Instructure Continues To Make The Grade

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About: Instructure (INST)
by: David Harper, CFA

Summary

Instructure continues to grow predictably. The stock's volatility has little relation to the company's pleasantly dull fundamentals, including tracking its 30% growth target.

The new CEO is focused on the corporate side of the business. If he is successful, investors will be rewarded.

Successful realization of the catalyst (quantifiable traction with Bridge) will cause investors to compare Instructure to an expanded peer set.

Instructure's (NYSE:INST) third quarter offered no surprises. The stock's disappointments and volatility during 2018 belie a solid, fundamental growth story that continues to be appealing in its decidedly dull development. But the same catalyst simmers below the surface, ready to thrill us in 2019! (Can you guess the catalyst? You'll need to keep reading...). INST is my largest holding and my high confidence has no reason to waver. I am not swinging for the fences here, this position is firstly informed by risk management and my desire to limit my downside. True, ironically, I am underwater; at the bottom of this article, I disclose the status of my equities portfolio, as usual. But let's not let a little bit of revenue deceleration (the apparent culprit) blind us to the opportunity that has yet to be captured in the financials. This stock has modest long-term downside risk due to: a sticky revenue stream, solid management, delighted customers, and a large TAM (two TAMs actually). Yet, the stock offers significant upside potential possibly as soon as 12-18 months. Revenue growth continues to track steadily at about 29.0% +/-2.0%; consistent with management's oft-stated long-term target of ~30.0% growth. Impressively, the cost of this revenue edged slightly downward as gross margins exceeded 70.0% (my numbers here are all GAAP, the non-GAAP margins are better):

INST income statement Q3 2018

In previous articles, I've argued that Blackboard, the market-leading publisher of learning management system (LMS) software to the U.S. higher education market, is in secular decline. This was not a clever argument so much as an ancient observation available to even casual observers of the LMS market. That is a story of the sad decline of a company that in truth was never great in the first place. (This is absolutely no reflection on the new CEO or new management team). Blackboard users are, on average, frustrated; Instructure's Canvas users are, on average, delighted. Canvas' net promoter score, NPS, is 69 which is at the upper end of "excellent" and almost in the highest "world class" designation. Instructure's employee ratings are similarly excellent (I happen to believe that glassdoor reviews are a valuable input).

According to Client Stat's recent 6th Annual LMS Data update, "If Instructure maintains its current pace, Instructure Canvas will also surpass Blackboard Learn by number of institutions in early-to-mid 2019." This chart plots the number of educational institutions (among those with more than 500 full-time equivalent students). As of Fall 2018, deployment of Instructure's Canvas has grown to 1,058 (green line below); which has almost reached Blackboard Learn's decline to 1,091 educational institutions:

LMS market share fall 2018

In short, we have every reason to expect Canvas to become the market leader in the US educational market as soon as next year. This is not to say that its sustained dominance is a foregone conclusion; the same article also notes that Blackboard has showed some recent signs of recovery. But when Canvas wins a university by displacing Blackboard, it becomes a very sticky stream of subscription revenue (net retention rates have always been above 100%, although I don't think they have ever disclosed the exact number).

As Gary Alexander already explained earlier in the week, Instructure's valuation is attractive. That assumes you are comfortable with growth-oriented metrics typical of high-growth, pre-profitable software as service (SaaS) companies. The key metric is: enterprise value to forward revenues. Instructure's clean balance sheet means that its EV/revenue multiples are near enough to its Price/Sales multiples:

  • Trailing Price/Sales of ~ 6.5x
  • Forward Price/Sales of < 4.0x (under conservative growth assumptions, source: stockrover.com)

Gary conservatively assumed massive revenue deceleration of 20% such that (emphasis his) "even under that cautious scenario, we would arrive at a revenue estimate of $250.8 million for FY19, putting Instructure's current valuation at just 3.5x EV/FY19 revenues." Comparable SaaS companies tend to earn forward EV/revenue multiples of at least 5.0. This is why the average analyst price target is reasonably at $48.63 (source: stockopedia.com as of 11/1/18) and mostly this is why I think the medium-term risk is modest.

Two items worth mentioning: new CEO and the catalyst

Dan Goldsmith, who joined the company only in June, was promoted to CEO. He succeeds Josh Coates who will transition to Executive Chairman. This was clearly part of the succession plan when Dan was hired, although I am not aware if analysts expected it to be announced this soon. Admittedly, executive turnover at Instructure has been a bit of a yellow flag. It was obvious to me, even on the July Investor Day call, that Josh wanted to "step up" to a Chairman role sooner rather than later. I happen to be a huge fan of Josh, he seems to personify Instructure's positive values. His ethical leadership qualities were a key reason for my initial investment and my belief that Instructure is a company that is "built to last" with good governance signals. Josh might be perfect for Instructure's educational market, and Dan might be what it needs for the corporate market. I'm a naive outsider by my summary view is that Josh brings the values and Dan brings the ambition.

