CHEGG INC CHGG S
December 12, 2013 - 9:24am EST by
deerwood
2013 2014
Price: 8.58 EPS $0.00 $0.00
Shares Out. (in M): 84 P/E 0.0x 0.0x
Market Cap (in $M): 720 P/FCF 0.0x 0.0x
Net Debt (in $M): -158 EBIT 0 0
TEV ($): 562 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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Description

Summary
Chegg (CHGG) is a $720M market cap, subscale textbook rental company that presents a very compelling short opportunity with a +50% nearer-term return potential.
 
Thesis
The textbook rental business is very capital intensive with rapid asset depreciation and customers who are highly price sensitive and tech savvy. CHGG competes against AMZN (Amazon Student), EBAY (Half.com) and several other much larger, established players. The Company went public on November 12, not surprisingly under the JOBS Act. To generate interest CHGG touts the growth potential from its non-textbook rental segment and attempts to categorize itself with higher multiple web services companies. Yet, this segment accounts for only 18% of LTM revenue and all growth has come from acquisitions. Since 2010 the Company has consumed $300M of cash even before cash used for acquisitions. LTM FCF was -$52M, EBITDA less textbook depreciation was -$22M and EBIT was -$33M. In order to simply maintain its textbook library, Chegg needs to spend $100M per year. Given the economics of the business it does not appear that it will ever generate positive FCF (or EBIT for that matter). CHGG currently trades at 2.3x EV/ Revenue and 13.8x EV/ reported EBITDA (excluding textbook depreciation expense). Awareness of CHGG’s challenges and low business quality should result in a meaningful price decline. VC’s hold 55% of the shares, some of which have been invested since 2007 and will likely be seeking liquidity. CHGG is presently GC at JPM and short interest is <3% of float.
 
Key Issues
This textbook rental business became very competitive in August 2012 when AMZN entered the space and Half.com (eBay) and Barnes & Noble expanded their efforts earlier that year. Concurrently CHGG’s EBITDA margins dropped from 22% in 2010 to 12% in 2012 while operating losses nearly doubled. Chegg states that it seeks to compete with AMZN and others on price so it can feed the rest of its business. In reality it is forced to match market prices. The unit economics associated with Campbell Biology, 9th Edition, the most popular US textbook (ISB: 0321558235), illustrates how competitive this industry has become: Chegg purchases new textbook at the $100 retail price and then rents it 2-2.5x per textbook at $27.50 each time, generating $69 in revenue. So at this point it won’t break even unless it can sell the used textbook for >$31 (assuming no overhead costs). Meanwhile Campbell Biology, 10th  Edition has been published and the used 9th Edition sells for <$10 (Campbell Biology, 8th Edition is currently available for $9.95 on Amazon). Even if a new edition isn’t released, the number of used textbooks being sold depresses the resale price incrementally every year it is in print.
 
 
 
The bottom line is CHGG doesn’t possess any cost advantages so can’t possibly successfully compete with AMZN on price. In a sample of the top 5 most popular textbooks, CHGG costs 10-25% more to rent than AMZN (for a single semester including shipping). Several websites and even a simple Google search compare rental prices across vendors. This is something a price sensitive, tech-savvy student can easily navigate. Also “grey market” textbooks that are printed abroad are readily available at comparable cost as rental. In March the Supreme Court rendered a decision that makes it more difficult for US companies to prevent the importation and sale of "grey market" goods – increasing the availability of copied textbooks.
 
Until 2011, 100% of Chegg’s revenue came from textbook rentals. To offset the increasingly unattractive economics of the textbook rental business, Chegg began acquiring other student products and has subsequently branded this collection of offerings “Student Hub.” The Company sells itself to shareholders as the “Netflix of student services” – it seeks to acquire students through discounted textbook rentals and then sign them up for other services such as homework assistance, recruiting and career services. Textbook rental is indeed a discount product, but that is where the comparison ends. While the convenience of a one-stop-shop for services does make sense in some industries, the value-add Chegg provides is very limited. The scarcest resource for a student isn’t time, but money. All the services Chegg sells are readily available for less (and in several instances for free) from much larger, more comprehensive providers. The customers it does acquire have a high churn profile (ie. students in college for 2-4 years) and most purchases are non-recurring and seasonal (the Company does not disclose its conversion rate from textbook rental to other services). Management touts the growth potential outside textbook rental, but all growth last year was a result of its acquisition of Zinch in late 2011. Its Zinch and Cramster acquisitions appear to be successful, however, its M&A track record is mixed (Notehall and Student of Fortune businesses were discontinued just one year after they were acquired).
 
Valuation
CHGG records textbook expense as capex and excludes all the costs of purchasing textbooks from its EBITDA calculation. The Company reported $40.6M in LTM EBITDA on this basis, but clearly textbooks have a cost. The useful life of a textbook is a little over one year, so a more appropriate method of calculating this number is: EBITDA less textbook depreciation expense, EBIT or EBITDA less net textbook purchases – all of which are negative and have been becoming increasingly more so as revenue has grown.
 
Photo
 
Chegg is currently trading at 2.3x EV/ LTM Revenue with a $720M market cap and $562M EV. Following the IPO, CHGG had ~$150M of net cash on the balance sheet, but it is consuming $50-60M of cash a year. One only needs to take a look at the challenges peer Nebraska Book (NEEB) has faced to get a sense of the industry dynamics. Incidentally, Neebo post-reorg equity trades at less than 6x EBITDA. At that multiple CHGG equity is worth less than $5 per share, 40% below current stock price (even if textbook expenses are not included in EBITDA). On an absolute basis, CHGG is not likely worth more than its liquidation or book value of $3-3.50 per share, 60% below the current stock price 

Additional Items

- eTextbooks: Electronic textbooks currently only account for 5-8% of all textbooks sold in the US and an equivalent proportion of those sold by CHGG, according to management. The slow rate of adoption has been a result of: 1) student preference for print; 2) limited cost savings at 80-90% retail price of paper-form; and 3) limited institutional adoption from professors. Although less capital intensive than print textbook rental, the eTextbook business has very low entry barriers and is already highly competitive. The growth of eTextbooks is likely negative for Chegg.     

-  Competitor Follett Corp recently launched includED, a program where it partners with colleges to include the cost of course materials in tuition. This program is fairly nascent but does present a challenge to the textbook rental business.

-  The IPO was led by JPM and BoA, both of which have a weak presence in Silicon Valley, indicating GS, MS and others passed on the offering.
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

- Awareness of CHGG’s challenges and low business quality
- Insider sales
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