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Blackboard, Inc. (NASDAQ:BBBB)

Q3 2008 Earnings Call Transcript

October 29, 2008, 4:30 pm ET

Executives

Michael Stanton – SVP, IR

Michael Chason – President and CEO

Mike Beach – CFO

Analysts

Michael Nemeroff – Wedbush

Tom Roderick – Thomas Weisel Partners

Amy Junker – Robert W. Baird

Trace Urdan – Signal Hill

Kash Rangan – Merrill Lynch

Brandon Dobell – William Blair

Kirk Materne – Bank of America

Terry Tillman – Raymond James

Bennett Notman – Davenport

Operator

Good day, ladies and gentlemen, welcome to the third quarter 2008 Blackboard Incorporated earnings conference call. My name is Tolanda and I would be your coordinator for today. At this time, all participants are in listen-only mode. We will facilitate a question-and-answer session towards the end of this conference.

(Operator instructions) As a reminder, this conference call is being recorded for replay purposes.

I would now like turn the presentation over to Mr. Michael Stanton, Senior Vice President Investor Relations. Please proceed, sir.

Michael Stanton

Okay, thank you, Tolanda. Hello and thanks for joining us today for Blackboard's third quarter conference call. I’d like to remind everyone that except for historical information presented, the matters discussed today may contain forward-looking statements under the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995. Such statements are based upon management's current expectations and are subject to a number of risks and uncertainties that could cause actual performance and results to differ materially from those discussed in the forward-looking statements.

Among the important factors that could cause actual results to differ materially from those indicated by such forward-looking statements are delays in product development, undetected software errors, competitive pressures, technical difficulties, market acceptance, availability of technical personnel, changes in client requirements, risks of international operations, general economic conditions, and such other risks as described in the Risk Factors section of Blackboard's most recent Form 10-Q on file with the SEC.

Blackboard undertakes no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes in future operating results.

A few administrative notes related to some of the metrics we will provide today. First, we will provide non-GAAP adjusted net income and non-GAAP adjusted net income per share on this call, as additional information regarding our operating results. The measures are not in accordance with, nor an alternative for GAAP and may be different from other non-GAAP measures used by other companies.

Blackboard believes that the presentation of these non-GAAP financial measures provide useful information regarding additional financial and business trends relating to the company's financial condition and results of operations. A reconciliation of GAAP and non-GAAP metrics has been provided in today's earnings press release.

The second administrative note relates to our contract value which we will also discuss today. Our contract value represents the annualized recurring ratable revenue under existing contracts with clients in effect at the end of the quarter without regards to the remaining duration or renewal of such agreements. This is not intended by management for the estimation of or as a proxy for future revenue to be recognized but management believes it is a useful tool for investors to evaluate our current operating performance.

We have once again provided supplemental information related to licenses and our contract value on the Investor Center section of the web site at investor.blackboard.com. The document is titled Blackboard Q3 2008 metrics.

On today's call are Michael Chason, President and CEO and Mike Beach, our Chief Financial Officer.

At this time, I will like to turn the call over to Michael Chason. Michael?

Michael Chason

Thanks, Michael. Good afternoon everyone. I am pleased with our results for the quarter as we delivered revenue and earnings in line with guidance and generated cash flow from operations in excess of our expectations.

Revenue for the quarter was $83.1 million, an increase of 35% over the third quarter of 2007. Net income was $2.1 million or $0.07 per basic share and $0.06 per diluted share. A non-GAAP adjusted net income was $8 million or $0.25 per diluted share for the quarter. Our cash flow from operations was very strong, coming in at just over $60 million for the quarter.

Before I discuss some of the new business we won in the quarter, I want to take a minute to address the most common question that we’ve been getting from investors over the past few months which is, how is the economy impacting Blackboard’s business?

A difficult economy presents both challenges and opportunities to the education industry. On the one hand, a slowing economy does have negative impacts on education spending as it does in other industries and we experienced a little of this in the third quarter.

These economic concerns were most pronounced in the US K-12 market, which as we have discussed previously is the most economically sensitive end market for our business. The reason for this is that a significant portion of K-12 funding comes directly from state and local taxes which have been negatively impacted this year.

In terms of our US higher education market, we have heard a few specific concerns regarding economic and budget pressures and we did experience longer sales cycles and another back-end loaded quarter. This was due to our customers closely managing their budgets and managing liquidity given the uncertainty of the economy and the volatility surrounding their investments. However, even though sales cycles were impacted, clients recognized the value of our solution and are moving forward with Blackboard purchases.

Obviously, these recent developments have made us more cautious as it relates to our outlook, particularly in the short term.

