Instructure Holdings, Inc.

Ladies and gentlemen, thank you for standing by and welcome to Instructure's second quarter 2022 earnings call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. Please be advised that this conference is being recorded. I would now like to turn the conference over to your first speaker, Denise Garcia, Investor Relations. Denise, please go ahead.

Thank you. Good afternoon and welcome to Instructure's second quarter 2022 earnings call. We will be discussing the results announced in our press release issued after the market closed today. With me are Instructure's Chief Executive Officer, Steve Daly, and Chief Financial Officer, Dale Bowen. Before we begin, I'd like to remind you that today's conference call will include forward-looking statements based on the company's current expectations. These forward-looking statements are subject to a number of risks, of significant risks and uncertainties, and our actual results may differ materially. For a discussion of factors that could affect our future financial results in business, please refer to the disclosure in today's earnings release and other reports and filings we file from time to time with the Securities and Exchange Commission. All of our statements are made as of today based on information available to us today and, except as required by law, we assume no obligation to update any such statements. During the call, we will also refer to both GAAP and non-GAAP financial measures. You can find the reconciliation of our GAAP to non-GAAP measures included in our press release, which is posted to the investor relations section of our website. With that, let me turn the call over to Steve.

Thank you, Denise, and good afternoon, everyone. Thank you all for joining us for our second quarter 2022 earnings call. During today's call, Dale and I will provide details on our second quarter results and provide third quarter and updated full year 2022 guidance. It has been a little over a year since Instructure reentered the public markets, and before discussing our second quarter results, I would like to take the opportunity to reflect on our progress over the last 12 months. We have exceeded our financial guidance every quarter since our IPO, and the four-year 2022 financial metrics we will be guiding to today are all significantly higher than consensus estimates were when we went public. We have advanced our structured learning platform strategy through record R&D investment and three acquisitions, and our K-12 assessment solutions are growing significantly faster than the corporate average. Our focused international strategy has resulted in profitable growth across all of our major regions, and the channel partner program we implemented this year is enabling us to cost-effectively enter new international markets. We have deleveraged significantly and continue to generate robust free cash flow, which leaves us with many options to create further shareholder value going forward. Looking ahead, we are confident in the resilience of our financial model, including solid top line growth and strong margins. Turning to Q2 results, Instructure delivered another strong quarter, exceeding our previously communicated guidance ranges across all metrics. Second quarter GAAP revenue was $114.6 million, up 22% year-over-year, while allocated combined receipts for ACR was $114.9 million, up 20% year-over-year. We think ACR, which adds back the impact of fair value adjustments to acquired unearned revenue, gives investors better visibility into the underlying growth of our business. We achieved non-GAAP gross margins of 77.6% in Q2, up 390 basis points year-over-year. This demonstrates our ability to continuously expand our gross margins as we scale and focus on operational efficiencies. Second quarter adjusted EBITDA grew 28% year-over-year to $39.8 million, a 35% margin, as we demonstrated further operating leverage on both the gross margin and adjusted EBITDA lines. Higher education and K-12 institutions in the United States and across our major international markets continue to choose Canvas as their next-generation LMS solution. Beyond the LMS, our instruction learning platform strategy gained further traction during the quarter as we continued to land large deals and grew ATR from assessments products at a strong double-digit rate. We expect to continue investing in the platform through organic development and strategic M&A as we strive to connect every aspect of teaching and learning and capture an increasing share of our $30 billion market opportunity. I now want to talk about four key highlights from the quarter. First, in Q2, we saw again strength in each of our key markets, U.S. higher education, K-12, and international. Higher education institutions across the country continue to choose Canvas for ease of use, scalability, flexibility, and superior UX. According to a recent report from Edutechnica, Canvas continued to gain share in the U.S. higher education LMS market over the past year. As of this spring, 42% of U.S. higher education institutions used Canvas, up from 39% last year. The data also