Author: Rody Boyd
From Seeking Alpha – Read/Decide/Invest
Roddy Boyd is an investigative reporter who has worked for Fortune Magazine, the New York Post, The New York Sun and Institutional Investor News. He now writes for http:/www.thefinancialinvestigator.com, an original financial investigative reporting web site he founded. He is currently completing his first book, “Fatal Risk,” on the collapse of AIG. The Financial Investigator (Roddy Boyd) does this for free. I am not paid or compensated. I do not buy or sell-short any securities mentioned or written about in this or any other story. I have no portfolio of investments or capital market exposure. There is no recommendation to buy or sell made here.
It looks to be easy street time for software developer Blackboard Inc. (BBBB) with the recent announcement of private-equity firm Providence Equity Partners’ offer to buy them for just under $1.65 billion.
Telegraphed since April, the deal appears to make sense.
Over the past decade Washington, D.C.-based Blackboard has made a name for itself with its nearly ubiquitous learning management system software. It sounds like a mouthful, but what LMS does is straightforward, enabling the student to communicate with a professor, log on to a private discussion board, download materials or to get their grades.
Just under 15 years old, this educational software niche has been a successful one for Blackboard. It’s not a terribly complex business model: They earn annual license fees from the software based on the number of students enrolled in a given “band” (i.e. between 4000-6000 enrollees), by charging fees if customers choose to have them host the software and in selling ancillary software to expand their core LMS product.
It all worked well enough so that the company’s chief executive, an energetic promoter named Michael Chasen, will have a $30 million nest egg when the deal closes in the fourth quarter.
But Chasen and Blackboard’s investors would do well not to count the money just yet.
When Blackboard’s business is carefully pulled apart, a very different picture emerges from what management has shown the world. In reality, it is two companies: The company that Providence thinks it is buying has grown rapidly and moved aggressively to expand its product offerings. Widely held, it is a market leading software company whose brand is well-known.
Then there is the real Blackboard, the very opposite of what a leading software company traditionally is. Michael Chasen doesn’t talk about this company on conference calls and its cadre of enthusiastic (.pdf) analysts never got around to going behind the numbers, where a declining competitive position, baffling acquisition binge and weakening financial state all merited research. Revealed in obscure footnotes and buried documents, Blackboard would just as soon it stay buried.
Consider, for example, Blackboard’s expanding footprint in the defense sector.
Though hardly a name brand defense contractor, since 2007, according to General Services Administration records obtained by The Financial Investigator, Blackboard has been awarded at least 16 contracts to provide its core LMS product, Learn, to the military’s archipelago of accredited undergraduate and postgrad universities as well as specialty instruction centers.
The arrangement works well. The Pentagon gets a manageable software program that helps instructors in subjects like military logistics and infantry tactics get a handle on the coursework flow of thousands of occasionally far-flung active duty military personnel.
Blackboard, on the other hand, has a neat little honeypot that has, in many ways, saved the company.
Consider this (.pdf) GSA contract, governing Blackboard’s pricing and licensing terms from 2007-2012, where the cost of Learn software licenses (for between one and 2000 users) is quoted at $52,833.30 on page 119. In contrast, this 2008 pricing list for the State University of New York quotes the same software at $33,500. Though Blackboard’s rate card does have an outline for providing discounts to its ProEd customers–see page 20 (.pdf) –it is not clear in analyzing these contracts that they were ever extended. In contrast, the often substantial discounts given to Higher Ed customers are clearly described in their contracts, such as this one (.pdf) for the Cal State University system. [For examples of actual ProEd unit contracts, click here, here (.pdf) and here (.pdf).]
Compare the list above to this list of colleges, all of whom use Blackboard’s Learn, on a cost per user basis. [Note: In the LMS business, a general rule of thumb holds that Higher Ed customers usually won’t pay more than $25 per user for software and related services.] Outside of the University of Oklahoma Health Sciences System, which Blackboard classified as a ProEd customer, these schools are generally paying less than $25 per user. With a few exceptions, the military schools are paying well north of $25. The divergence between the Higher Ed and ProEd contracts becomes even more apparent when the software price per user numbers from companies Blackboard has purchased–WebCT and Angel Learning–are factored in. [These older software packages are not Blackboard Learn.]
