Every now and then over the course of time, after sifting through hundreds of stocks, you get lucky enough to find an underfollowed name that by sheer lack of market sex appeal is a diamond in the rough. 2014's diamond in my portfolio has to be 2U, Inc. (NASDAQ:TWOU). This company has been given no breaks from the market until recently and has had to fight for every penny of share price appreciation despite a very one-sided bull story that just now turned heads on The Street with Q2 announcements. Turn heads it did. With the announcements that it recently took a major step towards profitability - which was way ahead of schedule and in the face of quite a bit of skepticism - the shares have ripped higher each day prior to yesterday, on the reaction to a senseless downgrade from Goldman Sachs. This article will make the argument that based on recently announced financial developments, overall health and strength of program pipeline, a unique blending of accounting methods, and a high barrier to entry that TWOU is a strong buy candidate that is on the front end of a multi-year bull run. The shares, up substantially since IPO and up since my last continuing coverage article, continue to be undervalued.
The Road Less Traveled
For those not familiar with the stock, I urge you to read any number of the articles listed under the ticker at SA. I also urge you to read my previous two articles so that you can follow my line of thinking and rationale as I may have just gotten lucky with this call. You definitely want to make sure you agree with me in my general thesis before purchasing at these prices as the stock is closing in on 52-week highs.
That being said, a general description from my continuing coverage article "2U, Inc. Remains On The Dean's List Of Steady Performing Stocks":
TWOU operates an online education platform that focuses on offering the exact same education to students that would be offered in the classroom. Believe it or not, many major universities do not currently have an online education platform in place. These so called "greenfield" opportunities have become the metals which with TWOU has built its foundation of revenues dating back to its initial offering at the University of Southern California in 2009. As time has passed TWOU has been able to acquire outside universities, multiple disciplines within existing universities, and further disciplines within existing programs - all adding to the base of consistent revenue derivation at the company.
It's taken TWOU five years of pounding the pavement and value prop pitching to close 17 programs at 12 universities. For those of you reading this and thinking a bear case can be made using low barrier to entry, forget it. Despite a significant obvious need for online education platforms at universities and a clear lack of industry leader to turn to, most universities have required return trip after return trip before allowing TWOU a chance at a greenfield launch - initial program implementations at each school.
Now that TWOU has overcome the initial barrier to entry, which was huge and set the table for the recent financial surprises, it appears to be cultivating a network effect with members of its initial "Core Four" programs who have moved to outside schools. Core Four programs are the initial four programs that TWOU had launched prior to 2013 and before that time derived substantially all of its revenue from. The TWOU story, while showing signs that it shouldn't be showing for at least another 12-18 months, is not a mature one. This company has just begun developing its market and its potential. What this has done is allowed for quicker contract closings and for in-the-door name recognition when TWOU makes a presentation. What does that do for cost per customer acquisition? Well, you can probably guess that it drives down the cost and expands back end margins. So that's the first part of the road less traveled that TWOU decided to embark down 5 years ago.
The second part is a play on the network effect that TWOU has built. Sure, it has worked hard to build its current momentum that we'll get to in a bit. Sure, it has worked hard to create an administrator tree with which to call upon when administration members of the Core Four promoted to other opportunities. What doesn't get mentioned in research reports is that TWOU could have chosen a road that would have had it showing much closer to profitability day one, and most likely being profitable as of right now, but it didn't. It chose the road that required confidence and long-term vision to choose. It chose the accounting road that would have it see perpetual margin expansion if it could see success. It chose a road that would have its financial numbers turn a profitability corner and never turn back.
Explaining what I'm talking about in detail requires a quick explanation of the accounting methodology used at TWOU. First, the company chooses to expense most costs as incurred - meaning on the front-end. This creates significant losses on the front-end of things like program implementation (from an infrastructural and hardware/software standpoint) and advertising program launches. TWOU could have capitalized both, especially the implementation, as a tangible asset and the advertising as an intangible asset and slowly depreciated and amortized the costs. It didn't. The company chose not to do this because it wanted to avoid anything pressing on margins down the road as it trusted the long-term visibility of revenues based on its "subscription" based model. When you expense major costs like this on the front end, if you can survive, the back end gets really attractive. Margins can expand perpetually as the maintenance costs are low when compared to the perpetual revenue stream coming in from the students' semester after semester. Other than content creation, which TWOU does capitalize as it wants to match the costs with revenues generated form the content, there are very little recurring costs. Even the content creation is sporadic in need as content (course content) generally only needs refreshing once every five years. That being said, TWOU has an immaterial amount of amortization each quarter coming from these capitalized costs - which matters because that is a major fixed cost that is unavoidable in this line of business. Controlling it is huge and TWOU has found a way to manage this cost as well as could be expected.