show that over 40% of US higher education institutions continue to run on legacy LMS systems, which provides us with a significant growth opportunity in the coming years. During the quarter, Northern Arizona University, or NAU, selected Canvas to replace its incumbent LMS provider after a rigorous 10-month evaluation process. The results of NAU's review and selection process, which are available on the university's website, demonstrate a clear preference among NAU's students and instructors for Canvas over the competition. NAU's purchase included three instructor learning platform products, Canvas LMS, Studio, and Catalog. Catalog will support NAU's online programs by enabling the university to quickly and efficiently publish any Canvas course to an online catalog. Instructors' focus on innovation and ability to creatively address opportunities in the online sphere are clearly resonating with U.S. higher education institutions. As we build out the Instruction Learning Platform, we expect our competitive differentiation in this market to increase further. K-12 districts are also excited by our Instruction Learning Platform product and vision. Demand for a portfolio of high-value assessment solutions remains robust, as educators seek to support the increasing need for innovative, standard-aligned interim and formative assessments to improve learning outcomes and mitigate pandemic-related learning loss. With an average revenue per user of two to three times the K-12 LMS, our assessment solutions also represent a significant growth opportunity for Instructure. During the quarter, Neenah Joint School District, which serves over 6,700 students across 14 schools in Wisconsin, chose Instructure as its next generation LMS solution. In the case of Neenah JSD, our unique ability to bundle our leading mastery connect assessment management system with Canvas LMS, as well as tight integration between the two solutions, drove the district's decision to partner with Instructure. LinaJSD also based its decision on the excellence of our support organization, which is a hallmark of Instructure's culture and a key competitive advantage. International remained the fastest growing part of our business in Q2. During the quarter, we signed an agreement with Brazilian College of Radiology and Diagnostic Imaging, or CBR, to power their digital transformation. CBR selected Instructure because we were able to offer them a tightly integrated solution which included Canvas LMS, Studio, and Catalog. Catalog proved to be an especially strategic asset in the deal as CBR, like many higher education institutions worldwide, looks to expand its course offerings online. Catalog not only provides a customizable storefront for institutions' online force and program offerings, but it integrates into most payment systems. Our ability to provide TBR with a payment gateway solution for the Latin American region was a key factor in winning the business. In addition, we continue to build out our channel program, to cost-effectively expand our international footprint. With our international higher education LMS market share in the single digits, we expect this segment to remain our fastest-growing segment in the years ahead. Second, our focused go-to-market and expanded set of offerings are resulting in higher penetration of products across our customer base through both cross-sell opportunities and new logo deals. During the quarter, DeKalb County Schools, an existing Canvas LMS customer, purchased Studio Impact and Services to improve the adoption of technology in the classroom and advance digital learning across its 94,000 student districts. As a reminder, Impact helps administrators evaluate the impact of educational technology while helping faculty and students seamlessly navigate new platforms. Third, we are making disciplined investments to expand our platform and drive long-term growth. Our high gross margins, strong sales execution, productive R&D investment, and low capital requirements allow us to reinvest in the business, pursue strategic M&A, and deleverage while maintaining industry-leading margins. Our enterprise software business model and vertical focus provide us with excellent visibility into our near-term revenues due to our long-term, non-cancellable contracts and the educational vertical's minimal sensitivity to macroeconomic volatility. We expect a rule of 50 outcome for the full year on an adjusted EBITDA basis, driven by our double-digit revenue growth and continued strong margins. In spite of the deteriorating macroeconomic environment, we continue to invest in R&D and sales headcount this year, and our appetite and capacity for creative M&A opportunities remains unchanged. We expect to continue investing in our business to drive consistent long-term profitable growth. Fourth, we continue to use strategic M&A with the goal of increasing our TAM and expanding our structured learning platform capabilities. During the second quarter, we advanced our instruction learning platform strategy through the acquisition of Concentric Sky and the rollout of Canvas badges and Canvas credentials to the