E-learning company 2U (NASDAQ:TWOU) tanked 60% after reporting earnings. If that sounds too dramatic to be the result of a few missed metrics, that's because it was -- 2U dropped that it expects significantly lower growth for the foreseeable future because of some drastic business model shifts. In this week's episode of Industry Focus: Tech, host Dylan Lewis chats with Motley Fool analyst and 2U shareholder Simon Erickson about the company's past and future. Learn what 2U did that made it so popular, why that strategy won't cut it anymore, and what it's planning to do in the future; how online education trends are shifting; what investors should track going forward; whether there's any hope left for 2U; and much more.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on Aug. 2, 2019.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It is Friday, Aug. 2, and we're talking about a tech stock that is dealing with a huge sell-off. I'm your host Dylan Lewis, and I've got lead advisor of Motley Fool's Explorer Simon Erickson, on Skype. Simon, it has been quite some time!

Simon Erickson: Dylan, it is such a pleasure to chat with you! Thank you for having me on the program today!

Lewis: I don't think we've spoken in a while. In preparation for the show, I was thinking back to some episodes that we had done together. There was one maybe two years ago, three years ago, where I had John Rotonti on and snuck you into the studio to pose as a listener on tour at HQ to ask him a question. We tried to get him, but that John Rotonti, he's just too smooth.

Erickson: He was. He took it very well. I bought him a beer after that for being a good sport about it.

Lewis: [laughs] That's The Fool way. We try to get you, but if we can't, we just have to put up our hands and say, "Job well done!"

Simon, the reason that I'm having you on today is, we are talking about a stock that is fairly heavily followed in The Fool universe. That's 2U. It's been a fairly rough week for this company. They reported earnings earlier this week. While the numbers looking backwards looked OK, looking forwards, the story was not so glowing.

Erickson: Yeah, that's absolutely right. We've gotten so used to judging companies on their quarterly earnings, whether they hit or missed the expectations by a penny or two. But 2U sold off on its second quarter results because its market is fundamentally changing. I think that's very interesting. That's what I like to look at as an investor that's in growth companies. Definitely a lot going on in that report.

Lewis: Yeah. Revenue came in slightly higher than expected. EPS, slightly larger losses than the market was expecting. The company did grow the top line at 39% year over year, but the stock sold off over 60% after the company reported earnings. That's the kind of thing where, that's not just one quarter of results that does that to a business. It is when you have a massive shift in what the outlook for a company looks like. We're going to dive into that a little bit later on. But before we get there, this is a name some people don't know. Simon, you want to give people a little overview as to who they are, what they do?

Erickson: Yeah, great idea, Dylan. 2U is the leader in online education. They partner up with large universities and they bring their courses to the internet. If you want to do a grad course or grad program at, say, USC or University of North Carolina, or anywhere else in the country, but you don't want to pick up your family and move there for the next couple of years, you can do it online. You can get the same degree, you can get all of the same curriculum, the lectures from the professors there and everything else. 2U will bring it to you to do over the internet. And you pay the same fees. You pay the university to get the degree from them. 2U takes care of all the marketing. It's all incremental for the universities, which is great. And they typically sign 10-year agreements. They give about two-thirds of the total tuition dollars to 2U. It's a win for students, for the universities, and for the company 2U itself.

Lewis: And it seems like a business that is at this very wonderful crossroads of education becoming increasingly important, but also this remote idea of both work and education. We've talked about so many businesses on the show that have made remote work or contract work possible. There's this increasing comfort, whether it's work or education, with people being remote or doing things online. This company is so well positioned to capitalize on that that I think it's a little surprising to see the brakes being pumped right now.

Erickson: There's a lot of recalibrating our expectations. I'm sure we'll talk a little bit more about this in a minute. The traditional model for 2U, since it was based right on those tuition dollars, was to get as many grad programs in as they could with prestigious universities that could charge a premium of tuition, and then capture that two-thirds of those tuition dollars for 2U. That was the traditional model. We're seeing that change a little bit right now, though, Dylan.

Lewis: One of themes of this earnings call was the, quote, "mainstreaming of online education." I think that exact string appeared six times during management's comments. What exactly does that mean here, Simon?

Erickson: In a nutshell, that means that there's more competition coming online. 2U was the largest partner of choice for universities because they had these national marketing campaigns, they could get people interested in a Harvard Business analytics degree or a UNC nursing degree, or an MBA from Rice University. There's a lot of ways they could attract students into those programs, and build out some really thorough curriculums for them, too, online. But the mainstreaming piece of this that just kept coming up on the conference call was a lot of universities really don't need that kind of scale. A lot of them are more regional colleges that are appealing for people that are in the area. Or, a lot of students already know which colleges they want to go to and what programs they want to be a part of before anyway, so they don't need that outbound marketing anyways. So, the mainstreaming basically means there's more choices available for students now as online education is becoming a little bit more understood and accepted by the students that are wanting to take those courses in the first place.

