Chegg's Recent Deal Is a Game Changer

 | Aug 07, 2014 | 3:47 PM EDT  | Comments
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Chegg (CHGG) had one of the least successful recent tech IPOs last November. The online student portal saw its shares immediately drop once they started trading after the company priced the shares above the high end of the range given by its underwriters.

The price action was immediately bearish and didn't really relent, and the first few earnings calls did little to help the stock price. In fact, those earnings made things worse.

When Chegg first started, it was a textbook rental company for college students. Think of the first version of Netflix (NFLX) with DVDs.

When current CEO Dan Rosensweig came aboard a few years ago, he set about trying to build up a purely digital aspect of Chegg. Dan, who is the former COO of Yahoo! (YHOO), was right to look for a new digital line of business (kind of like streaming has been for Netflix). It's obvious that we're not all going to rent physical textbooks forever.

Yet, Chegg had a problem post-IPO -- namely, that the old textbook business still counted for most of the company's overall revenue. Investors looking at the company had to balance a big old business in renting college textbooks with a new small but fast-growing business (i.e., digital revenue).

Chegg's message to investors was to ignore the old business even though the margins were low. It wasn't growing, and a lot of capital was tied up in inventory. Management said that this business was basically free marketing for the company to college students for its digital business, which includes matching high school students with colleges and study aids. Chegg said that this new revenue was fast-growing, high-margin and would eventually overtake the slower and older business.

But investors just couldn't do it.

They kept worrying about if Amazon (AMZN) was going to come in and undercut Chegg on textbook prices.

So Chegg announced a game-changing deal this past week along with its recent earnings. The company partnered with Ingram to basically take all of Chegg's old textbooks and its inventory risk off the books. It's not happening overnight, but that's basically where the company is headed.

The result was that the stock went up more than 20% the next day.

The physical textbook stuff had gotten in the way of what a good story Chegg had going with digital. This one move will now force investors to only value Chegg based on that story, and it's a good one.

Watch for Chegg to go back to the double digits in the next year.

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