market. Canvas Credentials enables higher education institutions to use digital badging to increase student enrollment and retention rates while providing a seamless way for learners to record and share their validated skills and achievements with future employers. We look forward to partnering with higher education institutions to establish and grow their non-traditional online programs using foundational technologies from Instructure, a significant TAM expansion opportunity. With our strong free cash flows and conservatively capitalized balance sheet, we believe we are in an excellent position to take advantage of inorganic growth opportunities that may arise as seller expectations adjust to the current market environment. Our M&A pipeline remains robust, and we expect to continue to pursue strategic acquisitions with the goal of expanding our TAM and enhancing the value of the instructional learning platform to educational institutions and their students. Turning to stimulus funding, the vast majority of $190 billion appropriated for K-12 schools under the Elementary and Secondary School Emergency Relief or ESSER Fund remains unspent. According to the Department of Education, as of the end of May, $141 billion or 74% of ESSER Funds have yet to be invested. Burbio, a data aggregator, reports that over 25% of ESSER III funds have been earmarked for technology spending. The Cal County Schools, a cross-sell example I mentioned earlier, utilized ESSER funds to help finance its additional investment in the Instructure Learning Platform. We expect many other forward-thinking Canvas LMS customers, like the Cal County Schools, to generate significant incremental demand in our K-12 segment using ESSER funds over the next few years. Last month, we were thrilled to host over 12,000 registrants at InstructureCon 2022 North America. Many of our 600-plus Instructure EdTech collective partners hosted virtual booths with partners such as Google, Microsoft, and Zoom, delivering virtual sessions at the conference. During the event, we unveiled our updated brand architecture supported by four brand pillars, Canvas for learning management solutions, Mastery for assessment and tools and content, Elevate for Data and Analytics and Impact for EdTech Adoption Engagement. We also highlighted product improvements that make the Instructure Learning Platform even more powerful in 2022. We look forward to hosting the three additional Instructure Cons later this year for Latin America, EMEA, and the Asia-Pacific regions. looking to the remainder of 2022 and beyond our pipeline for north american higher education rfb opportunities continues to build as many institutions which delayed major purchasing decisions during the pandemic look to upgrade their infrastructures in summary i'm encouraged by our strong second quarter financial results which exceeded our guidance ranges in all metrics We expect the favorable trends that drove our second quarter outperformance to continue for the balance of the year, which was reflected in our revised 2022 guidance. I would once again like to thank our customers, partners, employees, and shareholders for your ongoing support. With that, I will now turn the call over to Dale to talk about our financial results and the ongoing momentum we are seeing in the business. Thank you, Steve, and thanks again to everyone for joining us today. Before discussing our detailed financial results, I'd like to point out that in addition to our GAAP results, I'll be discussing certain non-GAAP results. The GAAP financial results, along with the reconciliation between GAAP and non-GAAP results, can be found in our earnings release, which is posted in the investor relations section of our website. In the second quarter, we continue to show a combination of strong top line growth and expanding adjusted EBITDA margins. Moving on the consistent gross margin improvement we have delivered in recent quarters, Q2 non-GAAP gross margin expanded by 390 basis points year-over-year to 77.6%. As Steve mentioned, we generated second quarter 2022 total GAAP revenue of $114.6 million, up 22% year-over-year, and ACR of $114.9 million, up 20% year-over-year. Subscription and support ACR accounted for 90% of our second quarter revenue at $103.2 million, up 19% year over year, primarily as a result of the continued momentum within our core Canvas LMS product, both domestically and internationally, in addition to strong upsell and crossover of our other products, especially assessments. Professional services and other ACR accounted for 10% of our second quarter revenue, at $11.7 million, up 24% year-over-year, driven by strong implementation and training services delivery in our high-ed business. Deferred revenue at the end of the second quarter was $283.3 million, up 13% year-over-year. Remaining performance obligations, or RPO, were $783.7 million at the end of the second quarter, up 17% year-over-year. And we expect to recognize revenue on approximately 74% of our RPO over the next 24 months. Discussing the remainder of the income statement, please note that unless otherwise stated, all references