Chegg, Inc. (CHGG) Q1 2015 Earnings Report, Transcript and Summary

Greetings and welcome to the Chegg First Quarter Fiscal Year 2015 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to Mr. Alex Hughes, Investor Relations for Chegg. Thank you, Mr. Hughes. You may now begin.

Good afternoon. Thanks for joining Chegg's first quarter conference call On today's call are Dan Rosensweig, Chairman and CEO, and Andy Brown, Chief Financial Officer. In terms of structure, Dan will open with the discussion of Chegg's business, and Andy will follow with a review of our operating results and our outlook for the second quarter and fiscal yearend 2015. A copy of our earnings press release, along with our investor presentation, is available at our Investor Relations website, investor.chegg.com. A replay of this call will also be available on our website. We routinely post information on our website and tend to make important announcements on our media center website at www.chegg.com/mediacenter. And we encourage you to make use of these resources. Before we begin, I would like to point out that during the course of this call we will make forward-looking statements regarding future events, including future financial performance of the Company. These forward-looking statements are subject to material risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. We caution you to consider important risk factors that could cause actual results to differ materially from those in the forward-looking statements. In particular, we refer you to the cautionary language included in today's earnings release, and the risk factors described in Chegg's annual report on Form 10-K filed with the Securities and Exchange Commission on March 6, 2015, and our other filings with the SEC. Any forward-looking statement that we make today are based on assumptions that we believe to be reasonable as of this date. We undertake no obligation to update these statements as a result of new information or future events. During this call we will also present both GAAP and non-GAAP financial measures. Our GAAP results and GAAP to non-GAAP reconciliations can be found in our earnings press release. Now I'll turn the call over to Dan.

Good afternoon everyone. We entered the year focused on improving the quality of our service, adding new services that take advantage of our scale, and finalizing the Ingram relationship to position us to be a 100% digital business by the end of next year. With the Ingram agreement now signed, we are effectively a digital company, which is how we are already operating. Therefore, my commentary will be on a pro forma basis, which shows Chegg's revenue as if the Ingram transition is in full effect, while Andy will continue to provide all our numbers until the transition is complete. Chegg is off to a great start in 2015. We grew Q1 revenue 34% year over year on a pro forma basis. We added 500,000 new members to the Chegg ecosystem. Total subscribers in the quarter top 750,000 for the first time. And our attach rate between print users and our digital services grew 40% year over year and is now up to 15%. We are really proud of the team's execution and we expect this momentum to continue throughout the year. For those of you new to Chegg, education is a $1 trillion industry undergoing massive disruption. The same dynamics impacting other industries, such as lower cost of technology, proliferation of screens, the move to mobile, and a new generation of consumers who expect to leverage technology to improve their outcomes are catalysts for disruption and are all positive dynamics for Chegg. We have spent the last five years building Chegg into a powerful platform, reaching nearly 50% of U.S. college students and 75% of college-bound high school seniors. Our brand has never been stronger, with research showing that Chegg already ranks as one of the top two brands that high school and college students consider helpful in their studies and school life. We focus on the student, because despite the massive spending on education, big issues remain around access, cost and relevance, which are leading to very poor student outcomes. Two recent real-world examples. In March, Sweet Briar College, a well-regarded liberal arts school, announced its closing its doors at the end of the academic year, despite having more than $85 million in their endowment. And Corinthian, a large for-profit college, abruptly closed its campuses without notice, stranding 16,000 students and leaving them without their degrees yet responsible for all of their debt. It's unfortunate, but most students just don't have adequate resources to evaluate college and make the best academic and financial decisions for themselves and their families. The ratio of guidance counselor to student is 1 to 500 nationally. And it's absolutely 1 to 1,000 in California. Therefore, it's not surprising that 41% of college students drop out, and for those who do graduate, they graduate with nearly $30,000 in debt and face nearly -- I mean 11% unemployment, while 45% end up taking jobs that do not require a four-year degree. Clearly the status quo is not working. In nearly every other industry, the consumer has been able to harness technology and the internet to more successfully direct their own future and improve their outcomes. Chegg is designed to helped students throughout the higher education journey and is rapidly becoming a must-use service for motivated students. We continue to expand our offerings to meet more of their needs while improving the quality of each of our services. We now provide college matching, scholarship matching, required materials in any format, homework help, tutoring, internship matching, and career planning. A wide array of high-quality services continues to grow our brand with students and is establishing Chegg as a student-first leader in higher education. The power of the Chegg brand has already positively impacted our growth rate and margin structure. Because of the popularity of our brand, we're able to attract over 85% of our customers organically, which translates into a very powerful funnel, allowing us to acquire customers at a very low cost. A core differentiator in our business is our ability to leverage the data in our student graph [ph] to drive increased awareness in usage of our services by matching the right students to the right service at the right time. This creates a very powerful virtuous circle. The more students use Chegg, the more relevant each service gets for them, and the easier it is to introduce them to new services. As a result, more than 70% of our members already use Chegg services other than print. We are very pleased with the growth that we're seeing from our newly launched services, Chegg Tutors and Chegg Internships. Both are taking advantage of our large funnel. And going forward, whether we build, buy or partner, we believe we are well-positioned to layer on newly -- on new, highly-relevant services across our platform that are increasingly personalized to each student's needs. The combination of our Ingram partnership and the accelerating transition in higher education and the quality of our offerings positions Chegg to be a high-growth, high-margin and high cash flow business by the end of 2016. With that, I'll turn it over to Andy to talk further about our financials. Andy?

