2U: Valuation Concerns and Market Opportunities

2U Inc's (NASDAQ: TWOU) stock has rocketed up 80% so far in 2017. What should long-term investors make of the company's share price? In this concluding segment of our recent Industry Focus podcast on education tech dynamos 2U and Chegg Inc (NYSE: CHGG), our hosts break down valuation concerns regarding 2U, as well as future growth opportunities that may compensate for stock volatility over the long run.

A full transcript follows the video.

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This video was recorded on Sept. 19, 2017.

Vincent Shen: 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?

Asit 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 Tinder, OkCupid, Match, 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.

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 recommends 2U and Match Group. The Motley Fool has a disclosure policy.