Perhaps a unique way to play the online education paradigm
2U (NASDAQ:TWOU), a company that many readers will not have heard of has pioneered a unique space in which it helps some of the leading universities in this country develop online learning programs that allow the prestigious institutions to leverage their expertise and earn significant revenue. The jury is probably still out on whether 2U itself is going to earn lots of money. I think that it will, and so I recommend buying the shares. But it isn't planning on earning lots of money for a few years and that may deter some investors. I think the many critics of this company's model are using highly selective statistics that are more polemical than objective in order to reach their conclusions. Vitriol is really no substitute for objectivity and diminishes the credibility of the argument.
Many of the critiques were written in the fall of 2015 and since that time, the share price trajectory has not worked out quite as anticipated. The company has had two quarters that substantially beat expectations and it brought forward its estimate of EBITDA profitability by a year. Overall, the company's shares made a top of $38/share in early August and fell steeply through the end of October and then recovered significantly before plunging again in this year's tech panic. The shares are now at about $27 up by 75% since their trough valuation at the bottom of the tech panic but down 29% since their peak. But the company has very high valuation and has yet to become profitable and so it is controversial, both as a business and as a potential investment.
2U suggests that it is a SaaS vendor. It is not, and really the technology it has created is nothing like the on-demand software model. That is unfortunate in the sense that it hurts the credibility of the business model. This company does have lengthy agreements with its University clients. But in essence, this company helps its clients by outsourcing much of the hassle of creating an online learning experience. But it is silly and not terribly accurate to call what this company does a SaaS business model.
I have argued elsewhere that SaaS models are potentially the most lucrative business models imaginable at scale for enterprise software companies. The economies of scale are here as well and they are visible in the numbers the last several quarters but this business will never generate the kind of profitability that real SaaS companies are likely to generate as they mature. Regardless of the 2-way or multiple way technology that 2U has developed, this is and will remain a relatively people-intensive business and one possible growth limit is simply recruiting the appropriate personnel who can achieve the company's objectives.
And not to understate the obvious, the for-profit education sector has been a political football and the current administration has more or less attempted to suppress it by denying students loans for tuition at for-profit higher education enterprises. This company avoids that issue in a unique way as its clients are the universities and not students and it would be hard to find evidence that graduates of the institutions for which it develops online learning technology have a poor track record in helping their graduates to get jobs.
There are a great many online learning programs offered by many universities these days. The current way of educating students is not a long-term business model. Tuition is already almost unaffordable for many households. The current model has not seen any material productivity gains in decades and it is unsustainable to continue to add scale to a process that loses money on marginal students and hope to make it up on volume.
The current solution to the dilemma is for universities to open what are called massive open online courses (MOOCs). The problem with MOCCs is that they are not really effective and offer a degraded educational experience. In an MOCC paradigm, the students have little or no real-time interaction with professors and fellow students and are supposed to learn mostly on their own time. While MOCC programs generate thousands of degrees per year, the degrees that are granted usually have some kind of an asterisk and are not worth all that much in a competitive job environment. 2U is going to have issues in persuading students that the kind of degree that it offers is equivalent to a traditional degree. And the cost of what 2U offers is anything but a bargain. But I think the model that they offer is a sensible compromise between the MOCC experience and the incredible costs associated with a modern college education in this country.
I think that everyone envisages a world in which a variety of IT solutions produce better educational outcomes for our kids than we have been able to achieve, more or less without technology. I am often appalled at what children don't learn in school these days that was considered normal half a century past. Gains in teacher productivity have been essentially nil for many years now, meaning that the cost of education (mainly RE taxes) has increased disproportionately and because so much of the tax burden for education is funded by property taxes, there have been boisterous arguments about whether the funding formulas unfairly disadvantage children living in poorer neighborhoods. Opposition to the Robin Hood laws passed in Texas to fund education more than 20 years ago were arguably the issue on which our 43rd president successfully ran for governor of the Lone Star state. 2U is only trying to solve a very little slice of that dilemma
So far, investment in the online education space, politely put, has not worked out well for most investors. In fact, anything to do with for-profit education has been toxic with a combination of less than stellar business models coupled with harsh government opposition have driven many for-profit education companies into the ground. 2U - that is really the company's name - has developed a clever niche that just might work. Sadly, I am hardly the first analyst to come to that epiphany. Of the 10 analysts that cover the name, 5 analysts love it and the other 5 just like it. That is not my favorite set-up when I look at potential investments. On the other hand, 2U has a nice track record of beating estimates significantly and it did so again, earlier this month when it reported earnings for its first fiscal quarter that ended on 3/31/16.
