2U, Inc. (NASDAQ:TWOU) Q3 2023 Earnings Call Transcript

2U, Inc. (NASDAQ:TWOU) Q3 2023 Earnings Call Transcript November 9, 2023

2U, Inc. misses on earnings expectations. Reported EPS is $-0.15 EPS, expectations were $-0.11.

Operator: Thank you for standing by. At this time, I would like to welcome everyone to the 2U, Inc. Third Quarter 2023 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions]. As a reminder, today’s call is being recorded. I will now hand today’s call over to Steve Virostek. Please go ahead, sir.

Stephen Virostek: Thank you, Tamika. Good afternoon, everyone, and welcome to 2U’s third quarter 2023 earnings conference call. Joining me on the call this afternoon are Chip Paucek, our Co-Founder and CEO, and Paul Lalljie, our Chief Financial Officer. Following our prepared remarks, we will take questions. First I’d like to cover a few housekeeping items. The earnings release and slide presentation are available on the Investor Relations website and a replay of this webcast will be made available later today. Statements made during our call will include forward looking statements regarding our financial and operating results; plans and objectives of management for future operations, including our strategic realignment plan; the implementation of our platform strategy and portfolio management activities; anticipated trends for learners and university partners; changes in laws, regulations and agency guidance for industry and other matters.

These statements are subject to risks, uncertainties and assumptions. Any forward-looking statements made on this call reflect our analysis as of today, and we have no plans or duty to update them. Please refer to the earnings press release and to the risk factors described in the documents with the Securities and Exchange Commission, including our annual report on Form 10-K for the year ended December 31, 2022, and other SEC filings for information on risks, uncertainties and assumptions that may cause our actual results to differ materially from those set forth in such statements. In addition, during today’s call, we will discuss non-GAAP financial measures, which we believe are useful as supplemental measures of 2U’s performance. These non-GAAP measures should be considered in addition to, and not a substitute for, or in isolation from, our GAAP results.

You can find additional disclosures regarding these non-GAAP measures, including reconciliations with comparable GAAP results, in our earnings press release and on the Investor Relations page of our website. So with that, let me hand the call to Chip.

Chip Paucek: Thanks, Steve. And good afternoon everyone. Revenue for the third quarter came in at $229.7 million, with adjusted EBITDA of $28.6 million. These were did not meet our expectations given weaker demand in our coding boot camps and continued enrollment softness in some of our higher price degree programs. We also know we need to strengthen our balance sheet and are working on it diligently. And Paul will talk about that more in a moment. That said, we did see a number of things that we believe we’re going in the right direction, which gives us confidence in our ability to return to profitable growth in the future. Our executive business grew 32% year-over-year and key leading indicators continue to improve in our Degree business.

Degree pipeline also remain strong. And we’re targeting over 80 new launches for next year. We’ve already signed contracts for over half of these programs. From a marketing standpoint, we’ve increased the return on our trailing 12-month marketing spend by a factor of 2 since implementing our new marketing framework in mid-2022. Learner prospects grew 3 million to 81 million at the end of Q3 and organic lead volume from the edX platform continued to increase, up to 46% of total leads generated. Lastly, we continue to see solid growth in our enterprise business, up 22% in the quarter, and based on current performance in a strong enterprise pipeline, believe it is poised to more than double next year. So let’s move on and unpack our results in more detail, starting with the Degree segment.

As we discussed on our last call, part of our platform strategy involves rotating out of degree programs that are not performing from a financial standpoint, from a debt to earnings standpoint, from a partner relationship standpoint, or for other reasons. We refer to this rotation as portfolio management, where we mutually agree with a partner to exit certain programs for a fee. The market for degree programs has changed over the years and some programs have become more difficult to run due to their pricing or other factors. Where we can’t work with our partners to make adjustments to improve these factors, we will consider whether exiting the program makes sense to improve the health of our overall portfolio long term. For example, we believe that affordability is key to the Degree segment’s success going forward.

But as you know, program pricing is a decision that rests entirely with the university partner. So we’ve taken a hard look at our portfolio through that lens. In that life, in the third quarter, we mutually agreed to transition out of certain degree programs with a client where we believe the long term future of those particular programs was challenged. This resulted in revenue in the quarter of $26 million related to the fee the university agreed to pay in connection with the transition. Early in the fourth quarter, we also mutually agreed to transition out of certain degree programs with USC. This will result in revenue in the fourth quarter of approximately $40 million. We thank USC for the role they’ve had in helping us build our company.

