Figuring out how to locate the smartest concentration of people in any one place is no easy feat.

Typically, it's either been measured by the proportion of college-degree holders or the raw number of college-degree holders that accumulate in a given place. Both approaches, according to Rob Pitingolo, an economics brainiac and 2010 college graduate, have flaws:

"The theory that there is economic value to having smart people together rests on the assumption that smart people collaborate with each other. You could have a whole bunch of smart people in one place, but if they don't interact with each other, what's the value?"

Pitingolo instead calculates what he calls "educational attainment density" by measuring college degree holders per square mile:

Is there value in corralling a bunch of smart people together in one place? What if they still don't collaborate? If they did, would you be willing to relocate?

Chegg may very well be the fastest-growing, most successful, second-generation e-commerce startup that you hardly ever hear about,except maybe for the fact that it’s raised more than $140 million. Chegg is the “Netflix for textbooks.” It lets students across 6,400 college campuses rent from a virtual bookstore containing 4.2 million books. Based on my analysis (which I get into more detail below), the company is on track to generate $130 million in revenues in 2010, up from $25 million in 2009, and $10 million in 2008. During the January, 2010 semester, I estimate the company made close to $1 million in revenue a day, up fivefold from $200,000/day the previous January, and it should double that this coming September. My analysis suggests Chegg will do close to $50 million in revenue this September alone. It is underappreciated, to say the least.

Chegg is disintermediating the $5B+ college textbook market by providing a low-cost, short-term, nationwide rental alternative to the high-priced university bookstore. This disruptive model will likely shrink industry revenues by half in the coming years, with Chegg in a leadership position to command 80%+ market share. The key questions, of course, are: 1) Is this a winner-take-all market, 2) What can Chegg do to fend off the likes of the major bookstore owners, Barnes & Noble and Follet, as well as Amazon and Apple, and 3) Is Chegg a harbinger of a new age of startup rental services?

Old School
The Chegg story is different from those of other breakout startups, such as Groupon and Zynga, in five key ways. First, rather than creating an entirely new industry, Chegg introduced a proven service concept and relied on established customer behavior (mail-order rentals) in an old, highly dysfunctional category, whose customers felt captive and where costs were spiraling out of control. Second, founded in 2003, the company took four years to find its business, so it was not a rocketship from inception. Third, rather than targeting a broad audience, Chegg focused on solving the pain point of a specific customer set desperate for an alternative. Fourth, Chegg, like traditional e-tailers Amazon and Zappos, requires a complex infrastructure to handle warehousing, shipping, and returns for millions of physical items, as well as a customer service desk that is highly seasonal. And fifth, because Chegg is innovating in an existing industry, the company faces rampant competitive threats from both the old guard and new entrants alike.

Not Just Extra Beer Money
According to the Department of Education, the annual cost of tuition, room and board for a four-year public institution is now $13,500, while a private university will set you back $30,400.

While college tuition costs have far outstripped inflation, having grown at an average rate of 7.74% per year since 1978, guess what constitutes the second highest educational expense for college students? Textbooks.

And those costs have grown at an average annual rate of 6.9% over the same time period, more than the growth of medical care expenses, causing real hardship to students who can already barely afford to put themselves through school. The issue of textbook affordability is so acute that in 2005 Congress asked the Department of Education to conduct a study on the matter and then released a plan in May, 2007 to make textbooks more affordable.

BMOC: Big Monopolist on Campus

According to the National Association of College Stores, students have historically been paying nearly identical prices for both new and used textbooks. Last year, the average list price for a “new textbook” was $64 compared to $57 for a “used textbook.”

When you consider that bookstores are making significantly higher margins on used vs. new books (35.7% to 22.3%) as a result of taking advantage of students by buying back (for very little money) the very books they just sold them last semester, its is clear that bookstores have little incentive to change. Students, on the other hand, are more than ready for a more economical solution that treats them like customers.

“Hi, I’m Chegg”

Chegg launched its rental service in 2007 and it quickly gained traction with students. Highly dependent on the fall and spring semesters when the majority of textbook-buying occurs, Chegg saw a nearly 2X increase in traffic to its website  from Fall, 2009 to Winter, 2010.  In January, it drew 1.3 million unique visitors, according to Compete. This was 10 times more than its closest startup competitor, Bookrenter. Based on its current growth pattern, I expect to see another 2X – 2.5X increase in traffic to the website this fall.

