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2U: An M&A-Oriented Education Technology Play

Education technology companies are in the limelight due the lockdown situation happening around the globe due to the coronavirus outbreak, and the eyes of private equity funds are on 2U Inc. (NASDAQ:TWOU).

The company has officially started sales talks with the likes of Boston-based Thomas H. Lee Partners and has advanced to the second round of talks after inviting bids from funds and other education software players. Management is possibly expecting a 20% to 30% premium on its current stock price in its upcoming negotiations. 2U has a base of tie-ups with some of the top Universities in the world, a wide variety of courses, a fast-growing level of student enrollments and a large addressable market. Given this background, the company is definitely a compelling pick for investors and arbitrage players.


What does 2U do?

2U is a software-as-a-service player that provides integrated, cloud-based solutions and technology-enabled services that enable colleges and universities to deliver online degree programs.

The Lanham, Maryland-based company's core client base is universities. Its SaaS technology consists of a learning environment, which acts as the hub for academic and social interactions between students as well as faculty. It also provides a suite of integrated applications along with this technology and has wide offerings in terms of technology-enabled services optimized with data analysis and machine learning techniques. These cater to the entire lifecycle of a higher education program, including attracting students, counseling them through the admissions application process, providing technical support, coaching solutions, in-program field placements and providing accessibility to individuals with disabilities. The company has a base of more than 2,500 employees.

A strong pipeline of programs

2U has tried to shift focus from core university programs to boot camps, but it continues to have a decent pipeline of programs for 2020.

The company launched new programs in 2019 that are expected to drive revenue for the next two years and almost all the top 20 programs had enrollment over 250 students. After focusing on masters' degrees as a domain, 2U has now entered the undergraduate domain, launching its first program for undergrad students.

In terms of profitability, 2U's mature programs have a margin as high as 38%, which means the company is on track for a positive bottom-line in this unit. Management says it has strong demand for the programs and is looking to expand internationally and enter new verticals such as architecture and pharmacy. 2U has never had a dearth of university partners, which remains its largest asset in the event that it is acquired. Some of the big names include Yale, Northwestern, Harvard, Syracuse, Emerson College, Simmons College, Georgetown University, University of London, London School of Economics and Vanderbilt University.

Alternative Credentials is the top-performing segment

While investors were initially unsure of this division performing well, it has proven everybody wrong. 2U reported sales of $157.5 million for the Alternative Credential segment, a 148% growth compared to 2018. A large part of this growth was inorganic and resulted from the Trilogy acquisition, but the organic growth was easily about 30% with the company launching 36 new courses, bringing their total to 127 courses.

There is strong demand for these short-term courses and the student enrollment has also been as per expectations across the portfolio. 2U has made excellent progress in its pipeline for alternative credentials and has already slotted 90% of the planned new courses in this segment for 2020. Its courses are with some of the top brands in the world, including Yale, Stanford, Oxford, Cambridge, MIT and LSE. The Trilogy acquisition is helping the company address a key component of student, university and industry demand with respect to market-driven training in rapidly evolving technical fields. It is this demand that is fuelling the growth of the Alternative Credentials segment as a whole. The Trilogy acquisition helped 2U in developing its boot camp expertise as it has a portfolio of over 100 boot camps with 49 universities.

Management believes its boot camp product line is critical to the long-term success of the university market. The fact that 2U is the only comprehensive provider of non-degree and STEM products to universities also makes it a market leader.

Decent results and a low valuation

As illustrated in the chart above, 2U's stock has shown a significant amount of recovery after the recent market crash and is slowly crawling back toward its three-month high.

The company reported decent financial results for the fourth quarter of 2019, where it managed to beat analyst expectations for revenue as well as earnings. Management reported sales of $163.18 million, which was above the analyst consensus estimate of $161.39 million, driven by triple-digit growth in the Alternative Credentials segment.

2U has recorded nearly 50% growth from the prior-year quarter, when its top line was $115.1 million, as a result of the success of its short-term courses and boot camps. The company's annualized top-line growth for the past three years has been as high as 28.4% and its core master's program enrollments have also shown good growth over the new short-term courses. The company's profitability was weighed down by restructuring costs, acquisition costs, stock-based compensation and several other factors, but it managed to report a loss per share of 18 cents, much better than the analyst expectation of a 22 cents per share loss. However, its most recent $750 million acquisition of Trilogy Education seems to have integrated will into the company and is generating positive revenue growth.

Final thoughts

After months of pressure from Sanchem Head Capital Management, 2U has finally started accepting bids and is moving to the second round of talks with investors. The acquisition seems possible and the management team is not wrong in expecting a premium over the current market price, but this acquisition process could last for a few weeks given how there is a slowdown in activity as a result of the Covid-19 virus. The current valuation of around 2.7 times enterprise value-to-revenue appears to be low given the limelight for education tech companies in the current environment, the large addressable market, 2U's current university partnerships and management's demonstrated ability to grow beyond the U.S. market and team up with international universities.

The controversial acquisition of Trilogy Education might have hit margins, but has certainly upped 2U's growth prospects with respect to short-term courses and boot camps. Investors and merger and acquisition arbitrage players entering at current levels should be able to make a decent return on this stock in the medium to long term.

Disclosure: No positions.

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This article first appeared on GuruFocus.