2U (NASDAQ: TWOU) has a really good story to pitch to investors – it’s a small wonder the stock has gone from $13 in its 2014 IPO to nearly $55 in September 2017. Half of these gains were achieved this year – since January, the stock has nearly doubled, while performance has remained good but not great.
TWOU data by YCharts
At face value, 2U’s story is nearly infallible. Education is one of the last realms to truly undergo an attack by Silicon Valley, and 2U is helping colleges and universities bring some of their degree programs online. In return, 2U takes a slice out of the tuition fees the university earns from students enrolling in these online-only programs.
If it was easy for 2U to roll out new program, then it could be considered a SaaS company and its valuation would be justified. But it’s not.
Consider ed-tech “peer” Instructure (NASDAQ: INST), for example. Instructure provides a learning management system (“LMS”); so it’s not a direct competitor to 2U. Instructure doesn’t really have to lift a finger to bring a new college onto its platform – its online grading system, course enrollment tools, and discussion boards are apples-to-apples no matter what university is using it. If a university wants to build custom features into its Canvas deployment, they can have their own developers build them. Instructure is a true SaaS company – it can expand broadly without expending too much effort and cost into each new deployment.
2U is different: its product digitizes an entire degree program into its online platform. For an online nursing degree program, for example, 2U has to employ its own developer army to transform that specific university’s lectures, course content, and media into the online format. 2U is more of a consultant – each deployment is different; it’s not a self-service model and it’s not easily expandable.
I would encourage investors to stay away from the hype surrounding this stock. 2U does have a cool, niche business and it’s clearly worth something – but certainly not the $2.5-billion valuation it has notched, at least not yet.
2U business model overview
“No Back Row.” This is the company slogan, positing that students will engage more in immersible online content from the comfort of their homes rather than slouching in chairs at the back of a crowded lecture hall.
2U partners with universities and colleges (it calls them “clients”) to digitize degree programs and bring course content online. 2U’s solution is intended to uproot the entire on-campus experience, delivering the full course lifecycle from enrollment to degree conferring via web browser.
2U’s solutions are primarily deployed for domestic graduate programs (“DGPs”), which are verticalized specializations in fields such as data science, nursing, education, and communications. Graduate-level students enroll in the university’s online program (built by 2U and “white-labeled” with the university’s brand) and 2U, in turn, gets a cut of the tuition.
The first deployment in 2009 was an education program offered by the University of Southern California or USC. See the timeline below for an indicative look at 2U’s expansion since then:
Figure 1. 2U degree program launch timelineSource: 2U investor presentation
2U currently has 47 DGPs in its portfolio across 22 universities. While it has some brand-name schools in its portfolio (USC, Berkeley, NYU, and Georgetown), the majority of schools in the portfolio are lesser known. Across these 22 universities, 2U has 28,865 students enrolled in its DGPs, on which 2U earns a tuition cut.
2U has aggressive expansion plans in the DGP arena – it believes there are 60-90 degree verticalizations in the graduate studies sphere, and it plans on having at least one program in each of them. In 2017, 2U plans on launching a total of 10 new DGPs (representative schools include NYU, Pepperdine University, Vanderbilt University, and the University of Dayton). See 2U’s planned launch pipeline below:
Figure 2. 2U DGP launch targetsAt a steady state, 2U believes each DGP can bring in $16 million of annual revenues. Note, however at the end of 2016, 2U had 41 degree programs and $205.6 million in annual revenues, meaning each generated only $5 million in annual revenues. Though this metric might be skewed by the newer programs with late-2016 launches, it’s still pretty clear that 2U has a long way to go to achieve its steady state per-program revenue target.
Also worth noting is that 2U acquired GetSmarter, a South-Africa based ed-tech company specializing in short-form courses, opening 2U’s door to shorter-term courses that typically grant certificates. 2U acquired the company for $103 million, including a $20 million cash earn-out if targets are met. GetSmarter claimed to generate $17 million in revenue in 2016, implying a 6x revenue purchase multiple, earn-out excluded. One of the key benefits in the GetSmarter acquisition was taking on the company’s established client base, with certificate courses from the likes of Harvard and MIT. The cachet of these world-class universities may lend more credibility to 2U’s model, and lead to expansion in new DGPs with these schools.
While it remains to be seen how 2U can leverage short-form courses to complement its DGP offerings, GetSmarter is a small part of 2U’s revenue base today and is unlikely to grow at a substantially quicker pace than 2U’s core DGP business.
Financial overview: 2U is not SaaS; DGPs are expensive to launch
One of the biggest mistakes investors make when investing in 2U is comparing it to a SaaS company. It’s not.
