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Chegg, Inc. (CHGG) – A Textbook Story Of Fiction

Nov. 14, 2016 11:40 AM ETCHGG3 Comments
Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Today, we shared our opinion and research on CHGG. Below is a synopsis of the topics covered in our full report, which can be found here:

www.scribd.com/document/331051344/Chegg-...

Exposing the promotional business "pivot" built on financial shenanigans, the manipulation of business metrics & pro-forma results, shareholder value destruction, and a structurally broken business model

Fair Value - $2.00 per share, 75% downside

IMPORTANT Disclaimer - Please read this Disclaimer in its entirety before continuing to read our research opinion. You should do your own research and due diligence before making any investment decision with respect to securities covered herein. We strive to present information accurately and cite the sources and analysis that help form our opinion. As of the date this opinion is posted, the author of this report has a short position in the company covered herein and stands to realize gains in the event that the price of the stock declines. The author does not provide any advanced warning of future reports to others. Following publication of this report, the author may transact in the securities of the company, and may be long, short, or neutral at any time hereafter regardless of our initial opinion. To the best of our ability and belief, all information contained herein is accurate and reliable, and has been obtained from public sources we believe to be accurate and reliable. However, such information is presented "as is," without warranty of any kind - whether express or implied. The author of this report makes no representations, express or implied, as to the timeliness or completeness of any such information or with regard to the results to be obtained from its use. All expressions of opinion are subject to change without notice and the author does not undertake to update or supplement this report or any of the information contained herein. This is not an offer to buy any security, nor shall any security be offered or sold to any person, in any jurisdiction in which such offer would be unlawful under the securities laws of such jurisdiction.

Executive Summary

Question: What do you do when your stock price declines by 50%, your diluted share count doubles due to egregious stock based compensation and poorly structured financing rounds with ill-conceived ratchets, and your business model is structurally broken less than two years after your mispriced IPO?

Answer: Why of course you announce a business model pivot on the back of nebulous non-GAAP metrics, concoct a story about a low-cost customer acquisition channel that ignores intense competition from Amazon.com and other economic realities, alter past financial metrics lower to overstate current period growth, create ebullient out-year financial targets only to surreptitiously adjust the target date and growth rates when results are below plan, reclassify your pro-forma revenue definition multiple times - while including physical goods-related revenue in your newly classified digital revenue category (attracting SEC correspondence in the process), further inflate revenue growth rates by recording one-time inventory transfers as profitless revenue, boast about your strong 80% [monthly] customer retention rate - which translates into something closer to 93% annual churn when the fine print is read, claim to grow subscribers 40% despite your own subscriber figure from the prior year's press release suggesting growth of 15%, inflate EBITDA by increasing capitalized expenses 340% year-over-year (as a % of revenue), make 10 acquisitions that obfuscate organic growth (and subsequently write-off multiple deals), and exclude "non-recurring" items from adjusted financial results for ten consecutive quarters to magically transform deep operating losses and cash burn into marginally positive adjusted EBITDA. And that run-on sentence is just the beginning…

Sell-side promotions and "hope-based" investments are often built on the foundation of a strategic business model pivot. These stories dismiss years of disappointing operating and financial execution as yesterday's news. Management teams and their cadre of sell-side promoters instead encourage investors to focus on non-GAAP metrics and aspirational target models years into the future. As a result, accounting warts, irreconcilable financial results, and operating inconsistencies that would traditionally cause severe stock price declines, can be marginalized and ignored… at least until the story is busted.

We believe Chegg, Inc. (CHGG) is an orchestrated promote. The carefully constructed, disingenuous bull thesis, is that CHGG is in the midst of a transition from a low margin textbook rental business into a high growth, high margin digital educational services company. This report extensively details why we believe CHGG has fabricated pro-forma financial results, misrepresented its unit economics, and repeatedly provided misleading metrics that are subsequently altered. Based on recent correspondence with the Securities and Exchange Commission (SEC), and conspicuous changes to its financial reporting, we believe CHGG's shenanigans discussed herein are under the microscope.