On a more positive note, we continue to see opportunities in which Blackboard solutions can benefit academic institutions, including a newly passed law in Michigan requiring K-12 students to take at least one online course before High School graduation. For Blackboard, this translates into sales opportunities to new K-12 clients and higher enrollments for existing K-12 virtual school client. A recent K-12 development related to the economy is the increasing number of districts moving to a four-day week. More than 100 school districts in 17 states have already gone to such an alternative schedule for financial reasons and we believe this will present increasing opportunities for Blackboard as there is a need for communication and collaboration tools, and an online environment to help round out the overall education experience.

And in higher education, we see opportunities in many areas particularly with our career and community colleges. Clients such as Capella and Mareckova community colleges continue to experience increasing online enrolments as the softening economy drives people to seek additional education and job skills re-training.

The current economic uncertainty creates some short-term challenges for our business but also creates some opportunities. Given these recent sales dynamics and the economic concerns, we are cautious in our guidance for the remainder of the year, particularly as it relates to the K-12 market and the upfront revenue recognition of some of our products and services.

Beyond 2008, we remain positive about the outlook for our business which is supported by our contract value growth of 25%, which we believe helps position the company for solid revenue growth with continued margin expansion in 2009.

Let's start with the review of our business. As I said, our North American higher education sales were generally in line with our expectations but concentrated in the last few days of the quarter. A few examples of the new business we signed in the quarter include Tulane University, which licensed the Blackboard Outcome System and related services; Northeastern State University in Oklahoma, which upgraded to the Enterprise Blackboard Learning System and added the Blackboard Content System; Georgia Perimeter College in Georgia and Owens Community College in Ohio expanded their relationship with Blackboard by licensing the Blackboard's Connect product; Wallace State Community College in Alabama licensed the Blackboard Transaction System and also became one of our newest Blackboard One client; and finally, Oakland Community College which upgraded to the Enterprise Blackboard Learning System and added our managed listing offering.

On the international front, I would like to highlight the University of New South Wales in Australia, a former WebCT client, licensed the Blackboard Community System and the Blackboard Content System. Another WebCT cross-sell in the quarter was the University of Birmingham in the United Kingdom which added our Managed Hosting offering to power their license of the Blackboard Learning System in this additional license. Finally, King Khalid University in Saudi Arabia licensed the Blackboard Community System and the Blackboard Content System.

In K-12, our new sales included the Great Oaks Institute of Technology, a vocational school district in Ohio which licensed the Blackboard Learning System, the Blackboard Community System, and the Blackboard Content System as well as the Blackboard Managed Hosting offering. Fairfax County Public School, one of our largest K-12 clients, expanded their relationship with Blackboard by licensing the Blackboard Connect product. And lastly, the Kentucky Department of Education licensed the Blackboard Community System and the Blackboard Content System as well as Blackboard Managed Hosting.

In terms of the Blackboard Connect progress, there were more than 200 new Blackboard Connect deals closed in the third quarter. Importantly, 40 of these deals were cross-sell to existing Blackboard US higher education clients.

Moving on to licenses, we ended the quarter with a total of 6,599 enterprise category licenses. Breaking out these licenses, we had 2,340 licenses of the Enterprise Blackboard Learning System, 839 licenses of the Blackboard Community System, 485 licenses of the Blackboard Content System, 30 licenses of the Blackboard Outcome System, 455 licenses of the Blackboard Transaction System, and 2,450 licenses of the Blackboard Connect offering. In terms of the Blackboard Learning System basic product, we had 793 licenses. The total number of licenses including the basic licenses at the end of the quarter was 7,392.

In terms of our Managed Hosting business, we finished the quarter with 583 hosted clients, which is a 16% increase over last year. Our client renewal rate continues to trend in line with where we ended last year, at approximately 92%. We were very pleased with the renewals from the third quarter as it represents the company's peak renewal quarter during the year.

We finished the quarter with an annualized contract value of approximately $272 million which represents an annual increase of 25% measured on a pro forma basis including Blackboard Connect, formally known as the NTI Group in both areas.

Out total headcount at the end of third quarter was flat sequentially at 1,080 people. We had 253 people in sales; 91 in marketing and business development; 231 in product development; 196 in support, managed hosting, and production; 135 in professional services; and 174 in operations.

Given the challenges we experienced, we will continue to closely manage the organization to maximize efficiency. Again, despite some of the near-term economic challenges we are facing, we remain positive about our long-term outlook and I would like to reiterate some of the key themes about our business. First, we operate in the education industry which continues to relatively insulated from macroeconomic pressures.

Second, we provide the industry-leading enterprise solutions that are well aligned to an institution's overall mission to provide services to students and faculty with cost-effective technology. Third, we have a foundation of more than 5,200 very loyal client relationships with institutions around the world. These are relationships that we continue to grow every year and are also responsible for generating a significant number of reference sales to new clients.