Another factor increasing costs for the military schools is the frequency with which they purchase the full suite of options Blackboard offers. For example, traditional colleges frequently choose not to buy additional data storage whereas military ones often do. This is a handsome boost for Blackboard since it charges $37,000 per year for one terabyte of storage; Amazon’s S3 service costs about $1,800. [Blackboard is far from the only LMS provider to do this however: Hosting providers for competitors Moodle and Desire2Learn charge at least $21,000 per year per terabyte of storage.]
Nor can Blackboard claim this is standard operating procedure in the LMS industry as Desire2Learn, a Kitchener, Ontario-based competitor, has long used a single pricing list for its customers.
The effect of these contracts on Blackboard’s bottom line is not entirely clear. The company doesn’t break out the performance of its ProEd unit–whose client base is various Federal departments and corporations–but it is virtually assured to be Blackboard’s most profitable.
Which is not exactly how the rules governing doing business with the federal government are set up. According to the letter of the law, if not its spirit, companies selling to the government are supposed to the abide by the “Most Favored Nation” principle in which the sale of goods or services is at a discount from list price “Equal to or greater than the discount given to the firm’s most favored customer.”
It’s difficult to see where Blackboard honored this idea.
FI.com asked Blackboard’s Michael Stanton about the pricing discrepancies. In an e-mail reply to a list of questions, he said,
Blackboard is fully compliant with all GSA requirements as confirmed by a recent comprehensive GSA audit. As is the case with most software and services companies, our pricing differs among clients based on a variety of factors including the version of the software licenses, the terms of the licenses, the quantity of software users, and various other customizable options.
Jonathan Doorley, an outside spokesman for Providence Equity Partners, declined to comment.
The outsized profits from the ProEd unit serve to cover up one of the central realities of Blackboard’s world: Its core business is declining. Its Learn product, according to the most recent 10-Q, was down at least 3% last quarter–and, once earlier, non-Learn versions of Blackboard LMS are considered, the drop could conceivably be as high as 7%–even with many contracts bearing annual 5% price hikes.
Dropping Blackboard, it would appear, is quickly taking root as the new campus tech fad.
The University System of Georgia, the Brigham Young University System, the Utah Education Network, the Pennsylvania State System of Higher Education and the University of North Carolina System have announced plans to quit Blackboard. What’s scary for Providence is that given the multiyear lag between the announcement of a new LMS vendor and the expiration of Blackboard’s contract, their absence won’t be seen until fiscal 2012 and 2013. Moreover, this is just a partial list. The previous four years saw UCLA, University of Hawaii, the Colorado Community College system, Bridgepoint University, Auburn University and Louisiana State University all depart.
The reasons for this exodus are naturally varied–and include pricing–but for the most part, however, they boil down to dissatisfaction with a nearly decade old software framework seen as, well, obsolete.
The Utah Education Network is a case in point. It left Blackboard, the market leader, for Instructure, a year old Utah-based developer with an open source product called Canvas. Consider the way messages are sent and received on Instructure’s Canvas: The receiver has a choice between traditional university E-mail, gmail, Facebook and text messaging; Blackboard’s system uses traditional E-mail and was designed before Facebook was created. For a student body that uses social media the way earlier generations used pencil and paper, the differences between the two competitors are profound.
Despite actively marketing Blackboard 9.1, many university technology administrators view Blackboard as having skimped on research and development to focus on growth via acquiring LMS competitors like WebCT and Angel at the expense of expanding and refining their products. (There is also a mounting body of snafus that has given momentum to an anti-Blackboard movement on the Internet and among university technology staffers.)
Even Blackboard’s much-touted mobile capabilities are in danger. A legal battle (.pdf) with Sprint (S) over Blackboard’s purported distribution of a WiFi version of Mobile Learn–something that would likely cut into Sprint’s potential revenues–threatens to derail its ability to offer a compelling mobile product as well as cutting into revenue growth at a time when all software applications are being sold to run on “Smartphones” and the like. Estimates of the annual revenue from its joint venture with Sprint run as high as $15 million.
Regardless, the loss of these customers is more than a business cycle issue. Peddling educational software isn’t like selling beer to a bar-owner; no minds are going to change next month. These revenues are gone for at least five years, if not forever. Also gone is the crucial, high-margin revenues from selling ancillary products like mobile and data storage that has become increasingly central to its business. Because of the multiyear nature of these contracts, the full effect likely won’t be seen in the financials until 2012 and especially 2013.
