Description

Recommendation

TWOU is one of the many formerly high-flying, money losing SaaS technology companies with ridiculous valuations at the peak that have now spectacularly crashed.  The Company’s stock is down 96% from its peak in 2018 and its bonds now trade at distressed levels.  While a lot of this reflects recent weaker enrollment numbers and much lower multiples for profitless SaaS companies, TWOU also faces unique risks that come from being in the heavily regulated for-profit education industry.  What’s interesting, however, is that management has done a decent job in rightsizing the business where it now generates respectable margins and positive free cash flow after lighting money on fire for years in order to grow the top line aggressively.  This year could be an important turning point for the Company in balancing growth with higher margins to be able to self-fund the business.  If the Company can get past the regulatory issues relating to revenue share without much harm to its profit potential, and the business continues to scale the way it has the last few quarters, the future could be bright for all investors in the capital structure.

Buy 2.25% senior convertible notes due ’25.  The short duration convert trades at ~65 and offers a CY of 3.5% and a YTM of 26.1%.  Assuming the Company can generate EBITDA of $150mm per annum, the convert creates the business at an undemanding 4.1x multiple.  The terms of the credit agreement are very restrictive here and include a springing maturity and so the Company will attempt to issue another convert to take out this paper by the end of FY24.  While daunting, the Company did issue a convert earlier this year to pay down expensive term debt and baring something crazy happening on the regulatory front, I don’t see why it couldn’t pull off another capital raise now that the business is generating cash flow.  

The equity with a market cap of $277mm trades at 7.2x EBITDA and also looks interesting.  With $109mm of cash on the balance sheet and the potential for $25 – 35mm of FCF this year, the stock is priced as if the business model is broken going forward.   And it very well may be due to unfavorable new regulations on the horizon or new competition (ChatGPT, etc.).  Personally, I can’t properly handicap these risks and prefer to invest capital in the credit while waiting to see what happens and how the Company responds to these threats before stepping into the stock.  

Company Overview

Publicly traded since 2014, TWOU is a provider of cloud-based SaaS technology and services focused on not-for-profit colleges, universities, corporations and other organizations.  Its technology helps these organizations deliver high-quality fully online degrees and short courses, while partnering with them to deliver technology-focused bootcamps.  It was founded on the idea that digital education has the power to unlock the potential of people worldwide. Through edX, its education consumer marketplace with 48mm registered users, the Company hosts a comprehensive range of education offerings, from free courses to degree programs.  The Company partners with more than 230 global universities and organizations and offers more than 4,000 online learning opportunities.  Some of its global university and corporate partnerships include the following:

TWOU’s offerings cover a wide range of topics including technology, business, healthcare, science, education, social work, and sustainability. Many of the offerings are stackable, providing students with an affordable pathway to achieve professional and educational goals. Its platform provides clients with the digital infrastructure to launch online education offerings and allow students to easily access high-quality, job-relevant education without the barriers of cost or location.

From 2008 to 2017, its offerings only consisted of graduate degree programs. In 2017, TWOU expanded into premium online executive education programs and in 2019, it further expanded into skills-based boot camps. In 2020, it launched its first undergraduate degree program and in 2021 expanded into open courses and micro-credentials and added a consumer facing marketplace.

TWOU operates in two segments: degree program (59% of FY22 revenues) and alternative credentials (41% of FY22 revenues).  Degree program segment focuses on technology and services provided to nonprofit colleges and universities to enable the online delivery of degree programs. Students enrolled in these programs are seeking an undergraduate or graduate degree of equal quality to campus education.  Alternative credentials segment focuses on online courses, executive education programs, technical, skills-based boot camps and micro-credential programs through relationships with colleges and universities. Students enrolled in these offerings are seeking to reskill or upskill for career advancement or personal development through shorter duration, lower-priced offerings. In addition to selling these offerings directly to individuals, TWOU also has an enterprise business that sells to organizations and institutions to enable upskilling and reskilling of their workforces.

In exchange for the upfront investments TWOU makes in university clients’ degree programs, it receives a fixed percentage of the tuition that university clients receive from the students enrolled in their degree programs. The Company only begins to recover these upfront costs once students are enrolled and universities begin billing students for tuition and fees.  Management estimates that, on average, it takes three years after signing an agreement with a university client to fully recover the upfront investment. The Company enters into long-term contracts with its partners, which typically include initial 10 – 15 year contract terms.  Contracts do not include termination rights for convenience and the contracts impose damages should the partner decide to not renew (typically two years revenue).  

In FY22, the Company accelerated its planned transition to a platform company. The plan was designed to reorient the company around a single platform to pursue a portfolio-based marketing strategy that drives traffic to the edX marketplace. Education is increasingly becoming unaffordable and edX allows students the ability to shop around for the best price.  Additionally, as with a platform such as Amazon where retail customers can compare before making a choice, edX can more efficiently and transparently match students with offerings from universities.  This also lowers the cost of acquiring students because using sites like Facebook and Google for customer acquisition has become very expensive.  As part of the transition, TWOU simplified its executive structure, reduced employee headcount, rationalized real estate footprint and implemented steps to optimize marketing spend.  As a result of the plan, in addition to marketing efficiencies, management expects to generate ~$70 million in annual cost savings. 