One final bit of color. We are here today at the EDUCAUSE 2008 Conference with over 7,000 higher education technology leaders from across the United States and around the world, and the attitude here seems to be cautiously optimistic. We have seen very high traffic at our booths in the conference hall, and our US and the international sales reps are holding meetings with clients and prospects throughout the week. One of the items that seems to be a popular topic of conversation is the pending release of Blackboard 9, the next-generation version of our e-learning solution which we believe is going to be a strong driver for future growth.

With that, I’m pleased to hand it over to our CFO, Mike Beach, to cover our financials and future guidance. Mike?

Mike Beach

Thanks, Michael. I’ll organize today’s financial review around the income statement, the balance sheet, and cash flow, and close with the outlook and guidance for the fourth quarter in full year of 2008.

Revenue for the third quarter of 2008 was $83.1 million, up 35% from last year and in line with our expectations. Product revenue for the quarter was $74.3 million, representing an increase of 38% over the same quarter last year. Professional service revenue for the quarter was $8.8 million, which represents an increase of 16% over the prior year.

In terms of revenue characterization we also break out revenue by the nature of the revenue streams, which include ratable recurring, ratable non-recurring and other revenues. For the quarter, ratable recurring revenues increased 42% to $65.5 million as compared to $46 million in the same quarter last year. Ratable non-recurring revenues increased 18% to $6.5 million as compared to $5.5 million in the same quarter last year. Other revenues increased 11% to $11.1 million as compared to $10.1 million in the same quarter last year.

Moving on to gross profit. Our gross profit for the third quarter, excluding stock-based compensation and the amortization of acquired technologies, was $58.7 million as compared to $45.5 million in the same quarter a year ago, representing an increase of 29%. For the quarter, our gross margin was 71% excluding stock-based compensation and amortization of acquired technologies. Total operating expenses, excluding the cost of revenues, stock-based compensation and amortization of acquired intangibles, were $43.9 million, representing an increase of 36% as compared to $32.4 million in the same quarter last year.

For the quarter, we incurred stock-based compensation expense of $3.6 million and intangible amortization expense of $9.7 million.

Our net income was $2.1 million compared to net income of $3.3 million in the same quarter last year. Net income per diluted share or per basic and diluted share was $0.07 and $0.06 respectively for the quarter. Our net income for the third quarter also benefited from a $2.4 million income tax benefit. Non-GAAP adjusted net income was $8 million or $0.25 per diluted share. It was in line with our guidance when you apply the effective rate we provided last quarter.

In terms of the balance sheet, we’re very pleased with our ending cash and cash equivalents of $118.7 million. Accounts receivable increased to $102.5 million at the end of the quarter from $65.8 million in the same quarter last year. This increase is due to the growth in receivables from acquired companies and overall growth in our business. Total deferred revenues increased to $191.5 million at the end of the third quarter, up 43% from the $133.7 million at the end of the third quarter last year. And current deferred revenues related to our recurring products totaled $167.4 million compared to $114.7 million in the same quarter last year, representing an increase of 46%.

Moving on to cash flow. Cash flow provided by operations totaled $60.3 million for the third quarter which was a record for us and represents a 57% increase compared to the third quarter last year. We are very pleased with cash flow for the quarter which reflects the strength in our business and the benefit of the collections process we put in place over the last 12 months. Capital expenditures were $4.9 million in the third quarter.

Moving on to guidance. For the fourth quarter of 2008, we expect revenue of $82.9 million to $84.9 million, amortization of acquired intangibles of approximately $9.8 million, stock-based compensation expense of approximately $3.9 million, net income of $900,000 to $2.2 million resulting in net income per diluted share of $0.03 to $0.07 which is based on estimated 32.2 million diluted shares and an estimated income tax benefit of approximately $600,000.

Non-GAAP adjusted net income of $7.2 million to $8 million, resulting in non-GAAP adjusted net income per diluted share of $0.22 to $0.25 based on an estimated 32.2 million diluted shares and an estimated effective tax rate of approximately 29%.

For the full year 2008, we expect revenue of $310 million to $312 million, amortization of acquired intangibles of approximately $38.3 million, stock-based compensation expense of approximately $15.1 million, net income of $800,000 to $2.1 million resulting in net income per diluted share of $0.02 to $0.06, which is based on estimated 31.8 million diluted shares and an estimated income tax benefit of $2.8 million. Non-GAAP adjusted net income of $24.4 million to $25.2 million resulting in non-GAAP adjusted net income per diluted share of $0.76 to $0.79 based on an estimated 31.8 million diluted shares and an estimated effective tax rate of approximately 33%.

