In this episode of Industry Focus: Consumer Goods, Vincent Shen and Motley Fool senior contributor Asit Sharma talk about two of the most exciting companies in education -- Chegg (NYSE:CHGG) and 2U (NASDAQ:TWOU).

Technology is playing a bigger role in the classroom every semester, and both companies are at the forefront of this trend. Find out how 2U is locking down partnerships with world-class universities to offer online programs, while Chegg changes the way students write and study.

A full transcript follows the video.

This video was recorded on Sept. 19, 2017.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen, and it's Tuesday, Sept. 19. We're a bit late to the party, since schools across the country have already been in session for a few weeks, if not longer, at this point. But this is going to be our back to school special. Joining me for this class via Skype, please welcome back senior Fool.com contributor, Asit Sharma. Hey, Asit, great to have you on the show!

Asit Sharma: Great to be back, as always, Vince! Listeners, you know who you are, for some of you, this is not late to the party at all. You're like me, you used to trip into class five minutes late, but you're right on time today.

Shen: [laughs] There you go. In previous years on Industry Focus, we've approached the back-to-school theme as an opportunity to review fundamental investing or financial topics. Last year, Asit, you and I actually talked about return on invested capital. We had some real world examples of how companies applied or used that metric.

This time around, we're actually going to look at companies in the education industry as potential investments. Some of you may have read or heard about the hits taken by for-profit universities, with enrollment at these schools declining rapidly over the past few years, and a few big names actually declaring bankruptcy as well. Instead, we're going to focus on companies that are working somewhat behind the scenes as technology becomes a big part of education, becomes a big part of how students experience the classroom, and as online programs become more popular. Asit, the first company that we'll cover is Chegg, ticker CHGG. This is one that you brought to my attention, and they offer a ton of different services to students. Can you give us a quick overview of the company?

Sharma: Sure. Chegg, or chegg.com, as students know it, provides textbook rentals to students. That's primarily what they're known for. Books were expensive when I was in school years and years ago, and they've only gotten more expensive. So with the tools that we have today, students can go online and go to CampusBooks or Amazon textbook rentals and rent a book at maybe a 50% discount, 60% discount, or 90% discount to the cost of the book and return it at the end of the semester. So this is what Chegg has primarily provided to students. In the past, it used to buy its own textbooks, operate them on an inventory basis, rent them out, make money that way.

But in 2015, the company actually signed an agreement with Ingram Content, which is a huge book seller, and it now has that company fulfill its rentals, and it just takes a commission of about 20% on each textbook that it rents. So it's a more capital-light model, which is more profitable. What the company has done in the meantime is turn its attention to services. It bills itself as a "student first" platform. That means, from the time you're in high school, it helps you select colleges, it helps you with standardized test prep. When you get into college, it has neat services such as this answer module where you can pose a question to one of 35,000 experts, and they will provide an answer, and that becomes part of a great content system that other students can later review. And it provides tutoring services, which can be as low as $0.40 a minute through this vast army of online tutors. So the company is trying to position itself as a student's best friend in getting through not just high school but college and graduate school. It's a massive market, there's a lot of market opportunity here for a company like this.

Shen: Chegg management actually cites in their latest quarterly report, the education industry in total, $1 trillion industry, 7% of the U.S. GDP. The company said that in 2016, last year, they served 6.5 million students. And there are 1.2 million actual subscribers to Chegg as of the second quarter of 2017, and that number is up 54% year over year. Those 35,000 experts that you mentioned answering questions, one of the services they offer, they've gotten 10 million questions so far through that service.

But the big thing to remember for this business is the transition from the textbook rentals, and now that it's taking that 20% commission, and now that Chegg considers itself a fully digital company -- just remember that relieved the company of having to worry about things like its textbook inventory, so no more depreciation expense, no more shipping, no more fulfillment, no more warehouses, no more personnel costs for that. Here are some financial numbers for their business segments. Even though the top line has declined as a result of the agreement it's made with Ingram, it's down 16% in 2016, their gross margin for the company is improving significantly. It was about 39% in 2015, then 53% in 2016. And full year guidance from management for this current year 2017 puts gross margin at over 65%. So you can see how quickly that's ramped up as they turn to focus more on services.

