This Fast-Evolving Small-Cap Should Soon Dominate The Digital Education Industry

Tim Begany's picture

Thursday, August 20, 2015 - 12:30pm

by Tim Begany

In business, progress doesn't occur in a vacuum. Innovation arises out of need, and is often adapted from concepts or technologies initially developed in unrelated industries. For instance, who could have guessed that Netflix Inc. (Nasdaq: NFLX) would inspire the creation of an emerging leader in digital education?

That company, Chegg, Inc. (NYSE: CHGG), is a fast-evolving small-cap with an online education platform for high school and college students. Streaming media has become this company's "killer app."

Chegg's roots go back to 2001, when several students at the University of Iowa launched a textbook rental website. With the help of outside investors, the founders expanded on that premise, deploying a Netflix-type business model. By 2010, Chegg had rented more than two million textbooks through a mail-based distribution system and was generating $149 million a year of revenue: The key virtue: students found that simply renting textbooks was cheaper than owning them.

These days, Chegg does much more than rent textbooks (though that service still accounts for roughly half of the company's $300 million annual revenue base). Over the past several years, the company has made a big push into the dynamic digital education space. Chegg now offers a series of subscription-based products that help 15 million students learn and study in a digital format.

Among the most popular offerings are Chegg Study and tutoring via Chegg Tutors. Through its web portal, the firm also offers college search, internship and career placement services.

"Five years ago, [renting textbooks was] all we could do," said CEO Daniel Rosensweig in a recent interview with TheStreet.com "Four years ago we didn't even have a penny of digital business. This year, we're predicting between $137 million and $145 million worth of digital [revenue.]"

 

Digital Revenue Through Deals

Chegg has been increasing its digital presence through partnerships and acquisitions. Last November, for example, the firm signed a multi-year deal with Washington, DC-based Blackboard Inc. to sell homework help, tutoring and career services through Blackboard's "Learn" page. Blackboard offers an education management system that is used by about eight million students. In return, Blackboard gets a small guaranteed payment and a cut of Chegg's Blackboard-related subscription revenue.

To augment job hunting services, Chegg partnered with online career specialist InsideTrack this past April. This deal gives Chegg users access to a catalog of live online workshops which address cover letter writing, interviewing techniques and other career search activities. For a higher subscription fee, one-on-one career coaching is also available.

Recent acquisitions include the October 2014 deal for Internships.com, which added two million users to Chegg's user base. The deal also conferred nearly 400 university relationships and 90,000 internships with 60,000 companies.

In June 2014 Chegg acquired InstaEDU, a leading provider of on-demand online tutoring services. Two months earlier, the firm purchased Campus Special, which informs students about deals available to them from local businesses. But the buyout made particular sense for a different reason: it added a highly popular summer internship program to Chegg's lineup.

The firm has made at least a half dozen acquisitions since 2010, but management smartly stuck to a strategy of buying promising early-stage businesses for relatively low prices. (Internships.com, for example, was acquired for only $11 million.) Thus, unlike many acquisitive companies, Chegg has typically made all-cash deals and currently has no debt. And because it pays low prices for deals, the firm still holds plenty of cash and other current assets -- roughly $100 million as of the end of the second quarter.

 

Company Shares Are Finally Getting Some Respect 

Chegg initially faced deep skepticism: Shares plunged sharply after the November 2013 initial public offering. Many investors doubted the firm could move past its roots to become a profitable digital educator. At around $8.60, shares are still well off the IPO price, though they're up more than 20% in the past year, thanks in part to Chegg's better-than-expected financial performance in recent quarters.

But history may prove that the critical turning point was in late February, when Chegg's stock soared by double-digits on news that print materials distributor Ingram Content Group was taking over the logistics of the textbook rental business. Under the agreement, students still rent textbooks through Chegg's web portal, and Chegg receives a commission for each rental.

This bodes well for future profits, since it creates substantial rental revenue without the high costs of inventory management and fulfillment. The deal also allows Chegg to focus on growing its share of the digital education market, which analysts see more than quadrupling in size over the next five years to almost $450 billion.

Risks To Consider: Chegg has come a long way in the past decade or so, but will remain as a speculative investment until the company achieves profitability (which is expected in 2016).

Action To Take: For a speculative stock, Chegg is one of the better bets around. A diverse suite of digital services and a solid revenue base make it a top play on the burgeoning U.S. education market. The company is seizing on the fact that this industry remains highly fragmented, which should provide fertile ground for growth through further acquisitions. Plus, Chegg has long been cash flow positive, and analysts see it posting a first-ever profit of $0.25 per share next year.

 

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Tim Begany does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.