Thanks, Dan, and good afternoon everyone. My comments today are on non-GAAP basis, when I discuss our financial performance and updated 2015 outlook. Throughout my presentation, I will also be referring to the investor presentation on our IR website. We ended 2015 with strong momentum and high expectations for digital revenue growth, subscriber growth and leverage in our business model. We are very pleased with our progress through Q1 and with the completion of the Ingram agreement. As a reminder, the Ingram partnership transforms our business. It frees up about $100 million in working capital annually, simplifies our textbook business, accelerates the growth of digital revenue, and reduces long-term operating costs, which we expect to yield a high growth, high margin and high cash flow business. You can see this transition illustrated on Slide 17 in the investor presentation. For consistency and so you can track the progress of our transition, we will continue to report print and digital revenue as separate lines for the remainder of this year. Similar to our last earnings call, we will also report our pro forma revenue, which as Dan said, shows Chegg's revenue as if the Ingram transition is complete and Chegg is a 100% digital business. This is a better reflection of how we operate the Company and our future business model. As such, in 2016, we will begin guiding only on digital revenue and non-GAAP EBITDA. With that, let me walk you through our Q1 results and our updated 2015 outlook. Q1 revenue came in better than expected, driven by strong digital revenue growth. Total revenue grew 14% year over year to a record $84.9 million, and digital revenue grew to $33.5 million. Our better-than-expected digital revenue was fueled by stronger subscriber growth. In our print business, as expected, revenue declined 9% year over year because of the transition to the Ingram commission-based model, which means we recognized approximately 20% of all transactions, and we recognized this in quarter versus ratably over the rental period. As Dan noted, we run checks business on a pro forma basis, and Q1 pro forma revenue would have been $48 million, up 34% year over year. Total gross margin for the quarter was 26%, a 14-point improvement year over year, as digital became a larger percentage of our business. In fact, digital gross margins increased 4 points year over year to 59%, highlighting the increased leverage in the model. First quarter operating expense was $27.9 million or 33% of revenue, compared to 36% the year before. Adjusted EBITDA loss was $4.3 million, a significant improvement of $12.3 million over Q1 of last year. Looking at the balance sheet, we ended the quarter with cash, cash equivalents and investments of approximately $79 million, and no debt. As expected, we ended the quarter with $85 million of textbook inventory, which we plan to cut in half by the end of the year as we transition ownership and warehousing to Ingram. Before turning to our outlook, as a reminder, our digital business today is comprised of two components: subscription and advertising. Subscription consists of Chegg Study, eTextbooks and Chegg Tutors, while advertising consists of enrollment marketing, brand partnership and commission-based revenue from partners such as Ingram. For 2015, we expect the split to be approximately 70% subscription and 30% advertising. As we enter 2016, this mix will of course change as Ingram commission-based revenue ramps. In addition, our business is seasonal and is driven by semesters, not quarters. The expected revenue seasonality for 2015 can be seen on Slide Number 19. Turning to our outlook, we expect for the second quarter total revenue to be between $61 million and $65 million, and digital revenue to be between $28 million and $30 million. Gross margin between 41% and 43% and adjusted EBITDA profit of between $1.5 million and $2.5 million. For fiscal 2015, we are improving our outlook to total revenue between $300 million and $315 million, and digital revenue between $135 million and $145 million. Gross margin between 34% and 36%, adjusted EBITDA of breakeven or better. And finally, we continue to expect between $15 million and $25 million in free cash flow for the year. This is an exciting time for Chegg and we had started the year on a positive note. Chegg is building a very powerful brand in a very large market. We believe the underlying strength in our digital services, combined with the transformation of our business model, sets us up to be a pure digital business with high growth, high margin and high cash flow characteristics. By the end of 2016, we expect our financial profile will be revenue growth of greater than 25%, gross margins at greater than 60%, and EBITDA margins at greater than 25%. With that, I'll turn it over to the operator for your questions.

Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Our first question is from Douglas Anmuth of JPMorgan. Please go ahead.

Thanks for taking the question. Two things I wanted to ask. You talked about subscription strength and then also a good increase in attach rates as well. I was just hoping you could elaborate there on what you're seeing, I guess specifically what you're doing to really drive the pretty big increase that you saw in attach rates and how that's kind of playing into the subscription strength there and which particular products you're seeing that in. And then secondly, Dan, we've seen some M&A in the space recently just around kind of education and training of professionals. How are you thinking about that segment going forward? And whether that's something that would still be attractive to Chegg over time. Thanks.

Yeah. Thanks for the question. On the first part, the whole Chegg business model is predicated on building a giant brand which we are very far ahead on, building a funnel, low-cost funnel, where I think we said today over 80% of our traffic is organic, and then building the student graph similar to the way Facebook has built its social graph and LinkedIn has built its professional graph. Because most of you don't get a chance to use the Chegg system, you're not familiar yet with the fact that it acts much the same way. So when a student comes in to the Chegg ecosystem, we know your college, we know your class, then we know your books, then we can guess your major. We can start to bring you Chegg Study when it's appropriate, particularly when you're using an eTextbook. When you're using an eTextbook, we not only know what book you're reading, we know when you're reading it, we know what page you're on. So the first part of the ecosystem was to build Chegg Study, which is just really having a phenomenal beginning of the year. And then after the acquisition of InstaEDU, the integration of building InstaEDU into Chegg Study as well as the rest of the ecosystem. So this is what we expected in terms of how we plan to build the Company, which is giant brand and giant reach, very inexpensive funnel. And then the internal funnel, leveraging the student graph, which we're really only at the beginning of, and yet it's still performing extraordinarily well. So we see tremendous momentum in Chegg Study. That generates additional great momentum into Chegg Tutors. And really we only have currently three subscription businesses, eTextbooks, Chegg Study and Chegg Tutors. And so they are already the ones generating that much graph [ph]. So we think those markets are huge and we think there'll be more opportunities like that, which leads to your second question which is about M&A. So we think LinkedIn's acquisition of Lynda sort of endorses our model, which is build a big brand, find the right customers, and find more things for those right customers within your network. We have always been very judicious about what we buy, so, you know, we really haven't done anything since I think internships last October and Tutors last June. So this is all organic for us because internships came with no revenue and Tutors had almost none originally [ph] last June, but is seeing incredible momentum. So we see -- as we see more opportunities like that where we can leverage our reach, leverage our ability to use our data to match more efficiently, take marketing costs out of any company buy, and generate such high-growth profit margin, then we will certainly look at those things. But like anybody else, we want to make sure they're the right things for the students and at the right price that we think get returns for our shareholders.

