Buying Growth In Education With Blackboard (BBBB)

Includes: BBBB, PSO, RELX
by: Travis Johnson

I think one of the most interesting things about investing is finding trends by keeping up on the news in a variety of areas, then thinking of ways to use those trends to make money in the market. One article about higher education in the Washington Post on Friday -- Colleges, Awash in Applications, Turning Away Even Top Students -- brought the swelling ranks of college undergraduates to mind. As someone who works in academia, this is something I think about a fair amount from time to time.

Nearly everyone has ideas about how to invest to benefit from demographic trends, but the one that gets most attention is the graying population as the baby boomers reach retirement (think health care, recreational vehicles, sunbelt real estate, etc.). While I have many investments that hope to take advantage of that, I think a more interesting trend to address at the moment might be the explosive growth in higher education.

This growth is taking place in a few different ways -- the trend we hear a lot about is the boom in distance education, for-profit universities and adult education with people going back to school to give themselves an edge in the workplace. That's certainly a viable trend, and Corinthian Colleges, Apollo Group, Strayer, and many others have been very lucrative investments for many folks.

But traditional schools are also booming and seeing more and more students than ever before. These schools are becoming more selective as they see larger and larger incoming classes, as the Post article above covers in some detail.

Companies that might be effective investments to exploit this trend are the academic publishers and academic services companies. Among publishers, I've looked before at Reed Elsevier (RUK), which I think is probably a solid investment but it's a company that I don't personally like very much for non-investing reasons (I work at a university, and Elsevier is like a leech on our budget). Another British publisher that pays a better dividend and is more leveraged to textbooks both in primary and secondary education is Pearson (NYSE:PSO). Pearson is just now recovering from some down years, has a very reasonable PE, and pays a nice 3.5% yield, definitely something I'll take a look at.

Among service companies, by far the most impressive one in my mind is Blackboard Inc. (BBBB), which I've mentioned before. BBBB is an interesting story -- they produce enterprise software which helps colleges handle the computing demands of managing the accounts and registration details for their burgeoning ranks of students and staff, but the more well-known software they serve is for course management. I've used this both as a teacher and student, and with the increasing size of college classes and the increasing numbers of classes that are taught online or as hybrid online and in-person experiences, demand for this kind of management software is climbing fairly dramatically.

The stock has been an irregular performer of late, and I think this might be a good opportunity to open a position while their earnings are entering a period that the company expects to be fairly poor. BBBB will be digesting their acquisition of WebCT, which was its best competitor, and that's going to significantly impact their reported earnings in 2006, to the extent that the company expects to report a loss for the year.

But the trend is definitely in their favor once this acquisition is fully incorporated -- they will have the lion's share of the market for course management software, and certainly the strongest selling position of any of their competitors (colleges like to go with strong suppliers that lots of other colleges are using, and they don't like change so renewal rates are around 90%).

There is certainly competition from some other providers, some people fear Microsoft will make a big push in this area, and open source options are available -- but the entrenched leader, which Blackboard is at this point, has a great advantage in this market, even if they're fairly small in the grand scheme of things.

No one wants to be the one who has to tell 4,000 cranky faculty members that they have to learn an entirely new piece of software in order to teach next semester, and as colleges face massive IT challenges not only in hardware replacement and overall migration to Vista but also in handling their thousands of students who are swamping networks by downloading movies and feeding their MySpace and Facebook addictions, the last thing they want is an open source solution that requires significant contributions from IT people who they have a hard time hiring anyway. An out of the box solution like those offered by Blackboard is ideal for this environment.

Beyond the business they're in and the catbird seat they occupy as they watch the renewal money come in, I really like that the company is small (well under $1 billion), the founders are still running the show and are very aggressively trying to build the business, and management still own a large portion of the company (which often is a good sign that their interests are in line with ours). It has been a pretty volatile company in its almost two years of life on the public markets, but the price seems to have stabilized a bit now that their low guidance for this year has been digested, and folks are starting to think about how strong a future Blackboard will be once WebCT is fully on board and they have a stable platform from which to continue growing and adding services and products.

There are certainly other companies that might profit from the expanding ranks of college students -- American Campus Communities [ACC] is a student housing REIT that owns a lot of housing on and near college campuses that can absorb those bodies, but as a REIT it doesn't really stand out from the pack with an average performance and an average 5.5% yield. And I can't think of anything more nervewracking than being a landlord for college students, so I'm not sure I'd want to take on the potential liability headache of this sector for such a small yield.

So today, it's Pearson and Blackboard that are looking like my most likely purchases in the education realm. I'll let you know if I decide to actually make a purchase in either (or something else).

