Instructure Is Poised To Leverage Its Leadership Position (NYSE:INST)

Investment Thesis

We ascribe a Buy rating on Instructure driven by 1) massive and underpenetrated TAM with growing focus and adoption on digital technologies 2) its leadership position within the US 3) expansion within international markets (K-12 market in rest of the world is worth $2.5 trillion and assuming even 1% tech penetration implies a massive $25 bn opportunity) 4) focused investments in AI capabilities to drive next leg of growth 5) customer stickiness and its ability to cross-sell driving improving utilization and aiding operating margins (43% of existing users use more than 1 Instructure products with average revenue per customer growing from $47k in 2018 to $64k in 2022). We believe the company is poised to leverage its leadership capabilities across the US and globally to drive technology adoption within the education sector which remains underpenetrated. Its relatively comfortable and improving balance sheet position and strong cash generating ability with robust operating margins enables them to drive continued investments and deleverage its balance sheet.

Company Background

Instructure Holdings (NYSE:INST) is the leader in both higher education and K-12 market within the US with a market share of 40% and 33% respectively. It has over 7,400 customers representing Higher Education institutions and schools in more than 100 countries globally. The company has transformed itself significantly since the acquisition by Thomas Bravo in 2020, selling its underperforming corporate LMS business and centralized its operations. Since then the company got re-listed on the bourses at a market value of $2.77 bn (~40% higher than the take private deal)

Historical Track Record

The company had reported strong growth in its revenue especially since COVID which has led to a stronger adoption of its LMS learning system as the schools and institutions looked for ways to find solutions to the unexpected shutdowns. Revenues grew at a record 22% CAGR during the 2018-2022 period leveraging its strong brand leadership within the overall LMS market. Its gross margins declined slightly as a result of the pressure within its corporate LMS business which it soon exited. However, its non-GAAP operating income margins went about 20% since the acquisition as a result of centralization of its operational costs, closing and consolidating its development facilities, restructure of sales and marketing teams by eliminating sales coverage in non-core international markets. Instructure’s 43% of existing customers and 60% of new deals included customers which deployed more than one product solution from the company.

Note: Gross profit are on GAAP basis. 2021 customer numbers are estimated.

Market Overview

Education market is about a $6.0 trillion industry having declined slightly compared to the pre-pandemic levels but is set to grow to $7.3 trillion by 2025. This is still in line with the GDP growth compared to pre-pandemic levels (6.7% of global GDP in 2019 vs 6.6% of global GDP in 2025)

Global Education Market (in trillions)

K-12 forms the bulk of the $6 trillion education market globally with higher education contributing about 30%. This provides a significant opportunity to the massive TAM that the company targets.

In addition, technology penetration has still remained significantly lower which has improved from 3% in 2019 to 5% in 2022 and is further expected to be around 5.5% by 2025 which presents a massive opportunity to drive growth.

The Industry also has favorable tailwinds with about $90 bn of ESSER funds still left to spend by next year. While the bulk of funding could go to upgradation of infrastructure facilities as well as teachers’ salaries, we believe a portion of the budget is likely to find its way within technology spending as well.

Competitive landscape includes several open source solutions such as Google Classroom and Moodle which do not provide the robust capabilities that K-12 schools and institutions pursue. Other competitors include Edmentum, Imagine Learning (both are private in nature with limited disclosure) and PowerSchool Holdings (PWSC).

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Instructure has better growth profile and average revenue per customer with industry leading margins on the back of its strong brand positioning, capabilities and pricing power. PowerSchool’s revenue growth was also primarily derived from inorganic acquisitions as highlighted in my coverage on the company and if we only compare INST and PWSC on organic growth basis, INST would rank significantly higher compared to low double digit organic growth of PowerSchool.