What does this mean to investors? What it means is that at some point, and before this quarter that "some point" was a moving target, the base of launched programs and secondary programs stemming from those initial launches would be generating enough revenue to overcome front end costs of the recently implemented and newly implemented programs (read: losses) and show the first signs of operating loss shrinking as a percentage of revenues. That, my friends, is called watching the margins - not the profit margins but the margins of the growth curves. The great stuff happens on the margins; you want to be long companies that show a trend-line reversal on the far margins of the trend-line, especially when that trend line turns north. That's exactly what happened at TWOU during Q2.
For the second quarter in a row - the company has been public for two quarters - TWOU exceeded all financially guided metrics. This helps explain the recent share price performance.
Now, TWOU has a history of being conservative with guidance and I noted that in my last article. Management has been able to do this because the market has had low expectations as sentiment has largely been bearish since the IPO and many of the analysts who cover the name had year end 2015 as a first checkpoint for profitability, not for profitability but as a checkpoint to be given guidance.
I don't think management will have the luxury of low-balling numbers any longer. During Q2 TWOU saw 32.4% revenue growth Y/Y on the Q and 35% revenue growth on the 1H. Both figures were higher than I had modeled and higher than every single other analysts' models on the recent conference call. This was the result of quicker acceptance and deeper penetration for recently launched programs and more effective marketing as a result of increased effectiveness of TWOU's program selection and optimizing algorithm. Both of these factors that helped act as tailwinds for revenue growth should only grow larger over time.
This is a huge reason to be bullish long-term. If TWOU can further cut corners on advertising due to a more efficacious program selection that would help reduce the largest recurring expense on the income statement. Why hasn't the company utilized this algorithm in the past? It has but because of a lack of scope of data the algo wasn't as effective as it is now and as it is trending to become in the future. This is something management is really excited about - the use of its analytics.
Something else this analytical engine does is provide further evidence of the secondary barriers to becoming a defensible leader in the space - something TWOU definitely is. What I mean by that is that developing this space isn't simply selling the idea of a program implementation to administration and then having a program launch. The local cultures have to be willing to accept an online option as a way to achieve a degree and the acquisition of the students has to be economically plausible. Being able to select schools, having the analytics (whatever they may be) to be able to more accurately select low hanging opportunities increases chances of long-term company success and with that all the other intangibles that come with seeing success after success - brand recognition, trust from administration, brand equity with students, etc.
I will be very closely watching the advertising spend figures for the new program to be launched at Southern Methodist University in Dallas, Texas in January 15'. If TWOU can show less advertising spend and equal scheduled penetration that would be a reason for me to adjust my modeling of revenue growth higher and with that net loss lower. The SMU program is also TWOU's first in Texas and the Southwest so it'll be interesting to see if culturally the South will acclimate to an online program. I'm watching this launch as the biggest driver and indicator of mid-term revenue growth.
The revenue growth wasn't the only sign of a changing direction of prevailing growth winds. As a matter of fact, it was what everything else did as a percentage of revenue that has The Street so bulled up:
This graphic here will eventually be looked at as the graphic that helped TWOU show the world it was an inevitability that the company would become profitable. This was a monumental moment in company history. That is no exaggeration.
Everything you want to see and take note of is in the middle columns, right hand side. The three month Y/Y comparison showed drops as a percentage of revenue for every single expense line item outside of G&A - which one would expect to increase as a percentage as the company continues to scale up and grow. This is the one line item that doesn't have to show trend line decreasing to still remain bullish. All of the other expense lines dropped in the quarter Y/Y pressuring the operating loss lower by 5.3%, and that line item falling is the smoking gun for profitability. The company is clearly growing the top-line faster than expenses and it is closing the loss gap. I can't tell you how big that is this early in development.
Consider this: TWOU doesn't have a great economy of scale. Although it clearly has the base of launched programs implemented to provide the economy of scale needed to show an initial closing of losses, TWOU isn't anywhere close to the level of efficiency it should someday operate at (as its algo gets better so will efficiency), TWOU has presumably the smallest amount of brand recognition and equity that it will ever have going forward, and TWOU has to this point mostly focused on launching primary programs that have much lower front and back end margins. As TWOU matures, its financials should all accelerate positively. Revenue will grow as a whole in size, expenses will decrease as a percentage of revenue and with maturation they'll decrease in actual dollar amount as well because of the accounting methods used (described in the sections above), and cost per customer acquisition should begin to fall as the analytics used by the algo get more dialed in and as TWOU begins to further flex its networking muscle.
Each quarter sequentially moving forward, now that TWOU has a larger base of launched and decreasing in aggregate cost programs in place, should show larger and larger drops from expenses as a percentage of revenue. (Remember cost per program decreases each month after initial launch because the costs begin to be offset by revenues derived from each program - this cost drops to zero after 3-4 years for primary programs and 12-15 months for secondary programs within a primary channel and after that costs become permanent negatives as the revenue derived from each program is greater, and grows greater with each semester, than front end cost.)