In FY22, the Company also created a new Flex revenue share model for degrees which expands the content portfolio and drives content velocity.  In this model, there is a much lower base 35% revenue share with the universities for the core set of services like the edX platform, integrated tech stack, high intent paid marketing, carrier services, among others. Universities can then choose to add services on top of the core package for additional revenue share.  This model gives universities choice so that they only pay for services they need and ignore services that they already have in-house.  Flex degrees so far have some great momentum for the Company and become profitable much sooner than full degrees because of fewer upfront costs and lower marketing expenses. 

Finally, the Company has also developed an Enterprise business focused on government and corporate buyers.  The Company believes that this business will be a significant growth driver in the near-term.  Currently, it represents only $45mm in revenues but grew 86% over the last year.  Enterprise is one of the fastest growing segments for competitors Udemy and Coursera – both achieved 50% growth rates for a segment that represents a third to half of their total revenues.  TWOU has historically focused exclusively on direct-to-consumer but is now looking to aggressively grow this business.  The cutting-edge content is already there on the platform and it’s just a matter of packaging it and delivering it to enterprise customers.  

Recent Regulatory Developments

The Higher Education Act prohibits the payment of incentive payments to any person or entity engaged in any student recruiting or admission activities.  However, under official agency guidance Department of Education issued a "Dear Colleague Letter" in 2011. The letter provides an exception to the ban when involving tuition revenue-sharing arrangements between institutions, and unaffiliated third parties that provide a set of bundled services. The Company believes that the letter makes it clear that the HEA permits revenue-sharing agreements where a third party is providing recruiting services as part of a bundle of services to the institution. This understanding, consistent with the department's position since 1992, spans five presidential administrations and serves as the foundation for the degree business model as well as the foundation for the rest of the industry.  Despite the letter’s official status, it is not codified by statute or regulation, and as a result can be altered or removed without prior notice or formal agency rulemaking. Any revision, removal, or invalidation of the rule could require significant business model changes. 

In February 2023, the DoE made two separate and largely unrelated announcements that were applicable to the Company. First, they announced a significantly expanded interpretation of who the department can regulate as a close third-party servicer under the HEA. Second, they announced a review of the 2011 bundled services DCL.  A change in bundled services legality would affect TWOU’s degree program segment, which is the Company’s profit engine and accounted for 59% of FY22 revenues.  If the DoE bans bundled services offerings outright, most of TWOU’s degree programs would be affected, forcing the Company to change its contract with universities to fee-for-service models. As a result, instead of a university paying a flat 60% of tuition to TWOU, it would pay a fee for each service it wants.  What this change does to the profitability of TWOU is anyone’s guess but a safe bet would be that EBITDA would take a decent hit at the outset. It’s worth noting that the recent policy change considerations have not yet impacted business as momentum from universities has remained strong and demand for its Flex degrees has accelerated.

To be clear, the DoE did not issue any new guidance with respect to bundled services.  It’s possible that people are confusing the department's third-party servicer guidance with the announcement that it's reviewing the bundled services rule. Essentially, in its announcement, the department stated it's reviewing the benefits and disadvantages of revenue-sharing arrangements that have been the norm for many institutions for more than two decades. 

Like many within the industry, the Company disagrees with DoE’s new definition of third-party servicers.  Many universities have spoken out against the department's actions.  Management highlighted that more than 90% of public comments made to the Administration regarding bundled services have been in favor of it.  As one of the technology service provider leaders in the industry, TWOU filed a lawsuit against DoE last month asking the court to declare this guidance unlawful and unenforceable. The lawsuit urges the court to reject the department's actions to revise the law and claim sweeping powers which are not authorized by Congress.

Summary Financials 

TWOU has been a high growth, high cash burn business for nearly its entire history.  Even as the top line more than doubled between FY18 and FY21, the business failed to scale as management stepped up sales and marketing expenses to drive even more growth.  When the investment landscape changed on account of much higher interest rates, management was finally forced to reevaluate its strategy.  

It was clear that for the Company to survive and thrive, it would have to grow users organically and not rely as much on advertising.  This would be a core element of the platform strategy built around edX that would transform the business.  When management started putting 2U programs and content into edX in late FY21, it found that lead volume for degrees, boot camps and executive education programs was very strong.  This early lead volume growth gave management the confidence to cut marketing spend to focus more on the organic marketing strategy.  In the second half of FY22, the Company reduced spend on sites like Facebook and Google by 35% and overall lead volume was only marginally down.  edX was replacing much of the lost volume at a cost of zero.