And finally, we are raising our cash flow from operations guidance for the year. We now expect cash flow from operations of $80 million to $85 million. As I’ve mentioned, we realized an income tax benefit of $2.4 million in the third quarter. As we've discussed in last couple of calls, depending on the amount of GAAP earnings and the mix of domestic and international income, we may experience some material variations in our GAAP effective tax rate. We point this out to highlight the possible variability in our effective tax rate for the remainder of the year and due to this complexity, we encourage investors to focus on the estimated effective tax rates provided with our guidance.

Finally, our guidance reflects the impact of the third quarter sales as well as expectations that sales will continue to be back-end loaded in the fourth quarter. While not immune from the effect of the macro environment, particularly in the K-12 market, we believe our contract value in 2008 positions us well for 2009 top line growth with continued margin expansion.

This concludes the discussion of Blackboard's financials. Now, let me hand it back to Michael Stanton for closing, Michael?

Michael Stanton

Thanks, Mike. Just a couple of notes before we run into Q&A. We’re going up in New York City over the next couple of days, meeting with investors and we also have a number of upcoming conferences including the Thomas Weisel One-on-One Conference in Chicago on November 18th, the Signal Hill Education Conference in Baltimore on November 20th, and the Credit Suisse Technology Conference in Phoenix in early December. So I hope to see many of you out there while we get on the road to touch base with investors.

This concludes our prepared remarks and we are now happy to take your questions. Tolanda , we’re ready to start Q&A.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Michael Nemeroff with Wedbush. Please proceed.

Michael Nemeroff – Wedbush

Hi, good afternoon. Thanks for taking my questions. Just a couple of brief ones. First, Mike Beach, could you reconcile the guidance to the tax benefit? I just want to compare what I have on the notes. By my calculations, I get to about $0.19 on the EPS for the quarter. Then also if you could tell us whether the core contract value for Blackboard was at or above that 20% figure that it’s been for the last couple quarters and then also if you could just touch on whether you have any concerns about cash flow and collections going forward as the credit crunch and schools may be possibly hoarding cash. And then I have just one follow up for Mike Chason. Thanks.

Mike Beach

Okay, as I highlighted throughout the year, we have got significant variability in the effective tax rate. You could see that in the Q3 benefit. If you apply the estimated effective rate from our prior guidance which was 37% to the non-GAAP earnings in the quarter, the earnings per share would have been $0.19.

Michael Nemeroff – Wedbush

So, is there anything else there?

Mike Beach

The only other kind of one-time item or unusual item in the quarter was the foreign currency. So if you look at foreign currency, we had a $200,000 negative impact to earnings which is worth about $0.01.

Michael Nemeroff – Wedbush

Okay. So excluding the tax benefit but adding back the FX, you get to about $0.20 which was in line with consensus, is that correct?

Mike Beach

Yes.

Michael Nemeroff – Wedbush

Okay.

Mike Beach

On the contract value for Blackboard would have been approximately 19% growth for the quarter year-over-year.

Michael Nemeroff – Wedbush

Okay, and about the last one on the cash flow?

Mike Beach

Yes. So we've obviously factored in kind of what we’re saying in the marketplace related to the cash flow guidance we’ve provided, and believe that – we haven’t seen a material slowdown in collections and are comfortable with the range we’re providing. There were some events that happened during the third quarter that could have had a negative impact on cash flow. We did not see that and those seems to be unwinding. Michael Stanton, you want to touch base on it?

Michael Stanton

Yes, Michael. We've talked about it, and I know you and other investors and analysts have raised an article that was first published in, I think, it was the New York Times related to common fund and some of the other challenges that higher ed institutions are facing with regards to liquidity. So I think it’s fair to say that our cash flow guidance for the full year of $80 million to $85 million which is raised assumes that there could be some amount of impact but we feel good about that number.

Michael Nemeroff – Wedbush

So you’re still tracking or still expect that 200 basis point improvement in the margin next year?

Mike Beach

So I think, as we look at next year, we clearly expect margin expansion and our goal is 24% EBITDA excluding stock-based comp. We give formal guidance as it relates to 2009 on our Q4 call as we historically have and at that time, we’ll nail down the exact margin. But that’s our goal and we do expect margin expansion over 2008, in 2009.

Michael Nemeroff – Wedbush

Okay, and then one, if I may, for Mike Chason. You’re at EDUCAUSE and you’re with several thousand schools down there. Can you tell us what the tone is there and how schools are thinking about their budgets going-forward into 2009? Then also, does the market meltdown here, does that impact the sale cycle, the length of the sale cycles potentially for statewide deals going-forward, and how much of that is baked into your guidance for next year? Thank you.