Not surprisingly, their Chegg Services segment accounts for an increasing portion of revenue. Now, it makes up the majority of the top line. In the latest quarter, the second quarter of 2017, it was reported that number for Chegg Services accounts for 79% of the top line, and year over year growth there was 50%. So the growth for this services part of Chegg's business is pretty spectacular and very impressive to this point. A big thing that I was really impressed by, that you also mentioned, Asit, as well, before the show, is how the company uses its tech and also its data to create a competitive advantage for itself as it scales up. Can you tell us a little bit more about that?

Sharma: Traditional education is delivered by huge infrastructure. If you visualize in your mind a university, it has dormitories, classrooms, salaries of deans to pay, benefits to all the faculty. It's a really low-margin business, even if you're a nonprofit traditional college. And what Chegg is doing is, I feel, the TripAdvisor model. Some of our listeners are familiar with TripAdvisor. Their service as a reseller of travel through online portals is supplemented by this knowledge base that's there. TripAdvisor reviews are a content that subscribers can access and non-subscribers, people who don't subscribe to other TripAdvisor services can get hooked into by reading reviews of travel destinations.

And this is the same as what Chegg is doing. By using low capital technology that can be used over and over again, and delivered through multiple formats, they can increase their margins over time and make students more loyal to them. One stat that stuck out at me is, they have 1.2 million subscribers to Chegg services as of Q2 2017. So in the second quarter of this year, they have 1.2 million subscribers, and that's up 54% versus the prior year. And what that tells me is, this light model, which is providing services digitally, is very sticky. A student who's used the experts to get a question answered, or maybe spent an hour with a tutor, or even used their writing services, which take a paper and format it in MLA format or one of the scientific formats for notation. Once you've used these services, you're much more likely to use this and pay for a subscription in the future. So through a subscription model for many of these services, they have a recurring revenue base that's building. And that's why I think that, although they're operating at a loss, the move to services was smart, because over time, recurring revenue is a stable predictable source of sales for a company, and they can gradually overcome that. 

I want to flip it back to you, Vince, really quickly. We can discuss what might be a little bit of an Achilles' heel. Whenever you look at these companies that are fast growing but are losing money, always look, listeners, to find the biggest item on the income statement, where they're really spending the most money incurring that loss. Oftentimes, it's compensation expenses tied to stock. I usually ignore that for a while. I want to see what real life expenditures are going on. For this company, it's technology and development. In the first half of 2017, roughly a third of total revenue, $39 million was devoted to technology and development. That shows you both of the opportunity and the hurdle for Chegg. It has to constantly invest to grow its subscriber base and provide these value-added services to students. What are your thoughts on that, Vince?

Shen: I think ultimately, in the beginning for a company growing this quickly, that's an acceptable risk, for it to be even that large a part of the income statement, as you said, because of the fact that, when it comes down to it, management has said that Chegg Study, which offers some of their textbooks, informational guides, and some of the tutoring services, and writing tools, which you mentioned in terms of the citations, those parts of the business have a relatively fixed cost structure. So once the investment is made, they have those strong profit margins to match them as they scale their businesses over time.

Keep in mind the ways that Chegg can expand. They can add subjects, they can add courses, as they add more questions to that Q&A network, that adds more students, the more students they have, the more cross-selling they can do. They mentioned, for example, that their Chegg tutoring customers, half of them come from other existing services. These are customers of other existing Chegg services. So it's that cross-selling nature.

And a big part of that is this data that they have, they call it the "student graph". I think it's a really powerful example of how the customers and their usage of this site is being leveraged more and more to strengthen the relationship with the company and increase the customer's value for the business. The company can take basically everything that it knows about you -- the textbooks that you rent, will give you an idea of the classes you take, and then the tutoring services that you need will also give the company an idea of what you're interested in and what you might need help with, for example, and create a very personalized experience for you. It's actually pretty shocking. There's a quote from the latest earnings call and Q&A section that I think really highlights just how much information the company can pull from in regards to the students who use their services. Here's the quote:

We collect data either because people provide it directly, or because we're able to track their behavior. If you rent a textbook, we know your college, we know your address, we know your class, we can estimate what your major is as a result of it, depending on your year and other books that you get, and we know your address, and of course, we have your credit card. When you use Chegg Study, we have a lot of that. But in addition to that, we know when you're studying, we know what time of day, we know what time of night that you study, we know which subjects are harder for you and easier for you, we know your preference in terms of whether or not you'd rather ask questions or watch a video, or whether or not you do step-by-step solutions. And of course, as mobile continues to naturally increase, we have geography information. So, it just keeps expanding every time we offer services. In the case of writing, we are increasingly now able to tell whether you're in high school or college. We can start to determine what your classes are based on the paper that you're writing. So this is all information that we're starting to get now that we didn't get before.