2U is a young company having been founded in 2008 and went public in March 2014 in an underwriting led by GS and Credit Suisse. The company's CEO is one of its founders Chip Paucek. Paucek, had previously been CEO of Smarterville, the parent company of Hooked on Phonics.
I don't suppose it will come as a great surprise to readers to readers to know that this company still makes losses although it has had a couple of quarters of break-even EBITDA. The company is really not a SaaS vendor and it simply doesn't and never will generate any substantial level of deferred revenue and hence operating cash flow is going to be relatively close to non-GAAP profitability. On the other hand, it is worth noting that the company has achieved cash flow positive status in its last two quarters, although this may be a timing issue on capex as opposed to something substantive. Unfortunately, the company does use moderate amounts of stock-based comp. This year's estimate for stock-based comp is about $17 million or a bit more than 8% of forecast revenues.
Again, hardly surprisingly, the result of the company's financial performance has engendered some seriously negative opinion expressed in some articles as I alluded to above. I think it is reasonable to say that this company would have a far more difficult time in reaching the public markets with its financial performance in the current environment. On the other hand, one of the articles which suggested that there is a limited market for what this company does seems a bit non-objective to me.
Do students really want to go to Yale or Northwestern or Georgetown online?
There are, to be sure, many issues involved in evaluating 2U's prospects but the first significant issue is basically demand. What this company does, which is to try to replicate something very close to the experience students get at a top notch university without having to physically go there, is something that has simply not been tried out in exactly the way it is being offered by 2U in the past. It is one of those things you really can't assess very easily because it has never been done in just this way in the past. The higher education market is vast. Some recent research says that students spend $555 billion a year going to college and spend $80 billion/year of that going to graduate school which has been the first focus of 2U's efforts. Needless to say, Federal and State funding for tuition support is substantial and that alone makes cost mitigation strategies imperative. While I believe that 2U will have little trouble in finding schools with which to partner, the question is how are students and faculty going to react to the new paradigm.
Many observers wonder just how many prestigious universities are going to sign up for partnering with 2U. For what it is worth, management has spoken about securing 6 agreements this year, 9 in 2017 and 12 in 2018. (By agreements, this company refers to specific courses that it co-develops with the university. It is the number of programs that is one of the gaiting items with regards to revenue generation.) By the end of 2015, 2U had 14 university partners and was offering 29 programs. The CEO had previously spoken about signing up 6 additional programs during 2016 and it has reached that goal. It has also signed up and announced 8 of the 21 programs it has forecast launching in 2017-2018. The company has no agreements that expire prior to 2021 and has signed renewal agreements with many of its university partners including one recently announced with USC-Rossiter School of Education.
I don't think it is terribly surprising that the educational institutions themselves are basically onboard with the concept. How else can they leverage expensive educational resources and receive tuition payments from students they do not have to house or feed or provide classrooms in which the students learn. These days, just the capital costs of new facilities are staggering and the facilities have to be maintained and some agreement needs to be reached with municipalities in lieu of real estate taxes. In New York City, the expansion of the two major universities, NYU and Columbia is taking place on exceptionally valuable land and has stirred significant community ire. I am given to wonder where UCLA 's Westwood campus could actually grow before it encroached on some of the most expensive homes in the nation and commercial facilities in Westwood village.