SaaS companies can extend their services to a new client at basically no cost, other than third-party hosting fees. A new Salesforce (NYSE: CRM) customer deploying Sales Cloud or a new Workday (NASDAQ: WDAY) customer deploying its HCM cloud platform uses the existing infrastructure out-of-the-box, at no additional development cost to the cloud vendor.
2U’s DGPs are anything but out-of-the box. Each new course has to be carefully tailored, with content laboriously curated and transferred online, at 2U’s expense. And not only does 2U have the responsibility of developing student content – it also has the primary responsibility for recruiting students into these universities’ programs. 2U pays for demand generation activities, and new program launches come with significant upfront marketing costs. Indeed, marketing costs are the largest part of 2U’s expenses.
While 2U does not disclose its per-program profitability and typical expenses, the below chart from 2U’s investor presentation shows how the company overall is doing from a margin perspective:
Figure 3. 2U growth and marginsWhile scale has allowed 2U to cut down its development cost margins to roughly half in the space of four years, it has been less successful in driving down program marketing costs, which eat up more than half of the company’s revenues. It advertises programs on behalf of the university, it digitizes the content and manages the tech backend – and it only receives a cut of tuition.
Note also that the chart above presents adjusted margins – 2U also incurs significant stock-based compensation expense that dilutes existing shareholders and makes the above margins appear more tenable.
In addition, 2U’s growth has slowed down somewhat in 2017. Q2 revenues of $65 million grew only 32% y/y, decelerating markedly from Q1’s 37% y/y growth. In Q2, 2U also guided to $282.7-285.7 million in FY17 revenues. Subtracting out $8 million for the estimated impact of 2U’s half-year ownership of GetSmarter (the transaction closed on July 1, exactly halfway through 2017), 2U is guiding to a midpoint of $276.2 million in organic revenue or 34% full-year organic growth.
This seems pretty rosy for a company that posted only 32% growth in Q2. Guidance ranges typically imply a growth figure that’s below the growth percentage achieved in the most recent quarter, not above it. There’s plenty of room for 2U to skid to the downside if it fails in meeting its targets. It may be banking on a swath of new program introductions – but a new DGP doesn’t generate revenue right away, at least not at scale. New DGPs, in the first year, bring more expenses than revenues, and it remains to be seen if 2U can scale its sprawling portfolio of DGPs toward true profitability.
2U isn’t a SaaS company, offering out-of-the-box solutions and easily extendable to an expanded client base. At best, 2U is a third-party consulting or business process outsourcing company that takes on the work of course development and program marketing on behalf of a university, and gets paid on a commission basis rather than with an upfront fee. At worst, because 2U actually takes on the bulk of risk and expense for its online programs, 2U can also be considered a for-profit education company, even though the universities it partners with are nonprofits.
We all know how unpopular for-profit education companies are, and the fate that typically befalls them. While 2U masks its identity by stressing its technology and SaaS angles, a look at the business model and the underlying profitability economics of its degree programs suggests something different.
Confusion among investors over 2U and the nature of its business has stirred great debate over 2U’s valuation, and thus far in 2017 the bulls have won, awarding it high-growth SaaS-style valuation.
Figure 4. 2U trading comps, EV/FTM revenues valuation
TWOU EV to Revenues (Forward) data by YCharts
Presented in the chart above are some of the software sector’s most expensive names. Each of these companies, like 2U, is growing in excess of 30%, but unlike 2U, these companies deliver software-style gross margins in the high 70s and 80s.
Due to 2U’s heavy upfront costs in developing programs and marketing them to potential students, 2U’s new program launches have little of the favorable economics that SaaS companies enjoy.
While SaaS companies also incur heavy expenses via large direct sales forces, they tend to hang on to clients much longer. Once deployed, an HCM or ERP system is extremely difficult to rip out, and software companies typically report gross client retention rates in the high 90s, indicating very little churn.
For 2U, students churn naturally. After the completion of a one or two-year degree program, students – and their valuable tuition payments – leave the installed base. And even among the students who don’t churn naturally via graduation, 2U reports only an 83% retention rate in its student base. Online graduate courses, after all, are much more non-committal than full, 2-year on-campus graduate programs and students can decide to quit any time.
With neither the profitability economics of a software company nor the retention capabilities of a true SaaS application, it’s a wonder how 2U manages to trade in the higher echelons of tech valuations.
Enthusiasm for the company’s innovative (if not flawed) business model has propped up the company’s valuation, but it’s supported mainly by hype and not fundamentals. Hype is much more difficult to sustain as a company ages and becomes less newsworthy, and when enthusiasm for 2U bursts, investors will be left empty-handed.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.