So I know it's a long quote, but you can get an idea of the CEO there listing out all the information they're able to pull from to target their services to the students, and exactly for the classes they might need, for their major, for their class level, whatever it may be. And I think that's very powerful as they invest in the technology behind that.

Sharma: Absolutely. What is slightly creepy to someone my age, but maybe natural to a younger person, this collection of data can be really great revenue fuel going forward. After college, maybe graduate school, you're also going to go into a career, and I think this is a nice segue into our next segment. You may want a certification, and Chegg will be there to help you study for that certification. But I think the next company we're going to talk about actually provides programs and certifications.

Shen: Yeah. Before we close out on Chegg and move on to another really interesting company that I've actually been following for some time and I'm very excited to talk about, I actually wanted to get a take on any concerns that you might have, Asit. I'll share some of my own as well, in terms of the valuation, and also any potential challenges for this company. Just from what I've seen, the stock has doubled year to date. It's more than tripled from its 2016 lows. It's currently trading at about $14.50 a share. Valuation wise, that puts it at over 6x sales, and almost 80x free cash flow, because it is not yet profitable.

With that in mind, the bottom line is strengthening. Again, it's strengthening pretty quickly with the help of the digital transition -- 2017 guidance from management, for example, for their adjusted EBITDA, was $41 million, versus 2016, that figure was just $21 million, so doubling in the space of a year. But the main concern that I've had ties to comments that management made about how Chegg Tutors is potentially going to become the biggest part of the company in the distant future. They basically alluded to the idea that schools are underinvesting in resources like office hours for students, so Chegg can essentially fill the gap with those affordable, $0.40 per minute tutoring sessions at any time of day and potentially any language to help students learn. But to me, the company talks about Chegg Study, its writing tools, how it's an initial fixed cost, it's insignificant but it scales up very well over time. In this case, the more tutors you need, that's much more of a variable cost that will not scale as well for the company. So that's just something I was watching. Anything that you'd like to call attention to as well for people who are following the company?

Sharma: Obviously, profitability is always one. It's hard to value a company which is losing money. You have to go to other ratios. What's the price to sales? You have to strip away the book loss according to generally accepted accounting principles, and look at EBITDA, which you mentioned. So it's always harder until the company becomes profitable to determine how it should be valued relative to its peers. That's one problem with Chegg. We tend to be long-term holders, as Foolish investors. I'm not sure if we have a recommendation on Chegg, and I'm not advising people to rush out and buy this company. But the longer your holding period, the easier it is to absorb some potential troughs as a company starts becoming profitable and the price adjusts to the valuation.

I will just say, on the concern you have, Vince, I share that concern in the sense that education is a cyclical business. That is, higher education, certification programs, graduate schools, when the economy dips, enrollments decrease. And as school gets more expensive, it's not a given that people will continually enroll in schools at this linearly growing rate. And that's sort of an assumption that underlines Chegg's optimism that, for example, with these study services or tutoring services, they're going to grow because academic institutions are under investing in office hours, etc. Well, if enrollment drops, that's a pressure on the demand for the tutoring services. If you're not in school, you're not going to be buying the tutoring services. So, we've seen in the past, cycles where education is roaring to life, and it seems like many of the stocks that you and I discussed for this show are having great years. So that's one concern with the valuation. Always remember that education is tied to the economy at large. When trades are flourishing because manufacturing is up, or services businesses are booming, also higher education tends to lift as well. But when we are in a recession, the opposite initially occurs until people start realizing that, one way or another, they have to get trained and tack on a degree or two to make money again. So it can be rocky in this industry, and I do share some of your uncertainty regarding the potential valuation of all the companies that are in this sector.

Shen: Yeah. Some of these concerns and themes that we've touched on will pass on to this next company. Up next, we have another tech-focused, fast-growing name in education that's helping students as well, but in this case, it's by allowing them to get their degrees online. The company is called 2U, ticker TWOU. We already mentioned at the beginning of the show that we wouldn't be covering the more controversial for-profit universities and online programs. Even though we're connected online constantly through our smartphones, through social media, and a lot of other platforms out there, online education still has to grapple with more negative connotations.