Well, while reading up on Blackboard, Inc. (Nasdaq: BBBB) this afternoon I put in what I thought was a fairly low limit order for a small entry position ... and as a result, I'm now the proud owner of a few shares of BBBB. I picked up my shares today at $28.26, a hair under my $28.30 limit order.

I think Blackboard's dominant position in academic enterprise software and course management software has them well positioned for several years of excellent growth ... once they have gotten over the speedbump of their WebCT acquisition, the costs of which should be pretty well absorbed by next fiscal year.

That's what I like about Blackboard's business model ... they want to be, in their words, "the operating system for education", a boom market, and they're headed in that direction. What about the numbers?

BBBB is going to have very low or nonexistent earnings this year, depending on whether or not you account for the costs of their WebCT transaction ... so we're not buying them for current earnings, and they don't pay a dividend.

What we're buying is growth. They see 31,000 or so institutions as being their addressable market, including the major categories of U.S. higher education, International educational institutions, and U.S. K-12 schools. They believe that this sector spends $28 Billion a year on IT, so if they can get a growing chunk of that business they'll certainly become a much larger company in the years to come (their market cap today is about $780 million and they had sales of $135 million last year).

They currently have 3,600 clients, many of whom are small customers that are prime candidates for upselling to enterprise-level services, including the 1,400 oof those who were WebCT clients that now have a much richer product menu to choose from. Blackboard says that WebCT's average client contract was worth, $24,000, while the average Blackgoard contract is $45,000 -- that gives them some great room for internal sales growth. And their customers renew at close to a 90% rate, which means excellent potential for ongoing revenue growth.

The acquisition is what's holding Blackboard back right now because of the unexpectedly large accounting costs associated with it -- costs that will keep the acquisition from being accretive for a couple years, and that were the reason for BBBB's recent swoon on their downgraded forecasts (though the combined company will be cash earnings accretive next year). I do like that they used cash and debt for the acquisition and didn't dramatically dilute the existing shareholders -- that's one argument for large management ownership.

BBBB disappointed folks with their downgraded guidance earlier this winter, but in the long run they see themselves growing quite dramatically. From sales of $135 million in 2005 they're expecting to hit about $170 in 2006 and $220+ in 2007 ... that is close to 40% growth in sales by my reading (that doesn't account for some costs), so this is a very nice underpinning to what should eventually become a capacity for dramatic increases in earnings.

This is, after all, a software company -- once the acquisitions costs are digested, earnings should be able to grow substantially as margins build along with sales. They're projected fiscal year GAAP income of .31-38 per share in FY 2007, which would give them still a relatively high forward PE of 75+ ... but they're projecting cash earnings per share, which takes out the accounting costs, of over $1 in 2007, which tells me that's when they think they're really going to be hitting their stride.

I'm glad to be in with a small portion now, but I also think that BBBB could fall significantly from here -- perhaps as much as 20-40%, though I don't guess it will be that severe. If it does and their long term prospects still seem solid, that's when I'd like to fill out my position.

Why might it fall? Well, this is impossible to predict -- but they're going to continue reporting losses for several quarters to come unless they've been seriously sandbagging their projections, and that's quite likely to impact the shares negatively even if we're all expecting losses.

And this is a relatively young company and a small one, acquiring a company that is not that much smaller than themselves. It's certainly possible that they're underestimating the costs they'll incur in the transition or the problems they might have with their 1,400 new customers.

But I look at their projections, which I think are lower than the market might make possible given the boom in education and the dramatic need for the services BBBB offers, and I see a lot to like.

They project growth from FY 2006 to 2007 as follows:

Revenue: 18%
Expenses: 14%
EBIT: 27%
Pro-forma net income: 51%
Pro forma cash net income including taxes: 44%

That's excellent growth, and it shows that they think they'll be able to take good sales growth and transform it into great bottom line growth (assuming you ignore the men behind the curtain, debt payment on their loan for the acquisition, and stock-based compensation -- since this reflects what I think the long term operational performance of the company can be, I'm OK with the pro forma nonsense).

They are diluting shares, but not massively -- they paid for the acquisition with cash and debt, so it looks like we're going to see average share count go up by perhaps 4-5% a year ... not ideal, and I'd like to see that number come down, but not outrageous for a software company.

So, I wouldn't be surprised if I'm buying a little too early here, but I think 2007 and beyond will be extremely strong years for Blackboard -- I'll hold my entry position and hope for some significant declines to present themselves as more lucrative buying opportunities.

BBBB 1-yr Chart

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