Blackboard Chalks Up a Win

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So once again, educational-software specialist Blackboard (Nasdaq: BBBB) has beaten guidance -- this time, its own. Let's check in with CEO Michael Chasen for his thoughts on the quarter: "We had strong financial results to begin 2008, with our revenue and earnings significantly beating our original guidance [thanks to] ... continued strong growth in our licensing and managed hosting sales and ... better-than-expected results from our acquisition of The NTI Group."

Sing it, Mike
And how. As we've come to expect, this Motley Fool Hidden Gems recommendation rolled out the usual laundry list of dozens of new and expanded relationships with educational customers in its first quarter. Blackboard already has relationships with Google (Nasdaq: GOOG), Discovery, more than 1,200 K-12 schools, and a whole host of institutions of higher learning. Not surprisingly, this educational entrepreneur enjoys a wide following among for-profit universities in particular, and it counts Capella, DeVry, ITT Educational Services, Washington Post's (NYSE: WPO) Kaplan division, Strayer (Nasdaq: STRA), and Career Education (Nasdaq: CECO) among its clients. But every quarter, we learn there were plenty more fish in the sea and that Blackboard has been casting its nets widely -- helping to push Q1 revenues up an impressive 24%.

Granted, the company swung from a profit to a loss of $0.11 per share. But that doesn't really concern me. As I mentioned in last quarter's earnings write-up, we've seen similar GAAP gyrations at companies as large as Symantec (Nasdaq: SYMC), and as small as Natus Medical (Nasdaq: BABY), in the wake of acquisitions.

For similar reasons, I'm not terribly upset by management's guidance. According to Chasen, we can expect that about $76 million in revenue booked over the second quarter will yield a per-share loss of at least $0.06. By year's end, management expects to book about $313 million in sales and lose $0.05 to $0.13 per share. Those figures suggest that GAAP profitability in the year's second half will begin to mitigate the losses incurred in the first half. Long story short, Blackboard's digestion of NTI may take a few quarters, but we're getting there.

Margin slips ... detention slips?
Not that I was entirely thrilled with last week's news. To the contrary, although I think the long-term story here looks good, in the shorter term, I'm tempted to give Blackboard detention for goofing off in a couple of classes.

Take profit margins, for example. With each passing quarter, I look eagerly toward the time when Blackboard begins benefiting from the growing scale of its business. But for sales to go up X%, and for profits to rise more-than-X% as margins expand, Blackboard must keep a lid on costs, and it's not doing that. In Q1, sales rose 24%, but pretty much everything else rose even more rapidly.

The cost of revenue was up 35%. General and administrative (G&A) costs rose in the high 30s, as did research and development, while sales and marketing costs leapt 43%. And that's just on the income statement. Over on the balance sheet, we also saw Blackboard's accounts receivable rise 31%.

In every instance, costs ran away from sales growth and erased any chance that Blackboard might improve its margins.

Math homework
Knowing that Blackboard's GAAP results are affected by noncore items, though, I wondered whether extraneous items might explain these rapidly rising costs. So I decided to do some digging. Although Blackboard routinely suggests that you back out the costs of "amortization of acquisition-related intangible assets," one thing management does not finagle is its stock-option expense. Despite having ample opportunity to exclude these costs when calculating its self-defined "non-GAAP adjusted net income," management declines to prevaricate.

To the contrary, Blackboard management clearly explains how stock options affect the numbers and shows how it attributes the costs of "stock-based compensation" to each category of expense. With one exception, I see no problems here. Stock-option costs allocated to cost of revenue, R&D, and G&A expenses all rose basically in line with the underlying costs for these line items. The only expense category hurt disproportionately by the stock-option program was sales and marketing, where costs nearly tripled. And that helps explain why marketing costs ran up so much more quickly than anything else did last quarter. Conclusion: Stock options aren't to blame. Even backing them out, Blackboard's costs are clearly rising more rapidly than its sales.

Show your work
This rapid rise in costs has me worried -- but not quite enough to make me want to cut class just yet. Considering the stock's valuation, I'm willing to give Blackboard some time to work through its issues. Here's why: According to Chasen, management expects to generate about $74 million in operating cash flow this year. Subtract from this the capital expenditures that he estimates will approximate 8% of revenue, or $25 million, and we're probably looking at about $49 million in free cash flow this year.

Thus, Blackboard currently trades for about 21 times this year's anticipated free cash flow. Weighed against analysts' projected annual earnings growth rate of 26%, I still see at least a small margin of safety in today's stock price. Not a lot, but some.

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