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[CHGG – Chegg] Low Cost Channel to Bundled Ed Tech and Challenges in the Publishing Industry

[CHGG – Chegg] Low Cost Channel to Bundled Ed Tech and Challenges in the Publishing Industry

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Oct 06, 2018
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[CHGG – Chegg] Low Cost Channel to Bundled Ed Tech and Challenges in the Publishing Industry
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If you were looking at Chegg in 2014, you’d have found plenty of valid reasons to pass on, or even short, its stock.  The company was plowing more than all its operating cash flow into textbooks and renting them out to students at increasingly discounted prices as it braved intensifying competition from Barnes and Noble, Staples, eBay, and Amazon.  Amazon, in particular, was poised to leverage the strength of its consumer relationships and bundle textbook rentals in a way that Chegg could not.  Even while Chegg pioneered the textbook rental model1 – allowing students to pay $30-$40 to rent a book listed for sale at over $200, to the consternation of publishers who profited for decades by raising textbook prices to extortionary heights2 – it knew that this was a commodifying business with deteriorating returns on capital and so sought new avenues of growth, acquiring its way into “digital solutions”.  But so was everyone else, including the very publishers Chegg was relying on for physical books.  There was no discernable moat surrounding any part of Chegg’s business.

But the crucial thing that Chegg had going for it, what underpinned its successful product pivot and its growing dominance in higher education services today, was a concentrated focus on meeting student needs, first and foremost3.  Textbook rentals, which could often save students 30%-40% off the price of a new version that a student may never reference again after the semester, was a first step in this direction…but it was certainly never intended to the be the last.  When it comes to textbook rentals (or just about anything else, really), Amazon might always win on price, convenience, and selection, but I don’t see them creating holistic study solutions that help students learn.  The vertical is too small and doesn’t build on existing advantages.  Publishers, meanwhile, are married to the traditional approach of marketing to professors and institutions, who do not actually buy the textbook themselves and therefore, have little incentive to push back on pricing.  I would argue that the only way you could have cast a charitable eye at the ostensibly confused, “diworsifying” acquisitions Chegg was making years ago, let alone have had even a smidge of conviction that the company’s strategic pivot would have translated into the success that it has, was by understanding that culturally, Chegg was guided by a zealous student-first orientation that its most obvious competitors at the time simply could not afford to share.

But before it could pursue anything in earnest, Chegg had to free up the capital consumed by its rentals business.  In 2014 it entered into (and in 2015, expanded) a non-exclusive agreement with Ingram, whereby Ingram would procure, warehouse, and ship the physical textbooks that students rented off Chegg, who in turn earned a 20% commission on each rental and, more importantly, retained the student relationship4.  By mid-2015, Chegg stopped investing in its print textbook library and by early 2017 had liquidated whatever books remained on its balance sheet.  Now, in switching from a wholesale model (where it buys the book and rents it out at a mark-up) to an agency model (where it earns a commission), Chegg only recognizes ~10% of the revenue that it used to from each book rental, and that’s most of the reason why revenue from “Required Materials” (revenue share from print textbooks + rental and sale of eTextbooks) has declined from $214mn in 2013 to $69mn LTM.  The dollar profits realized under both models are more or less the same5, and the 5.4mn printed textbooks and eTextbooks rented or sold in 2017 is only down a bit from the 5.5mn rented or sold in 2013.  So, when you look at the following charts…

…it may appear that growth in Chegg Services (subscription based digital learning tools) is substituting for the rapid decline in book rentals and taking gross margins along for the ride, but that’s not really what’s going on.  You are merely witnessing the change in revenue model for book rentals combined with torrid 35% annual growth in Chegg Services, which I estimate accounts for ~85% of Chegg’s total gross profits today.  But Chegg arguably couldn’t have gotten to where it is without the brand resonance it nurtured over the past decade as a significant purveyor of the course materials that every student needed.  By the time it struck its agreement with Ingram and turbocharged its transition into services, Chegg was ubiquitous across college campuses6, with the brand and content to cost effectively funnel students to Chegg Services.  Since 2010, Chegg has paid ~$200mn in cash and stock on a whole bunch of small/mid-sized acquisitions valued in the tens of millions that collectively make up Chegg Services, whose $218mn in revenue is responsible for essentially all of Chegg’s $3bn enterprise valuation today.  By far the most central of these properties is Chegg Study, known back in the day as Cramster (here’s a version of the site from 2009)7, an online application that for $14.95/month offers step-by-step solutions (not just the answers, but how to arrive at the answers) to questions found in in over 30k ISBNs8 (up from just 400 ISBNs in 2010, when the company acquired it).

Chegg Study isn’t exactly “capital lite” – the company still has to pay licensing fees to publishers for the textbook questions to which it provides the solutions – but it certainly consumes far less capital than the legacy rental business and is a helluva lot more scalable too, since unlike textbooks, which can only be only be rented to one person at a time, licensed content can be consumed by a practically unlimited number of subscribers at very little incremental cost.  It’s the difference between Blockbuster and Netflix.  The Netflix comparison is becoming ever more apt as Chegg increasingly relies on its own “original content”.  A Chegg Study subscriber can post a question and have one of Chegg’s 70k outsourced experts9 return with an answer within 4 hours.  In the ~3 years since Expert Q&A was launched, students have asked over 13mn questions, which combined with step-by-step textbook solutions, sums to a proprietary content library of 24mn answers, +42% y/y, over 3/4 of it coming from Expert Q&A, whose expert network has nearly doubled from 38k a year ago.

This trove of proprietary solution content is growing by 6mn-7mn answers every year, an increasing mix of it supplied by Expert Q&A, and scaffolds several competitive advantages.  First, it yields lots of free site traffic.  62% of Chegg’s traffic comes from unpaid search.  If you copy and paste a textbook question into the Google search bar, there’s a very good chance that the first result will link to a Chegg solution.  Moreover, thanks to Chegg’s 84% brand recognition on college campuses, another 23% of Chegg’s traffic is direct.  So together, 85% of Chegg’s traffic comes from unpaid sources10, a considerable customer acquisition advantage that would be difficult for competitors, who have far less capacious libraries, to replicate.  Second, more content makes for a better product, which in turn fuels student engagement.  The average subscriber uses Chegg Study once/week and consumes 200 pages of content during the course of a semester.  In the first half of 2018, Chegg Study witnessed 315mn content views, up 60% from a year ago.  As students engage, they ask more questions and are supplied more answers, birthing content that gives rise to more free traffic and more student engagement.  That said, textbook questions don’t really change from year to year, so there is some limit – an “asymptote”, if you will (a word that seems to be creeping its way into tech business vernacular) – to the value contribution of content.  Furthermore, I would guess that there are diminishing returns to content, as with every passing year a growing proportion of the most pertinent questions will have already been asked.

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