline in customers is a red flag for the company.

Company fundamentals

The company may already face competition

The company believed it had the highest unsupported brand awareness among its peers. However, Google Trends results suggest the opposite result.

A Google Trend search comparison not only shows that Grammarly is widely searched among users, but it also reveals that searches for Chegg have declined over the past five years.

The company believes that the industry is still in its early growth stages. According to Google Trends, ChatGPT seems to be gaining attention much faster than the company. In our opinion, ChatGPT fits the definition of a growing company more than Chegg.

In the Q4 2022 earnings calls, management responded to analysts that they believed ChatGPT was not a threat and that the company’s strategy for responding to ChatGPT was to use it.

Our ability to partner with these companies proves how valuable our audience is to some of the biggest brands. The hot topic right now is AI and machine learning. We have all seen that big language models like ChatGPT have caught the attention of many people. We believe that AI will have a significant impact on human capabilities and humanity as a whole.

But AI and machine learning models aren’t new to Chegg. We’ve been using these technologies within our platform for years, and we believe these continued advancements will benefit Chegg as a student. As an example, we have been using GPT 2 in our writing products, improving our ability to provide support with grammar, interpretation, and set structure.

We believe that if ChatGPT becomes a threat to the company, it may be challenging for the company to maintain its position in the market due to limited resources. In the section below, we discuss whether the company has invested heavily in acquisitions and buybacks, which can strain its financial capabilities to respond to competition.

The company chose to spend on acquisitions and buybacks

The company raised $984 million from a convertible bond in 2020 and $1091 million from an equity offering in 2021. Instead of spending on its research team, the company decided to use the funds to make acquisitions and buy back its stock. The company believed that acquisitions were the way to grow and we could see its acquisition footprint at 10k. The company has made a couple acquisitions since 2010.

Beginning in 2010, we made a series of strategic acquisitions to expand our service offerings, including adding Cramster Chegg Study in 2010, internships.com adding Chegg Internships in 2014, and Imagine Easy Solutions adding Chegg Writing and programmatic advertising in 2016. Cogeon GmbH to add Chegg Math in 2017, WriteLab to add enhanced features to Chegg writing in 2018, StudyBlue to add our flashcards in 2018, Thinkful to add our skills-based learning platform in 2019, Mathway in 2020 to add Chegg Math to strengthen our Math offering. , and to add the Busuu language learning service in 2022. We completed our initial public offering (IPO) in November 2013, issued a follow-on offering in August 2017, 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 to buy Busuu. Busuu operated at a loss and had only $21 million in cash and $16 million in deferred revenue. Chegg incurred $368 million in goodwill from the acquisition. Chegg’s actual 2022 revenue was $766 million, down 7% from the $820 million projected in pro forma revenue. This indicates that Chegg or Busuu will underperform in 2022. Furthermore, the company had forecast a decline in revenue in 2023. The company’s acquisition strategy seems not to be working well.

Additionally, the company spent $623 million on buybacks over the past 2 years.

Despite this substantial buyback, the stock was still trading near its 52-week low. This is also a sign of concern for investors.

Industry trends suggest the opposite of what the company thinks

The company attributed the drop in revenue to a decline in U.S. college enrollment in 2022.

According to the National Student Clearinghouse, total undergraduate college enrollment in the United States has fallen by more than 7% since the start of the COVID-19 pandemic, or a loss of more than 1 million students. Chegg derives a significant portion of its revenue from students attending US colleges; And as such, a continued decline in the number of students enrolled in U.S. colleges could materially adversely affect our business, growth, results of operations, and financial condition.

However, according to the National Student Clearinghouse, an educational nonprofit organization with a nationwide network of 3,600 colleges, representing 97 percent of postsecondary enrollment, enrollment has stabilized in 2022 and started to increase in the spring of 2023. Management does not have a pessimistic 2023 outlook. Align with this trend.

Fall undergraduate enrollment began to stabilize in 2022, shrinking by only 0.6 percent, or about 94,000 students, compared to fall 2021.

Community college enrollment is expected to increase in spring 2023 (+2.1%), driven by strong growth among dual enrollees (ages 17 and under) and freshmen. Community college growth is occurring in all campus settings while undergraduate enrollment is increasing only at four-year institutions on suburban campuses. Overall undergraduate enrollment was steady (+0.2%) this spring, with only the public four-year sector experiencing a drop in undergraduate enrollment. Total enrollment (undergraduate and graduate enrollment combined) remains unchanged from spring 2022.

Evaluation and motivations

We make the following assumptions based on the company’s financial and current market conditions:

1. Company revenue remains flat in 2023.
2. 20% WACC
3. 3% terminal growth rate
4. 20% Free Cash Flow Margin (2022)
5. Net Debt -84 million (Q4 2022)
6. Shares outstanding 127 million (Q4 2022)

By applying the DCF method, we arrive at an equity value of $1,005 million ($7.9 per share), which represents a 52% drop from the current stock price.

With the sensitivity test below, we can see that the stock is undervalued only if the free cash flow margin of the stock rises above 30% and the WACC falls below 15% or the WACC falls below 10%.

For the above scenarios, the triggers can be:

• A company improves its profitability by restructuring or increasing product prices. The company improved its gross margin from 67% to 74% through the sale of its print textbook library. The company has an opportunity to increase its gross margin by taking steps such as working with ChatGPT and selling its redundant software. In 2022, the company had high operating expenses, which were 73% of its revenue. However, there is potential opportunity to improve the company’s margins by integrating recently acquired software and personnel into its core Chegg platform. This can result in cost savings for the company, which in turn can increase profits.

• A possible decline in Treasury yields as a result of a rate cut by the Fed or a recession could lower the WACC. In many of our analyzes using the discounted cash flow (DCF) model, such as our report Warby Parker progresses at a constant pace, we found that certain stocks can benefit from economic downturns. In particular, companies that show resilience to economic downturns or are in the early stages of growth may see their stock prices rise as long as they continue to operate. This is because a lower WACC means a lower cost of capital for these companies. If the company can sustain its operations, the market is comfortable supporting the company with funds. We believe that the education industry could potentially benefit from the recession, as people who have lost their jobs are often more inclined to further their education and acquire new skills to remain competitive in the job market. Therefore, a recession or rate cut can be a catalyst for stocks.

Risks

Recession risk

As we discussed in the motivation section, we think the education industry has the potential to thrive during a recession.

Furthermore, governments often allocate more funds to education during economic downturns, creating more opportunities for company growth.

However, the company’s performance does not seem to follow the recent general trends in the education sector. Therefore, it may not be a foregone conclusion that recession will increase the required revenue for the company.

summary

We think the company enjoyed its initial success for too long and was more focused on shareholders than on its customers. A company’s acquisition growth strategy provides only short-term benefits to the company and limited help in building a niche.

Also, the company attributed the decline in revenue to macro effects. This argument contradicts the statement that the market was still in the early growth stage.

Moreover, the company may face stiff competition from emerging AI rivals in the future but the company spent the bullets on buybacks.

Overall, we find that the company’s outlook and strategy are not convincing.

There are some catalysts for the stock but we think the upside is limited. We rate the stock as Neutral.