Like most promotes, CHGG and its sell-side partners use buzzwords and endorsements that appear to legitimize the story. For example, the sell-side points out that the company was initially funded by prominent venture capital firms such as Foundation Capital, Insight Venture Partners, and Kleiner Perkins. The CEO, who was the former COO at Yahoo!, is a veteran Silicon Valley executive who "talks the talk" when discussing the transition from a capital intensive textbook rental business to a high margin digital services business. On its most recent earnings call, the word "Platform" was used eleven times to describe the new operating model, while Google, Netflix, Spotify, and Uber were audaciously listed as "compelling macro trend" comps in the most recent investor deck. Bulls paint a compelling picture of a textbook rental customer base that creates a low cost competitive advantage for Chegg Services to acquire customers. Without appropriate diligence, management's elevator pitch sounds enticing to retail investors and resonates with analysts.

We believe there is one problem with the compelling investment story…IT IS FICTION.

CHGG's strategic business model pivot has been marked by underperforming acquisitions, weak execution, intense competition, and value destruction. Worse still, we believe CHGG's management has utilized accounting gimmickry, deceptive segment reorganizations, and non-GAAP adjustments that directly violate SEC reporting standards. Management has consistently inflated the company's non-GAAP profitability by excluding acquisition-related compensation costs, transitional logistic charges, and/or restructuring charges for 10 consecutive quarters, while simultaneously including one-time gains on textbook liquidations. Management's vague "pro forma" revenue metric is devoid of the reconciliations required by the SEC's Reg. G, while the company's aggressive and inconsistent investor presentations appear designed to consistently overstate organic revenue growth.

CHGG's core textbook rental business is in secular decline marked by commoditization and intense competition from Amazon, Pearson, and others. By management's own admission, the textbook rental segment, which serves as the low-cost customer acquisition funnel for digital services, will decline by at least 10% in 2016 and 2017. Rather than candidly address the pervasive challenges in CHGG's core business, management has pursued a "digital" business strategy through subscale, poorly performing acquisitions. Over the last six years, CHGG has acquired 10 companies, of which four have been total write-offs, and just one has performed to plan.

The amalgamation of these ten acquired properties represents CHGG's supposed high-growth, high-margin digital services segment. But the facts tell a different story. We believe CHGG's management made multiple alterations to its segment reporting to obfuscate the floundering, low visibility, dynamics of its digital segment. Previously, management stated that its all-important digital revenue growth would be 60% in 2016. Our analysis suggests 60% growth is a blatant misrepresentation and digital revenue growth will be just 16% in 2016. Additionally, based on CHGG's own disclosures, we show that customer churn in digital services is approximately 93% annually. And while management claims its fastest growing services business, Chegg Tutors, will pull blended corporate margins higher, our analysis shows this segment generates a mere 30% gross margin.

We believe management has persistently altered its reporting methods to flatter digital growth. As such, it comes as no surprise that CHGG's historical revenue reporting segments are replete with discrepancies that fail to reconcile from quarter-to-quarter. In the last three years, CHGG has reported three different revenue derivations, which we believe blatantly overstates digital revenue growth and masks an inability to hit financial targets. The SEC appears to share our confusion based on its correspondence with CHGG management asking for an explanation for certain revenue segment reporting.

While management's promotional cadence has been self-enriching, shareholders have suffered. In CHGG's 10-year history, management has raised more than $400 million, including $180 million from the company's IPO just three years ago. Despite incessant capital raises, CHGG has (1) never generated a profit, (2) has an accumulated deficit of $370 million, and (3) will end 2016 with less than $60 million of cash in the bank before considering $35 million of acquisition earn-out obligations and expected free cash flow burn of $25 million.

No wonder sell-side analysts have been such unabashed supporters!

Like all promotes, the too-good-to-be-true story can only persist for so long before facts trump fiction. While CHGG beat sandbagged Q3 guidance (Chegg Services revenue was down sequentially despite only a partial quarter of its Imagine Easy acquisition in Q2'16), the company guided Q4 below consensus estimates and cut 2017 expectations. We believe more negative revenue revisions are coming. With CHGG's accounting shenanigans exposed, competitive pressures intensifying, and 2017 guidance that appears highly unobtainable, we believe the rubber will soon meet the road. CHGG's pivot is nearly complete and in 2017 management can no longer utilize its "pro-forma revenue" cookie jar to hide poor results. We believe CHGG is trapped and management's only options are (1) attempt larger acquisitions to plug the impending revenue hole, or (2) confess that actual growth rates and profitability are less than what management has led investors to believe.

We believe CHGG's intrinsic value is less than $2.00 per share, which would represent 75% downside from the current trading price.

