A Hot Sector?

By David Harper | December 21, 2005 AAA

Earlier in the year we recommended Blackboard (BBBB) to our members. We were looking for the best investment we could find in the elearning sector. Blackboard's stock has almost doubled for the full year 2005 (an appreciation our members have largely taken part in), so I thought I would revisit the sector to see if I could find any other compelling opportunities. For such a tiny, emergent sector, you have quite a few choices but they are very small companies. I saved my three favorite companies for the end of this article.

Longtime readers know that I prefer undefined sectors – industries that occupy the crevices "in between" other established sectors. There is a well-regarded business book called Blue Ocean Strategy by W. Chan Kim and Renee Mauborgne. The idea is that companies do better to skirt direct competition in "bloody red oceans," where several competitors already struggle against each other with established products and inevitably they devolve into price competition.

The authors argue for innovation: create products that address currently un-served even un-defined markets (i.e., blue oceans). Elearning is currently occupied mostly by "blue ocean" competitors. The interesting thing to me about the elearning pure plays listed below is that you see very little direct, head-to-head competition. Rather, each serves an emergent but different "blue ocean" market (e.g., content creation, application service provider, test certification, overall learning management system, human capital tools).

Elearning occupies a converging space between three traditional sectors: software; traditional (K-12), university & postsecondary education; and corporate training (or human resources). Naturally, software enables the online delivery of learning, so several software companies already occupy the elearning space. Macromedia will continue be a dominant player because they offer some of the best tools for content creation, including the wildly popular Flash player.

Their elearning offering (called Captivate) has not done as well as their other products, but no matter: Macromedia products are leading the shift from HTML-based pages to rich media websites, which gives them a rich future in elearning. Macromedia was acquired this year by Adobe Systems (ADBE), an acquisition that, in my view, cemented Adobe' position as one of the best public software companies you can own for the long-run.

The education market is growing at double digits (in fact we recently made a recommendation here but seeing as it was made recently we are going to have to save it for our members only). One wedge of the elearning pie is content creation, but another wedge can be found in learning management systems (LMS). These are the tools-made by companies like Blackboard (BBBB)-that help schools and trainers to manage their online educational programs.

All schools, from high schools to colleges to distance learning schools and corporate universities, require systems to manage their learning programs, track students and outcomes, and facilitate student collaboration. Finally, elearning occupies a toehold in the corporate training market. This is traditionally considered a human resources domain, but going forward, it will be known as human capital or talent management.

Currently, companies spend varying amounts of their staff budget on things like formal education, certification programs, coaching, and performance management. In my personal opinion, elearning will grab market share from traditional consulting firms that engage companies in people-intensive, higher-priced projects where elearning initiatives can instead demonstrate better return on investment (ROI).

Here is a chart of known pure plays in elearning. By revenues, it runs from the small SkillSoft (at about $200+ million) to the very small Scientific Learning Corp (SCIL) at only $30 million. Some might include publishers like Scholastic Corp (SCHL) and media companies like Disney (DIS) in a broad definition of elearning, but I do not.

You can see this is indeed small company investing! Institutional investors will avoid this sector, for the time being, and consequently they will completely miss out on the opportunity because the industry is not sufficiently large and well-defined to warrant an "asset allocation."

SkillSoft PLC (SKIL) is headquartered in Dublin, Ireland. The company offers a wide library of business training courses to several recognizable clients including Hilton (HLT), Merck (MRK) , Cigna (CI), and Prudential (PRU). The stock is below $5 and has suffered a prolonged slump for over three years. This is largely due to the cloud of an ongoing SEC investigation triggered by a significant financial restatement; the fallout has included a $30 million settlement in 2004.

However, sales continue to grow and the stock offers a P/E of less than 17x against anticipated full year 2005 earnings per share (EPS) of at least $0.33 (upwardly revised on the last conference call). They sell both course content and learning technology solutions. They just released a virtual classroom technology called Dialogue. This is sort of a system for online meetings enhanced with tools that allow participants to conduct online training; you might think of it as peer-to-peer (P2P) training. As SkillSoft's fundamentals have exceeded their internal expectations for three consecutive quarters, the stock warrants a closer look at this time.

PLATO Learning (TUTR) is a tough stock to analyze but would be interesting if you believe in management's turnaround. The CEO said of 2005 that it was "a turnaround year for PLATO Learning. Many of the systems and processes needed to sustain a growing profitable business had not been previously established." At first blush, their vast array of educational courses designed for the K-12 (kindergarten to twelfth grade) market looks quite compelling to me and seem to be generally well-reviewed by customers. After four years of losses, the company has issued guidance that 2006 will be a profitable year.

