|Shares Out. (in M):||37||P/E||NM||NM|
|Market Cap (in $M):||1,697||P/FCF||NM||270|
|Net Debt (in $M):||-97||EBIT||-23||-14|
|TEV (in $M):||1,600||TEV/EBIT||NM||NM|
|Borrow Cost:||General Collateral|
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Given that INST was recently pitched as a long at 13D Monitor’s Active-Passive Investor Summit, we thought that this would be a timely write-up.
INST is a software company with two main products:
In 2018, ~19% of INST’s revenue came from outside the US. In non-US regions, Moodle, which is open source, has a commanding market share (57%-67%) of the LMS market.
Substantially all of INST’s growth has been driven by share gains from Blackboard, which are now beginning to slow
We estimate that ~2/3 of INST’s revenue comes from the U.S. higher education LMS market. The U.S. higher education LMS market is already fully saturated, so all of INST’s growth in this market must come from share gains. In the last several years, essentially all of INST’s share gains came at the expense of Blackboard. From 2013-2018, Canvas gained 3,011bps of market share (measured by enrollments). Over the same period of time, Blackboard (including ANGEL and WebCT, both of which were acquired by Blackboard) lost 2,229bps of market share. Much of the remaining share losses came from Moodle as well as a number of LMS’s that were discontinued during this period.
Exhibit 1: North America Higher Education LMS Market Share
Source: MindWires Consulting
Blackboard appears to have improved customer retention, a competitive shift which will fundamentally alter INST’s growth algorithm
INST’s growth began to slow in 2018, with billings growth declining from 38% in 2017 to 22%. Management blamed this slowdown on a reduction in RFP activity, but didn’t offer an explanation for why RFP activity was down. Based on our work, including multiple calls with LMS customers and an evaluation of publicly-available LMS evaluation reports prepared by universities, we believe that the reason for the slowdown is that Blackboard has improved customer retention (resulting in fewer customers going to RFP to begin with). Indeed, Blackboard’s CEO alluded to this dynamic in a recent interview: "Ballhaus [Blackboard's CEO] went so far as to say that Blackboard's improvements in client retention was the primary factor in the overall market slowdown last year ." – Phil Hill, MindWires Consulting (describing takeaways from an interview with Blackboard’s CEO). This improvement is being driven by a multitude of factors, as outlined below.
Exhibit 2: Trailing 12 Month New Higher Ed LMS Implementations
Source: MindWires Consulting. Note that implementations lag final customer decisions, so this chart suggests that the spike in RFP activity took place in the 2016/2017 timeframe.
Exhibit 3: Blackboard SaaS Deployments
Source: MindWires Consulting
Many of Blackboard’s changes began to take place after the current CEO Bill Ballhaus joined the company in 2016. Ballhaus previously served as the CEO of SRA International. Blackboard’s Chief Client Officer, Tim Atkin, also joined from SRA International after serving as COO there. Several Blackboard customers that we spoke with mentioned that Blackboard’s direction began to shift noticeably around the time that new management took over.
It’s worth noting that switching costs for LMS’s are material, so even if Blackboard’s recent changes do not fully close the gap between the quality of its product and Canvas, they still may be sufficient to have a material impact on the velocity of market share changes. The most significant switching cost is the need to pay for two LMS systems simultaneously during the transition period (generally 1-1.5 years). Additionally, there is a natural inertia given that faculty generally prefer not to have to learn a new system as long as they are generally satisfied with the LMS that they’re currently using. Furthermore, as previously noted, Blackboard actually possesses certain advantages over Canvas, such as its robust set of advanced tools.
On our math, every 100bps difference in Canvas’ annual market share gains translates to a ~280bps impact on 2019 revenue growth. For the reasons outlined above, we believe that INST will likely gain share in the domestic LMS market at a pace similar to or (far more likely) slower than the ~300-350bps p.a. rate seen in 2013-2015, which implies 2019 organic revenue growth materially below the 23% growth rate implied by guidance. If we roll forward our estimates (assuming that the rate of domestic K-12 and international revenue growth naturally moderates given a larger base), we estimate a mid/low-teens growth rate for 2020/2021, well below consensus which calls for 23%/21%/19% revenue growth in 2019/2020/2021.