Here is a snippet of a press release announcing the Syracuse University partnership with 2U to develop a J.D. Degree Program that well illuminates the thinking of many universities. "This partnership will enable the College of Law to reach talented students nationwide and allow us to grant unprecedented access to Syracuse Law's outstanding legal education" said Kent Syverud, chancellor and president of Syracuse. "The J.D. program will feature live, face-to-face online classes and dynamic course content delivered through 2U's platform. Syracuse Law faculty will create coursework using 2U's proprietary Bidirectional Learning ToolTM which empowers law professors to teach online…"
Of course, Syracuse is enthused about the program. It has the opportunity to substantially increase its revenues without hiring more professors (although that is probably tendentious and open to clarification) or building a single new classroom or dorm or having to deal with a large potential population of students. Education, even in an institution like Syracuse, is a business and businesses that can increase revenues with no additional capital costs and can avoid the complexities of trying to find student housing, student health, and sustenance facilities have found a really nice opportunity.
The cost of a 2U education is not inconsiderable and the tuition is the same as a student would spend to get a degree at the physical institution. But all the same, while the income to the university is almost all incremental, the cost to the student is far, far less. Student housing is expensive, the expenses of restaurant meals are not inconsiderable and such things as needing a car to go to school can weigh heavily on student finances. Because of the way 2U structures its programs it is far easier for a student to find work or remain in a job than is the case in a traditional site-based educational process.
There have been articles I have read that question whether or not this course or that course is going to achieve the scale needed to justify the investment that 2U makes to develop curriculum in conjunction with the university. One such course that was cited as being less than fully subscribed is the Masters of Information and Data Science that is offered by UC Berkley. At the moment, 2U's partners offer 25 different courses using the 2U technology. I assume that with 25 different courses being offered by 2U, some are likely to be more popular than others. Just on the face, 191 students each paying $60k+ for their tuition would produce nearly $12 million in revenue. We don't know the specific terms of the Berkley contract but typically 2U gets 60% or more of the tuition generated. The company cites an 84% student retention rate. Retention rates for students using 2U technology are far greater than it is for students in MOCC's with which some readers may be familiar. That is not terribly surprising given that the universities themselves actually are the ones who set admission standards and admit the students. In any event, the numbers suggest that so far, 2U has generated about $6 million + from the Berkley relationship. Management says that its upfront investment in a typical course partnership is $7 million to $10 million over 3 years. If an unsuccessful program really almost breaks even, then the profit potential of the other successful programs must be quite significant indeed. But I am not so sure that being able to get a Masters in Information Science will not turn out to be far more popular as a course than the initial enrollment might suggest.
So far the largest student pushback about Universities offering courses built on the 2U technology has been the Yale School of Medicine where its Physicians Associate program is still awaiting accreditation. The original announcement came last March and some of the students were, to put it mildly, very upset about the school's decision. Their concerns were that it would decrease the value of their PA degree from Yale. There were also concerns that current students in the program weren't adequately consulted. The resident students were said to be concerned that, "the rigor and reputation of the online degree will not match those of the regular degree." One student, a 2014 graduate of the Yale PA program said, "I'm afraid that an online version only compromises the quality of the PA education and ultimately puts patients and America's health care system at risk."
I am not writing this article in an attempt to assess the quality or potential quality of the Yale 2U program. I can read, however, and the issues of accreditation are those of bureaucracy run wild. The issues are not program quality or program outcomes but whether or not the program was an expansion of what is being offered, or a new kind of program. No guesses for which definition was accepted. Yale now thinks the process of accreditation will take another 18 months but apparently the potential for the program - and by that I mean the financial potential - is great enough that the school is staying the course.
I don't think that anyone would pretend that going to an online program would match the overall student experience of a physical education at Yale. There is, to be sure, something to be said for the value of camaraderie, student and faculty support and so forth that can be obtained only in a residence program. There is even more to be said for the experience of enjoying a pizza at Frank Pepe's. In fact, I am yearning for a clam pie about now. On the other hand, the online program that will be offered require the students to do clinical rotations at pre-approved off-site locations. And the program also requires the online students to be on campus for two weeks to learn practical skills.
I am not going to solve this debate in this article. I haven't the skill set or the tools to write a scholarly paper on the subject and I doubt that many readers would be interested in such a work if I could do it and it certainly would help readers achieve positive alpha.