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This initial report details the following topics, representing just the tip of the shenanigans on the CHGG iceberg:

1) CHGG's inauspicious background and value-destroying CEO

I. Disastrous pre-IPO ratchets have caused substantial shareholder dilution

· Increasingly onerous ratchet conditions on multiple rounds of pre-IPO financing and indefensible stock-based compensation have resulted in the unjust enrichment of CHGG's management at the expense of its unaffiliated shareholders. In less than three years, shareholders have suffered nearly 100% dilution.

II. Dan Rosensweig's dubious leadership track record

· Mr. Rosensweig served as CEO or COO of three companies prior to CHGG. He destroyed significant value at all three companies.

· Mr. Rosensweig was most recently CEO of Guitar Hero, one of the most popular video game franchises in history. Under Mr. Rosensweig's stewardship, sales collapsed, a leadership change ensued within one year, and Guitar Hero was temporarily discontinued.

2) CHGG's textbook rental business is commoditized & faces increased competition

· A bullish perspective on CHGG assumes the company's textbook rental business can serve as a low cost customer acquisition channel for its higher growth, higher margin digital segment. This thesis appears to be false. Based on our analysis, CHGG's textbook rental business has decelerated for three consecutive years and will decline by nearly 10% in 2016.

· Amazon has entered the textbook rental business and is aggressively targeting CHGG's core customer base. Barnes & Noble Education, which operates over 750 college bookstores, recently launched a price match guarantee.

· Based on reviews of textbook rental comparison sites, CHGG is generally the most expensive rental option.

3) Chegg Services stability, margins, and growth characteristics are misrepresented

I. Chegg Services faces persistently high customer churn

· CHGG management claims Chegg Services renewal rate is 80%. However, management does not openly highlight that this is a monthly renewal rate. Annual churn is approximately 93%. Claims that Chegg Services is a recurring business are false.

II. Chegg Tutors pricing implies management misrepresented gross margins

· Management claims overall gross margins will be driven substantially higher by growth In Chegg Services. However, public disclosures do not support management's claims. CHGG's fastest growing digital business, Chegg Tutors, appears to have gross margins of just ~30%.

III. Management has historically squandered shareholder capital through poor acquisitions

· In the last six years, CHGG has spent nearly $140 million of shareholder capital on 10 acquisitions.

· 4 of the 10 acquired companies/products have been shut down or discontinued, while 3 acquisitions are behind plan.

· Based on our analysis, we believe just one of management's growth acquisitions is performing to plan.

IV. Chegg Services subscriber growth is significantly overstated

· While CHGG management claims subscriber growth accelerated in Q3'16 to over 40%, we believe management furtively revised the metric to exclude declining eTextbook customers and included Imagine Easy subscribers.

· Based on our analysis, normalized subscriber growth decelerated to just 15% in Q3.

4) CHGG has consistently misrepresented its financial & segment reporting

1. Management has repeatedly reorganized reporting segments to artificially inflate digital growth

· Since CHGG came public three years ago, management has reported revenue under three different segment derivations.

· Each revenue reclassification appears to coincide with a specific quarter in which management would have failed to achieve its financial targets.

II. Normalized digital revenue growth is significantly below management's target

· Based on company disclosures, we believe normalized digital revenue growth would be just 16% in 2016 had management maintained consistent reporting segments.

III. Multiple revenue reclassifications have discrepancies with reported pro forma financials

· In August 2015, CHGG management publicly stated pro forma revenue was $142.7 million in 2014.

· In February 2016, the same 2014 historical revenue was inexplicably adjusted downwards by 6% to $134 million.

· We believe the alteration of historical pro forma results was intended to set a lower bar in previous years to artificially enhance perceived current year growth.

IV. The SEC requested information regarding CHGG's revenue reclassifications

· In December 2015, the SEC sought an explanation for why management included CHGG's Ingram commission on physical textbook rentals in its "digital" segment.

· CHGG management defended its segment reporting in correspondence with the SEC. However, just two months later, management again altered its revenue classifications in what appeared to be another brazen tactic to obfuscate organic growth.

V. Did CHGG's inventory transfer sales to Ingram artificially inflate revenue?

· Under CHGG's GAAP filings, the company's "Sales" line item includes just-in-time sales of print textbooks and other required materials.

