Investment Bankers and Blackboard’s Future, Part One: If …

This is a guest post by Jim Farmer, Chairman of Sigma Group Inc.

On Friday July 1,st after this was written, Blackboard Inc. was acquired by “affiliates of Providence Equity Partners” for $1.64 billion. They will also assume approximately $130 million in net debt. Providence will pay $45 per share; it closed Thursday at $43.38.

The Washington Business Journal reported:

The transaction is anticipated to close during the fourth quarter of 2011. Upon closing Blackboard will become a privately held company, remain headquartered in Washington and continue to be led by its existing senior management team.

This suggests a more complex deal than the publicly available information suggests.

Blackboard’s April 19, 2011 press release reads; “Blackboard (NASDAQ: BBBB) today announced that it has retained Barclay’s Capital as its financial advisor in response to receiving unsolicited, non-binding proposals to acquire the company.” On Thursday, June 23, The Chronicle of Higher Education, citing the Wall Street Journal, reported: “Providence Equity could announce a deal to buy Blackboard, Inc. as early as next week [the week of June 27 – July 1].”

If this acquisition is completed,1 the question then turns to the impact it will have on higher education.

From the Wall Street perspective Blackboard is a very successful and well managed company. The founders’ goal at Cornell University was to save faculty time by automating typical faculty communications with students, and making the administrative tasks of a lecture more convenient for students. Since then, through software development and recent acquisitions, Blackboard has a suite of complementary learning applications. Blackboard’s learning management products have become a successful source of revenue. Some acquisitions products, such as Blackboard Connect, seem to be leading in their market segment.

However, the expectation of private equity firms for earnings exceeds Blackboard’s 2010 earnings. A combination of higher prices for annual software licenses and reduction of staff and lower services will, in the short run, be needed to achieve this higher profitability.

Differing Views of Blackboard’s Future

On June 29th Blackboard’s stock price was $43.64. Two analysts projected stock prices of $65 and $55 per share this year. Likely influenced by the potential of education technology.

Some market signals suggest Blackboard may not meet the expectations of the private equity investors. Analysts are now projecting Blackboard stock prices of $30 to $55 with an average of $49.13. Three months ago 9 analysts recommend buy or strong buy; this month only 4 make this recommendation. The short position for Blackboard is 29.6% increasing 3% in the past month. Research by Michael S. Drake, Ohio State University, and Lyn Rees and Edward P. Swanson, Texas A&M University shows: “Short interest, therefore, appears to capture predictive information that can be used by investors in trading against analysts’ recommendations to increase returns.” If this is true, Blackboard stock is more likely to go down than up. This makes investment by a private equity firm more risky.

Inside Higher Education’s Joshua Kim is much more optimistic. He writes: “Some large information conglomerate will purchase Blackboard from whatever investment firm bought it in 2011, paying a premium to gain expertise, market share, and intellectual property in the fast growing (and long-term expanding) global market for educationally related services”.

Objective of Private Equity Funding

Providence Equity is an investment banker; the firm’s goal is profit. To maintain Blackboard’s stock price at Oracle price-earnings ratio of 20—equivalent to an annual 5% return on investment (ROI)—earnings would need to increase from 2010’s $16.6 million to $74.9 million. That is, net revenue increases and cost reductions—typically reduction of staff—of at least $58.3 million are needed to be comparable with other public software companies. A reduction of 290 positions would achieve only half of the needed increase in net income. This would be 16% of the Blackboard work force. The average annual ROI of private equity firms for buyouts is 19.6%, though they may accept a less aggressive figure for one or two years. Assuming a market capitalization of US$ 1.5 billion, earnings would need to be $292 million. This is $271 million more than current projections for 2011. To meet their expectations software prices would increase 52.3%.

There is a possibility of selling off some of Blackboard’s acquisitions at a profit. These sales would reduce the cost to investors, though the resulting company would be different. Information on the performance of these acquisitions separately is not publicly available.

