Stars Through Thunderstorms
Faster, bigger, higher — that was the environment we lived in for the past 12 years. Founders raised money faster, rounds were bigger, and valuations higher. FOMO was real as was free capital. Investors rushed to pay for businesses two years forward, valuing them at an x multiple on y revenue at some point in time in the future… During the first lockdown of 2020, I re-read Benjamin Graham’s The Intelligent Investor and was trying to understand why the current market was paying such high multiples, and how the environment was different compared to previous decades… Certainly, the multiples of today’s business reflect more visible SaaS models, but the abundance of capital, FOMO, and irrational behavior had stretched valuations significantly.
Fast forward to 2022 and we are in an environment of depressed multiples. The World economy is constrained by supply chain troubles, a war disrupting energy supplies, rising inflation, and increasingly divided societies. Multiples for growth companies are down about 2/3rds, and while the music hasn’t stopped, we’ve gone from Katy Perry to Tchaikovsky.
5x used to be a 2-year forward, in some cases 3-year forward multiple, now it is a 12-month trailing multiple and only businesses with robust fundamentals raise money. Investors are no longer paying for futures but for visibility and margins, and if a company’s bottom line is not close to a profit, the stock is thrown in a penalty box. Since covid began, many companies doubled revenue, customers, and users, but their shares are cut in half. With inflation and interest rates still going up to the right, there is no sight of calm.
But what we know is true over time is that business fundamentals and sustainable growth are directly correlated to enterprise value creation. As Peter Lynch said, “People may bet on the hourly wiggles of the market, but it’s the earnings that waggle the wiggle long term.” Accordingly, we continue to focus on companies that score high on our 5 Ps — People, Product, Potential, Predictability, and Purpose, as those ultimately lead to strong earnings.
Some of the recent noise suggests that Edtech is in reversal, with companies being roman candles as things are back to normal, and with Edtech valuations back at discounts. Well, in reality things are different. Yes, Edtech stocks are down 60% but that’s in-line with the broader market for growth stocks and SaaS companies. Meanwhile, we continue to see strong underlying trends in our sector; in K12, essentially all after-school activity is shifting to digital, in higher ed, degrees are getting augmented/improved and all of the growth is happening online, and in workforce learning, the opportunity is massive and growing. The quality and breadth of businesses continue to be impressive and fundamentals are holding strong.
There are certainly temporary headwinds due to macroeconomic pressures. In U.S. K12 for example, there’s a lack of teachers and mismanagement of ESSER funds which has caused some companies to lower their projections. In Higher Ed, weak enrollments have been slowing down growth, and in the workforce, tightening budgets are pressuring renewals and new bookings. But learning needs are significantly outweighing current macro headwinds. The importance for individuals and companies to up-skill and re-skill is increasingly more critical if they want to stay competitive in the global economy.
The good news is today’s leaders are more diversified and more global than ever. Course Hero, Chegg, and Quizlet started out with U.S. college students but over the past few years, they expanded globally and did so organically. Coursera, Roblox, and Duolingo were born global. And many non-U.S. companies have expanded internationally at impressive speed; Emeritus, Hotmart, Kahoot!, GoStudent, Quizizz, Brightchamps, Photomath to name a few. Compare that to the first generational leaders of Edtech who were all focused on their local markets and serving only one age group.
More good news is today’s leaders deliver education in engaging ways. It’s all about driving frictionless learning, and gamification is a great example of how that can be done. Kids learn through play without realizing they are getting schooled. As Byju likes to say — it’s like covering broccoli with chocolate. Roblox and Minecraft are two stars that teach kids to code, build, and collaborate in a metaverse type of environment. Others like Quizizz and Kahoot provide the tools for teachers to create engaging games for in-class and after-school work. Duolingo has been acing gamification in the language learning space as reflected by its daily to monthly active users engagement (DAU/MAU) of 27%. In Education, a DAU/MAU of 25% or higher is strong, above 30% it’s impressive!
But short-term engagement doesn’t guarantee long-term retention. While it’s great to find services with high DAU/MAU and time spent, it is equally important to offer a valuable service to keep learners engaged on an ongoing basis. Remember Clubhouse? It was red hot two summers ago with users spending 70 minutes a day on the app. (I had to google if they still exist…they do). The service was engaging when people were in lock-down, but the product lacked real purpose and ended up as a roman candle.
Accordingly, it’s not only about short-term engagement but also long-term retention. Think of services like Spotify, Netflix, Amazon Prime, Uber — all retain users for prolonged periods of time because their services are valuable and engaging. In Edtech, we start to see some examples of that with Coursera, Kahoot!, Duolingo in B2C, and with Guild Education in the workforce. In each case, the products are engaging and learners stick around. Generally speaking, strong annual retentions are at 60%+ in B2C and at 130%+ (on a net dollar retention basis) in B2B.
