Description

Executive Summary

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.

• We believe INST is a short.
• Since its founding, the majority of INST’s revenue growth has been driven by a single factor: share gains from Blackboard. Based on our customer diligence, we believe that this growth driver is likely to subside (and indeed, has already started to show signs of subsiding) as a result of Blackboard’s improvements in customer retention.
• The opportunity exists due to sleepy sell-side analysts and a lack of easily-accessible information on Instructure’s privately-held competitor Blackboard, which has led to a lack of awareness of many of the changes that have taken place, and continue to take place, in the Learning Management System (“LMS”) landscape. Specifically, Blackboard has addressed the principal causes of its market share losses to INST by closing the technology and user interface gap between its LMS product and INST’s, while at the same time INST has significantly increased pricing.
• At its current 6.6x EV/Sales multiple, we don’t believe that INST’s valuation is properly discounting what we believe will be a significantly more challenging environment for revenue growth going forward.

Business Overview

INST is a software company with two main products:

• Canvas: LMS application for education customers. LMS’s are used by instructors at higher education and K-12 institutions to share syllabi and course documents, submit grades, host class discussions, administer quizzes, etc. The higher education LMS market is essentially fully saturated, while K-12 institutions have yet to widely adopt LMS’s. Canvas utilizes a per-user (i.e., per-student) pricing model with lower pricing for larger customers and built-in annual price escalators. Pricing also depends on the set of features utilized.  Pricing is considerably lower for K-12 customers than higher education customers.
• Bridge: Employee development and engagement platform designed to enable corporate customers to develop, retain and promote employees by improving performance and engagement. We estimate that Bridge comprises ~10% of INST’s revenue.

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.

Investment Thesis

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 [2018]." – 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.

• Factor #1: Blackboard’s churn rates were temporarily elevated in 2016/2017. Because Blackboard was beginning to introduce significant changes to its product around 2016 (see further details below), many Blackboard customers that wouldn't have otherwise been sufficiently motivated to shift off Blackboard likely decided to kick the tires on competing LMS vendors during the 2016/2017 timeframe. In other words, the uncertainty created by Blackboard's pending changes was an accelerant for deal activity in 2016/2017. In reviewing publicly-available LMS vendor evaluation reports prepared by universities, this was the single most common reason cited by customers for the decision to evaluate new LMS providers (see selected quotes below; note that these only cover a small sample of the total number of instances we found during our research). The data also seems to bear this out: INST's annual market share gains jumped from 384bps/288bps/323bps in 2013/2014/2015 to 700bps/789bps in 2016/2017 (see Exhibit 1 above). There was also a clear acceleration in deal activity in 2016/2017 (see Exhibit 2).
• "[T]he system that powers Chalk (Blackboard) is undergoing significant changes, and the impact would be similar to changing systems completely. In light of these circumstances, the LMS Review Faculty Committee was brought together to recommend a direction for the next LMS for the campus." – University of Chicago LMS Review Assessment Plan
• "Making the switch from Learn to Ultra will be sufficiently disruptive and comparable to the effort to switch to any other LMS. For this reason, we are planning a comprehensive review of all LMS alternatives so that we can make a smooth transition to our future platform with plenty of lead time and minimal disruption." – Purdue University LMS Proposal
• "While the LMS TF [Task Force] is cognizant of the challenges associated with potentially switching LMS platforms, it is also aware of an impending change to Bb Learn that will impact UC. Bb has provided UC and other institutions with early access to their next generation LMS, Bb Ultra. Bb Ultra will feature a new interface that in many respects departs from the existing design, necessitating both professional development for faculty and a change in how UC builds courses. In short, the LMS TF recognizes that change is coming to UC regardless of whether UC remains with the Bb LMS." – University of Cincinnati Recommendation to Pilot Canvas
• "In 2016, Blackboard announced a future depreciation of the current form of Blackboard for a new cloud-based version called Blackboard Ultra. Cloud servers avoid maintenance downtime and stay up 24/7. ASU decided to look into new Learning Management System options because either way they were going to have to transfer all the classes to a new system.” – Arizona State University
• "Our current version of Blackboard will soon go out of support, so we will be faced with transitioning users to a new interface. Given that we are facing a change one way or the other, now is the time review our options so we can make the best choice going forward." – St. Edward's University LMS Evaluation

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.

