Chegg's Scaling Efforts In A Fragmented Industry Reveal Long-Term Potential

About: Chegg, Inc. (CHGG)
by: Wealth Insights

Chegg has aggressively expanded from a textbook marketplace into a multi-faceted education technology company.

The business model is revolutionizing the way education content is consumed, and we see strong growth ahead.

Unfortunately, the stock is overvalued at 60X 2019 earnings. We like Chegg as a growth play if the stock sees a pullback after a massive run since January.

One of the highest expenditure categories in the US economy is education. Each year in the US, hundreds of billions of dollars are spent on college tuition. Meanwhile, it is estimated that nationwide student loan debt has now surpassed a total of $1.5 trillion. Given the staggering cost to pursue education, the importance of succeeding in college is as important as ever (taking out thousands of dollars just to drop out of school or fail is a great way to set back your financial progress throughout life). Chegg, Inc. (CHGG) is a student resource and services provider that is thriving in this environment. The way Chegg has diversified its business through acquisitions is providing scale and innovation not currently seen in the education industry. When you consider that the company has penetrated only a fraction of the market (students), the long-term growth potential becomes evident. We like Chegg as a long-term growth play. However, investors should be aware of valuation at all times - even when it comes to a pure growth stock such as Chegg.

The Evolution Of Chegg

Chegg got its start in 2003 as a start-up as an education materials marketplace and, by 2007, had focused its business on renting and reselling used textbooks. As somebody who attended college from 2008 to 2012, I can vouch for how expensive textbooks are every semester. Books can cost more than $1,000 per semester, and are often repurchased for pennies on the dollar (assuming the school hasn't updated to the next "edition", making your textbook worthless). Being able to economically rent textbooks has become largely successful and helped get Chegg off of the ground level.

Fast forward through the past decade, and Chegg has been busy rapidly investing in acquisitions that have fleshed out the company's offerings to students.

Source: Crunchbase

Today Chegg is an education technology company that offers a variety of services to students. Chegg offers services and resources for students at the high school and college levels. Textbook marketplace, scholarship and college research, test prep, tutoring, and math/writing help - all offered from an integrated source.

The Results Thus Far

Chegg's expansion into various service-based offerings has become the company's "secret sauce". Since 2012 Chegg has realized explosive subscriber and service revenue growth every year. Service revenue has grown at a CAGR of 45% since 2012.

Source: Chegg

This rapid growth is helping Chegg scale its operations, and operating margin has drastically improved over the past few years. As the company continues to grow and acquisition spending slows down, the company's profitability will follow suit. The company is already cash flow positive.

Source: YCharts

The Potential Is Enormous

The question for investors becomes "how big can Chegg really get"? The company faces a massively underutilized customer base. While it's obviously unrealistic to expect a 100% subscription rate, just 3.1 million of 36 million students in the US use Chegg. In time, that number could easily at least double. The "Chegg" brand is still developing and the word is still spreading. This doesn't even factor in the eventual tapping of international markets.

Source: Chegg

The service helps itself by appealing through accessibility. Being able to digitally access these services either through a computer or smart phone is making inroads with students. It gives students a convenient medium of information rather than having to physically go to a professor's office for example.

Is The Stock A Buy Today?

When looking at the actual stock, it is important to clarify that Chegg is a bona fide growth stock. The valuation is going to seem extremely high. If we take 2019's projected EPS per analyst estimates of $0.68, the stock currently trades at a lofty 60X earnings. The stock has almost doubled, up 89% in the past year alone.

Source: YCharts

To determine if the stock is worth buying, we need to project the business out a ways. Analysts are estimating that Chegg will grow earnings per share at a CAGR of 20% over the next five years. That would look something like as follows:

  • 2019: $0.68
  • 2020: $0.82
  • 2021: $0.98
  • 2022: $1.18
  • 2023: $1.41

If we assume a range of earnings multiples, the stock price five years out would look something like:

  • 20X: $28.20 (32% LOSS)
  • 30X: $42.30 (2% GAIN)
  • 40X: $56.40 (36% GAIN)
  • 50X: $70.50 (70% GAIN)
  • 60X: $84.60 (104% GAIN)

So after a five-year period, Chegg would need to uphold a 50-60X earnings multiple AND hit on growth estimates in order to realize a notable gain on your investment from today's price levels. It is safe to say that despite outstanding growth prospects, the stock is overvalued. Could the stock outperform analyst estimates? Sure it could. But intelligent investment decisions factor in a margin of safety. The stock has been on a run since January, so we would like to see the price come back down. A share price of $20-21 would be ideal for investors looking to profit over a five-year holding period.

Wrapping Up

Chegg's aggressive expansion is bringing both scale and capabilities to education that are frankly quite exciting from an investment standpoint. We are very bullish on the business model and find a lot of room for growth in the years ahead. With that said, the stock has reached a nosebleed valuation, thanks to a massive run over the past few months. Even though Chegg is a pure growth stock, investors should wait for a pullback in order to benefit from the success we see the company having down the road.

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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.