Chegg: Opportunity Stems From Misunderstanding

Summary

• The Chegg story is incredibly misunderstood, making waters very murky.
• But investing when the water is murky will ultimately yield clarity.
• Use this opportunity to profit.

Until last week, you had probably only heard of Chegg (NYSE:CHGG) if you are the parent of a high school or college student. However, since Monday, February 22, Chegg has been on the radar of many investors. On that day, what will be known as "Black Monday" in the conference room at Chegg's headquarters henceforth, the company's stock plummeted 35%.

The question that now faces investors is whether the company's earnings report warranted a 35% decline in share value. Could the company really be 35% less valuable than the day before?

Earnings

Chegg's Q4 earnings report was mixed. Although the company reported earnings of $0.02 compared to estimates of a $0.12 loss, revenue fell 19% year over year to $68.2 million. 2015 is the first year in Chegg's history in which the company reported positive EBITDA for a full year, but investors clearly did not care about this feat.

To a company like Chegg - one that is currently in the midst of a business model transition - revenue is far more important than profit. So it doesn't help that the company lowered its Q1 revenue guidance to between $60 and $65 million.

Misunderstandings

Chegg is undergoing a large transition from a textbook rental company to one whose focus is on student services. The disconnect between the company, analysts, and investors is the chief reason why Chegg has fallen dramatically from its IPO price of $12.50.

This disconnect has created murky waters. Chegg CEO Dan Rosensweig understands this, though, and stated in a recent interview on Mad Money that he will focus on making it easier for analysts to understand the transition. After all, stocks trade relative to expectations. If the expectations reflect a revenue figure that is unachievable by the company, then the stock will get crushed. Once analysts begin to make more accurate estimates - ones that Chegg can actually meet or exceed - then the waters will begin to clear. If investors are willing to swim in murky waters at first, then I believe that they will be rewarded with clarity.

Arguably, the most misunderstood element of Chegg is its revenue cut from textbook rentals. Almost all of Chegg's textbooks are now being distributed by Ingram (IM), and this changes the amount of revenue that Chegg can claim. Previously, when Chegg was distributing the textbooks itself, the company recognized 100% of the revenue. Now, because the distribution process has been handed over to Ingram, Chegg recognizes a 20% commission on all textbook rentals.

This shift makes Chegg's textbook rental business cash flow positive, but comes with the drawback of recognizing less revenue. However, in my opinion, the positive cash flow from Chegg's textbook rental business is going to be instrumental in the company's success. The cash generated from textbook rentals can be invested in faster growing services - such as an on-demand learning marketplace and SAT prep - that could prove to be the company's main revenue drivers in the coming years.

Another misunderstanding is how e-textbooks affect Chegg's revenue. Chegg has historically recognized 100% of the revenue from e-textbook sales. Interestingly, Rosensweig claims that e-textbooks used to be growing at 60% a year but have since slowed to 0%. In his Mad Money interview, Rosensweig explained that this decrease does not actually stem from volume, rather it is due to an unforeseen imbalance in the price of textbooks.

Students are choosing to rent textbooks in print rather than e-textbooks because the former are far cheaper. Rosensweig exemplifies this with Chegg's most popular textbook, Campbell's Biology. The price to rent this book in print is $20, compared to $107 for the e-book version. Who would purchase an e-book when he or she could rent the paper version for one-fifth the price?

What is important to take away from Rosensweig's example is that the growth rate of e-textbooks only creates a superficial top-line issue for Chegg and does not represent a volume or business issue. This also is not a bottom-line issue because Chegg has said in the past that e-textbooks are going to remain a flat business. The future of the business - the piece of the puzzle to which investors should be paying more attention - is the slew of services that Chegg provides. Many of these are growing at a 30% clip or higher.

It is also imperative to note that even though Chegg's revenue may be declining as a result of its recognized revenue share, the company is not losing customers. We know that customers are naturally being diverted toward paper textbooks because they are cheaper, and that from these Chegg makes a 20% commission. This is the leading reason for the slowdown in e-textbook sales. But we must remember that Chegg has not lost customers. These are the customers who will remain in the Chegg ecosystem; the ones who will fuel the growth company's services in the coming quarters.

Chegg's Big Opportunity

In my opinion, Chegg's biggest opportunity is the on-demand learning space. This is one segment of the education market that has not been saturated, so it is imperative that Chegg invests heavily in this opportunity. Fortunately, this is exactly what the company plans to do.

Chegg recently launched its on-demand marketplace, but ran into the best problem imaginable: it could not keep up with demand. As of Q4, the company had 11,000 tutors working with students, but, according to Rosensweig, Chegg was still unable to fill 50% of students' requests. Rosensweig knows that in order to be the company in the on-demand learning space, he needs to have a tutor available for any subject at any moment. He claims that the company will solve this problem in Q1 and that it can be a profitable service by Q2.

If Chegg is able to create the best on-demand learning marketplace, then I think that this will prove to be the largest revenue driver for the company going forward. As revenue from this service and others begins to materialize, Chegg's textbook business will naturally become a smaller portion of the total.

How To Take Action

A lot has to go right in order for Chegg's story to play out according to plan. The company has to keep investing in its quickly growing services businesses. At the same time, though, Chegg can't starve itself because the company's story will eventually change from one about revenue growth to one of profit growth.

Furthermore, Chegg needs to do a better job at explaining the many moving parts involved in the company's transition. I believe Rosensweig when he says that this is a focus of the company going forward. In his interview on Mad Money, Rosensweig gave his vote of confidence by saying he plans on buying "substantially more than [10,000 shares]" of Chegg and that "[the market's reaction to earnings] is just ridiculous."

Since Chegg's "Black Monday," the stock has rebounded from $3.47 to $4.30 at the time of writing. Whether or not you should follow in the steps of the company's CEO and purchase shares is dependent upon your time horizon and risk tolerance. For those with a multi-year outlook, I would strongly recommend considering Chegg. With that said, my advice is to scale into your position over several quarters to reduce some of the risk that is associated with the stock's current volatility. Patience is a virtue, and I believe that it will pay to be virtuous with Chegg.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CHGG over 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.