Michael Chason

That’s a good question Michael. I’ve had a really great opportunity over the last two days and of course, will continue throughout today and tomorrow to meet with a good number of both clients and prospective clients, as well as speak with a number of other leaders in the industry. And I see that the attitude here, as I indicated in my talk track, is basic cautiously optimistic.

Certainly we’re staying down and talking with schools about expanding their licenses and how they can better utilize our technology to take into consideration if the schools may be under a slight amount of budget pressure next year, so looking to our technology to help reduce expenses, allow them to put more students in a class and especially in the community college and the commercial college system that actually expects to see increasing enrollments as more people go back to school to continue with their education if there’s an economic slowdown. So all of those are factors that I think are tied into people looking to continue to purchase our software.

As we have said, we do believe in this past quarter, it did influence the sale cycle, just a general concern about the economy, but not specific cutbacks yet in the budget. And I think that we can expect that to continue, a slightly longer sales cycle on higher ed but not the same kind of reduction in budgets that we’ve seen tied to the K-12 space.

And the last part of your question?

Michael Nemeroff – Wedbush

I think it’s about the sale cycle statewide deals.

Michael Chason

I don’t think we have enough experience yet with statewide deals to specifically say whether this is going to have any influence on them. Of course, the statewide deals we’ve done have been on longer sale cycle. But I do think that as states look for ways to save money, improve education, and again, potentially prepare for increasing enrollment in their state institutions, there could be more discussions with senior level executives about doing statewide deals. So I think that economic pressure could be an impetus for more conversations around that.

Michael Nemeroff – Wedbush

Great. Thanks for taking my questions. Nice quarter.

Michael Stanton

And really quickly, let’s try to – we’ll limit questions to a single question and a follow-up. We got a lot of people. We got eighty plus people on the line. So operator, next question.

Operator

Your next question comes from the line of Tom Roderick with Thomas Weisel Partners. Please proceed.

Tom Roderick – Thomas Weisel Partners

Hi, guys. Thanks and good afternoon. I wanted to dig in a little bit more on the bit of caution related to the K-12 market. Michael, can you just touch on, first of all, why you have some more upfront rev rec in that market and then maybe address some of the dynamics taking place in that market, why you’re seeing some tougher spending trends and budgeting trends in K-12 versus post-secondary. Thanks.

Mike Beach

We don’t see a greater concentration on upfront recognition. In Michael’s remarks, we were just pointing out that that is something that we’re being cautious on across the board, not specific to the K-12 market. I’ll let Michael talk to you as well.

Michael Chason

The K-12 space is different from the other education markets that we focus on. It’s obviously more closely tied to state budgets and taxes, in particular property taxes, and so both as we see concern about where those budgets are going for next year as well as quite frankly even cuts that’ll be made in the budgets that have already been distributed for this year that obviously affects budget planning and the sales cycle, which has a direct effect on our sales in the K-12 market space.

Tom Roderick – Thomas Weisel Partners

Okay. When you look at the post-secondary part of your business, can you give us a sense as to how that’s broken out between state-funded universities and in private universities?

Michael Chason

I think the breakout of this will be generally in line with the general breakout between public and private institutions.

Mike Beach

Yes, I’d say it’s roughly 60/40, and in favor of public.

Tom Roderick – Thomas Weisel Partners

Okay and last question from me, just in terms of outcomes. You've announced a fair number of wins over the last several quarters, sounds like you got Tulane in this quarter, can you talk about what if any live implementations are out there and what are the sort of the top reference accounts on outcomes?

Michael Stanton

Sure, Tom. On the outcomes side, I would say that obviously Tulane is a new client and not up yet, so any of the newer clients that are up in the last two or three quarters, I think it’s safe to assume that they’re not up and live. I think clients like Mississippi was an early adopter. Seton Hall University is going to be another one that stands out.

Michael Chason

The thing that you have to recognize is when we do an outcome system implementation, it's a slightly different than our other products that are up and running right as soon as they download. Schools often take the time to put in place the business process around it, so when they’re looking at the date and examining it, they’re tracking to that over time. So for implementations to be fully successful, it is really kind of a multi-year process and year one is about to get itself established. So you'd really need to look to our very early adopters, I think, to get specific good proof points on the success they’ve seen with the system as Mike Stanton mentioned.

Tom Roderick – Thomas Weisel Partners

Okay, thanks guys.

Operator

Your next question comes from the line of Amy Junker with Robert Baird. Please proceed.

Amy Junker – Robert W. Baird

Hi, good afternoon. Can you talk just a little bit in terms of your guidance for the fourth quarter? Does that include perhaps some greater expenses as well that are related to some of these larger Connect deals you’ve signed recently? I’m just wondering if we’re going to see a little bit of the same phenomenon we saw in the second quarter with some of those expenses coming through before the revenue.

