Description

The thinking among bulls is that 1) distance learning/online education is growing rapidly, particularly for graduate programs (2) 2U has a marquee client roster (3) the company has greatly expanded its client/program roster over the past several years which will drive strong (~30%) top line growth (4) as programs mature and enrollment increases losses will disappear and the company will move toward its long term EBITDA margin target of 30-35%. 

While we can’t argue with points 1&2, we take issue with the potential for an extended period of top line growth and doubt that 2U ever achieves anything better than a 15-20% EBITDA margin.  Our reasons for disbelief are as follows:

1)     1)  Competition is vast – 2U competes with other outsourced services providers as well as universities handling the online infrastructure themselves.  Direct competitors include: Pearson (which acquired Embanet Compass in Oct 2012 for $650 million or an estimated 5x 2012 revenue or 4.3x forward) and John Wiley & Sons (which acquired Deltak, also in 2012) in addition to private competitors HotChalk and Everspring Partners, among others.  A few hours surfing the internet show that most schools offer online degree programs.  In fact, two of 2U’s large clients offer other online degree programs independent of 2U (while Accountancy and MBA programs at UNC Chapel Hill are done with 2U, other degree programs including a Masters in Public Health at Chapel Hill are offered w/o 2U; similarly USC offers an MBA w/o 2U).  It is hard to see how this dynamic doesn’t squeeze profit margins (particularly upon renewal). 

2)      2) Conceptually it makes sense to us that over the long term, the university has the reputation and will garner the lionshare of the economics for successful programs.  If a program attracts many qualified students and has an initial contract margin of 25-30%, we find it tough to believe that the economics are not re-cut upon renewal. 

3)      3) As revenue growth from largest clients flattens out, total company growth is set to slow.  We estimate that growth for USC has slowed to 5-6% and believe revenue has been flattish for Georgetown for the past several years. 

4)      4) While the client roster contains many well respected academic institutions, the selectivity of these schools is likely to prevent 2U from achieving the scale necessary to achieve targeted profitability in many of its programs. 

5)      5) While pure software companies can and do generate 30+% EBITDA margins, software is only a part of what 2U provides.  Given that 2U is responsible for all marketing and marketing expenditure (but school determines admissions), we think this is a structurally a lower margin business than pure-play software companies. 

6)      6) Though we think it is possible that 2U’s best contracts can generate a 30% EBITDA margin, the reality is that 2U is and will be a portfolio of contracts – some of which apparently are homeruns (i.e. USC which has 1,000+ students per program) whereas others are likely to experience more modest success and some will be money losing failures.  Again we suspect that highly successful programs are likely to see less favorable terms upon renewal, particularly where the school has a relationship with an alternate provider or has offered other programs using in-house infrastructure/marketing. 

7)      7) Potential for adverse selection – Given that universities likely have a better idea of enrollment potential, it is likely that schools will ‘partner’ with 2U for programs where they do not expect to admit enough students to make in-house fulfillment/marketing worthwhile but would like to garner incremental revenue from offering an online program.  Similarly, given the long-term nature of contracts and reputational risk to 2U for non-performance, we see potentially significant exit costs for money-losing programs. 

Model

We assume that 2U is able to compound revenue at a 24% CAGR between 2016 (uses company estimate of FY16 revenue) and 2020.  However, we think we are being more than fair in assuming that 2U is able to achieve a 16% EBITDA margin by 2020 (11-13% EBITA equivalent after capex) which is only about ½ of management’s guidance which seems to assume that every program is a success and that there is no clawback/recut of economics upon contract renewal.  Our difference in the margin profile of the business say that while some contracts are/will achieve a 30% margin, the portfolio as a whole is likely to achieve something significantly lower as many programs never achieve critical mass.  And we expect that high margin/successful programs will be re-cut with terms more favorable to the university partner. 

With a $1.7 billion market cap, $190 mn in net cash this gives us an EV/ 2020 EBITDA of 20x (or 26x discounting our 2020 estimate back 3 years at 10%).  We think 10x EBITDA (implies ~19x 2020 net income, undiscounted or 25x on a discounted basis) is a multiple which is more reflective of the quality/competitive position of the business, it’s customer concentration but allowing for its above average growth profile. 

Risks

-Takeout – I think this is unlikely as a) I assume this was shopped prior to IPO (b) Wiley & Pearson have already acquired their beachheads (at a lower multiple) in the business but in the ZIRP world I can’t rule it out

Catalyst

-Margins not coming through as planned

-Acknowledgement of one or more program disappointments

-Revenue deceleration

-Market loses fascination with all things SAASy

Catalyst

Catalyst

-Margins not coming through as planned

-Acknowledgement of one or more program disappointments

-Revenue deceleration

-Market loses fascination with all things SAASy