How Fast is Chegg Growing?

Sometime in 2008, Chegg began publishing on its homepage a real-time tally of the total dollars the company was saving its customers. Thanks to screenshot captures and Google image search, I was able to put together the following chart, which shows the explosive growth the company has experienced since the beginning of 2010. The company passed the $100 million savings mark on January 11, 2010 after two years of operation and needed just an additional three months to cross $200 million in May.

Financial Report Card

Jim Safka, the former Chegg CEO, said in an interview that the company generated $10 million in revenues in 2008.  According to a company press release, Chegg saved students just over $16 million in 2008. That means the company is saving students 63% off the list price of books and making 37% in revenue. Using this ratio, I estimate the company did close to $1 million in revenue per day during the winter semester 2009-2010, an increase of four to five times its daily average of $200,000 a day during “off peak” business days.

Based on this ratio, I estimate Chegg generated $25 million in 2009 and will do $130 million in revenues in 2010, accounting for increased traffic and awareness, almost half of which ($50 million) will come in September alone.

Based on my analysis, Chegg is likely operating at breakeven or at a slight loss each month, making the bulk of its profits in September and January. The reason for this is the complex and expensive warehouse and customer service operations required for this business.

Chegg hires three different tiers of employees: full-time engineering and marketing, warehouse, and customer service. Chegg needs to preserve as much flexibility as possible with its customer service and warehouse teams, so that they can be ramped up or down depending on the time of the year. When things are slow, the company still needs to carry the costs of its warehouse.

With a strong affiliate program that costs the company 8% of revenues, and its textbook buyback program, Chegg’s profitability comes down to how effectively they manage three aspects of the business: 1) textbook wholesale cost, 2) warehouse efficiency, and 3) customer service operations. These are three competencies that are very difficult to learn and mimic, creating strong barriers to entry.

Chegg is clearly planning for continued future growth. In February, the company announced plans for a brand-new warehouse facility in Shepherdsville, Kentucky, which will cost the company $27 million and employ another 100 full-time and 1,200 seasonal employees.  Based on my analysis, Chegg will likely have to double its monthly revenue run rate to $10 million in order to cover these additional expenses. Chegg had previously raised $55 million in debt in November, 2009 to invest in this area.

Is This A Winner-Take-All Market?

The nascent textbook rental market is looking a lot like the early days of the online DVD rental business. Online-only startup, Netflix, managed to out-innovate, out-operationalize, and outlast its deeper pocketed rivals—mainly Blockbuster—that had the added advantages of a local physical storefront and customers who already rented movies!

The potential challenges for Chegg look a lot like those facing Netflix a few years ago (and a key one that does not):

• Lack of a physical footprint on campus
• Industry long dominated by a few, deep-pocketed players; in this case, Barnes & Noble and Follett, which operate more than 1,500 campus bookstores between them
• Impending threat of digital replacement of physical goods
• A seasonal product need that does not fully utilize operational capacity

But here is what Chegg does better than anybody else, which makes it difficult to compete against and win:

1. Test Quickly and Fast Rollout: The company can test concepts in discernable communities with limited risk and capital outlay. At the formation stage, the company could limit the number of books it needed. As it grows, it can roll out new services quickly after proving out the concept at say, Florida State.
2. Marketing: There is nothing as viral as a college campus. FTW!
3. Operational Excellence: Like Netflix, Chegg is excellent at pick, pack, ship, and return. This is incredibly difficult to do. And will become more so when the company begins experimenting with extending the model to other books. See #1.
4. Scalable: Chegg will always have better inventory than local bookstores and better pricing. There is nothing stopping Chegg from offering other kinds of books for rent.
5. Customer Service: 30-Day refunds, free return shipping, customer support, tree planting. As I mentioned above, managing for peak and off-peak times is difficult.

Based on my financial analysis above, operating a physical bookstore and running an online rental service require different core competencies. I believe this is a winner-take-all business and that Chegg should control 80%+ market share over time.