Mike Beach

Amy, yes, I think the earnings stance from the guidance is really just driven from the lowest revenue expectations. So, that's just showed the revenue expectations flowing to the bottom line. We haven’t really increased expenses related to deal-related cost. One thing we do anticipate is lower net or lower interest income, so higher net interest expense for the quarter given the return that we're currently getting on our investments based off taking a very conservative approach in investing those funds.

Amy Junker – Robert W. Baird

Okay, that’s helpful. And just a follow-up, can you share with us what the contribution to the quarter was from NTI and how much you wrote off during the quarter as well?

Mike Beach

The NTI revenue was roughly $10 million recognized in the quarter and I believe the adjustment is around $2 million; the write-down is $2 million.

Amy Junker – Robert W. Baird

Great. I’ll pass it on. Thanks.

Operator

Your next question comes from the line of Trace Urdan with Signal Hill. Please proceed.

Trace Urdan – Signal Hill

Hi, guys. I don’t mean to beat a dead horse here, but I wonder Michael if you could maybe be even a little bit more specific about what you’re experiencing in K-12 because I think you mentioned that you saw budgets actually being reduced and I’m not aware of any other vendors in the States that have actually acknowledged anything like that. So wondered if you had some anecdotes to that situation that you were involved in where deals got pushed back or budgets that you thought you would have access to went away, anything like that that would sort of back up those cautionary comments?

Michael Chason

Sure. I want to be careful. Really what we’re talking about is concern over budget reduction from what the K through 12 space is hearing about the state shortfalls and then how that might translate to affect their current budgets and that’s therefore slowing down or even delaying potential purchases.

Trace Urdan – Signal Hill

Okay. So have you all experienced any disruption in your own business as a result of those fears?

Michael Chason

Well, again, we continue to have higher renewal rates which I think goes to show that once our systems are installed at a school, they become mission-critical and I think generally immune to the overall swing to the market. But certainly in the quarter, we did see less sales because of the concern in the K through 12 space over budgets and budgeting. We both saw longer sales cycles as well as we believe institutions really holding off on making any purchasing decisions.

Trace Urdan – Signal Hill

Okay, thank you.

Operator

Your next question comes from the line of Kash Rangan with Merrill Lynch. Please proceed.

Kash Rangan – Merrill Lynch

Hi, thank you very much. One financial question, actually two of them financial questions, relatively quick. Number one, gross margins in products, what I would imagine to be high margin, has been trending down over the last year or so. I’m just curious to get your perspective on what’s driving that? Any investments you're making? I noticed roughly year-over-year gross margin in products is about down 400 basis points. I’m wondering what could potentially cause the trajectory to go the other way potentially next year. And also secondly, maybe I missed this in the first part of the call but were you able to recognize the revenues from the three K-12 ideas that you booked in the June quarter and you obviously recognized the commission expenses, but I’m wondering if you had an update on driving those three deals and how they’re coming along? Thanks.

Michael Chason

Okay. So the second question first, (inaudible). The three state wide deals, the two smaller deals in Florida and Mississippi, revenue recognition started on those. The larger deal, the New Mexico deal, we won’t expect revenue to start until very late in the fourth quarter on that and that's consistent with what we expected last quarter. As it relates to the margins, really the – what’s impacting the gross margins on product this year are the NTI acquisition. So, the Connect business both has lower gross margins because of the telco cost component of the sale. So gross margins are going to be in the low 60% on those sales or on that revenue stream. And then you've got to factor in the loss deferred revenue related to that transaction which is all product revenue which is another $2 million. So when you factor those in, that’s what’s having a negative impact year-over-year on the gross margins. We do expect gross margins going forward are going to be in the 70% to 75% range.

Operator

Your next question comes from the line of Brandon Dobell with William Blair. Please proceed.

Brandon Dobell – William Blair

Thanks, guys. Actually which of you guys are better for this question, but if you could characterize any differences between customer behavior in K-12 or in the public institutions serving in both secondary in terms of appetite for signing up as a new customer versus your discussions around cross-sell or up-sell, particularly maybe around hosting, is it different discussions or the same thing – as you seem cautious still no matter what stage of a prospective customer or existing customer you’re at?

Michael Chason

I’m not sure that we’ve actually seen a specific change from just – those are generally different discussions that we have and all of the clients or potential clients see value in our solution. But yes, it is a slightly different discussion whether we are talking about a new client coming on board versus a client that is looking at expanding the relationship. I’d say across the board that certainly we are cautious at this point and that’s contributing to a potential slower sales cycle. But I would say they are also messaging – for both new clients and existing clients are looking to expanding is how they can use our software in these more difficult times to continue to be able to be more effective and efficient in their teaching and make their instructors more effective, handle more students in their classes to greater outreach at cheaper cost. So our messaging has slightly changed for each of those potential sales opportunities but I would not say this is a big difference in talk track [ph] between them.