Recent acquisitions may be an attempt to obfuscate declining fundamentals
To date in 2019, INST has already made two acquisitions: Portfolium and MasteryConnect. Prior to these acquisitions, the last time that INST acquired a company was in November 2017. INST has not disclosed the revenue impact of either Portfolium or MasteryConnect. Curiously, following the more recent of these acquisitions (MasteryConnect), INST reiterated its previous revenue guidance despite what was likely a ~$5mn-$10mn revenue uplift from the acquisition. Acquisitions such as this are always a yellow flag to us. While impossible to determine definitively, it’s possible that these acquisitions were motivated in part by a need to hit revenue guidance and mask declining growth in the company’s core market.
To illustrate the impact of these acquisitions on INST’s 2019 revenue growth, we ran a simple sensitivity analysis to determine the company’s organic growth rate based on assumptions for the revenue multiple at which these companies were acquired. Assuming these companies were acquired for 4x blended revenue multiple (note that MasteryConnect received ~$30mn in venture funding before being sold to INST for $42.5mn, so it was likely acquired at a low revenue multiple), the organic revenue growth rate implied by management’s guidance would be 16.5%.
As a money-losing SaaS company, valuation is a somewhat difficult/imprecise exercise. At a high-level, we believe that with <20% organic revenue growth, INST would trade at a 3.5x-5.0x revenue multiple vs. today’s ~6.5x multiple. This would imply a share price of $27-$37, or 24%-45% downside.
As a sanity check, we also ran a long-term DCF using a 9.5% WACC and 2.5% terminal growth rate. Even giving the company credit for the high-end of its steady-state operating margin guidance (20-25%), INST would be worth only ~$22-$30/share assuming annual Canvas U.S. higher ed LMS market share gains of 200bps-400bps over the medium term. For reference, INST would have to grow revenue at a ~17% CAGR from 2018 all the way to 2033 in order to justify its current valuation. Given that our math suggests that INST's revenue growth rate could slow to below this level by 2021, we consider such a scenario to be highly optimistic. With respect to margins, it's worth highlighting that Blackboard earned ~24% EBITDA margins on ~$710mn in revenue in 2017. Given the saturated nature of its core market, we doubt that Instructure can reach this type of scale.
INST was recently pitched as a long at 13D Monitor’s Active-Passive Investor Summit. While we did not attend the event, Bloomberg reported that the presenter stated that INST could unlock value by separating the Canvas and Bridge businesses, that Bridge could be an attractive target for a strategic acquirer, and that Canvas could be worth $2.5bn-$3.0bn on its own. Even to the extent that INST could indeed create value by separating the two businesses, it’s important to note that Bridge is only a small portion of INST’s total revenue. We would also point out that Cornerstone OnDemand (CSOD), which offers a competing product to Bridge and has revenue of $500mn+, currently trades at ~5.5x revenue, lower than INST’s multiple. Additionally, Saba Software (another Bridge competitor) was acquired by Vector Capital for ~2.5x revenue in 2015. Furthermore, assuming that Bridge is 10% of INST’s revenue, the $2.5bn-$3.0bn valuation for Canvas cited in the Bloomberg article would imply an 11x-13x forward revenue multiple. For reference, Adobe, a best-in-class software company with 40%+ EBITDA margins that is estimated to grow top-line at a high teens rate over the next few years, trades at just under 12x revenue.
As of the publication date of this report, we have short positions in the stock of Instructure, Inc. (“INST”). We stand to realize gains in the event that the price of the stock decreases. Following publication of this report, we may transact in the securities of the company covered herein. All content in this report represents our opinions. We have obtained all information herein from sources we believe to be accurate and reliable. However, such information is presented “as is,” without warranty of any kind – whether express or implied. We make no representation, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results obtained from its use. All expressions of opinion are subject to change without notice, and we do not undertake to update or supplement this report or any information contained herein. This report is not a recommendation to short the shares of any company, including INST, and is only a discussion of why we are short INST. This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment or security discussed herein or of any of our affiliates. This document is for informational purposes only. All market prices, data and other information are not warranted as to completeness or accuracy and are subject to change without notice. Our opinions and estimates constitute a best efforts judgment and should be regarded as indicative, preliminary and for illustrative purposes only. The information contained in this document may include, or incorporate by reference, forward-looking statements, which would include any statements that are not statements of historical fact. Our forward-looking assumptions, expectations, projections, intentions or beliefs about future events may turn out to be wrong. These forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks, uncertainties and other factors, most of which are beyond our control. Investors should conduct independent due diligence on all securities discussed in this document and develop a stand-alone judgment of the relevant markets prior to making any investment decision.
Slowing/reversal in share gains, negative sell-side revisions, valuation compression
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