2U: Don't Expect A Huge Tailwind Out Of The Coronavirus
- Shares of 2U have drifted ~10% higher after the company reported mixed Q1 results that beat on EPS but were in-line on revenues.
- Investors have expected the coronavirus to push up enrollment in 2U's online education programs.
- So far, however, we've only seen enrollee growth in 2U's core grad programs decelerate.
- 2U's cash buffer also remains quite thin, especially for a company that has to invest a lot upfront to get new programs running.
Though almost every company in the stock market has been routed this year, a select few technology stocks have seen their values maintain or even rise. Companies in this coveted group include e-commerce names like Amazon (AMZN), remote work stocks like Zoom (ZM) and Docusign (DOCU), as well as online education provider 2U (NASDAQ:TWOU). Though 2U briefly lost more than half of its value when the market hit its nadir in mid-March, the stock has come roaring back since and recovered all of its year-to-date losses, especially after the company's recent Q1 earnings release.
I have long been bearish on this name, and the coronavirus and the shifting of education to online venues hasn't changed my thinking on this stock. Investors should continue to steer clear of 2U and invest in more beaten-down areas of the tech sector.
Is the coronavirus really going to lift 2U's demand?
The majority of the market is betting that the shelter-in-place order and the increased openness to online education will drive a sudden spike in demand for 2U's offerings. 2U's CEO, Christopher Paucek, has posited on the Q1 earnings call that he expects the coronavirus to be a long-term tailwind to the company:
First, we all witnessed how COVID-19 created an urgent need for every university to move their programs online. This rush to remote learning happened almost overnight. A lot has changed in the last six weeks, and today we know much more based on the daily conversations we've been having with partners across our portfolio. We now believe that this forced transition online will substantially increase the demand from universities for our core product offerings and new solutions. The need to deliver truly high quality online programs not just remote live lectures, at a time when universities are facing unprecedented financial constraints and challenges makes our traditional full investment model even more compelling and valuable. We can call this already. We could not say that three or four weeks ago, but it's now apparent. We expect to announce our next undergraduate program shortly.
Second, we expect to see increasing student demand for quality online offerings. The data here is early, but our funnels are filling and converting currently at higher rates than before the pandemic. Historically, the higher education market has been negatively correlated to the overall state of the economy. There's a long history here."
On the other hand, I don't think the shelter-in-place situation necessarily creates a clear tailwind for 2U. I believe this argument to be flawed on two primary counts:
- While higher education overall might be countercyclical, grad degree programs should be less so in this particular downturn. It's true that in prior recessions, when people have been laid off and job prospects are thin, many opt to take the opportunity to go back to school. However, in this particular recession, the majority of layoffs have happened in lower-skill service industries, while most office workers have continued their jobs remotely. 2U's core offerings are graduate degree programs, and are unlikely to take in an influx of out-of-work employees who don't qualify.
- With most colleges now shifting online, 2U's offerings are no longer that unique. 2U bulls might be arguing that the forced transition to online learning has made virtual classrooms more palatable and accepted - but now, everyone is doing it, and 2U is no longer unique. Whereas previously 2U provided the infrastructure and the know-how to help universities digitize certain courses, most schools have now jerry-rigged their own solutions together. While some universities may turn to 2U for assistance in setting up new programs, a great many have found that they're capable of building out their own online education tools.
Net/net, while I don't think the coronavirus will prove to be a headwind to 2U's business, neither do I think it'll provide the clear lift investors are hoping for.
Data so far hasn't shown any improvement in enrollment
So far, we haven't seen fundamentals turn around. In Q1, 2U reported $175.5 million in revenues, growing grad program revenues by 14% y/y - accelerating two points over Q1's 12% y/y rate, but still a far cry from the growth rates in the mid-30s that 2U was capable to achieving in late 2018. Overall revenues were also only in-line with Wall Street's consensus target of $175.7 million.
And despite the improvement in grad program revenue, enrollee counts aren't growing as quickly as we'd like. In Q1 in particular, 2U's grad program enrollees grew only 16% y/y to 45,734 - decelerating four points below last quarter's 20% y/y growth rate, and the first time that enrollee growth has slowed to the teens.
Figure 1. 2U grad program enrollee trendsSource: 2U Q1 earnings deck
We can see that the two-point sequential acceleration in revenue was caused by a slightly-better average revenue trend, with 2U's revenue per FCE (full course enrollee) improving to a -2% y/y decline in Q1 versus a -7% y/y decline in Q2. We still find it concerning, however, that 2U has so far been unable to stabilize per-enrollee revenues, especially with development costs rising.
Liquidity is tight
Another secondary concern arises in 2U's balance sheet, shown below:
Figure 2. 2U Q1 balance sheetSource: 2U Q1 earnings release
As of the end of Q1, 2U had only $138.2 million of cash on its balance sheet, against $244.6 million of debt. Now, after the close of this balance sheet, 2U had executed a $330 million convertible debt offering (due in 2025 and accruing 2.25% interest), but it expects to use the majority of the proceeds to refinance its long-term debt, and after doing so will only have $65.3 million of proceeds to apply toward working capital. This gives 2U about $203.5 million of liquidity, alongside a net debt position of $106.4 million (though slightly boosting its liquidity, 2U's convertible debt refinancing doesn't actually change its net cash/net debt position).
2U likes to present its cash flows on a trailing-twelve month basis - and indeed on a TTM basis, 2U's most recent -$58.5 million cash burn doesn't appear to heavy against its >$200 million of liquidity.
Figure 3. 2U cash flow trendsSource: 2U Q1 earnings release
But 2U's expenses run much higher. In a case when 2U's ability to collect tuition payments is jammed and delays cash flow for whatever reason, its current high run rate of expenses could put it into a liquidity bind. In Q1, for example, 2U's operating costs ran at $229.4 million; after netting out $49.0 million in depreciation/amortization, stock comp, and non-cash lease charges, its "cash" operating expenses ran at $180.4 million this quarter, about half of which was in marketing and advertising costs.
2U's growth depends in large part on its ability to both build new grad programs and advertise heavily to fill seats on those programs (recall that 2U bears the full upfront cost of setting up and marketing new programs; universities primarily lend only their branding and course content), so the company won't be able to curtail operating expenses liberally without harming its growth. If 2U does end up needing to cut advertising/student outreach budgets to preserve cash, we could see grad program enrollees continue to decelerate further.
The market appears to be quite sanguine on 2U's prospects, but I'm skeptical that the coronavirus will present a true tailwind for 2U. If anything, I believe we'll see many more universities start offering their own online course content without intermediaries like 2U, given that building digital infrastructure has become a top-tier necessity for universities in the wake of the coronavirus. Given this stock's outperformance since the beginning of the year, expectations for 2U are high - I'd continue to stay on the sidelines here.
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