But, ultimately, the programs we agreed to exit no longer align with our platform strategy. Paul will dig into how these transactions show up in our results and the impact on our outlook. I wanted to highlight a couple of points when thinking about portfolio management. One, in every transition, 2U and the school are hyper focused on ensuring that students are well served and have a seamless experience. And two, transitioning out of these programs through portfolio management is in the best interest of the company. It allows us to reallocate resources from programs we’re exiting to programs remaining in the portfolio, and it also allows us to generate significant cash in the near term that we can use to strengthen our balance sheet and invest in our growth areas.

While on the subject of portfolio management, you might be wondering whether we’re engaging in these activities because of softness across the entire degree portfolio. I wanted to give you some color to show why that is not the case. We think it’s helpful to look at the performance of the remaining three portfolios independent of portfolio management. Similar to a same-store sales comparison. A key leading indicator for degree performance is submitted application volume. And for the programs in our current portfolio, over the past few months, the 90-day submitted application volume has remained over 10% higher than the prior year. We expect that this will translate to increased enrollment starting with the January 2024 cohort with revenue following.

This gives us high confidence in the growth profiles of the Degree segment going forward. In addition, the profitability of our current portfolio remains strong. So at the end of the day, the underlying Degree business has many positive attributes that we believe will drive profitable growth in the future. But the story of the Degree segment is not just about portfolio management and the health of the current portfolio. We’re the market leader in OPM for degrees, and we’re building on that lead. We’re indeed transitioning to an overall more competitive and affordable portfolio, and we’re well positioned to do so because of our flex revenue share model, which enables us to profitably deliver lower cost degrees. As a reminder, our flex model allows universities to obtain our product and service stack with a tiered revenue share model based on what they need.

It also allows for a shorter overall contract, which can be desirable for some partners. Most partners have been selecting our core services plus enhanced marketing and placement for revenue share of 50% to 55% to 2U. University demand for our flex degrees continues to be incredibly strong. We’re launching over 80 degrees in 2024, up from our previous target of 50, over 70 of which are flex, and we’ve signed contracts for over half of these programs, as you can see in the earnings release. We believe these new degrees can generate $120 million of revenue at steady state, and will more than replace the revenue of the degrees being exited through portfolio management. Our new flex model is allowing us to radically alter the makeup of the Degree business.

We’re aggregating degrees that we believe will meet significant market demand with competitive pricing. The average tuition price of our flex degree programs is $40,000, about 50% less than our full model degree programs. We also think this demand for our flex degrees is just the beginning. Based on current interest from university clients, we expect degree signings to continue at this rate and anticipate that 2025 will have a similar number of new launches as 2024. So to sum up what’s happening in the Degree segment, while portfolio management may complicate current period results, the cash generated from these transactions, the health of the current portfolio, and the significant demand for new flex programs give us confidence that the segment can return to really solid growth as we enter 2025.

Moving on to Alt Cred. Q3 presented some challenges due to significant softness in our bootcamp business in coding, which was disappointing. Coding is now running at pre-pandemic levels of enrollment after a 2022 enrollment that was very, very strong. This underperformance impacted both the top and bottom lines in the segment. However, noncoding offerings in the bootcamp business like cyber showed growth. Turning to the other side of Alt Cred. Our executive education business performed nicely in Q3, growing 32% due to platform organic growth and a really compelling artificial intelligence product line. These are the only cohort based products in the market at scale, which creates fantastic retention and student outcomes. Also, organic leads in this part of the business are up 12% year-over-year.

Across all of Alt Cred, we continue to believe that the key to success is cohort-based programs, which drive high completion rates and strong student outcomes. But given the Q3 performance in coding, we’re taking a hard look at all aspects of this business and are committed to making it profitable and cash flow positive as soon as possible. Before I turn it over to Paul, I wanted to provide a quick note on regulatory matters. We continue to strongly believe that revenue sharing will continue, particularly given the vocal support for the model from universities and other third parties. As regulators listen to their stakeholders, we believe they’ll see the importance of third-party arrangements for driving innovation, access and affordability in higher education.

With that, I’ll hand things over to Paul to discuss the results in more detail.

Paul Lalljie : Thanks, Chip. And good afternoon, everyone. During the quarter, we continued to make progress implementing our platform strategy, which we believe will drive benefits for students, universities and shareholders. Revenue from the third quarter totaled $229.7 million, with Degree segments revenue of $137.6 million and Alternative Credential revenue of $92.1 million. Operating expense for the quarter totaled $256.6 million, a decrease of 24% from the third quarter of 2022. Adjusted EBITDA for the quarter totaled $28.6 million, a margin of 12%, while adjusted unlevered free cash flow on a trailing 12-month basis was $31.9 million. Overall, the third quarter was challenging due to enrollment softness in our coding bootcamps and continued enrollment declines in our higher price degree programs.