But I think that is also what makes 2U really unique. This company is partnered with over 20 schools, and its roster includes some very prestigious names like Georgetown, New York University, Harvard and Yale. 2U maintains a focus on very specific graduate programs like business or nursing. The hope is to attract students who want to further their education and their career opportunities without uprootin their entire lives, so they'll have a preference for an online program. The programs that the company offers through these schools are a mix of pre-recorded content and live classes where students can see each other. They can still give presentations, ask questions, and participate as they would in a traditional classroom experience. They're trying to recreate that online. The company's motto is "no back row". Class sizes are very reasonable, they average 12 students. In the end, students will earn the same degree as their counterparts who actually attend the school in person. The students, through 2U's partner programs, generally pay the same tuition, as well.

Asit, I'll turn it over to you again. What parts of this business really stand out to you?

Sharma: First of all, 2U -- listeners, if you're looking this up, Vince gave you the symbol, it's TWOU -- if there's anybody today from the marketing department of 2U who happens to be listening, we feel your pain. I believe there's a song that's featuring Justin Bieber which has now taken the top of the Google results. If you try to google this, you're going to get a Justin Bieber video. You have to scroll down, use that scroll button to find it. It's worth looking up.

Shen: [laughs] Yes, I noticed that as well.

Sharma: [laughs] The most recent quarter, revenue for 2U is up 32% to $65 million. That leaps out at you. This is a fast-growing company. How it's been able to do this is the partnerships that Vince mentioned. It has a very strong pipeline. The company tends to look one to two years ahead to author new programs. What I mean by a program is an online offering with a reputable school which is an extension of their existing curriculum or a brand new program.

A really prominent example that the company just announced is a new certification through the Harvard Business School, it's called the Harvard Business Analytics Program. In many cases, 2U is partnering up, suggesting a totally new program or persuading a university to take an existing program, tweak it, and offer this online version. And it's a much more sophisticated approach than we've seen universities themselves be able to put out. It is more geared toward profit-making. Some of you may have taken MOOCs, which are massive online open courses. I hope I got the sequence of that right. Universities have proven to be very interested in the online learning model. They participated in the MOOCs in the past few years to build a familiarity with offering distance education. But 2U takes it quite a few steps further. The first advantage they have is, as Vince mentioned to me when we were chatting about the show, he said it's really a technology company more than anything else. And you can see that in their CMS, which is their content management system. It's the combination of real time, synchronous learning with educational pieces that are there that you can link to and get more in-depth on a subject. Some of you who have taken online courses may have counted on the Blackboard system, which was a pioneer for many years. This is Blackboard on steroids, really.

Beyond that, for a university to offer a degree program like this online, there has to be something in it for the university that helps them make money off their model. And what distinguishes 2U is, its back end is second to none. The company offers a host of analytics to colleges that help them acquire new students, it helps them churn statistics on what's working and what's not, it provides back-office functions, and all this is offered as software-as-a-service. So it's cloud-based, it's very easy to utilize. It's another revenue stream for the company. What I see in 2U versus other entities which have tried to provide distance education, online education, is a really technology-based approach which pays dividends for both the students and the colleges. It puts analytical tools in the colleges' hands, which they didn't have before and really don't have the wherewithal to develop on their own.

Shen: I also think it's important to know, in terms of the way 2U approached some of these very prestigious universities and sell them on the idea of partnering on an online program, which again, some of these are still grappling with negative connotations, 2U will, for example, invest upfront up to $10 million in each partner university, getting them set up and ready to onboard students and begin with the program online. And the reason why the company is willing to do that is, the contracts that they sign with universities tend to be quite long with contractual terms of about 10 to 15 years. Beyond that, there's tuition sharing between the company and the university, with the company usually taking about 50% to 60% of the tuition. In the end, the company and the university again also have pretty aligned interests, which is to attract new students but also keep students enrolled in the 2U affiliated programs, and for them to do well. On the other side of that, 2U also handles a lot of the recruitment in the marketing for these programs where it provides that technological infrastructure and support that you mentioned, Asit. Through the end of 2016, for example, 83% of students who have entered relevant programs with 2U and these universities either graduated or remained enrolled. That's a pretty strong number there.

Something else I wanted to touch on as we wrap up here is, this is another company, like we talked about with Chegg, that relies heavily on data. 2U has developed what they call a proprietary algorithm that allows them to identify the universities and programs that they think are going to be the most successful as part of the 2U umbrella or portfolio. They look at things like the existing market for a degree, student demographics. In the end, with the company putting in that $10 million, for example, there's still definitely a risk. The payback period is typically four to five years. On the bright side, the majority of the company's earliest university partners have already chosen to renew, so they've seen the success that 2U has helped them to generate with these online programs, they want to continue.