I think the net of what my conclusions are is: a) many universities need/want to expand their student populations for many reasons - mainly economic, but it is also said to expand their global reach; b) expanding on-site is extremely difficult, time consuming and doesn't solve the basic problem that the incremental cost of an additional student is not equal to the tuition that can be charged; c) 2U's programs, which are not in the same category as the MOOCs that are being offered by some universities, is a decent financial opportunity for the universities; d) the approach offered by universities using the 2U technology is far less costly for most students. They avoid all the expense of essentially moving and setting up a household and can continue to live with their parents or even go to work and e) while some students who are going to resident programs might be unhappy that the student base is being expanded, there appears to be a certainly element of both "rent seeking" and of "ludditeisim" in their complaints. Something like the 2U technology is going to come to the education world because it is cheaper and achieves more or less the same outcomes as current bricks and mortar education.
OK - Maybe I believe that a hybrid online educational process is the wave of the future and that 2U is at the forefront of that movement. I have my doubts, but I want to move on. Does the 2U business model have enough operating leverage to scale or is the company doomed to limp along just marginally profitable?
The basic issue in terms of the profitability of the business model is the cost of marketing and sales. That ratio was just over 50% last quarter and while that is down from 57% in the year-earlier quarter it is still at levels that do not allow this company to achieve GAAP profitability. Most of the company's 900 bps improvement in margins came from modest cost constraints on sales and marketing. G&A expense at 20% is also far too high for a company of this size. G&A expense did not come down this quarter as measured by ratios. For the full year of 2015, marketing and sales costs declined as a percentage from 59% to 54%. On the conference call, management essentially said, that beyond the time of the EBITDA break-even and cash-flow break-even, the rate of improvement in margins is going to slow significantly.
The basic reason for the relatively slower growth of margins is the faster pace of new program additions. This company needs new program additions in order to grow. Each new program has significant operating and capital costs in its early years. The greater number of new programs that are launched in a particular time period, the greater the growth of both sales and marketing expense and in other opex categories as well. The company has already spoken about ramping the number of new courses it introduces substantially as I indicated earlier so it is not too surprising that the rapid trajectory of margin increases cannot be sustained. 2U has a model in which much of the revenue growth from a new program comes in the first couple of years and then the revenue flattens.
The conference commentary, despite the excitement around reaching EBITDA profitability a year earlier than planned, was all about sustaining rapid growth and sustaining rapid growth involves launching new programs. While like many tech companies that make promises of a highly profitable business model at scale, it seems as though this company is going to define scale until revenues double or more from current levels. If investors are looking for high levels of earnings growth, near-term growth in GAAP profitability and accelerated improvement in both operating and free cash flow, this is not the company in which to invest at the moment.
With an enterprise value right around $1 billion and with the forecast level of revenues for this year being just above $200 million, the EV/S is 5. That isn't that bad for a company who has a sustainable 30% growth rate. On the other hand, since the company doesn't yet generate even non-GAAP earnings at this point and it will be another year until it can reach free cash flow break even, those metrics are not meaningful at this point. The company has had a consistent history of beats and raises in the 9 quarters since it went public and I believe that it would be reasonable to expect that kind of pattern to continue as well.
The business model is going to be easy to fix whenever the company wants to fix it - just reduce both the ratio of sales and marketing and G&A spend. In a growing company as this is, it doesn't mean cutting heads, it means increasing them at a slower pace than the growth in revenues. One assumes that at some point, going to an online study program, particularly in the graduate school area online will become mainstream. But that hasn't happened yet and new programs and new verticals and new relationships have to be marketed and marketed intensively. While the EV/S has come down significantly over the past couple of years with the share price increasing more slowly, overall than the growth in sales, there is still risk that it could contract more.
