Chegg Will Profit From The Transformation Of Postsecondary Education (NYSE:CHGG)

(Source: Chegg)

Chegg, Inc. (CHGG) is known for its “students first” mandate, providing low-cost educational support services for university and college students, and also providing textbooks at a low cost. Services, referred to as Chegg Services, consist of “Chegg Study, Chegg Writing, Chegg Tutors, Chegg Math Solver, Thinkful, and Mathway”. The other area of business, that the company refers to as Required Materials consists of low-cost textbook sale/rentals and also eTextbooks. Chegg partners with several third parties, including MacMillan, McGraw Hill, and Cengage Learning.

Being an online educational service for students, Chegg has been a major beneficiary of the education system shutdown last spring due to the pandemic. In fact, revenue jumped 57% YoY for Q2 2020, which ended in June.

(Source: Chegg)

The exciting part is that online postsecondary education is set to explode this fall, as students have few options other than online learning, without skipping a year. Chegg should benefit tremendously from this current macroenvironment as students spend more time in front of a computer and less time in the physical presence of professors and teaching assistants.

Transformation of the Postsecondary Education System

The pandemic has forced the transformation of the postsecondary education system, something that I believe is long overdue. The existing educational system has resulted in massive student debt, while providing less-than-ideal job placements upon graduation. The shift to online education will drive down the high tuition fees, as institutions will find it difficult to justify the existing fees as courses are offered online. The bright side of all this is that online education opens up new markets, providing a wider reach for universities, including that of international students. I should mention that the international market is an area that Chegg is planning on expanding into.

In my opinion, the increase of Chegg Service usage during the pandemic is not likely to recede once the pandemic subsides. The reason is simple: postsecondary education is extremely competitive, and marks are important. Once students experience the benefits of the online services, they won’t likely stop using them once they physically return to school. And quite often, the parents pay for such services and see the benefits.

Stock Chart

The stock price exploded back in May with the release of 2020 Q1, breaking out from resistance at ~$45 to a high of $90, before falling back during the summer lull. Now the stock is poised to resume its upward trajectory as the fall semester gets into full swing.

(Source: Yahoo Finance/MS Paint)

The Rule Of 40

One industry metric that is often used for software companies is the Rule of 40. The rule provides a single metric for evaluating both high-growth companies that aren’t profitable and mature companies that have lower growth but are profitable. Revenue growth and profitability (expressed as a margin) must add up to at least 40% in order to fulfill the rule. Analysts use various figures for profitability. I use the free cash flow margin.

The rationale for the Rule of 40 is as follows. If a company grows by more than 40% annually, then you can tolerate some level of negative free cash flow. But if a company grows by less than 40%, then it should have a positive free cash flow to make up for the less-than-ideal growth. This rule accommodates both young, high-growth companies as well as mature, moderate-growth companies. The 40% threshold is somewhat arbitrary but typically divides the digital transformation stock universe in half, separating the best stocks from the so-so ones.

For a further description of the rule and calculation, please refer to a previous article I have written.

The two factors required for calculating the Rule of 40 are revenue growth and free cash flow margin. Chegg’s annual revenue growth for the latest year is 40%. The company’s TTM free cash flow margin is a decent 17%.

(Source: Portfolio123/MS Paint)

Therefore, the Rule of 40 calculation for Chegg is as follows:

Revenue Growth + FCF margin = 40% + 17% = 57%

Its score is significantly higher than the necessary 40% needed to fulfill the rule of thumb, suggesting that this company has a healthy balance between growth and profitability.

Interestingly enough, when I examine the forward efficiency score, a term that I invented that is essentially the Rule of 40 on a forward-basis using earnings as opposed to free cash flow, Chegg makes it into the top 10 stocks in my digital transformation stock universe of consisting 170+ stocks.

(Source: Portfolio123/private software)

Stock Valuation

There are numerous techniques for valuing stocks. Some analysts use fundamental ratios such as P/E, P/S, EV/P, or EV/S. I believe that one should not employ a simple ratio, and the reason is simple. Higher-growth stocks are valued more than lower-growth stocks, and rightly so. Growth is a significant parameter in discounted cash flow valuation.

Therefore, I employ a technique that uses a scatter plot to determine relative valuation for the stock of interest versus the remaining 170+ stocks in my digital transformation stock universe. The Y-axis represents the enterprise value/forward gross profits estimate, while the X-axis is the estimated forward Y-o-Y sales growth.

The plot below illustrates how Chegg stacks up against the other stocks on a relative basis based on forward gross profits multiple.

(Source: Portfolio123/private software)

A best-fit line is drawn in red and represents an average valuation based on next year’s sales growth. The higher the anticipated revenue growth, the higher the accepted valuation. In this instance, Chegg is positioned slightly below the best-fit line, suggesting that the company is fairly valued on a relative basis relative to its peers.

Investment Risks

There are several risks that investors should consider before investing in Chegg. First of all, I view the current stock market action to be reminiscent of the dot.com era, immediately prior to the crash starting in 2000. Technology stocks were performing well beyond what many analysts considered acceptable valuations. It wasn’t long before the market turned into a disaster, and the same could happen here, although I believe that there is much more substance behind the internet companies than existed 20 years ago.

While I believe that Chegg is navigating the current economic environment nicely, a prolonged recession could impact the company’s results. The pandemic will eventually go away, but the recession, or some say depression, could linger for a prolonged length of time.

While I expect that Chegg’s revenue will continue to grow, there could be less demand for the company’s services once students physically return to university/college. That is something that only time will tell.

Summary and Conclusions

Chegg provides online educational services to postsecondary students. These services include the Chegg Study subscription service, which assists students with their course work. Students can also reach out to live tutors, use the Math Solver subscription, and have access to other useful educational services. The company also offers textbooks and eTextbooks via several publishing partners.

I believe that Chegg is in an ideal position to capitalize on the future of postsecondary education as it shifts toward online remote learning. The company’s 57% YoY quarterly revenue growth is just the beginning, and the latter part of the year should be huge. The stock price surged in May, and it appears that we are about to see further appreciation as the year progresses.

Chegg not only has strong revenue growth but also a pretty decent cash flow margin of 17%, allowing this company to easily fulfill the software Rule of 40. The fair stock valuation on a relative basis and future prospects make this investment a no-brainer. For these reasons, I am giving Chegg a Buy rating.

Digital Transformation is a once-in-a-lifetime investment opportunity fueled by the need for businesses to convert to the new digital era or risk being left behind. And the pandemic has dramatically accelerated this paradigm shift. You can take advantage of this opportunity by subscribing to the Digital Transformation marketplace service. 

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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