Great. Thank you.

Thank you. The next question is from Brian Fitzgerald of Jefferies. Please go ahead.

Thanks guys. Any color around Chegg Tutors? Does tutor growth and minutes per tutor continue to -- at the same pace we saw last quarter? I think it was growing in excess of 200% year over year, minutes per tutor were nearly doubling. There must be some seasonality there at some point, semester seasonality at some point too as we get into summer. So, color around that. And then, how do you think about pricing and segmentation in the future around Tutors? Could we see kids structured by -- pricing structured by subject, by tutor quality, by ABC [ph], et cetera? Thanks.

Yes. Thanks for the questions. So, yes, we are seeing tremendous growth of Tutors. That is, we have a number of marketplace businesses, but that is probably our biggest in terms of the opportunity that we see today. We can see our tutoring business as a marketplace on a global basis bigger than all of Chegg is today. There's no reason why that shouldn't be the outcome many years from now. And it's a winner take most markets. So the marriage of Chegg's reach, Chegg's brand and then the supply and the technology of the tutoring system we though was the perfect match, and we're seeing that. So, yes, we are seeing very similar growth that we've announced in the past. We're being very reluctant to, you know, to give out numbers every quarter because, to your point, we want to make sure we understand all the seasonality of these businesses as we get them. So we have a January, February, March in the first quarter, and then sort of after mid-May and through June and July and through August, we only have summer school, and then it gets huge again. So we are seeing similar growth rates to what we talked about in the past. It is the Uber for tutors, and we want -- we are building that. The ability to, again, know your school, know your class, know your subject, know your interest, know your needs, and be able to not only bring up self-help like Chegg Study, but now tutoring where you can do it for as little as $0.40 a minute, is democratizing tutoring. And we are seeing the incredible interest in the product and actually usage of the product. As it relates to the pricing question, we are so early in all of these businesses that we have the same questions you do, which is, what are the right pricing at the right time? We are certainly building the technology that will allow us to do a tiered system. We already are testing a different price in college guidance counseling. So in some cases we have gotten dedication of free hours from people who are willing to help families, so this is the first student in the family ever to go to college. And then we have a premium service that we're contemplating, which is to allow those people who need more time and have more money. So the technology that will allow us to understanding pricing by subject, you know, it could even be surge [ph] pricing like Uber has in terms of around finales and midterms, but the ability to do it based on different subjects or even different quality of reviews. So, yes, that is all technology that we are building today and we'll be able to utilize at some time next year, we imagine. But it's still too early for us to know what the right circumstances to apply it. At the moment though, the goal is to win that tutoring marketplace business, which we're well on our way to do, because we think it's huge. And so today, just having incredibly low pricing, high quality, I think we have over 13,000 tutors now on the site, and that number is us making sure that everyone we bring in is high quality. The demand to be a tutor is much higher than the numbers that we show today. So, so far we're seeing no obstacles to that business.

Great. Thanks, Dan.

Thank you.

Thank you. The next question is from Jeff Silber of BMO Capital Markets. Please go ahead.

Hey guys, it's Henry Chien calling in for Jeff. I just want to dig in a little bit more on the subscription business. In terms of the upside or the raised guidance. Would you be able to break out or just comment on which particular services maybe outperformed your expectations?

Yes. So like I said, when you look at our digital businesses as a whole, they were at or better than what we'd expected. We talked about, you know, when you look at the subscription side of the business, those are the ones that performed higher. We are particularly higher with Chegg Study and Chegg Tutors. But they all grew slightly better than what we'd originally anticipated. And as you're aware, as I've mentioned at least on the call, that that is about 70% of our overall digital business.