Catalysts, Caveats and Competition
There are plenty of competitors in the online education space. But they do not do exactly what this company does. If you want to get an online MBA degree. or nursing degree or JD degree from a prestige university, at this writing 2U is the only company that offers that specific capability. Because of the focus on essentially replicating the university admissions process, the retention rate is 84%, dramatically higher than the other companies in the space. At some point, I suppose, that is going to change but VC funding for ed-tech, certainly isn't what it used to be. Certainly the political assault on for-profit learning organizations has created an environment that is unfriendly to new start-ups selling online education for a profit. Overall, I think the biggest competitive moat this company enjoys is the large upfront costs that are required for a new venture that wants to replicate its strategy of partnering with prestige universities. There is also likely to be the issue of credibility for a start-up. In addition to developing technology, the early years of this company were spent recruiting universities with which to partner. 2U clearly hasn't got the capacity to partner with every prestige university in terms of offering courses emanating from those institutions. But I think it will be hard for a new entrant to land the first few partner universities.
There are some real caveats to mention that extend beyond competition and the barriers to entry. The company has seen some management turnover in the first months of this year. Is there anything beyond the fact that people move? Management says no and offers credible reasons why each individual departed. It is an issue to be considered.
At one point, investors were concerned with the revenue concentration this company had with just a few universities. As time has passed and many more universities are partnering with 2U, that concern has diminished. In addition, concerns have been expressed at the satisfaction of universities with 2U's service and some comments focused on the renewal risks. At the very least, there are no renewals with any of the universities coming up until 2021 and the company has seen a significant number of renewals from its initial cohort of customers.
I think the real caveat here is the pace at which this system of learning is fully accepted by professors and students. Most professors and essentially all students and their parents simply do not care about university finances. At the end of the day, like most people, I suppose, both professors and students are rent seekers and want to keep their club as exclusive as possible. The rent they are seeking to maximize is the value of their degree and they seem to feel that it would be threatened by online degrees. Things change in the world. If it costs dramatically less to get an online degree from a high quality university and the quality of the experience and the quantifiable outcomes are similar, the kinds of courses that 2U facilitates are going to substantially grow and the reputation and value of the courses will gradually enhance.
Obviously, a company that doesn't earn money and has a billion market capitalization is expensive. And given that management intends to maximize growth and will do at the expense of any further dramatic increases in profitability is surely likely to deter some investors. It is what it is. If the company continues on its growth trajectory it will reach $600 million + in annual revenues by the end of the decade. I think if that happens, most everything else falls into place. I think it is going to happen. I have tried to lay out the facts as objectively as possible.
The major catalysts going forward for 2U are likely to be additional announcements of new course initiatives and new university partners. The company is starting to offer some courses for undergraduates but not to the extent where the offered courses replace the resident student experience. Success in that program, while hardly guaranteed, would be a huge catalyst if it moves forward given the far greater size of the TAM for undergraduate education spend. And needless to say, earnings releases will often move the shares, although the response to the latest beat and raise quarter announced by the company on May 5th was barely perceptible.
2U is a company trying to build an unduplicated niche in the online education field. Its mantra is to help facilitate prestige universities to offer online degrees in selected graduate fields of study using both an online approach coupled with some physical hands-on interactions. It has been quite successful in signing up a significant cohort of universities including one, Yale, in the Ivy league and another, UC Berkley, amongst the bright lights in the American higher education pantheon.
The company has a high valuation and no profits and no cash flow. While 2U will reach EBITDA "profitability" this year, a year ahead of schedule, the basic valuation metrics aren't there yet, although the EV/S metric of 5X is dramatically lower than it was a few months ago when the shares were 40% higher and the sales level was significantly lower than it is today. On the other hand, the company has indicated that after it reaches EBITDA profitability, it intends to improve margins far more slowly than heretofore in an effort to broaden its business base and to achieve true levels of scale.
I think that this kind of hybrid online model that 2U offers, addresses many of the issues faced by today's universities and the student bodies of most prestige institutions. I think it is impossible to continue to expand prestige universities at a significant rate given the high capital costs incurred, the incursions into residential neighborhoods and the issues surrounding ever higher tuition. This kind of online model is one of the few opportunities that universities have to enhance the productivity of their staff and to earn additional tuition without the risk of setting up courses in new disciplines. I have tried to point out some of the risks above and that may deter some risk intolerant investors. This investment may not offer the kind of asymmetric returns many investors wish to have.
But this is an interesting name to consider for most growth, risk tolerant investors and while it is anything but a defensive or value stock, in the right kind of market it will achieve noticeable positive alpha.
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.