Focus on AI Play

Instructure in its latest InstructureCon announced a host of product features packed with AI that we believe could enable INST emerge as a compelling AI play with a better understanding of emerging education use cases. It announced product innovations across key strategic areas including

1) AI-assisted course templating that enables educators to create page layouts quickly

2) Conversational AI injected into Analytics that enables educators to directly ask questions of their data and drive actionable insights for the students

3) Learner passport to give students verifiable evidence of competencies and streamlined turnkey versions of Canvas LMS, Credentials, and Catalog

In addition, it announced a partnership with Khan Academy to develop an AI powered tutoring and teaching assistant tool, Khanmigo. This would focus on not just answering student queries but to enhance the teaching experience for the educators as well as deepening the engagement for students. The company’s focus on new capabilities to improve teachers’ efficiency as well as drive better personalization and understanding of the concepts for the students could well be a big opportunity.

Current Trading and Earnings Preview

The company reported a strong growth during H1 with revenues growing over 14% YoY driven by record renewals in Q2 from customers that were onboarded during COVID underpinning the brand’s strength and customer stickiness. In addition, cross-selling of its products particularly Assessments, also helped improving utilization and drive incremental revenue growth. Remaining Performance Obligations (RPO) jumped 9% YoY and 5% sequentially to a record $850mn+ providing further visibility on the future revenues. Gross margins in Q2 jumped up to 65.4%, partly helped by a pull forward of ~$300k worth service revenue from Q2 and an unexpected credit from a hosting provider which is expected to normalize going forward. Despite that, non-GAAP operating margins stood at record 38% driven by moderating sales and marketing spends and operating leverage with higher utilization and revenue growth outpacing the spends.

Management expects Q3 revenues to be $132.5 mn which was primarily in line with consensus, up 9% YoY. In addition, non-GAAP operating margin is expected to improve to 39%, up 70 bps sequentially. For the full year, the company expects revenues to be ~$526 mn and non-GAAP operating margins of 38.1% at mid-point, implying fourth quarter revenues of $133.6 mn, a muted sequential acceleration but up 7% YoY. This also represents a slight sequential deceleration in its operating margins at 38.5% but still above the overall curve. We believe the company is likely to meet its guidance primarily as a result of strong visibility as a result of higher RPO, improving utilization along with improving traction within the international markets. The company also announced a CFO change with Peter Walker named CFO effective November 13,2023 while the existing CFO Dale Bowen will be available for the transition till March 2024.

Valuation

We value INST using a DCF approach with a 10 year horizon period and assume a cost of debt of 6% as per the company’s existing cost of debt and a 12% cost of equity. Considering the current debt/ equity ratio, we assume a WACC of 11% and perpetuity growth rate of 4% given the strong growth prospects. We assume average revenue per customer to grow steadily at a ~5% CAGR during the coming decade and total customers to continue growing at high single digit growth in line with the historicals.

Considering non-GAAP gross margins improve to low 80%, we believe the improved utilization and normalizing marketing spends would drive operating margins above the 40% mark during the forecast period. We assume capex spends as % of revenue to be in line with the historicals and assume no change in working capital adjustments and expect company to continue generate healthy free cash flows (FCF margin to be stable around 35%). We value the company with an implied share price of $29 and ascribe a Buy rating. On a PE basis, this implies the company is trading at 25x 2024 EPS and 1.6x on a PEG basis. INST still appears attractive comparing with other vertical SaaS peers who are trading at higher multiples.

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Source: Seeking Alpha, Author

Risks to Rating

Risks to rating include:

1) Return to in-person schooling can drive investments away from technology spends

2) Declining enrollment trends within the overall higher education market due to affordability challenges, macroeconomic scenario or competition from alternative education market

3) Consolidation within the industry could pose competitive challenges

4) Company is majority owned (85%) by Thomas Bravo, a PE firm, which can look to sell down a substantial stake at any time and affect shareholder policy changes which can pose an overhang for the stock

Final Thoughts

We believe Instructure is perfectly poised to grow within a growing education market amidst rising technology spends leveraging its significant brand leadership. In addition, the company’s focus on deepening its next generation AI capabilities could be a significant growth driver amidst a rapidly shifting technological landscape. We initiate at a Buy given the brand leadership, customer stickiness, cross selling capabilities, expansion within international markets and its strong cash generation ability.