Strategic Plan

In order to further ensure its position as market leader, I believe Chegg should position itself as the “Amazon for College Students” and cater to their unique university needs. The company should also go deep into expanding its classroom offerings, such as class notes and digital goods.  Here are some other things it could do

1. Partner with bookstores for physical presence and kiosks a la Red Box
2. Expand its assortment of books to leverage its operational expertise and capacity
3. Expand classroom offerings and potentially acquire companies in this space, such as lecture capture company, Echo 360
4. Embrace digital a la Netflix and partner with publishers
5. Work with Apple and e-reader company Kno (started by Chegg founder Osman Rashid)

The big question for Chegg down the line is how do they counter the cyclicality of the textbook business with more steady streams of revenue.  I’d rent a novel for $5 if there was an easy way to return it.  Wouldn’t you?

A new dual-screen tablet from California startup Kno aims to make electronic textbooks into a viable business.

It’ll need some luck: Tech giants like Amazon and Apple haven’t yet cracked the e-textbook market, despite multiple attempts.

“If you look at why e-textbooks have failed in the last ten years, the biggest problem is the size of the screen,” says Osman Rashid, co-founder and CEO of Kno. “Textbooks won’t fit into a 10-inch or 12-inch screen so you have to scroll up and down and right and left.”

“It makes for a poor learning experience,” he says.

Kno founders say they can fix that. The device has two 14-inch LCD touchscreens that fold in like a book. The idea is to make textbook pages fit perfectly across the screen and flow from one digital page to another. Kno made its public debut at the D8 technology conference Wednesday

The tablet will be powered by an Nvidia Tegra processor. It will include a stylus for handwriting recognition, have a full browser, support Flash and offer six to eight hours of battery life. The Kno will offer 16 GB or 32 GB of storage–enough to store 10 semesters’ worth of files, documents and books, says Rashid.

But it you are thinking a lightweight, cheap, easy-to-tote machine, Kno won’t be that.

The device, scheduled for release in December, will weigh about 5.5 lbs, or as much as a full-size notebook. And while the price hasn’t been fixed, it is expected to be “under $1,000,” says the company. Compare that to a $500 iPad that weighs 1.6 lbs, or a $260 Kindle at 0.6 lbs.

Kno is still a good deal, insists Rashid.

“If you are a parent, you know your child is carrying 20 lbs to 25 lbs of textbook in their backpack. Now you can replace the entire backpack with a 5.5-pound device,” he says.

Apple’s iPad has led to renewed interest in tablets, a category that few consumers had shown much interest in. Since Apple launched the iPad in April, it has sold more than 2 million devices. The demand for tablets has spurred other companies makers including Asus, MSI, Dell and HP to create would-be iPad killers.

But tablet-like devices from startups have been disappointing so far. Despite its 12-inch screen, the JooJoo has been widely panned for not delivering the kind of zippy, delightful experience that’s made the iPad so appealing.

Kno’s closest rival, the Entourage Edge, is also disappointing. The Edge is a dual-screen device with an E-Ink screen on the left and a 10-inch LCD display on the right. But this Frankenstein-ish monster is hobbled by a slow processor and by its weight.

Kno isn’t like these other tablets, says Rashid.

“You have to put yourself in a student’s shoes and not a technologist’s shoes,” he says. “The iPad or all these other devices aren’t created from the ground up with students in mind.”

Unlike the e-books marketed for fiction and nonfiction best sellers, electronics textbooks haven’t really taken off, because students have some unique requirements.

Textbooks are better in color, since they often have illustrations and graphics to help students understand the concepts. That’s why black-and-white displays like the E Ink are extremely limiting. Most digital textbooks are distributed as PDF files, but they are not formatted perfectly, says Rashid, who also co-founded the online textbook-rental site Chegg.

“So if a professor in a class says ‘Turn to page 74 in your book,’ you don’t know if the page 74 on your PDF corresponds to the one in the physical book,” he says.

And there’s the problem of scrolling when pages don’t fit into the screen. Kno’s tests showed that about 47 percent of textbooks fit on a 12.1-inch screen. Most freshman and sophomore books didn’t fit that screen size. On a 10-inch screen, similar to what an iPad has, only 11 percent of textbooks fit.