Brandon Dobell – William Blair

Okay. So is it fair to assume that your – as part of you’re kind of cautious commentary and cautious outlook in the near term, is that more driven by your expectation or what you’re seeing in the market from a new sales perspective or is it we expect the cross-sell opportunity to be impacted or is it a combination of both?

Michael Chason

I would – at this early stage, I don’t think we have any good amount of specific data, so I would say it’s generally applicable to both of those situations.

Brandon Dobell – William Blair

Okay. That’s fair. And one more kind of I guess numbers question here for Mike Beach. As you think about the sequential or year-over-year growth in the enterprise licensed account, you guys have talked about 10%, 11%, or 12% of the basic licenses up-selling as enterprise, I would imagine as that number gets smaller that low-hanging fruit opportunity probably dissipates to a certain extent. How do we reconcile the need for the business to continue to grow that enterprise license account with kind of a smaller pool of basic customers to pull from? I’m just trying to get a feel for how we should model the enterprise line going forward, irrespectable of what you guys are seeing on the macro side, it’s more about the mechanics of that up-sell opportunity.

Mike Beach

I think there is still is an opportunity in that base and it has been trending down for some time. Obviously, the percentages have been picking up a little bit over time too, so the absolute value of customers going from basic to enterprise is not dropping off significantly year-over–year. I think we’ve been generating significant growth off of the larger dollars sales to new customers, a trend this year which helps offset any small losses we could have in that area. And it’s still – we still have 800 basic customers, so the pool is still fairly significant.

Brandon Dobell – William Blair

Okay and then maybe a final one. With the tax rate bouncing around and gets strong cash flow, how do we think about cash taxes going forward compared to the provision on the income statement, just trying to get a better feel for a kind of true free cash flow conversion on a sustainable basis?

Mike Beach

Yes. So we’ll provide much more detailed information on our Q4 call related to that when we finalize the budget, finalize the year and know where our NOLs end up. I think the best way to think about it right now is that we’re going to pay $4 million to $5 million in cash taxes this year. I think next year that would probably double. We still will have some level of benefit from the NOLs. And on our next call, we’ll give you more of effective cash tax rate that we’re using to model the cash flow number for ‘09.

Brandon Dobell – William Blair

Okay, great. Thanks.

Operator

Your next question comes from the line of Kirk Materne with Bank of America. Please proceed.

Kirk Materne – Bank of America

Yes, thanks very much. Maybe Michael Chason, you can take this one, but when you guys started to see some slowdown, you all maybe in the cell phone industry have one of the better opportunities in terms of Greenfield, new sales in terms of you’re not really restricted by having a saturated customer base. You have a lot accounts you obviously haven’t talked to before in both Higher Ed and K-12. I guess, have you guys talked to your sales heads about trying to build out a broader pipeline knowing that the conversion rates are obviously going to be lower. I guess have you started down that path as you head into 2009 and I guess how long does it take to sort of start building up some more qualified leads to maybe either substitute in for ones that are getting either downsized or getting cut out altogether?

Michael Chason

Well, I want to be careful here because actually we’re not seeing that. Our existing clients are less likely to expand their relationships versus bringing new clients on board, because the clients that are currently our technology realize the benefit and know that if they were to expand their relationship with Blackboard, that would actually give them additional cost savings at the school through implementation and through again, as I’d mentioned, being able to get more students in the existing classes, have more distance learning courses online, have their teachers to be effective. So, because they already have that experience with some of our software, in some ways, they’re actually better positioned to know that if there are going to be budget constraints in the future, technology is a way to address those budget constraints.

Now, at the same time, certainly we want to make sure that we’re taking advantage of the Greenfield opportunity in front of us and our sales people are really focusing on both, but I wouldn't say that they’re focusing on the Greenfield opportunity over the other opportunity. They’re continuing to focus on both of those going-forward.

Kirk Materne – Bank of America

And I guess I understand your comments about the existing customers, but clearly in terms of every salesperson’s going to have some sort of net new customer metric they have to hit, have you been pretty specific with your sales organization in terms of broadening, testing a wider net given the macro economy right now and how long does that sort of start – how long does it take to have that start to have some impact in terms of your pipeline as you head into 2009?

Michael Chason

Again I think because of our model, we’ve had a little bit better visibility into this coming so we certainly have been working closely with our sales force both to better refine the messaging and in general, but primarily because of a longer sale cycle, to make sure that we’re casting a wider net both across new opportunities as well as expanding existing clients. And I do think we’re starting to see that reflected in our pipeline and the work our sales team is already doing it.