It is objectively too early to evaluate Dan, but I'm expecting that investors are likely to appreciate his strategic sensibility and sales-orientation. He was a management consultant and his speech style reflects a strategic thinker. As myself a management consultant to Boards for eight years, the speech reminds me very much of the smart high-level-thinking strategy consultants I met along the way. But unlike many of those guys, it sure sounds like he has not been hiding out in the corner office. It sounds like he's been out on the road meeting employees, prospects and customers. Prior to Instructure, he was a management consultant and then spent eight years at Veeva Systems (he was one of their first ~ 30 employees). He was Veeva's Chief Strategy Officer and then ran their international business, overseeing its expansion. Based on the Q&A in the earnings call, Dan seems to be especially focused on Instructure's corporate "Bridge Suite" strategy. Instructure has effectively two products, although each is an emergent suite with add-ons. Canvas is the relatively established LMS for schools, and Bridge is the newer LMS for corporations. Bridge is only three years old. When Josh was asked about the recent Bridge wins, he seemed to credit Dan's idea to begin articulating a coherent Bridge Suite strategy:

I think where we really started getting traction [i.e., in Bridge wins], actually, is when Dan came in and said, hey, guys, from an outsiders perspective, let me come in and help really rewrite this script to make sense of this Bridge Suite approach. And we've seen pretty incredible uptake since then. And like I've mentioned before, the first half of next year, we'll be announcing a couple of more modules to make that Bridge Suite story even stronger. - Josh Coates on Q3 call

You have to follow Josh to understand that he doesn't oversell or exaggerate (this tendency created a problem on an earlier call when he was casual about guidance), he understates. So this remark caught my attention. That's interesting, that Dan (who actually has no EduTech experience aside from a Board seat) impacted Bridge so dramatically and quickly. And many, if not most, of Dan's comments on the earnings call were actually about the Bridge Suite (rather than Canvas). Judging by his words, all of which I've read carefully, that's where his head is. This is a good thing for investors.

This brings me to the catalyst: while we can somewhat presume predictable, non-sexy growth of the Canvas product in domestic and international school markets, the dramatic success of this company is likely to hinge on signs of prominent toehold(s) and meaningful penetration into vast corporate markets and verticals. Sticky growth into more universities, given Canvas' world-class reputation (and veritable fan base), is all but assured. In my estimation, progress on this front will merely get us to the said price targets in due time. But we might fall asleep along the way. Progress in these schools is piecemeal and gradual; as management consistently reminds us, educational markets are highly localized. Each country and market needs its own, different sort of attention. If Canvas were Instructure's only product, this company (even with the #1 product) was never going to achieve the 40% or 50% growth rates that investors expect of its early-stage SaaS peers. It's become clear to me that many investors do not understand this reality. The educational market is too heterogeneous, legacy-entrenched, long-winded and clunky. For the same reasons, Blackboard's decline is slow and prolonged.

However, the total addressable market (TAM) for Instructure's Bridge Suite is arguably bigger yet certainly more homogeneous with respect to international customers; i.e., easier to scale especially from a sales standpoint. But this corporate LMS market will also be fiercely competitive. We are at least two decades into a maturing awareness of the non-negotiable criticality of human capital to companies who rely on intellectual capital, where the LMS will be an inevitable component. In the future, every services company will subscribe to an LMS. My position size reflects my belief in this. To me, the most relevant (i.e., smartest) questions on the earnings call had nothing to do with gross margin points or even the revenue growth fluctuations, but instead were about (i) why did Bridge notch so many recent wins against Cornerstone, and (ii) when will the new Bridge add-ons be announced, the add-ons that give shape to the corporate product roadmap?

I'm encouraged the new CEO is attached to Bridge and has already influenced the Bridge Suite strategy. With respect to Bridge, what we did not get on this call (aside from significant albeit anecdotal Bridge wins; e.g., MassMutual, StubHub, Fiserv, SafeAuto Insurance) was quantitative evidence of Bridge's traction, aside from this:

Bridge is still on track to do what we've been talking about, 15% to 20% of new bookings for this year, and again, we'll have more to report on it next quarter. But so far, it looks like it's on track. - Steven Kaminsky, Instructure's CFO

It remains to be seen. My hope is that Instructure will soon (within the next three quarters) demonstrate and illustrate that Bridge has a real future in the corporate talent management space, where Cornerstone, Workday, and even Oracle are staking out territory. Most analysts have price targets of $45.00 to $50.00 on Instructure, which to me represents a reasonable medium-term floor based on extrapolation of revenue, earnings, and cash-flow in the current (predominantly educational) market. But if Instructure can (1) continue to announce more notable corporate (Bridge) wins/displacements while (2) unveiling exciting Bridge add-ons (and features) that truly manifest the Suite strategy, and (3) show investors that Bridge is its own growing business by breaking out some numbers, then these price targets will get raised and soon become distant floors. I'm sorry but under such a scenario, they will need to get raised: Instructure will begin to be compared additionally to a new and very attractive peer set. My thesis is that Instructure will eventually be included in new peer set. A peer set that, for this company, is apparently not currently on investors' radar. Don't get me wrong: if Instructure does not prove metrics on the corporate side (Bridge) at some point during 2019, I'll probably fall out of love. Canvas is a great product, but in terms of investor sentiment and the scant attention paid so far, it's going to be all about the Bridge!

My Tech Turtle portfolio

Since my last article, I added Zuora which had been on my watchlist and became attractive to me in the tech sell-off (I just can't resist the subscription theme). I'm getting hammered with the ugly stick on AMAT, which maybe is some kind of justice for buying into a sector that I seem to know nothing about (It's worse, I don't even know what I don't know when it comes to semiconductors). My contrarian bet in Lennar remains, well, contrarian (-17%). But I am getting ready to add a homebuilder position(s); as I slowly research the sector, it seems like we're getting into a perfect setup for a value investor. My portfolio is heavily technology, but I'm happy that my value-orientation seemed to hold up okay (so far) after the month that is now notoriously referred to as "October." Thank you for reading!

david-tech-turtle-portfolio

Disclosure: I am/we are long INST.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Per the final exhibit, I am long AAPL, AMAT, AYX, BAC, CHGG, CLDR, CVS, DISCK, DOC, FB, GOOGL, HDP, HPQ, INST, INVH, LEN, QTWO, SBUX, SFM, VWAGY, XROLF, and ZUO