Okay, got it. And I'm sorry if I missed it, but did you give out the year-over-year growth rate for paying digital customers and total digital customers for the quarter? And if you could just comment on the advertising business and how that's going as well. Thanks a lot.

Yes, so, we'll kind of -- that's a good question there. So on the ad side of the business, the ad businesses did super well for the quarter once again. I mean we had high expectations both for the subscriber business and the ad business. The ad business also did well. And as you are probably aware, part of the ad business is we, now and as we go forward, is going to be the transition to the Ingram commission-based businesses. And that will continue as we move through the year and clearly accelerating the next year as we approach being 100% digital company.

And as it relates to the growth rates, we're happy to give them. They're quite good. I think subscriber growth is over 40% year over year. And the total digital growth was 89% year over year. And I think that reflects two things. One, as Andy said, the ad business going really well. And second, the fact is, as our subscription businesses continue to improve, not only are we improving number of subscribers versus our expectation, but the quality of the service are going up, that we're seeing longer time and longer usage on the service. So we're again reluctant to give too many of the details too early in these businesses' lifecycle, because we're learning as we go along, but everything is up into the right right now as it relates to the subscription businesses. Remember there's just three of them. And so we see many more of these opportunities going forward. It's just eTextbooks, Chegg Study and Chegg Tutors, and we had a great beginning to the year.

Got it. Appreciate the color. Thanks a lot.

Thank you.

Thank you. [Operator Instructions] The next question is from Matt Blazei of Lake Street Capital Markets. Please go ahead.

Yeah, hi. This is Mark Argento for Matt. Just a couple of questions. One, you mentioned in your prepared remarks kind of a target operating model. And just wanted to better understand kind of what revenue levels do you see that kind of target model of 25% revenue growth, obviously, really hard to pin, but the margin structure, you know, 65% plus gross margins and 25% plus EBITDA margins.

Yes. So we talked about that, and actually I'd refer you to I think Slide 17 of the investor -- on the Investor Relations deck. Kind of gives you a graphical view of how we see things and the transition that we anticipate that we'll go through through this year and through 2016. But we do anticipate that, as we exit 2016, we'll be operating at those levels, certainly on a pro forma basis. So that's an anticipation. When you think about it, you kind of peel back the numbers today, if you take the midpoint of our digital guidance, which would be right around 140, and you do a rough estimate of what the -- and that's growing at plus over 50%, and then you take a look at the Ingram business, $200 million textbook of business, that's about 40. So you get about $180 million business. That's slow growth for 40 but it's a very high growth for the digital businesses. It's not hard to envision that would be a high-growth, high-margin business. This past quarter on a pro forma basis, we grew 34%, right? So it's -- we've got a high-growth business, and we would anticipate that that would continue. That's how we get to the guidance as we exit through this transition.

That's helpful. I'll take a look at that slide. And when you're looking at the digital business, is there a big difference in terms of gross margin profile between the subscription business and the kind of the ad/marketing part of that digital business?

You know, it doesn't vary a whole bunch, to be real candid with you. We talked about our long-term model greater than 60%. That's essentially where they are today. In my prepared remarks I said we're 59% in Q1, but for the year it's going to be somewhere in the 60s. Within each of the individual businesses, there's some variations, but when you take a look at ad versus subscriptions, they are, you know, fairly close. Now what happens with those businesses, as we start -- particularly on subscription business, that we start adding subscribers, it scales, you know, scales more. A good example of that would be Chegg Study. The concept is a fixed fee, as we add subscribers, the incremental margin is much higher than the average. But for at least, for the short to midterm, I think the 60% range is appropriate.