However, there are some bright spots in this quarter’s results and key leading indicators, and we’re taking significant actions to drive profitability and free cash flow. Our results this quarter and outlook for the year are impacted by three items, portfolio management of $25.8 million, softness in our bootcamp business of approximately $10.5 million, and cost management actions taken in the quarter that are expected to reduce ongoing operating expense by $43 million. As we discussed in our last earnings call, part of our platform strategy involves rotating our degree portfolio away from degree programs that no longer align with our business objectives and replace these programs with degree offerings that better align with our strategy, like our flex degrees.

They have favorable cash flow profiles due to lower capital expenditure requirements and lower marketing expense, given our ability to leverage the edX platform for marketing. Many of our planned 80-plus 2024 launches are programs that we’re taking over from another provider. These programs are already operational, so we expect them to reach steady state cash generation more quickly than degree programs where we’re starting from scratch. Before I move on to a discussion of our results in more detail, I thought it would be helpful to give you an overview of how we account for portfolio management and its financial impact. When we and our university partners agree to discontinue a program, our partner agrees to pay us a fee, which we recognize as revenue when the agreement is signed.

Actual cash payments are scheduled in the agreement and occur over the next 12 to 24 months. From a cash flow standpoint, portfolio management generates near term cash that strengthens our balance sheet and provides us with the flexibility to launch new programs and invest in our growth areas. Please keep these dynamics in mind as I discuss the results for the quarter and our expectations for the year. Now for a closer look at our results for the quarter. Revenue for the quarter totaled $229.7 million, down 1% from revenue of $232.2 million a year ago. Revenue from our Degree segment was $137.6 million, essentially flat when compared with the third quarter of 2022. Degree segment revenue included $25.8 million of revenue from our portfolio management activities in the quarter as we mutually agreed to exit a handful of degree programs with a university client.

This was the primary driver of our 26% year-over-year increase in average revenue or full course equivalent or FC enrollment. Degree FCEs decreased 21% year-over-year, reflecting the impact of portfolio management and the implementation of our new marketing framework in mid-2022. Revenue from our Alternative Credential segment was $92.1 million, a decrease of 3% on a year-over-year basis. Average revenue per FTE decreased 11% and FC enrollments increased 9%, driven by strong performance of our exec ed offerings, which increased 18%, primarily due to continued strength in our artificial intelligence courses. Partially offsetting this increase with softness in our largest bootcamp vertical, coding. Remember that our exec ed offerings are lower priced than our bootcamps, and this shift in mix led to a decrease in average revenue per FCE.

Now for a discussion of operating expenses. For the third quarter, operating expense totaled $256.6 million, a decrease of 24% compared with the year-ago quarter, mainly due to a non-cash impairment charge of $79.5 million in our Alternative Credential segment in the third quarter of last year, and we did not have a corresponding charge this quarter. The remaining decrease of $300,000 was primarily driven by a $9 million decrease in personnel and personnel-related expense, partially offset by a $3.7 million increase in paid marketing costs in the Alternative Credential segment and a $2.5 million increase in restructuring charges. In the quarter, we reduced headcount across the business by 12%, resulting in approximately $55 million of annual savings, including $43 million of OpEx. This reflects our continued focus on improving EBITDA and cash flow.

Turning to our profitability measures, net loss for the quarter totaled $47.4 million compared to $121.7 million in the third quarter of 2022. Reflecting the revenue and operating expense drivers I mentioned previously, as well as higher interest expense of $3.3 million from our convertible notes issued in January 2023 and our revolver. Adjusted EBITDA in the quarter was $28.6 million, a margin of 12% compared to a 14% margin in the third quarter of 2022. Adjusted EBITDA for our Drug Discovery segment was $43.6 million compared to $44.9 million in the third quarter of 2022. For the Alternative Credential segment, adjusted EBITDA loss of $15 million increased 21% from $12.4 million in the prior year. Next, I’ll turn to the balance sheet and cash flow statement.

As a reminder, the timing of payments from our university partners follows the academic calendar with the exception of payments made as part of portfolio management activities, which as I said earlier are typically paid over 12 to 24 months. Accounts receivable increased $25.9 million to $113.2 million from the end of our second quarter, primarily due to $13.1 million related to portfolio management and the delayed receipt of a $15 million payment from a university partner which was collected in October. We ended the quarter with cash and cash equivalents of $53.9 million, a decrease of $12.8 million from the second quarter of 2023. Cash at the end of the quarter includes approximately $20 million from our revolving credit facility, which we use to manage working capital due to the delayed payment from one of our university partners.