If Blackboard were acquired by a company for its strategic importance the company could be worth more than an investment purely for profit. There was some speculation that Datatel Inc. would attempt to acquire Blackboard to have a combination of administrative and academic systems. Investors could acquire Blackboard for its “talent” rather than products—a Facebook strategy. The costs of this strategy are reported to be more than $1 million per employee.

Raising License Prices and Cutting Costs to Create Capital

Because the cost of increased licenses does not significantly increase overall costs to the company, increased license revenue becomes net income. Blackboard claims its annual price increases have averaged 3%. In May 2002, according to one CIO, Blackboard increased its prices by about 20%. The price increases for newly acquired WebCT were reported of 358% for one state system. These are, of course, only two reports, and are likely more extreme examples. Because of the high cost of changing application software – the cost of converting content and retraining faculty – prices in existing installation can be raised without immediately losing customers.

In 2008 Oracle increased software support prices 15 to 20% and 47% for the recently acquired BEA Web Logic software.

Educause reports 96% of colleges and universities have a course management system installed. These systems have been installed for an average of 5 to 7 years. About 50% of the course management systems are now open-source.

Software companies can also reduce costs. There are some activities that can be eliminated that will not cause decreases in revenue for several quarters. The Blackboard Institute, which has made important contributions to the community, is an example.

It is also possible to reduce research and development without an immediate impact on the software product and its competitive position. Customer services can be reduced, a common practice in software companies, as anyone who has waited hours on hold knows. And marketing can be reduced without immediate loss of market share; though it does threaten future market share.

It may be counterproductive for Blackboard to raise prices. Although contract costs should be public for public institutions, there are few published examples. Data from the reports of two state universities is shown in Table 1. These are not representative of average institutions, but suggest raising prices may be difficult because of the surge of lower-priced open-source alternatives. Interpretation of Oracle Student Learning prices should be done cautiously; Oracle gives a number of discounts based on other Oracle products that have been licensed, for groups of institutions rather than a single institutions—such as the California State Universities system, and sometimes just because it makes a needed sale.2 (This is less frequent since Oracle acquired PeopleSoft—a competitor that followed that practice).

The data in Table 1 are for two different Moodle Partners who have proposed hosting. The Desire2Learn license may be a one-time fee with annual support that is less. (Oracle’s annual support is 22% of current license price for the same product). Similarly Blackboard may have proposed a similar annual license for University B that follows Blackboard currency pricing model.

The eLearning Guild conducts a survey each year of the 100 top learning management systems. Moodle was earned first place for both 2008 and 2009 with its market share increasing from 19.8% to 20.1%; Blackboard, in second place, decreased from 18.4% to 13.1%, a loss of 5.3% of market share in one year. Oracle increased from 2.7% to 3.2%. These percentages include both company and academic installations.

A Change of Management

The acquisition could provoke a change of management.

The current Blackboard managers are extremely knowledgeable of education and learning systems, have modified the company’s strategy to changes occurring in education, and maintained strong investor relations. Ray Henderson is respected for his broad knowledge of the publishing industry, learning processes, and software. Likely the forthcoming changes at Blackboard will benefit a strong competitor—Desire2Learn. It too has a talented and dedicated management team. CEO John Baker has been an exceptional leader and responsive to the changing needs of higher education.

If Blackboard is acquired, key officers can “sell” their current stock holdings. Based on the stock prices since the acquisition was announced, the amounts they will receive are shown in Table 2. The data is provided for historical and stock prices and the May 10th projection of Stifel Nicolaus.

If the acquisition is completed, Providence can easily increase revenues, at least for a few quarters, by increasing annual license prices. But to sustain the company and its brand they will have to resolve several potential problems in a challenging environment: Retain the education community’s respect, restrain prices in the face of competing open-source projects and Desire2Learn, integrate the separate products into a suite, and continue software development and product support. This is not simple or certain.

Part two will examine the acquisition from the perspective of mergers and acquisition focusing on analysis typical of a proposed merger.