to our expenses, operating results, and share count are on a non-GAAP basis. Please note that when I refer to margins in the upcoming comments, I'm referring to margins calculated as a percentage of ACR. Our strong gross margin profile is supported by our optimized cloud architecture and flexible support model that scales to meet seasonal customer demands. In the second quarter, gross profit was $89.2 million, representing a 77.6% gross margin, up from 73.7% in the second quarter of 2021. We couldn't be more pleased with our enhanced operating model and continued operating leverage on this gross margin line. Turning now to operating expenses. Sales and marketing expenses for the second quarter were $24.7 million or 21.5% of ACR compared to 20.7% in the second quarter of 2021. Research and development expenses for the second quarter were $15.5 million or 13.5% of ACR, down from 13.8% in the second quarter of 2021. We continue to invest in engineering headcount to pursue our ambitious product roadmap while leveraging offshore talent to drive ongoing R&D efficiencies. General and administrative expenses for the second quarter were $10.4 million, or 9% of ACR, up from 7.5% in the second quarter of 2021, driven largely by the addition of public company costs. Non-GAAP operating income for the second quarter was $38.7 million, representing a 33.7% operating margin, up from 31.7% in the second quarter of 2021. Second quarter adjusted EBITDA was $39.8 million, representing a 34.6% adjusted EBITDA margin, up from 32.5% in the second quarter of 2021. Non-GAAP net income for the second quarter is $35.9 million, or 25 cents per share, on a fully diluted basis, compared to $20.7 million, or 16 cents per share, a year ago. Turning to the balance sheet and cash flow statement. We ended the second quarter with $87.6 million in cash, cash equivalents, and restricted cash, and $492.5 million of long-term debt, net of discounts, resulting in a 2.44 times net debt to trailing 12 months adjusted EBITDA ratio. As a reminder, the timing of cash collections is highly seasonal in our business, with the vast majority of annual license fees invoiced in the second and third quarters and collected during the third and fourth quarters. As a result, our cash balances and cash flows are lower during the first half of the year and build significantly during the second half of the year. Operating cash flow was $8.6 million during the second quarter and $100.2 million over the last 12 months. Free cash flow was $6.6 million during the second quarter and $94.2 million over the last 12 months. Adjusted unlevered free cash flow was $16.2 million during the second quarter. Over the last 12 months, adjusted unlevered free cash flow was $134.2 million. As a reminder, our strong free cash flow conversion is driven by our favorable billing terms, low capital expenditures, and our accumulated tax assets, which we believe will act as a tax shield for the next several years. I will now conclude the call by providing guidance for Q3 and revised guidance for the full year of 2022 for ACR, adjusted EBITDA, and adjusted unlevered free cash flow. For the third quarter of fiscal 2022, we expect ACR in the range of $118.5 million to $119.5 million. We are raising our fiscal 2022 ACR guidance by $4 million. And we now expect ACR in the range of $465.8 million to $469.8 million. Normalizing for the bridge divestiture, our full year ACR guidance growth rate is 14% at the midpoint. As a reminder, on February 26, 2021, we sold bridge, our corporate LMS business. Bridge contributed approximately $4 million ACR during the first quarter of 2021. We expect third quarter adjusted EBITDA in the range of $42.1 million to $43.1 million, representing an adjusted EBITDA margin of 35.8% at the midpoint of the range. For the full year, we now expect adjusted EBITDA in the range of $167.5 million to $171.5 million, representing an adjusted EBITDA margin of 36.2% at the midpoint of the range. Our increased fiscal year 2022 adjusted EBITDA guidance reflects higher ACR growth and stronger gross margins as we continue to optimize our third-party technology costs. We are also increasing our full year 2022 adjusted unlevered free cash flow guidance, and we now expect adjusted unlevered free cash flow in the range of $185.5 million to $189.5 million. In summary, we are pleased to have exceeded our second quarter guidance ranges and to be raising our full year 2022 guidance ranges across all metrics. We are executing at a high level as we continue to display legacy LMS competitors and gain wallet share with our instructor learning platform solutions. We believe that there is no other company that's better positioned than Instructure to lead the digital transformation of education and we've only scratched the surface of this 30 billion market opportunity. Our financial profile is compelling with solid top-line growth, best-in-class margins, and superior adjusted unlevered free cash flow conversion. We look forward to updating you on our progress throughout the remainder of 2022. With that, Steve and I are happy to take any of your questions.