Chegg: A High Margin Platform Is Here

| About: Chegg, Inc. (CHGG)


Management has successfully pivoted CHGG's business to an all-digital, higher margin platform.

CHGG has launched a number of low downside, high upside services, which could create substantial growth.

Despite the recent appreciation, I still believe that CHGG represents a good investment opportunity.

Companies with business models that are outdated often face difficulties transitioning and pivoting the company to a new direction. However, Chegg's (NYSE:CHGG) management has successfully altered its business model and has positioned it to generate substantial shareholder value. In the last few years, management transformed Chegg from a textbook rental company to a learning platform in order to address a bigger and more attractive market.

New Business model: Transition Away From Textbook Ownership

GAAP revenue has been decreasing in recent quarters, but that is not cause for concern. The reason for the decline in revenue is due to its transition from owning print textbooks, where it recorded 100% of the transaction value, to a more profitable revenue model where its partner, Ingram, will own the print textbook inventory and Chegg will receive approximately a 20% commission from each transaction.

This new business model allows Chegg to not only reduce its risk of holding onto textbooks, but also allows it to free up capital to invest in other growth opportunities. Management has guided that it successfully completed the textbook transition at the end of 2016.

Third Quarter Release

On a y/y basis, CHGG saw net revenue decrease 12% to $71.3 million. (However, the declining revenue is not a cause for concern and is just a function of its changing business model, which I discussed above). Importantly, CHGG's service revenue growth was prodigious, expanding 44% y/y to $29.7 million in the quarter, now accounting for 42% of net revenue, compared to 25% in Q3 of 2015.

Another huge positive for CHGG was that it exceeded more than 800,000 Chegg Services subscribers in a quarter for the first time. CEO Dan Rosensweig discussed the subscriber growth in the Press Release and was very positive, saying "this was driven by strong growth across the board in new customers, retention, and engagement."

Retention was especially strong with an 80% renewal rate for Chegg Study subscribers in Q3 2016. This high retention rate is very positive and shows that Chegg customers value the service.

Source: Q3 Earnings Call Slides

Management also discussed a few other notable positives from the quarter:

  • Over 3.8 million questions viewed in Chegg Study in Q3 2016; and
  • Over 65% growth in tutoring minutes from Q3 2015.

Also, management gave positive guidance for the fourth quarter and fiscal 2017:

Q4 Guidance

  • Total net revenues in the range of $55 million to $60 million;
  • Chegg services revenues in the range of $41 million to $44 million; and
  • Gross margin between 65% and 67%.

Fiscal Year 2017 Guidance

  • Total net revenues of $230 million;
  • Chegg services revenues of $172 million; and
  • Adjusted EBITDA of $35 million.

Chegg: A Platform of Services

Chegg's management has prudently been adding several services in order to keep customers on its platform for many years. (The lifecycle of an ideal Chegg customer is shown below).

Source: Q3 Earnings Call Slides

Management discussed this goal in their most recent Press Release: "We believe we are building the brand and platform that students from middle school into their early careers will turn to first because we help enable a much broader set of improved outcomes that include accelerated learning, less debt, and of course better jobs."

Chegg's platform now includes numerous products and services including: digital textbooks (eTextbooks), supplemental materials, multi-platform eTextbook Reader software, Chegg Study, Chegg Tutors, Chegg Test Prep, Chegg Writing Tools, College Admissions and Scholarship Services, purchases of used textbooks, internships, careers, college counseling, enrollment marketing services and brand advertising.

Source: Q3 Earnings Call Slides

Margin Growth, Synergies and Acquisition Potential

Margin Growth

By becoming a platform, CHGG is pivoting into a less risky market, with higher margins and upside potential. CHGG is now operating a fixed cost platform where additional sales do not increase its expenses. In the Press Release, Chegg's CFO, Andy Brown, discussed this phenomenon:

In fact, our Q3 gross margins were higher than expected at 45.8%, as a result of increased benefits and synergies from our learning services. Notably, much of the incremental revenue goes straight to the gross margin line, as digital services like Chegg Study and our writing tools have a relatively fixed cost structure. In other words, as the services grow and achieve scale, our margins should continue to increase.

Source: Q3 Earnings Call Slides


Chegg's platform also benefits from an expanded user base in another way. CEO Dan Rosensweig discussed the other way it benefits during the Q3 2016 earnings call:

As more students use Chegg more often, we are able to rapidly improve the quality in relevance of each of our service and on a per student basis.

This creates a powerful virtuous circle which we believe improves each service and helps us introduce new offerings for students at the right time at a very low cost.

In addition, about 50% of Chegg Tutors customers are continuing to come directly from Chegg study, which we believe reinforces the fact that each of our services are even more powerful as a platform. Textbooks remain a significant pain point for students and a low cost customer acquisition channel for Chegg that helps us build our brand, add to our data, and ultimately attach students to Chegg, and with Chegg's multiple services.

Chegg is creating a competitive advantage with the size of its platform. The network effect will create a moat against competitors entering its markets. Not only will it benefit from a lower cost of customer acquisition from cross-selling, but the self-regulatory mechanism of using ratings will allow for Chegg to filter out and have the most effective tutors and counselors on its platform. (I'll discuss the self-regulatory system further below).