Renaissance Learning (RLRN) sports a market capitalization of more than $600 million. The company competes with PLATO in the K-12 market. In June they acquired AlphaSmart, a maker of portable PDA-like educational hardware devices. A few knowledgeable industry analysts are bullish on the stock, but for myself, I simply do not see the growth catalyst. The company is introducing products into the English as a second language (ESL) market.

But I am dubious on the AlphaSmart acquisition as I doubt proprietary hardware platforms will flourish; I think it is more likely that applications will continue to trend toward so-called device independence. Put simply, students are likely to run these applications on their own phones or portables or PDAs or whatever (Microsoft's (MSFT) xBox?). Further, if you look at organic growth for the combine company (i.e., the pro forma sales that does not give Renaissance an automatic bump just for the acquisition), you see slightly declining revenues year over year.

The Princeton Review (REVU) still garners more than half of their revenues from test preparation, including the SAT and post-graduate admissions exams (e.g., the LSAT for law school, the GMAT for business school and the GRE for general postgraduate degrees). Despite double digit top-line growth in several of their key markets and one of the more recognizable brands in the K-12 space, this company has inexplicably been unable to convert sales growth into profitability.

They recently hired a couple of outside executives with proven operational experience and appropriately dedicated 2006 as a year for "driving productivity and growing the business profitably." I am not inclined to give them the benefit of the doubt, but if you do take a closer look at this company, I would focus on their online course offerings. They claim this is the fastest growing product line; if they are indeed strong here, this could be a good investment. But I would need to satisfy my hunch that their strength in traditional classroom methods (and the franchise model) does not necessarily translate into online innovation. The winners in the K-12 market will absolutely need to innovate their online offering.

The more interesting players in the space (aside from Blackboard) may be the smaller companies. Please be careful: each of these three companies generates revenues of less than $100 million. You should be aware of the extra risk posed by small and micro cap stocks.

Specifically, I think Saba Software (SABA), eCollege.com (ECLG), and SumTotal Systems (SUMT) are each worth a closer look. In November, Saba completed a merger with Centra software. The combined company generates sales of about $100 million and approaches elearning from a "human capital" angle. This means their products are meant to help companies optimize their people investments with learning tools, performance management and talent management. In the long run, this is undoubtedly a good market. The mantra that "people are our best assets" has not been even partially realized in most companies.

Investments in people have suffered because managers lack a concrete way to track return on investment (ROI). But clearly talent management will become a strategic priority for most companies-in the long-run, the importance of intangible investments (e.g., those in people) will rival and exceed tangible asset investments-as they realize such a priority is competitive imperative. I think this company is well positioned to grab some of the dollars current spent on management consultancies.

When we recommended Blackboard earlier in the year, we were of course seeking an elearning theme, and we almost recommended eCollege.com (ECLG). This is still an exciting company and similar to Blackboard the stock has almost doubled in 2005. Against guided 2006 EPS of about $0.40, this gives the stock a P/E of almost 50x – after its appreciation you would need to be very brave to buy at this valuation!

Top line growth is sizzling at 20+% and their cash flow trend exhibits a steep upward trajectory. They have an interesting business model as they are an application service provider (ASP): they host software and tools for their clients, helping them to manage and deliver education. This is a winning idea and fits with the larger shift to web services; i.e., the shift away from installed software and toward browsers that pull software services from remote clients.

Finally, SumTotal Systems sells a product call Toolkit which has deservedly won several industry awards (I have used a demo version). Toolkit is an easy-to-use, off-the-shelf system for creating and deploying elearning courses. This is ideal for corporate clients in the so-called informal learning market. And, indeed, the company has been winning new customers at a quick clip; e.g., last quarter, they added customers at Wells Fargo (WFC), Volkswagen of America, Honda (HMC), and Lehman Brothers.

The stock is trading below $5 which is well below their initial trading price of $8 in March 2004 (the company started trading after it was created by a merger between Click2learn and Docent). Despite this valuation slump, sales are growing by double digits, earnings are just about to breakeven into positive territory and cash flows (both free cash flow and operating) are trending very positively. Worth a closer look!

On the corporate side, the elearning industry depends heavily on IT spending and is therefore cyclical (e.g., it is currently soft). But make no mistake: in the long-run, industry growth will significantly outpace the average. Eventually, it will be a full-fledged sector. In the meantime, it will be a challenging and volatile place to invest.

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