2U: Growth For Free
Summary
- 2U is losing money due to high marketing cost.
- Assuming more normal levels of S&M spend in a steady state, the stock appears undervalued.
- Investors interested in the Edtech space are essentially getting future growth for free, with a company that has an impressive track record and a leadership position in the OPM space.
2U, Inc. (NASDAQ:TWOU) is a $2.3 billion market cap global (however primarily US-based) Edtech company. The company had for a relatively long-time a nice growth story attached to it, where growth has come both from the organic side (driven by heavy S&M spend) and growth through M&A.
As shown below, the stock was on fire during 2017 and half-way through 2018. But questions around ramp-up in profitability put heavy pressure on this equity. The recent upturn is, in my view, linked to increased interest in everything Coronavirus resistant and the fact that the company put up a decent Q1 2020 result.
Source: Seeking Alpha
There have been several articles on Seeking Alpha covering from different viewpoints TWOU's merits or faults. In this article, I will briefly present the current bull and bear case and then put forth a more neutral value case (although more on the bullish side) and why the stock is an attractive play if an investor is seeking exposure to the Edtech space.
Bear case
- TWOU provides relatively advanced graduate degree programs, which target white-collars and not necessarily the blue-collar workers hit hardest by the Coronavirus. Hence, when significant parts of the unemployed seek further education, these enrollments will not necessarily push up demand for TWOU programs, i.e. unfavorable product mix.
- The company was an early entrant into the space of online college education (the company started providing educational services in partnership with USC during 2009) and when colleges and universities develop their own offerings from scratch they will not need TWOU to act as a middleman. Furthermore, the universities will have a better bargaining position and demand a larger share of the total price paid by the consumer (student).
- During 2019 the company made a large acquisition. Due to this, the company took on debt. The net cash position of $471 million (debt + leases - cash) as at 31 December 2018, became a net debt item of $143 million as at 31 December 2019. The equivalent figure was $180 million as of 31 March 2020 and since the company's EBITDA is negative (LTM figure was $(104) million), the company may face a liquidity issue.
- Although top-line growth has been impressive (Q1 2019 was 44%), the organic growth was "only" 15% (excluding the impact on sales growth from the acquisition of Trilogy).
Bull case
The company explains the bull case themselves well in the latest earnings presentation:
- Online Program Management is a growing $7 billion market. TWOU has a leading position in this market.
- They partner with the best brands (e.g. Harvard, John Hopkins, Berkeley, etc.) which provides a moat compared to other players.
- Education is counter-cyclical, when people get unemployed some of them enroll in higher education.
- They provide online education which is good if a pandemic enforces closure of face-to-face education.
- They have multiple avenues of growth, shorter courses, and boot-camps in addition to full coursework graduate training.
- They will have attractive steady-state margins due to the aforementioned moat.
My view
I generally hold a long-term view when investing. If I can't see myself holding an equity for 3-5 years, I generally avoid putting my money into something. It is impossible to know what is going to happen tomorrow or the next quarter (if somebody would know with absolute certainty what is going to happen in the future, he or she would be the richest person in the world). But if historical financials are impressive, the strategic circumstances favor a given company and the stock can be had at a decent price, good things are more likely to happen compared to when one of these criteria are not met. This is my main conclusion concerning TWOU.
All of the financials I reference in this section can be found in the table below. The company's revenue growth (CAGR 45% FY11-19) has been fueled by acquisitions, purchase of intangibles and heavy S&M spend (S&M as % of revenues has averaged around 55% during the last six fiscal years).
Although the company has operated with a loss during the whole period FY11-19 (operating loss was $246 million during FY19), this has mainly been driven by S&M spend (during FY19 the company spent $342 million on S&M). If the company were to decrease this spending at a given point in time, its profitability would increase, while of course slowing the top-line growth.
Due to the recorded net loss, the company's ROIC was negative during the period FY11-19 (I define ROIC as FCFE (net income + D&A - Capex) over invested capital (NWC + Goodwill + Intangibles + PP&E), while if we were to adjust for excess S&M spend this would result in a positive ROIC.
So what would a normal level of marketing expense in relation to revenue? A survey by Deloitte (referenced in this WSJ article) puts the average spend in the educational industry at 11% of revenue. While there are ambiguities around what exactly different companies include or exclude in this spend, let us assume (on the high-end) that TWOU would spend around 20% of revenues on S&M. What would TWOU's intrinsic value be given this change, not taking into consideration future growth?
As highlighted below in the table, I calculate the difference between actual spending and this 20% scenario and add back the difference to net income. E.g. FY19 net income was $(235) million while I add back $228 million in excess S&M. Furthermore, I add back an impairment charge of $70 million to land at an adjusted net income figure. This translates into an adjusted FCFE figure and suddenly TWOU is showing positive ROIC figures.
During the last six years, the adjusted ROIC figure would have been 17%, with a minimum of 12% and a maximum of 24%. During my research, I normally see ROIC figures between 7-12% for mature profitable businesses operating in commodity businesses. Given the leadership position and strong partnerships TWOU has, giving the company a strong moat for competitors to climb, it is not unreasonable to assume a range of steady-state ROIC of 15-25%.
Translating this assumption into a valuation and given the invested capital structure per Q1 2020 (invested capital was $857 million) I land at a valuation range for an intrinsic value of $30-$50 per share. The stock was trading at around $37 as of this writing. Given the impressive growth history, an investor is essentially getting the growth for free, assuming my assumptions hold.
I don't foresee debt as an issue, since if the company were to cut spending on S&M to more normal levels, Net debt/Adjusted Ebitda would have been around 1x (as shown in the table below).
Source:
Seeking alpha, public filings (10-K), Author analysisRisks
The main risk concerning the future of TWOU is in my view the loss of partnerships with famous universities, as universities are pursuing their own offering instead of working with the company. Universities can also use this scenario to increase their bargaining power in negotiations around fees with the company.
Conclusion
There are both convincing bull and bear arguments around the future of TWOU. However, I find the stock attractive at these levels, since considering steady-state S&M levels, the stock is currently worth between $30 to $50, and given the current stock price this implies an investor essentially receives the growth potential for free.
This article was written by
Analyst’s Disclosure: I am/we are long TWOU. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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