If Blackboard’s business fundamentals are seemingly slowing down, its financials are becoming downright ugly. For a company in the software business, where large profit margins and rivers of cash flow are the norm for market-leaders, Blackboard’s 7.6% operating margin last year–it was 5% in 2009–seems more suited to an auto parts supplier. Even media conglomerate Pearson PLC’s North American Education unit–whose educational software rival Pearson LearningStudio (formerly eCollege) competes with Blackboard for online college business–managed a 17.7% operating margin last year.
The conclusions are stark: Blackboard does not have a product that the marketplace is willing to pay up for and that if the ProEd unit’s customers either get wise to what they are paying or, like so many colleges, decide to hoof it, Blackboard is in dire straits.
How “un-software company like” are Blackboard’s financials? To whit: Days sales outstanding spiked to 115 from 73 year-over-year and the company posted negative free cash flow of $20.3 million for the first six months of the year. The poor free cash flow and the principal and interest due on a $160 million convertible bond issue led to a near-disastrous quick ratio–a barometer of short-term corporate liquidity–of 0.5x, down from 1.2x. In other words, without a looming buyout, there would be some very, very pointed questions directed at management because of their troubling working capital efficiency.
As it is, Blackboard’s financial reality is so wan because the company has spent five years and more than $350 million buying companies that provided them with analyst- and shareholder-pleasing revenue growth–often in ancillary business lines–but little else. Case in point: The July 2010 purchases of educational software providers Elluminate and Wimba for $116 million in cash. Both companies were in the red, and sinking deeper at the time of the deal. While at least $25 million in revenue was added to the top line, keeping the growth bulls sated, Elluminate and Wimba likely need a few years, if not more–Elluminate, for one, was down to $211,000 in cash (from $7.8 million the prior year) and its annual revenues had dropped 11%–to restore both growth and profitability. The company hasn’t even bothered to disclose the cost to acquire Presidium and iStrategy, a call-center operator and data/analytics shop, respectively. The Presidium acquisition is especially baffling in that call centers traditionally have margins lower than Blackboard’s already anemic levels.
The spate of purchases has made Blackboard the software equivalent of the Island of Misfit Toys, a company whose spectrum of deals did little to add to corporate long-term value, are hard to turnaround or rationalize and are brutal on the company’s return on capital. Perhaps the best that can be said of them is that like the Island’s toys, most of these deals seemed like a good idea at the time.
There is a frenetic quality to the purchases, as if Blackboard would get around to “the details” later. An example of this is the May 2009 pickup of Angel Learning Systems for $95 million.
Paying more than four times Angel’s $21 million in revenue, the company had three large university customers–Michigan State, Penn State and SUNY–and also specialized in the smaller school market. Things might have stayed all right had Angel not struck a deal with its then largest customer, publishing giant Houghton Mifflin, to develop the software for an LMS system Houghton called Think Central 2. It was, in the purest sense of the word, a disaster. The lawsuit (.pdf) stemming from the deal is eye-opening, claiming that despite numerous attempts, Angel was unable to create a workable product. This summary judgement (.pdf) lays out a breathtaking chronology of failures, suggesting Angel’s software development abilities were highly limited, if nonexistent.
Making things worse, several other customers have declined to re-sign with Angel, including many of the SUNY colleges.
Blackboard’s Stanton declined to discuss the specifics of the case but said that Angel’s renewal rate is “A couple points higher” than the corporate renewal rate of 90%-92% of customers.
Blackboard CEO Michael Chasen pulled off a fantastic trade: He sold a company that was in the early stages of becoming a victim of marketplace dynamics to a private-equity shop that appears not to have done its homework. Eventually, however, the truth will out.
Their key customer, the Pentagon, is going to figure out that in a time when it is fighting multi-front wars and might be facing steeper budget cuts, it bought software colleges are increasingly taking a pass on at prices higher than anyone else.
The recourse stands to be a bitch.
The Pentagon will either pay much less when they renew those contracts or they will go with another LMS provider and take Blackboard’s last profit margin with them.
Where Providence falls along this line, well, that’s a very different story. They caught the falling knife and paid a premium for the right to do so. It’s not clear whether they continue to ignore the facts and pretend Blackboard has a product base primed to explode and is throwing off the river of cash private-equity shops dream about or if they acknowledge their mistake and demand a lower price.
Either way, Michael Chasen deserves credit for having kept the show going for so long. His future in American business is secure: There will always be a place in the world for a man who can sell people what they don’t need at a price they can’t afford.
Disclosure: I do not have any sort of investments in the securities of any company I write about, nor for that matter, in anything at all (save for my house).