Falling Behind: Chegg’s Strategic Blunders in the AI Race (NYSE:CHGG)

Introduction

Chegg (NYSE:CHGG) operates in the education services industry, providing online tutoring, textbook rentals, and homework solutions to students worldwide. Chegg’s revenue is driven by subscriptions to their services including Chegg Study, Chegg Writing, and Math Solver.

At present, Chegg appears to be trading at its fair value, around $7, reflecting its current market position and performance. However, the company faces significant challenges, particularly with the rapid advancement of artificial intelligence. Many companies will successfully leverage AI and grow rapidly because of it, but Chegg is not one of them.

Performance History

Chegg had its IPO in 2013 with shares priced at $12.50, however, prices quickly fell, and they traded under $10 until 2017. From April 2017 to March 2020, their share price steadily grew, then it began to rapidly increase. COVID-19 restrictions that March led nearly all universities to host classes virtually. Many students struggled with the change in teaching style, and it was now very easy to utilize Chegg for homework assistance. Subscriptions rose and Chegg reached its peak stock price of $113.51 in February of 2021.

Since then, the stock price has fallen to a mere $6.90, a roughly 94% decline in just three years. This steep fall can be traced back to several key factors that have impacted investor perception and Chegg’s market value.

Initially, the surge in Chegg’s stock was fueled by increased accessibility to students during remote classes. As educational institutions resumed in-person classes, the heightened demand for Chegg’s services diminished, leading to a drop in subscriptions.

Another major issue affecting shareholders was the company’s ability to adapt to emerging AI trends. Before May of 2023, Dan Rosensweig (CEO of Chegg) was mostly skeptical of the effect ChatGPT would have on their business and even denied that subscriptions were taking a hit due to ChatGPT. Then, on May 2^nd, he reversed the message and admitted that AI was causing a massive drop in subscriptions and simultaneously decreased earnings projections. This led to a 48% drop in stock price.

After stock prices plummeted, Chegg began a massive share repurchasing program, with plans to buy up to $2 Billion of their own stock. These stock buybacks are concerning for a company in Chegg’s position. Stock repurchases are not inherently a negative signal. Healthy companies often use buybacks to reward shareholders by increasing the value of outstanding shares. In this case, however, Chegg seems to be repurchasing shares to artificially maintain a level share price. Their repurchases are less about rewarding investors and more of a short-term fix to keep stock prices from falling more drastically than they already are.

AI Implementation

By all accounts, Chegg has botched the implementation of artificial intelligence into their services. This started with Chegg not advancing AI capabilities in the early stages, such as in 2020 when one of their product leaders, Matthew Ramirez, advised the CEO that “generative AI would be the bus that ran down Chegg if it didn’t prepare itself.’ When Chegg finally acknowledged the importance of AI, their implementation was reactive rather than proactive, seemingly rushed and not well-thought-out.

The benefit of AI for answering academic questions is obvious. With ChatGPT, you can get instant results to your questions. On top of that, GPT-4 has scored within the 90^th percentile on the bar exam and has even passed the CFA 1 exam, which has a human passing rate below 50%. The speed, quality, and cost of AI answers are very appealing to students.

It was only after their share prices plunged that Chegg began introducing AI into their answers through their new service, CheggMate. But for Chegg to retain subscribers, they need to prove they offer something that ChatGPT does not. Their lackluster integration of AI technologies has failed to impress or retain subscribers, at a time when competitors are offering more advanced and appealing AI-driven solutions. Such as ChatGPT-4, which is the best-performing AI on the market for a comparable price to CheggMate. Or Learneo’s QuillBot, which is already impressing students and offering unique value by specializing in helping students write papers.

What still makes Chegg unique is their human-written expert answers. They are the only education service company right now that can provide real expert answers to students relatively quickly. Instead, they are now pushing AI answers on students and then poorly regulating that the “expert” answers were actually written by experts, with many students reporting that the person who answered their study question clearly used ChatGPT to create the answer.

Chegg’s Unique Value

If Chegg still has unique value, it’s in their ability to provide quality, human, answers to study questions. They can do this by capitalizing on the strengths they already have and heavily marketing themselves as real expert answers. With free AI services being readily available (such as ChatGPT 3.5), students are likely to only subscribe when they require complex answers that AI is unable to provide. This is the service Chegg can excel at.

Additionally, Chegg can continue offering AI products (such as CheggMate) as a standalone service. This allows them to capture some of the AI market and better position themselves for future advances in AI.

Financial Analysis

Chegg has a complicated financial history over the past several years. Their revenue has been gradually declining but hasn’t seen a massive drop due to AI yet. They’ve also been rapidly paying down debt since the pandemic and repurchasing shares. These moves might’ve helped their stock price in the short term.

There are several notable trends in Chegg’s financials that are cause for concern. First, their revenue has been steadily declining since their peak in 2021 and is expected to decline another 3.39% this year based on their most recent earnings call.

At the same time, expenses have been increasing across the board, with administrative expenses increasing an average of ~22%. Rising costs and decreasing revenue have caused a rapid decline in operating income. Chegg went from a $78 million operating income in 2021 to a negative $67 million just two years later. If this trend continues, we can expect to see operating losses reach as low as a quarter billion dollars in 2024.

Using these financials to perform a DCF analysis returns a valuation of $6.13. However, many assumptions must be made.

• We cannot include net borrowings when calculating FCFE because of the accelerated repayment of debt.
• We must estimate FCFE using revenue due to the volatility of net income.
• WACC is calculated using a Monte Carlo analysis assuming 11% market return, and a calculated beta of 0.82 using five years of historical data. The WACC of 6.38% has a standard deviation of 1.64%
• Revenue for 2024 and 2025 is projected based on analyst consensus.
• We assume revenue growth to be –2.61%. This is the average growth rate of 2022-2025 actual and expected revenue. Revenue growth from 2020 to 2021 is not included in average revenue growth. This revenue growth was caused by increased subscriptions due to remote education. It is an outlier compared to revenue decline over the past two years.

Analysis Risks

Chegg’s revenue decline and rapidly increasing expenses will result in lower FCFE each year. I calculate the present value of future cash flows per share to be $6.13, slightly below the current price of $6.90. This suggests that Chegg may be slightly overvalued, but still trading near its fair value. However, it is critical for them to offer a product that can compete with free AI services, or their value will only continue to lower.

Conclusion

Chegg is a growth stock that is no longer growing. Their stock price saw major growth during the COVID-19 pandemic, caused by increased accessibility for students. Since then, they have failed to demonstrate how they will remain relevant in a constantly evolving market. Their implementation of AI into their services was poorly planned and poorly executed. The company failed to prepare for the threat of AI and did an even worse job integrating AI into their services.

The company went public at $12.50, the surge to $113 was caused by optimism that CHGG would see continued growth and success in a more virtual world. Without that growth, the company offers little value to investors, and their current share price of $6.90 is likely an accurate representation of their fair value.

Hold CHGG if you believe they can still make AI work in their favor. Otherwise, CHGG is a company that will continue to see losses year after year. I recommend selling.