From a cash flow perspective, our portfolio management activities executed through October of 2023, which includes the USC programs Chip discussed are expected to generate approximately $96 million of cash over the next 12 to 24 months. We delivered adjusted unlevered free cash flow of $31.9 million for the trailing 12 months ending September 30, 2023, an improvement of $33.3 million compared to the 12 months ending September 30, 2022, reflecting higher profitability and lower capital expenditures. Before I turn to a discussion of guidance, I want to mention that we’re constantly evaluating our liquidity and financial situation. As part of this effort, we’ve been in active discussions with note holders to refinance our convertible notes, improve our balance sheet and optimize our maturity profile.

We intend to continue to do so targeting a successful outcome in the near term. Now for a discussion of guidance for 2023. We now expect revenue to range from $965 million to $990 million, reflecting the continued softness we have discussed, particularly in coding bootcamp enrollments and the expected timing portfolio management. From a cash flow perspective, we are working on additional portfolio management activities that can generate cash of up to $49 million. When combined with the $96 million already executed as of October 2023, this totals approximately $145 million by mid-2025. Adjusted EBITDA is now expected to range from $165 million to $175 million. At the midpoint of our adjusted EBITDA range, we expect year-on-year growth of 36% and a margin of 17%.

A few points to note for our full year 2023 expectations. We anticipate $50 million in stock-based compensation, $45 million in CapEx, and approximately 81 million shares outstanding. In closing, we recognize that our management decisions regarding our portfolio may introduce some complexity to our results, but the key point is that we’re creating a more robust portfolio that will aid us in achieving our goal of profitable growth, while generating cash in the near term. With strong leading indicators in our Degree segment, a robust degree pipeline and the rising demand for our executive education and enterprise offering, we’re confident we’re on the right path. And now, I will hand the call back to the operator to begin the Q&A session.

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Q&A Session

Operator: [Operator Instructions]. Your first question is from a line of George Tong, Goldman Sachs.

George Tong: You’re transitioning out of your degree programs as part of your portfolio management strategy. In general, how much do fees from these program shutdowns compare with the initial capital invested and foregone future revenue streams?

Paul Lalljie: George, a couple of things here. I think the way to look at it is where the program is from a revenue projection perspective. And it is often used as a starting point to begin that discussion with our partners to mutually agree on what that ending number is going to be. Oftentimes, the fees would cover near term revenue, as well as any capitalized costs that we may have had as part of the production of that program.

Chip Paucek: George, this is Chip. What I would add is these are very positive transactions for the business. And the thing about what’s happening in the Degree business is this rotation to things that we think will be much more affordable and will sell better on the platform. Here’s the way I think about it from a comp standpoint is like Chipotle doesn’t get paid to shut down stores that it wants to shut down. And we do feel like we’re doing that very effectively now.

Operator: Your next question is from the line of Ryan MacDonald with Needham.

Ryan MacDonald: Maybe just double clicking on the Alt Cred business and sort of the weakness in the bootcamps. Maybe just can you explain a little bit more on what might be going on there, especially as we’ve seen, sort of, I think, in sort of other direct to consumer education players starting to see maybe some counter cyclicality and some tailwind in those segments. Maybe just a little bit confused by what might be driving the softness on the bootcamps.

Chip Paucek: Very fair question. It was entirely focused on coding. So cyber, data, exec ed, all of those were up. The AI bootcamp that we launched, launched well, but did not ultimately – we just had to roll that out to that many folks. So coding itself is where the problem was. And we think that that is related to coding jobs in the market, and I’m sure influenced some by AI. So, the fact is, it surprised us. It’s definitely the story of the quarter for us, and we just have to own it, move ahead and build that business better. But the other bootcamps were up.

Operator: [Operator Instructions]. Your next question is from the line of Josh Baer with Morgan Stanley.

Josh Baer: Couple more on the program management activity. Just wanted to confirm, when that revenue comes in, does it drop pretty much straight to EBITDA?

Paul Lalljie: Josh, a couple of things. It depends on the costs that are associated with it, depending – so, for example, we do have capitalized cost that is then taken to the P&L as part of that acceleration. Sometimes we have other fees that are associated with it, whether it’s an upfront payment that we would have signed up that we amortize over a long period of time. But the flow through margins, if you will, is higher than normal, but it’s not 100%.

Operator: [Operator Instructions]. Your next question is from George Tong.

George Tong: Just a quick follow-up. So, with program management, what inning would you say you’re in in rightsizing the number of programs? How much of your overall portfolio of degree programs do you think will need to be pruned in order to get to a comfortable mix approach?

Chip Paucek: We’re in the late innings. Q – George Tong Late innings, okay.