Acquisition Target

Chegg's business model makes it very attractive as a takeover target. A bigger player could integrate Chegg's services into its system and quickly add revenue without having to substantially incur costs to do so. For example, Amazon (NASDAQ:AMZN), could integrate Chegg into its platform and leverage its enormous base of Student Prime Members to grow all of Chegg's different services. Furthermore, Amazon may be interested in acquiring Chegg to get access to the student demographic and behavioral data that it has stored over the years. This could prove lucrative to Amazon by allowing it to learn how to better sell to this demographic.

Platform Offerings

The services that Chegg is launching on its platform are all relatively low risk/high upside opportunities. To give readers an insight into how they work, I decided to outline a few of Chegg's offerings, specifically, guidance counseling, tutoring, career services, campus deals, and test prep.

Guidance Counseling

One of Chegg's offerings is an affordable online college guidance counseling service. Chegg's goal is to democratize the college counseling industry to provide access to all students. Chegg will leverage its InstaEDU on-demand technology and network of expert counselors to help students find the right college. Although this service is free in many public schools, there is a dearth of counselors in some districts and private counselors cost an average of about $4,000 per child. Thus, Chegg is filling an apparent need in the market.


The service launched at $24 per hour but, now, the lowest pricing offering is $30 per hour. The service marks another low downside/high upside initiative. The reason this offering is low downside/high upside is because Chegg is essentially the middleman where it can generate revenue simply by connecting counselors with students. The only downside is the initial cost to set up the technology behind the service.

Even if this project is not incredibly lucrative in itself, it may help Chegg in other regards. First and foremost, it will build a relationship with students entering college and that is crucial for a company that is highly tethered to textbook sales. Second, the service is complementary to its tutoring and career services and it may drive traffic to those avenues as well.

Chegg Tutor

The tutoring service runs on the same per-hour basis as the counseling service and pays the counselors/tutors the same per-hourly amount. Under the "Become A Tutor" tab, advertises that tutors start at $20 per hour (implying $10 per hour goes to CHGG).

Becoming a tutor is relatively easy. I became one to test the interface and it was incredibly intuitive and simple. It allowed me to connect with my Facebook, then I inputted my education level, areas of expertise, standardized test scores, then uploaded a picture of my transcript and student ID card, and I was set up and ready to tutor.

Those that are pessimistic about this service may argue that Chegg makes it too easy to become a tutor and the quality of tutors on the site will suffer accordingly. However, Chegg has a self-regulatory mechanism which will filter out bad tutors because students give their tutors reviews. Therefore, those that are not effective tutors will not receive work. Unlike tenured teachers, Chegg's tutors have an incentive to be effective and those that are not will simply not receive tutoring jobs. With each added tutor and rating, Chegg grows its network and reinforces its network effect, adding to its competitive advantage.

Chegg Career Services

Chegg also started another low-risk, high upside venture in the form of a career services segment. Chegg will leverage its user base and brand awareness to attempt to encroach on LinkedIn (NYSE:LNKD), which was recently purchased by Microsoft (NASDAQ:MSFT). This opportunity has the ability to expand Chegg's offerings and generate significant revenue by matching employers with potential employees.

Source: (Chegg owned)

Chegg Campus Deals

In April of 2014, Chegg acquired The Campus Special, LLC and The Campus Special Food LLC, a company offering local campus deals, serving students at over 500 universities nationwide. They operate a site called Chegg paid approximately $14 million in cash and $1.6 million in common stock for the acquisition. Using this deal feature will allow Chegg to leverage its brand and cross-sell to its large user base. During the conference call, management discussed the cross-selling opportunity, citing that 70% of active members in the first half of 2014 used its services for something other than printing textbooks.

Chegg Test Prep

Test prep represents a huge market opportunity for Chegg. Chegg's test prep software can be as low as $29.95 per month, which represents a significant discount from traditional tutors and other test prep offerings, such as Kaplan, which costs $1599 for its online course and doesn't even include any personal tutoring.

This service was recently launched in 2016 and also provides huge upside since the software was a fixed cost to develop and each additional sale provides revenue without generating additional costs. Further, Chegg can cross-sell its tutoring service with its online test prep software for students that want personalized assistance.

Source: Q3 Earnings Call Slides

Valuation and Conclusion

Chegg's valuation does not seem extremely cheap from a financial ratio or basic balance sheet snapshot. Currently, CHGG trades at a price-to-sales ratio of 2.64 and a price-to-book value of 3.19. Moreover, as of last quarter, September 30, 2016, CHGG had $316.2 million in total assets, with $101.1 million in total liabilities. With a market capitalization of close to $700 million and CHGG currently running at a loss, albeit a small one of $15 million per quarter, CHGG does not appear to be a great value play. However, I believe that the hockey-stick type growth potential, with its limited downside, high upside fixed cost structure, justifies the current valuation and positions CHGG to generate substantial returns for its investors.

Disclosure: I am/we are long CHGG.

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.

Additional disclosure: My cost basis in CHGG is $3.30.

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