Okay. That's helpful. Then last question, regarding free cash flow, I think you guys reiterated that 15 to 25 number. I think that's the same number you had in Q4 for the full year this. When we think about cash from operations versus maybe other impacts of the cash, like liquidating or selling down some of the inventory, is the free cash flow number impacted by what's going on with the transition with Ingram on the traditional business, or is that kind of more of a cash -- a good cash from operations or cash flow from operations number?

Well, it's a little bit of a combination of both, right? So we, you know, we think the cash flow guidance that we gave, 15 to 25, is a nice bump-up from last year. It's a combination, as you can imagine, when you look at cash flow, there's a lot of variables, working capital balances, along with the cash flow from operations. What I would remind you, however, is that it doesn't reflect the whole impact of the transition. We believe actually free cash flow becomes much better next year, which is 2016, as a result of, if you recall, we are extending some payment terms to Ingram that we don't -- we get the full benefit of the cash flow into 2016 and then even better into 2017.

And we expect that to be approximately $25 million. So the free cash flow would be 2x [ph]. We -- Chegg is -- we expect Chegg to be, from operating business, a very high free cash flow business and very high-margin business and a very high-growth business. And the reason that we're reporting out pro forma is because we're already operating the Company as if the transition is done. All the documents have been signed, all the work has been done. You can see from first quarter the subscription businesses are even ahead of where we anticipated, the ad businesses are going well. We completely de-risked the textbook business both in cash use as well as any ownership of inventory that we have, will go down from $84 million to $40 million by the end of this year, and then close to zero if not zero by the end of next year. And we only have one big quarter left of inventory that we own, which will be the biggest quarter of the year. And as you've seen from the last two quarters, we have the ability to compete in that business quite effectively and better than anticipated. So we are really excited about the business that we've created. We've worked very hard for five years to get this into the right position, and I think now what you're seeing is some of the benefits of that. And as we're able to communicate it even clearer, then I think there's going to be a lot more excitement here, because the business has really started out well.

Yeah. It looks like you guys are making good progress, so, congratulations. That's it for me. Thanks.

Thank you.

Thank you. [Operator Instructions] Okay. With that, I would like to turn the conference back over to Mr. Rosensweig for any closing remarks.

Thanks. And just so my wife is listening, it's Ro-sen-swayg. So as you can see from our numbers and the significant performance versus our own expectations in Q1, that we're off to a tremendous start. The concept of Student Hub where somebody is focusing on the needs of the student first is clearly something that resonates with students, with over 50% of all students currently using Chegg, 75% of all high school students currently using Chegg and our service. We're really just at the beginning of the kinds of services that we can offer. And we feel that 2015 is that transformative year for us where the Ingram deal in the rearview mirror and the digital business being the only business that we really have to operate going forward. Our business gets -- grows faster, has higher margins, more free cash flow, has less risk, and frankly, just easier to operate, because of all the logistics required in the print textbook business. So we were very excited about entering the year. We're more excited now. I think it's reflected in the new guidance that Andy has put out, that the year is off to the kind of start that we would hope. So we're just going to continue to execute and execute, execute. We see this as a $1 trillion market and we see more opportunities, Doug, to your question, to see possible areas for us to grow. We're certainly going to grow -- continue to grow organically, which all of this is, and then when we see opportunities, we'll seize them. So, thanks everybody for joining the call. And just on a personal note, as you all have heard, I and others lost a tremendous friend this week in Dave Goldberg, and I just want to acknowledge him for everything that he's given to my family and to our Company. He was a big fan of Chegg, he's a huge fan of education, and a close friend of my family, my daughters and myself personally. And all of our love goes out to him. And in that honor, all the music scholarships that Chegg will give from now on, which we give many a year as we work with big music artists, as you just saw, we just had a deal with U2 and Ed Sheeran, before that Taylor Swift, they'll all be given in the name of Dave Goldberg, because he not only was a great man but a huge music entrepreneur. And so I just want to make sure that I had a chance to communicate that. Thank you everybody for joining the call. And we look forward to talking to you in August. Thanks.

Thank you. Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.