Lewis: This is often what we see when someone has a great idea, right? When there's something that just makes so much sense, you have this early business that decides to innovate and create that space, and then you have all of this follow-on interest once the business model is proven and once it's accepted -- in the case of education, maybe the credentialing and the social stigma is maybe removed. This market is not done growing anytime soon. The estimates that I've seen for online education is that it could grow at a 10% CAGR over the next six to seven years. I think what we're seeing, and what management's alluding to with this conference call is, yeah, other people have caught on to this growth story, and we're not the only player in this space now.

Erickson: That's right. Even Clayton Christensen, who's my investing hero, the father of disruptive innovation, who also taught at Harvard Business School for decades now, he even said, it's getting harder and harder for students to justify education that costs $100,000 or more of student loans when you get out. That's just really hard to do. It's hard for companies to pay for those students that are demanding higher starting salaries to pay back their loans. So, you're starting to see more of these online education programs. You're starting to see even other stuff outside of four-year universities -- things like accreditations, short courses, boot camps, all of these are popping up, and it's making it more difficult for that traditional model. 

To your point, Dylan, there's two aspects here. You said it was a 10% CAGR over the next six or seven years at the top of this. But really, for a company like 2U or a university that partners with 2U, there's a funnel that determines how well the company's going to do, and then also how well the shareholders are going to do. At the very, very top of that funnel is the total number of applications. These are the prospective students that are saying, "Yes, I'm interested in applying to get a degree from your university." We heard from 2U that that number was actually lower this quarter than it was in previous quarters. There's more competition now from other schools that are pulling students away from that very, very top of the funnel, and it's getting harder for 2U to convert. Even the step below that, once you have students that are interested, we've also seen that 2U's partners are getting more stringent and selective about the admissions that they're letting into their own courses. They want to keep the class sizes smaller so they can offer more personal attention that they think that they deserve to give to those students. That is also, not only the number of students are being sought from other universities, but even the universities that 2U is partnering with are getting a little bit tighter in the number of students that they're letting in, too. 

I love 2U, don't get me wrong, I've been a shareholder for years and have personally interviewed Chip Paucek, their CEO. But I think when you look at this, the reason that the stock sold off so significantly isn't necessarily because backwards earnings were bad. They looked like they were fine. But going forward, the inputs that are going into the models of those price targets that Wall Street analysts are creating and publishing out there, you've now got a smaller number of students going into each one of those programs, and a more selective number of students that are admitted to each one of those courses within the program. I think it's pretty hard to make the same case as before. That's why we saw the stock sell off dramatically.

Lewis: Yeah. Simon, so often with tech stocks in particular, because the businesses scale so well, the story early on is, "We're going after total addressable market. We're going to be worrying about profitability later." So long as you continue to have that top line growth, that customer acquisition, people are happy to wait for the actual bottom line to start growing. It seems like, based on what management has said, they are ready to start making the switch from a TAM story for 2U to one that is much more free cash flow and profitability-oriented.

Erickson: Yeah, absolutely. They said it directly, even, in the conference call themselves, that they were going to adjust the velocity of new program launches to support profitability and positive free cash flow. What that translates to is, "We have to be more careful about the new partners we bring in. We need to be upfront about, we need to have this many students per course, or, we need to have this many people admitted into your program, for this to make economic sense for us, to put the work we're going to put in for the marketing of your program, for building the curriculum, for all the infrastructure, for the IT stuff, to get this up and running."

The current path that they had at all points up until now is not sustainable. They're going to have to change their strategy.

Lewis: Yeah. When the story has been growth for a long time, the market's going to punish anything that interrupts that growth. 

Simon, one of the reasons that I wanted to have you on the show was, as I was combing through ideas for the week, I was on Twitter and I saw this thread that you had put together breaking down some of the most important quotes from the management call. It's impossible for this not to be the story. This needs to be the story this week. Anytime a stock sells off 60%, we're going to be following it. We've mentioned some of those quotes already. I want to at least focus on one more and get some of your commentary and what you make of it. 

Let's start with, "I'm not ready to tell you how many programs we will do as it's still a work in progress, but I expect it to be substantially fewer than 21, probably less than half of that." Simon, when you hear that, what does it say to you?

Erickson: Yeah, gosh! 2U was targeting 21 new programs, new graduate school partners, in the year 2020. Now their CEO is coming out and saying, "Hey, we're probably going to have less than half of that." Just like you said earlier, Dylan, that is a resetting of expectations, not only for the company, but for all of the investors that thought we were in growth mode, bringing in new partners, bringing in new tuition dollars, new students. I mean, to drop that down to less than half, that shows that the old model isn't going to work anymore, and we have to recalibrate what we're expecting going forward. 

I think when you read between the lines of what that's saying, in terms of numbers, now it's from 21 to 10, but if you have to have a certain threshold to justify working with university partners -- 2U has already tapped a lot of the larger programs out there. They're already in UC, UNC, University of Southern California. There's a limited number of large programs that can support that ad spend and the infrastructure work. So now it's a new game of getting smaller schools on board and/ or offering different offerings. It's going to be a whole new frontier for 2U going forward.