These decreases come first because overall revenues will continue to expand with new program launches, historically larger enrollments at existing programs, and slight increases in tuition for existing programs; and second because previously launched programs expenses have already been accounted for on the front end and because advertising dollars can be spent in a more targeted, effective way. Unless TWOU comes up to a contract expiration (its contracts are between 10-15 years currently with its first contract expiration coming in late 2019) and loses a program the program launches will not outpace the programs in place.
TWOU guided as much on a recent call listing the following schedule of launches heading into 2015:
- January 15: Master of Business Administration: Whitman School of Management: Syracuse. TWOU's prop selection algorithm for new programs gave a very strong reading as to the penetration that the new school should see from an enrollment standpoint.
- January 15: Master of Data Science: SMU. First degree in the state of Texas; greenfield opportunity as SMU had no option for this degree on its campus.
- Q2/2015: Master of Arts in Counseling: Northwestern University
- Mid-2015: Master of Sciences in Accounting: Whitman School of Management: Syracuse
- END-2015: Master of Communications Program: SI Newhouse School of Communications: Syracuse
These launches, while important top-line drivers, will certainly have large front end expenses but not large enough to offset expenses rolling off the books from prior quarters. These programs should be the first to have a net positive effect on the company at launch stage. For clarity, what I mean is that the launch expenses for the following programs (because of the launch scheduling being so slow and well planned) should be swallowed up by revenues flowing in (essentially cost free) from TWOU's oldest programs at USC. It really helps from a modelling standpoint to think of the launches like that. The newest launches, from this point going forward, will offset by the oldest launches. This is expenses to revenues - the matching principle of accounting at its finest - only TWOU chose not to use the matching principle; its business model just worked out that way because of the consistency of its recurring revenues.
Remember, one of the biggest benefits of owning TWOU's model is that it is not transaction-based and runs very little risk of becoming transactional. You're buying a "subscription" based model that has shown an inception to date retention rate of greater than 100% (shown below in a graphic in the conclusion of the article). Because TWOU chose not to use the matching principle (capitalizing costs to match revenues down the line as the revenues from those costs are derived) and instead paid the costs as they were incurred the oldest program can perpetually slide down the moving line to offset the newest programs expense. I hope that makes sense because that is the entire bull story going forward at TWOU. The financials above evidence this theory in execution. It helps to think of the new programs and old programs needing to find a dance partner for TWOU to be successful. TWOU needs the older programs revenues to "dance" with the newer programs expenses for those expenses to not show, really what I'm saying is not press down on the net loss line. This has just recently started with TWOU having more older programs than newer program dance partners. Excuse the simplicity of the metaphor but that's the best way I can describe how I have been modeling trend line projections since before the IPO.
Also, this is a worst case scenario we're talking about here. Yes, the current scenario is the worst case scenario. You're looking at a company with no benefits outside of the benefits it has worked for. TWOU mentioned on its Q2 call that recently it has had the embarrassment of riches of having to turn down programs that were interested in implementing a greenfield because it didn't think the programs could maintain the level of service TWOU wants associated with its name. I'm betting and the Street appears to be betting now that it won't be long before quality programs, programs like the Northwesterns and SMU's that TWOU has already landed, begin calling in proactively. When that happens you're going to want to have a loaded boat of shares.
Where's the trade?
I know we spent the majority of this article discussing concepts rather than hard numbers but the hard numbers really speak for themselves. Not much explanation was needed outside of showing that expenses were decreasing as a percentage of revenues. That's accounting/business/trading 101. They also weren't doing that as a result of anything quirky like as sudden decrease in stock based comp or anything else that would be considered one-time. They were doing it because a company finally made the jump from growing losses to shrinking them. Getting to be along for the ride has been a pleasure.
As bulled up as I am, The Street is on board but they aren't foaming at the mouth yet.
- Goldman Sachs: Neutral - $18
- Compass Point: Buy - $20
- Credit Suisse: Outperform - $20
- Barrington Research: Outperform - $20
- Needham & Company, LLC: Buy - $18
These price targets imply between a 7-18% share price appreciation. I think TWOU can do a midpoint to that between now and its next earnings, which will be the final continuing coverage article for 2014. As I was last quarter, I am expecting TWOU shares to appreciate on a mixture of technical and fundamental developments another 10-15% by Q3 EPS announcements.
I also am expecting the company to once again exceed revenue guidance, which for Q3 is $26.6-$27.3MM and to exceed Adjusted net loss guidance, $7.3MM-$6.7MM. I've just grown to trust management and to expect them to be able to hit or beat the targets they give out.
Again, TWOU has shown the right mixture of long-term vision and short term metric hitting to warrant a long position that can be left alone or actively managed.
Retention rates, growing enrollments and revenue per enrolled student, decaying on-book expenses, and low overhead make TWOU a great buy and hold on all durations.
I recommend a buy for anybody looking to add a fast growing company who is further developing its leadership position.
Good luck to all.
Disclosure: The author is long TWOU. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.