• Factor #2: Blackboard SaaS rollout has closed the technology gap vs. Canvas. Blackboard began introducing the SaaS version of its product in late 2016. This addressed one of the main weaknesses that has historically driven Blackboard customers to Canvas: Canvas was built from the ground-up on multi-tenant cloud infrastructure, whereas Blackboard historically used a single-instance model. For Blackboard customers, this meant that system downtime was required for software updates and maintenance, among other technical issues. Blackboard’s move to SaaS is already gaining traction among customers: ~25% of Blackboard customers are now using Blackboard’s SaaS deployment option (Exhibit 3). Notably, because customers generally need to sign 1-3 year contract extensions when they upgrade to SaaS, this should be viewed as a leading indicator of whether a school plans to stick with Blackboard. Our calls with Blackboard customers indicated that universities that have moved to Blackboard’s SaaS deployment model have seen appreciable improvements and that the migration process is relatively smooth, an observation that was corroborated by our review of university’s publicly-available LMS evaluations (e.g., per Temple University’s LMS Evaluation: “The University recently moved to a cloud-based solution for our existing Blackboard user interface which has reduced the amount of unplanned down-time and has created greater reliability [with] more than 99% up-time”).

Exhibit 3: Blackboard SaaS Deployments

Source: MindWires Consulting

• Factor #3: Blackboard Ultra rollout will close the user interface gap vs. Canvas. In addition to its SaaS offering, Blackboard has also begun the rollout of Blackboard Ultra, which is an overhaul of its user interface and design. Blackboard’s poor user interface has been one of the major pain points that has driven Blackboard customers to Canvas. For instance, despite the fact that Blackboard is generally regarded as having a set of tools and features that is likely superior to that offered by Canvas, instructors are often unaware of many of the tools available on Blackboard due to the challenges of navigating its non-intuitive interface. While Blackboard is still in the early stages of rolling out Ultra after a troubled development period, we were able to speak with a few university CIOs whose universities were among the first to adopt Ultra. These CIOs spoke highly positively of the improvements to the interface and the seamlessness of the transition. Notably, these customers believed that Blackboard Ultra’s user interface is just as good as that of Canvas. One customer that we spoke with ranked the user interface of Blackboard Learn 9.1 (pre-Ultra Blackboard), Blackboard Ultra, and Canvas as follows: Blackboard Learn = 6.0/10, Ultra = 8.5-9.0/10, and Canvas = 8.5-9.0/10.
• Factor #4: Canvas has already addressed the low-hanging fruit among former Blackboard customers. Many of the customers that Canvas has won from Blackboard were not originally customers of Blackboard, but rather were customers of one of the several LMS providers (e.g., Angel, WebCT) that Blackboard acquired and were subsequently rolled over onto Blackboard. With most of these customers having already switched over to Canvas, incremental customer wins will have to come from long-time Blackboard customers, a much heavier lift. Based on our primary research, we believe that “forced” Blackboard customers have represented a substantial portion of the customers that Canvas was won from Blackboard over the past several years.
• Factor #5: Canvas has significantly increased pricing. While INST does not disclose pricing metrics for Canvas, per one university Chief Information Officer that we spoke with that had evaluated both Canvas and Blackboard at various points, Canvas was approximately half of the cost of Blackboard around 2013 (two years after Canvas was launched), but INST has since raised prices significantly to the point where it is essentially at price parity with Blackboard today. Notably, this particular university was part of a buying consortium with pre-set pricing arrangements for most of the major LMS vendors, suggesting that this CIO’s observations regarding Canvas’ pricing are likely relevant to a large swath of universities in the US.

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%.

Valuation

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.

Risks

• Our variant perception is primarily centered on slowing growth in the U.S. higher education market. An acceleration in the company's other end-markets (domestic K-12, international education, and Bridge) could be sufficient to offset declining growth in the company's domestic higher education business.
• Improving profitability could provide support for the multiple even as growth slows
• RFP activity rebounds and Canvas’ share gains in the US higher education LMS market come in ahead of our expectations. While our diligence suggests that Canvas’ share gains are likely to slow going forward, we would note that the number of customers that we have spoken with represents only a small sample of the large number of diverse US higher education institutions.

Disclaimer

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.

Catalyst

Slowing/reversal in share gains, negative sell-side revisions, valuation compression