Lewis: I think that right there is one of the reasons why it's important to look at the customer base that someone that offers a tech platform, a software system, whatever, has. So often, we look at customer concentration, and within that, it's really important to understand, OK, out there in the field, all of the potential customers, how many of those big fish already exist for this business? How many of them are already under their hood? If it's a lot of them, then a lot of the growth's going to be coming from smaller players. That's fine, but you need to be making more from the big fish as well. You can do that if you have more students coming in the door. It doesn't sound like that's happening, though, Simon.

Erickson: Yeah, that's right. They're already working with about 50 grad programs. They've got, actually, some other things to that they're offering, which has been the pivot that the company has proactively been taking, which is these short courses and these lifelong learning courses. These are the things where, if you're going to a full four-year university, you might rack up over those four years $100,000 or more of tuition dollars, which sometimes goes directly to student loans. But there are other options for if you're wanting to continue your education. You don't have to go all-in for a graduate program. There are other things now that are offered like these short courses, which can cost between $1,000 to $5,000. This is something like, if you wanted to get accredited for the Harvard Business analytics program, which is the first one that 2U offered, you can now have that as a differentiating factor for your resume as you're applying for a different job. 

Something else that we've started to see are these things that are called boot camps. These are things that, if you want to get a skill set in coding, or in doing the UI for a website, or doing cyber security, stuff like that, you might not need to go to a full-course university that's having you take a lot of other courses too that aren't directly applicable to what you want to do. You might want to be more focused on a select skill set. So, for $10,000 to $20,000, you can often do a lot of these boot camps. 2U has done a pretty good job of getting ahead of this trend with acquisitions that they've made to build out these career, lifelong learning capabilities.

Lewis: Taking a step back, and not just looking at this quarter, but looking at this company now, Simon, you mentioned that you're a shareholder. I am not a shareholder, but I know that a lot of people that listen to the show, a lot of people that follow The Fool, know about this company, may own this company. What do you make of it, seeing this huge sell-off? And then, you take a little bit of a further lens out, there are some people who probably have a cost basis around $80 or $90 for this stock. It's now trading around $13. How are you feeling?

Erickson: Well, I'm right there with you guys. Anyone who's feeling it lately, I'm a long-term shareholder too that has a much, much higher cost basis than the shares are trading at today. I'm holding on. I think I'm going to see what the company has to say in their investor day in November. I do have a lot of faith in Chip Paucek as their CEO. I think he's very visionary and sees these trends developing out there. 

But, what do I make of it? I think the biggest takeaway is that the old model of going for these exclusive partnerships with these large universities where there was prestige, and you were able to afford a very high tuition price point, those days are done. I think now, the new game is going to be -- and certainly, 2U's acquisitions of both GetSmarter in 2017 and then Trilogy recently, which gave them the exposure to short courses and also those boot camps -- they're telling everybody, "We're a leader in this space. We see the industry changing. We're investing in our company to take advantage of those things."

The one thing that might be the best news for shareholders is, they actually did make a really good acquisition with GetSmarter in 2017. This is a company they paid $103 million for back in May 2017. Within two years, Dylan, they had quadrupled that segment's revenue and already made it earnings accretive. So, for shareholders, that's the kind of thing that you want to see -- where you're getting ahead of the trend, you're investing in something, and you're actually letting the rubber hit the road and making money off of it for your shareholders.

Now, Trilogy was a $750 million acquisition recently. That's 7X more than what they paid for GetSmarter. This is these boot camps. Higher price point. We're not $100,000 for four years at a university like that, but this is something that you might pay $20,000 to get differentiated recognition for. 

If they can continue to grow the number of schools that they're working with, land expand to offer these continual learning options, and still make the EBITDA margins that you want to see as a shareholder, there is still faith. This is definitely not a dead thesis. This is a company that still has a lot of potential out there. It's just that there's a lot more question marks now because we haven't proven this. And it wasn't the 2U of the past that we knew and that was scaling at those large universities. 

I think there's still a lot to like. I'm going to hold on to my personal shares, as a disclaimer. But there's going to be a lot more changes coming the next couple of years, that's for sure.

Lewis: I guess if there is a cherry on top of this whole situation, it's that we got to have a nice conversation, Simon. It's been a while and it was great to chat with you! Hopefully we can get you back on the show again soon!

Erickson: It was a sure pleasure on my end! Thanks for having me, Dylan! 

Lewis: Alright listeners, that does it for this episode of Industry Focus. If you have any questions or you want to reach out and say hey, you can shoot us an email over at industryfocus@fool.com, or you can tweet us @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes, or you can catch videos from the podcast over on YouTube. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass today! For Simon Erickson, I'm Dylan Lewis. Thanks for listening and Fool on!

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.