Kno, which was started in September last year and now has about 90 employees, says it has written its own software that will “normalize” books in the PDF format. It will also add interactive elements to the books and allow students to make notes and annotate the margins of an electronic textbooks.

Similar to Amazon’s Kindle, Kno hopes to have its own bookstore.

The company has inked deals with four major textbook publishers, including McGraw Hill, Pearson and Wiley.

Kno won’t have 3G connectivity but it will be Wi-Fi capable, so users can wirelessly download textbooks on to the device. Eventually, Rashid and his team hope to add other educational services such as the ability to buy accessories like a scientific calculator or even request tutoring from a tutor.

Rashid says students are unlikely to feel any pain from the lack of 3G access in the tablet. “Students are pretty wired on campus and at home, so Wi-Fi should work well,” he says.

For 400 years, higher education in the US has been on a roll. From Harvard asking Galileo to be a guest professor in the 1600s to millions tuning in to watch a team of unpaid athletes play another team of unpaid athletes in some college sporting event, the amount of time and money and prestige in the college world has been climbing.

I'm afraid that's about to crash and burn. Here's how I'm looking at it.

1. Most colleges are organized to give an average education to average students.

Pick up any college brochure or catalog. Delete the brand names and the map. Can you tell which school it is? While there are outliers (like St. Johns, Deep Springs or Full Sail) most schools aren't really outliers. They are mass marketers.

Stop for a second and consider the impact of that choice. By emphasizing mass and sameness and rankings, colleges have changed their mission.

This works great in an industrial economy where we can't churn out standardized students fast enough and where the demand is huge because the premium earned by a college grad dwarfs the cost. But...

2. College has gotten expensive far faster than wages have gone up.

As a result, there are millions of people in very serious debt, debt so big it might take decades to repay. Word gets around. Won't get fooled again...

This leads to a crop of potential college students that can (and will) no longer just blindly go to the 'best' school they get in to.

3. The definition of 'best' is under siege.

Why do colleges send millions (!) of undifferentiated pieces of junk mail to high school students now? We will waive the admission fee! We have a one page application! Apply! This is some of the most amateur and bland direct mail I've ever seen. Why do it?

Biggest reason: So the schools can reject more applicants. The more applicants they reject, the higher they rank in US News and other rankings. And thus the rush to game the rankings continues, which is a sign that the marketers in question (the colleges) are getting desperate for more than their fair share. Why bother making your education more useful if you can more easily make it appear to be more useful?

4. The correlation between a typical college degree and success is suspect.

College wasn't originally designed to merely be a continuation of high school (but with more binge drinking). In many places, though, that's what it has become. The data I'm seeing shows that a degree (from one of those famous schools, with or without a football team) doesn't translate into significantly better career opportunities, a better job or more happiness than a degree from a cheaper institution.

5. Accreditation isn't the solution, it's the problem.

A lot of these ills are the result of uniform accreditation programs that have pushed high-cost, low-reward policies on institutions and rewarded schools that churn out young wanna-be professors instead of experiences that turn out leaders and problem-solvers.

Just as we're watching the disintegration of old-school marketers with mass market products, I think we're about to see significant cracks in old-school schools with mass market degrees.

Back before the digital revolution, access to information was an issue. The size of the library mattered. One reason to go to college was to get access. Today, that access is worth a lot less. The valuable things people take away from college are interactions with great minds (usually professors who actually teach and actually care) and non-class activities that shape them as people. The question I'd ask: is the money that mass-marketing colleges are spending on marketing themselves and scaling themselves well spent? Are they organizing for changing lives or for ranking high? Does NYU have to get so much bigger? Why?

The solutions are obvious... there are tons of ways to get a cheap, liberal education, one that exposes you to the world, permits you to have significant interactions with people who matter and to learn to make a difference (start here). Most of these ways, though, aren't heavily marketed nor do they involve going to a tradition-steeped two-hundred-year old institution with a wrestling team. Things like gap years, research internships and entrepreneurial or social ventures after high school are opening doors for students who are eager to discover the new.

The only people who haven't gotten the memo are anxious helicopter parents, mass marketing colleges and traditional employers. And all three are waking up and facing new circumstances.