· Our analysis shows "Sales" revenue should correlate with "Rental" revenue. However, in 2014 and 2015, "Sales" revenue inexplicably re-accelerated, diverging from "Rental" revenue declines.

· We believe CHGG artificially inflated revenue growth by recording initial inventory transfers to Ingram as profitless revenue.

VI. CHGG appears to be in direct violation with SEC Regulation G

· Despite the SEC's recent Compliance and Disclosure Interpretations on perceived non-GAAP financial reporting abuses, CHGG management appears to willfully disregard Regulation G with its reporting of non-GAAP profitability and revenue metrics.

5) Management's egregious compensation & other conflicts of interest

I. Abusive stock compensation transfers value from investors to management

· CHGG spends nearly 23% of its pro forma revenue on stock-based compensation, which is more than 500% greater than its peer group.

· Sell-side models appear to neglect over 11 million anti-dilutive shares from the company's current share count because CHGG is unprofitable.

· At market prices, a potential acquirer would need to absorb a 12% increase in the outstanding shares based on vesting schedules and current options.

II. Management's excessive pay is not tied to performance

· In 2015, CHGG failed to achieve all performance based compensation targets and the total shareholder return was negative. In recognition of this "performance," the Board of Directors rewarded Mr. Rosensweig with $10 million of compensation.

· Since coming public three years ago, CHGG's stock price has declined by 45%, underperformed the Russell 2000 by 60%, and management has repeatedly missed performance targets. Nonetheless, Mr. Rosensweig has received nearly $24 million in compensation.

6) Weak operating performance, cash burn, & acquisition earn-outs impair the balanced sheet

I. Management has misrepresented recent business momentum

· In Q2'16, CHGG management boasted that EBITDA more than doubled year-over-year.

· Excluding one-time gains/losses on textbooks liquidations, EBITDA actually declined year-over-year.

II. Significant increases in capitalized expenses may be overstating EBITDA

· After exiting textbook rentals, CHGG should have minimal capital intensity.

· Historically CHGG spent 2-3% of revenue on capital expenditures. However, YTD'16 capitalized expenditures inexplicably jumped to 9% of revenue.

III. Management quietly pushed out its target operating model by one year

· Throughout CHGG's transition from a textbook rental company to a digital business, management has stated its target operating model of 25% revenue growth, 60% gross margins, and 25% EBITDA margins would be achieved by 2017.

· In early 2016, without explanation, management inexplicably moved its target model date to 2018 and lowered its growth target in an investor presentation.

IV. CHGG's business model(s) perpetually destroy capital and burn cash

· In its most recent earnings call, management stated CHGG generates a lot of cash.

· This statement is patently false. In less than three years, CHGG's cash balance has declined from $160 million to less than $60 million.

· Despite relying on excessive stock-based compensation in lieu of cash compensation, management expects to burn ~$25 million of free cash flow in 2016.

V. Imagine Easy earn-out payments may impair CHGG's balance sheet

· In addition to paying $25 million to close its Imagine Easy acquisition, CHGG committed to a $35 million incremental earn-out, with $27 million due in 2017.

· With approximately $55 million of cash at year-end and an annual burn rate exceeding $25 million, we believe CHGG will need to access the capital markets in 2017.

7) Rubber meets the road in 2017 & VC's and insiders are voting with their feet

I. CHGG will struggle to meet 2017 guidance

· Based on our analysis Chegg Services' revenue has decelerated for three years to under 30% growth. To achieve 2017 guidance, the segment's growth must meaningfully reaccelerate.

II. VCs and insiders heading for the exits before the next reset

· Three of CHGG's top six pre-IPO investors have sold their entire positions for a loss.

· Since August 2016, CHGG's Chief Product Officer has sold more than 80% of his holdings.

8) CHGG is significantly overvalued

I. CHGG trades at a substantial premium to education-focused peers and a broader consumer internet basket

· CHGG trades at 42x EV/EBITDA compared to 5x -7x for publicly traded education-focused peers.

· Despite GAAP revenue declines, decelerating pro forma revenue growth, negative free cash flow, and a structurally broken business model, CHGG trades at a substantial premium to both AMZN and LNKD.

II. Generous valuation implies 75%+ downside

· Applying a generous peer group valuation multiple, we believe CHGG's intrinsic value is $1.72, or 75% lower than recent market prices.

Analyst's Disclosure: I am/we are short CHGG.

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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