However, the transition will take time and there will be bumps along the way.  As the Company pulled back on sales and marketing spend, enrollment trends have predictably weakened.  This outcome should not be surprising as ‘profitability governs resource allocation with revenue as an output’.  Marketing and sales expense was 42% of revenue in the most recent quarter, a full 10 percentage points lower than Q1 of FY22.  This resulted in full course equivalent enrollment declining 9% which drove a decline in revenue of 6%.  Enrollment decline accelerated from the previous quarter’s decline of 3%.  Obviously, it’s not comforting to see enrollment numbers drop like this, but it also doesn’t make any sense to have unprofitable students.  

Apart from challenging enrollment metrics, the Company reported a stellar Q1.  This was the first quarter where TWOU generated positive cash flow and EBITDA grew 146% Y/Y.  The Company continues to leverage the domain authority of edX to drive organic leads and marketing efficiency – in Q1, edX generated 41% of organic leads, up from 37% in the previous quarter. Most importantly, while marketing expense was down meaningfully, total number of leads increased by 7%. 

The next major project for management will be to get the alternative credential segment to EBITDA breakeven.  While the segment represents 41% of revenues, it currently loses a considerable amount of money.  In FY22, it lost $56mm and barely showed any improvement over the previous year even as revenues grew by 43%.  Management expects this segment to be EBITDA positive for FY23 as marketing spend will be cut significantly over the course of the year and the enterprise and boot camp businesses continue to post very strong growth.

Looking further out, the Company is targeting medium-term (3 – 5 year) revenue growth of 8 – 10% and long-term (5 – 10 year) revenue growth of 10 – 12%.  This guidance appears aggressive considering revenue growth in FY22 was only 2%.  Management is forecasting revenue growth acceleration led by strong growth in enterprise, as well as subscription learning models, free “Try-It” courses, and a normalization of full and flex degree program launches.  Additionally, management is targeting EBITDA margins of 17 – 19% over the medium term and 24 – 26% over the long term.  Again, this appears aggressive compared to 13% in FY22.  Management expects this expansion to be achieved by driving increased marketing efficiency.

Capitalization

For a SaaS type business, the balance sheet is significantly levered with total net debt in the amount of $804mm, or 5.4x EBITDA.  There’s $379mm of bank debt and $527mm of convertible unsecured debt outstanding as of the most recent quarter.  Liquidity is strong with $109mm of cash on the balance sheet and an undrawn $40mm revolver.  The interest burden of ~$55mm is heavy on account of the very high interest rate on the term loan.  It wouldn’t surprise me if the Company was able to refinance the bank debt at significantly more attractive terms within the next year or two.  

In January 2023, the Company amended the term loan agreement to extend the maturity date from December 2024 to December 2026.  At the same time, it raised $127mm of new capital from Greenvale Capital, a current shareholder, and The Berg Family Trust, in the form of $147mm convertible bond issue.  

Using cash on hand and the proceeds from the new convert, the Company paid down the term loan balance from $567mm to $380mm. As part of the refinancing transaction, in addition to extending the maturity date, the lenders provided a credit facility in the amount of $40mm, which is currently undrawn.

The amendment also includes restrictive covenants such as maintaining minimum recurring revenues, a minimum fixed charge coverage ratio, a maximum consolidated senior secured net leverage ratio and a maximum consolidated total net leverage ratio, and restrictions on making certain investments. 

Additionally, as per the amendment, the scheduled maturity date of the term loans can be accelerated to January 2025 if more than $40mm of 2.25% converts remain outstanding at that time.  Similarly, the maturity date of the revolver can be accelerated to January 2025 if more than $50mm of 2.25% converts remain outstanding at that time.  Additionally, the amendment restricts the Company from making any cash payments to settle a conversion, repurchase, mandatory redemption or maturity payment with regards to the convertible notes. 

Interest rate on the term loan will be base rate or SOFR rate plus a margin of 5.50% for base rate loans and 6.50% for SOFR loans.  Interest rate on the credit facility will be base rate or SOFR rate plus a margin of 4.50% for base rate loans and 5.50% for SOFR loans. There is a prepayment penalty of 1.0% for the term loan.  

The 2.25% converts with a face value of $380mm were issued in April 2020 and mature in May 2025.  The conversion price is currently way out of the money at $28.27/sh. 

The 4.50% converts with a face value of $147mm were issued in January 2023 and mature in February 2030.  The bond was issued at a big discount of ~16%, raising only $127mm.  The conversion price is currently way out of the money at $9.00/sh.

Thoughts on Valuation 

I’ve valued TWOU at $860 – 1,330mm based on an EBITDA range of $125 – 175mm and a multiple range of 6.0 – 7.0x.  At this valuation, the secured debt is fully covered, the unsecured debt is 90 – 179% covered and the equity is worth $0 – 5.24/sh.  Clearly, these are conservative valuation assumptions for a technology business and do not incorporate any of the growth scenarios that management presented at the analyst day not that long ago.  However, as an investor focused only on the bonds, I believe these assumptions are fair given all the business model transition risks and the regulatory uncertainty that TWOU is currently facing.

Catalyst

* raise new capital to take out '25 convert

* refinance bank debt at improved terms

* continue to cut back on unprofitable marketing spend even at the expense of revenue growth