Kirk Materne – Bank of America

Alright. Thanks. And just last question for me, given the cash flows remained very steady despite the macro economy and your business model actually helps that along, can you just maybe, Michael Beach or Michael Chason, can you just talk about how you guys review your capital structure now in terms of whether some of that cash can either be put back through buybacks or you pay down some debt? I guess in this environment, it doesn’t make some sense to sort of review the capital structures you come up on the end of the year given the macro economy and maybe divest in, frankly, where your stocks are trading at this point as well.

Mike Beach

We’re not opposed to really any of those. We look at the smartest way to deploy our cash and obviously in this environment, having a strong balance sheet is something that’s important, and we will look at all the options over time, but pleased with the cash position we have today.

Kirk Materne – Bank of America

I’ll leave with that. Thanks.

Operator

Your next question comes from the line of Terry Tillman with Raymond James. Please proceed.

Terry Tillman – Raymond James

Good afternoon. Thanks for taking my questions. The first question just relates to the Blackboard Connect-ED product. If I look at the actual unit growth, it has come down. Maybe that’s unfair because we are law of larger numbers but I was hoping maybe you could me kind of reconcile that. And I was thinking in terms of Blackboard Connect-ED, I mean, are you seeing that being more resilient though even if state budgets are tighter? They’re finding money in other places because of the risk mitigation factors at.

Michael Chason

Yes, it’s actually – let me answer the second part of your question first. So here at EDUCAUSE, there’s a big industry study that comes out every year that talks about the key issues and trends across all of education put up by Casey Green, and he indicated that the study and his work is showing that the number one issue over the next year that higher education institutions are concerned about and facing and putting plans in place around is actually emergency notification and communication. So, I think that goes to show that even in these economic – even in these specific times with these economic challenges, it is still a top priority for institutions.

Now, I want to be careful though about looking at the overall unit number. After the combination of Blackboard and NTI, our sales team is focused on trying to do more strategic sales to leverage the existing relationships we have with the Blackboard higher ed clients into larger dollar deals. So we’re very pleased with the results that we have so far and where we are seeing both the contract value number overall for the company trending up and the number of new licenses over obviously what is a much larger total unit base count.

Terry Tillman – Raymond James

Okay. And then just a follow up related to Version 9 in the roadmap here and you have a beta program that’s out now. Could you remind us again is that – when that’s going to be released? And then secondly at a point that that’s released, could that actually maybe open up some pent up demand potentially an upselling in the WebCT installed base? Thanks.

Michael Chason

Sure, so right now, the Version 9 of our product which is the next step in our NG Solution is in beta. As soon as we complete the beta process and make sure that we’ve incorporated all of the necessary feedback and adjustments the product will then be released to our client base. Now remember, we’re on an annual subscription, so our clients all will eventually upgrade to that version of the product and that doesn’t give us a direct revenue uptick, but over time as we then go from having two code bases, which is right now the WebCT and Blackboard code base with single code base, we do believe it will be expense saving.

In addition, we do believe having our next generation solution out there in the marketplace will cause us to be both more competitive in new sales, generate additional interest as well as be a factor for clients to upgrade from Basic to Enterprise. So we do think it’ll be a revenue driver both in ’09 and 2010 once it’s been released to market.

Operator

Your next question comes from the line of Bennett Notman with Davenport. Please proceed.

Bennett Notman – Davenport

Good afternoon, guys. Thanks for taking my question. Could you just talk a little bit – it sounds like most of the caution you’ve seen so far has been domestically, can you talk about whether that’s beginning to spread internationally and then what impact, if any, the stronger dollar is having on you guys there?

Michael Chason

Well, really what we’ve been – the big area of impact for us has been in K-12 and primarily our K-12 marketed in and based out of the United States. So internationally, we’re primarily in the higher education market which while we certainly as we mentioned has seen a little bit of a slowdown in the sales cycle hasn’t had the same type of budget impact. So I’d say internationally, again, we remain cautiously optimistic about the higher ed business globally. As far as the dollar, Mike Beach?

Mike Beach

So, as you know, we sell predominantly in US dollar. I haven't seen a push back related to that. Obviously, customers have benefited from that over the last several years and we think the pricing of our product even with the change in the dollar is appropriate to the markets that we serve.

Bennett Notman – Davenport

Thank you.

Operator

At this time, there are no further questions. Ladies and gentlemen, this concludes the presentation. Thank you for your participation. You may now disconnect and have a great day.

Executive

Thanks Tolanda. Thanks everyone.

Operator

You're welcome.

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Source: Blackboard, Inc. Q3 2008 Earnings Call Transcript
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