Another key trend today is the embrace of enterprise learning as the 4th education system — which is part of the broader trend we call Life-long Learning. While the current macro environment is creating headwinds and enterprise customers are slimming down on budgets, the need for individuals and for companies to up-skill is increasingly more important with multiple forces disrupting the workforce; on one hand, AI is automating jobs and eliminating “easy” labor, on the other hand, post-covid adjustments are creating disruptions. As a result, the gap for digital skills is widening and the need for outcome-driven education is growing. We are seeing a wide range of providers targeting the worker, from MOOCs to bootcamps to micro credentials, and L&D budgets that used to be a “nice to have” are now a “must have” for anyone who wants to stay competitive.
Mr. Market is betting on Edtech. The reason edtech companies were “undervalued” in past decades was a combination of lower engagement, poor retention and limited LTVs — if you were in K12, you targeted middle-to-high schoolers; if you were in higher Ed, it was college students; in workforce, it was transactional. In all cases, LTV was maximum 1–2 years and retention rates were in the lower double digits.
Today, many of the leading edtech companies have significantly longer reach and help learners through multiple phases. Retentions are above 50%, LTVs are rising, and businesses achieve significantly higher scale and better margins. Point in case, currently there are more than 20 private edtech companies with over $250M in annual revenue and with gross margin profiles similar to SaaS companies. In 2015, there were none.
While top-line growth is key, margin efficiency is also very important. For more than a decade, startups could thrive with aggressive spending and growth at all costs because access to capital was free. But in today’s environment that doesn’t work. Access to capital is limited and only available to those who display growth and visibility to a profit. Our team run an analysis comparing P/S multiples of publicly listed companies from the past 12 years, segmented by revenue growth and gross margin levels, giving us an overview of “normalized” P/S multiples.
Basically, if a company’s sustainable revenue growth is 40% and the gross margin is 70%, that business was valued at ~10x revenue. But that worked in the past 12 years when interest rates were close to zero…today’s picture is different.
That same company is now trading at 5.7x revenue which is a reduction of 45%. And if the gross margin is lower, the discount is deeper. As an interesting reference point, in 2006, a typical SaaS company with 20% revenue growth and a 30% EBITDA margin traded at ~5x P/S.
Public Edtech companies, although only a handful today, are generally priced better than the broader market. Robust fundamentals coupled with increasingly recurring revenue streams and lean margins are putting Edtech closer to sectors like SaaS.
We compared the above basket against the Bessemer Cloud Index (EMCLOUD), which tracks 75 high-growth SaaS companies with a median revenue growth rate of 32% and a median E’22 P/S multiple of 5.9x. While Edtech is slightly lower with median revenue growth of 16% and a 4.3x multiple, on a growth-adjusted basis it trades at 0.3x P/S/G while the Bessemer Cloud Index is at 0.2x P/S/G. So essentially, Edtech is valued similar to SaaS.
Looking at the most recent results, we see promising momentum with market leaders punching good Q2 numbers to their scorecards; language learning leader Duolingo reported an impressive 51% revenue growth driven by an even more impressive 71% subscriber growth, with an improving 5% EBITDA margin. LMS star Instructure delivered 22% revenue growth with a strong 35% EBITDA margin, while course creation provider Thinkific posted 38% top-line growth but at a negative 55% EBITDA margin. Security training leader KnowBe4 punched in 37% revenue growth with a 14% operating margin and a 24% free cash flow margin.
Meanwhile, Coursera, which democratizes access to the world’s leading universities, had a hiccup with revenue growth slowing to only 22%, which was below their 30%+ goal, but with gross margin improving to 62%. Its close competitor Udemy posted similar top-line growth of 21% but with a lower gross margin of 57%. The two outliers are Chegg and 2U who in recent years experienced softening fundamentals but are perhaps ready to rebound. Both grew their Q2 revenue by 2% and are profitable.
In search of greatness, we look for businesses that display high Return on Education (RoE) — services that democratize access to top-quality education, doing so while lowering the cost and improving outcomes for the individual and for the company. RoE is a key part of our investment thesis and is directly correlated to ROI; the higher the RoE, the better the investment outcome.
Great companies also display network effects with organic growth, resulting in higher profitability. One way to measure that is the Rule of 40 — a gauge for recurring revenue and profitability, with a combined growth rate and EBITDA margin of 40 or more. For example, Kahoot!’s revenue growth of 96% and its EBITDA margin of 10% give it a 106 — they are killing it on that metric. A handful of the above companies are at or above the Rule of 40, and several others are expected to do soon.
Another gauge for strong fundamentals is the “rule of 2” — when revenue growth exceeds marketing spent as % of revenue by at least a factor of 2x. For example, Duolingo is growing revenue at 51% and has marketing spent at 17% of revenue, so its factor is 3x. On the contrary, Udemy is growing its top line by 22% but its S&M is 45%, implying a factor of 0.5x. Not surprisingly, DUOL is trading at 13x P/S while UDMY is trading at 3x.
In general, marketing spent should not exceed 50% of revenue, but in some cases, there are advantages to moving faster and grabbing land. This strategy works well in an environment of low interest rates and free capital, but in times like now, it is the prelude to the finale.
Disclosure: GSV owns shares in Coursera, Course Hero, Guild Education, Quizizz, Brightchamps, Photomath, Emeritus.