In the end, the ability to scale each of these programs for a greater number of students, or for a university, to help a university scale to more programs, that opportunity also exists. And when you look ahead, 2U has spoken to some of the growth that it hopes to see and to capture through additional partnerships, and by also expanding abroad. Management has pointed to a long-term goal of 200 programs. Earlier this year, they also acquired GetSmarter for about $100 million. GetSmarter offers short courses, and it also has relationships with schools like MIT and Oxford in the U.S., U.K., and South Africa. So again, that's the early steps of part of that international expansion.

To close out with some of the financial side, valuation side, revenue has been growing, as you mentioned, Asit, over 30% annually for several years running. The gross margin is 80% for this company, but it's not yet profitable, and it's spending a lot of cash to maintain that growth. Until 2U is able to diversify its partner universities, it does also face some customer concentration risk that listeners should know about, since just three schools, USC, UNC, and Simmons accounted for about two-thirds of the company's revenue. Even though you might partner with new universities, sign up new programs, the enrollment in the most popular programs will ultimately overshadow those new ones depending on what the enrollment size is. And this company trades for almost 12x sales. Closing thoughts from you, Asit, things that you're watching, thoughts on valuation, anything that you'd like to discuss?

Sharma: On valuation, very similar to what we discussed with Chegg, until a company turns a profit, a little bit hard to gauge how much you should be paying. I zero in on the loss. Just to keep apples to apples, we talked about Chegg having its largest expense as technology and development. 2U's largest expense year to date has been marketing, and that's very typical. $72 million marketing costs, it's about 55% of revenue of $130 million. I actually see that as a little problem point but something very positive about this company.

Vince, you mentioned the long-term contractual nature of the programs it's signing up. Right now, there's a very heavy burden on 2U to market, to spend on acquiring students and building these programs from the ground up. But if you can fast forward in your mind, say 10 years from now, an institution like Harvard, a program which it's building on something that's extremely topical today for business, the Harvard Business Analytics Program, we see analytics being used in big data everywhere. That program is probably going to acquire a lot of prestige within the same contractual period that it signed up for with 2U, especially if they renew for another long period of time. So at some point in time, the prestige at these programs will start to draw students on their own, just as you have a familiar name like Wharton Business School, they really don't need to market so much. People want to attend and get a business degree from that institution, University of Pennsylvania, in that particular program. So I see that this marketing cost as an initial upfront investment in building these long-term programs. And if everything goes well, that should decrease over the years. And I feel optimistic that the company will be able to turn a profit. I didn't know a lot about this until Vince introduced it me, but I am intrigued by 2U, both because the market for high-quality education is so vast, and because they're so technology-centric. I would love to revisit it in the future. When they turn a profit, we can talk more about valuation. But a very interesting company, from my perspective.

Shen: Thank you, Asit. Last thing that I wanted to mention is, the CEO, Chip Paucek, offered an analogy that online education is like online dating in that it started with a very negative stigma, but over time, you look at the popularity of TinderOkCupidMatch, dozens of other services, that stigma has fallen away. And I think 2U is in a very unique position right now as the leading company that offers what it does with the software as a service. It's taking 50% or more of tuition and schools, as they see the popularity of these programs grow and the prestige of the programs grow, they can partner with a 2U, for example, and not have to make that large, initial investment that they would have to do if they went in to launch something like this in house. And we've seen schools in the past attempt things like this, and it hasn't been quite as polished, or hasn't been as strong of an offering. But right now, 2U, this gold standard for online education. Right now, with it only being focused on graduate programs, if the opportunity expands to undergraduate and other parts of the educational cycle, I think it's in a very advantageous position to do well.

Otherwise, I think that's all the time we have for today. Asit, I know you wanted to cover a few international opportunities as well but I think on our next show together, we can have a quick pow-wow and talk about some of the international companies and the education growth that we're seeing abroad, as well. Thanks again for joining me on the show!

Sharma: Thank you! For the first time in many moons, I feel like cracking a book after this episode. [laughs] 

Shen: Absolutely. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Thank you, Fools, for listening! Have a great week!

Asit Sharma has no position in any of the stocks mentioned. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon and TripAdvisor. The Motley Fool recommends 2U and Match Group. The Motley Fool has a disclosure policy.