Introduction

This article delves into PowerSchool, an intriguing company co-founded by Steve Jobs. Unlike previous discussions focused on entrepreneurs, we will briefly touch on the history of the company, followed by an exploration of its business environment, products, competition, platform, the future of the EdTech sector, the integration of AI, industry pain points, and more.

Foundations of PowerSchool: A Mission to Transform Education

Founded in 1997 by Greg Porter and Ross Miller, PowerSchool received initial investment from Steve Jobs, who played a foundational role in the company. In 2001, he led the company to be acquired by Apple. From the outset, PowerSchool provided software known as SIS (Student Information System), which encompassed all the "behind-the-scenes" needs of schools—such as grades, attendance tracking, and workforce management—essentially serving as an ERP system for educational institutions. It is important to note that the company focused exclusively on K-12 schools from the very beginning, a point that will be revisited later. In 2006, Apple sold the company to Pearson, which helped continue the development of the SIS.

From Acquisition to Expansion: A Shift in Strategy

By 2014, PowerSchool generated revenues of $97 million with an operating profit margin of 20%. In 2015, the private equity firm Vista Equity Partners, specializing in technology, acquired PowerSchool and altered its strategy: instead of being a standout company in the U.S. with a single product (SIS), they aimed to expand into a comprehensive platform for schools, effectively providing every software solution they needed.

Over the years, the company made several acquisitions, including Headed2, Chalk, Hobson, Hoonuit, Schoology, AccelaSchool, and PeopleAdmin—most of these acquisitions were small, under $10 million. However, two relatively large acquisitions were Sungard for $850 million and HOBSON for $320 million. As a result, their product offerings evolved into a complete platform featuring 19 products, covering classroom tools, back-office solutions, talent management, and financial management—a comprehensive ERP system. Typically, the company discusses four main product categories: "in-class," "out-of-class," "resource management," and analytics.

In 2021, PowerSchool went public with revenues of $558 million, a growth rate of 28%, and a 70% market share in the U.S. The company offered 17 products, with a gross margin of 66%, an operating margin of 3%, and EBITDA of 20.5%. It is crucial to highlight several key points in the company's narrative—firstly, what problems is PowerSchool solving?

Addressing Challenges in Education: PowerSchool's Impact

Two significant issues persist in the U.S. education system: first, 1.2 million students do not graduate high school, and according to the CEO, 20-25% of these students face challenges due to a lack of personalization, insufficient attention, or inability to complete their studies. The second issue lies with the faculty (teachers), who experience a relatively high turnover rate due to two main factors: low salaries and the fact that only 43% of their time is dedicated to teaching, with many claiming they lack the relevant tools to teach effectively, which diminishes their motivation to remain in the role.

How does PowerSchool fit into this picture? For teachers, it enhances effectiveness through seamless integration of their software systems and automation, easing their workload. For students, the software allows for more accurate identification of at-risk students and tracking of their progress. The company's "dream" for years has been to make learning more personalized using AI, enabling content customization for each student to reduce dropout rates.

Now that we've established the context, let’s discuss school budgets. Each school receives funding (both federal and state) averaging around $180 per student for IT expenditures. Using PowerSchool's suite of tools costs approximately $80 per student, meaning that employing PowerSchool not only addresses the schools' challenges but also helps them become more efficient.

Current Performance: Revenue Growth and Market Share

Today (2023), PowerSchool operates at a revenue run rate of $636 million, reflecting a 15% growth rate over the past three years, with an EBITDA margin of 33% or a free cash flow margin of 30%. The company holds 80% of the market in the U.S. and slightly in Canada (93% of revenues come from the U.S. while Canada contributes 5%). PowerSchool boasts 19 different products, serving 50 million students and 15,000 clients, reflecting a 10% market growth.

The business model is primarily SaaS, with 87% of revenues coming from cloud subscriptions and the remainder from professional services. This accounts for a relatively low gross margin of 67%, which is expected to increase as the company grows, granting it a competitive advantage against cloud providers.

Since its IPO, the company's strategy has focused on acquiring new clients (more schools). The company is now shifting its strategy to focus more on existing customers and growth outside the U.S. through partners (distributors) that will assist the company. Since the IPO, PowerSchool has executed all of its stated objectives.

Growth Drivers & Competition

What are the growth drivers here? Currently, 80% of the company’s growth comes from its existing customers, with a net retention rate of 109.5%, mainly through selling additional products and implementing modest annual price increases of 2-3%. To provide context, the average revenue per student currently stands at $12, with potential to reach $70, and the churn rate is low.

International growth presents a significant opportunity, as the rest of the world accounts for only 2% of revenues.

Now, let’s discuss the business environment and competition, breaking it down by product. Three main areas are: the company’s flagship product (SIS), which constitutes 50% of revenues with 20 million users. Here, PowerSchool primarily competes against “legacy” clients or smaller competitors like Infinite Campus.

In the second product category, Classroom (in-class solutions), which makes up 26% of revenues, they face tough competition from Instructure and its product Canvas, which is owned by the private equity firm Thoma Bravo (also focused on technology). Regarding market shares in this sector, PowerSchool and Canvas each hold approximately one-third of the market, with the rest composed of older solutions.

The third product category is Talent, contributing 24% of revenues, where they compete against Frontline, recently acquired by Roper for $3.7 billion.

Looking Ahead: Opportunities and Challenges on the Horizon

So, why is PowerSchool succeeding today? The market remains large, valued at around $100 billion, with many outdated legacy products still prevalent. PowerSchool is the only player with a comprehensive end-to-end platform rather than just one product. Furthermore, it is the most cost-effective option when bundled, holds a strong brand in the sector, and remains focused on the K-12 market, while competitors like Instructure also target the higher education space dominated by players such as Oracle, SAP, and Workday, which leads to a lack of focus.

Bulls vs Bears

Let's explore the bullish thesis for PowerSchool.

• Market Leadership: A leading market position.

• High Barriers to Entry: Significant entry barriers (regulation, high switching costs).

• Growth Potential: A sizable market opportunity of about $100 billion, offering investors a chance to back a company that isn’t cyclical.

• Education Stability: Even in downturns, educational budgets tend to remain stable, and PowerSchool provides a mission-critical solution that cannot be overlooked.

• Positive Forecasts: Market predictions indicate the company will grow at a low double-digit rate of about 10-12% annually, with improving profitability.

• Attractive Valuation: A pricing multiple of 22 PE or 20 on free cash flow, with competing vertical SaaS companies like Roper/Tyler trading at averages of around 35 times cash flow or about 30 times earnings, despite their slower growth compared to PowerSchool.

Conversely, the bearish thesis considers:

• Market Saturation: The company already holds a significant market share, making growth acceleration difficult, with a potential year-over-year slowdown in growth.

• Debt Load: The company is leveraged (with a net debt of $650 million), though it’s worth noting that the debt-to-EBITDA ratio is reasonable at 3.

• AI Integration Challenges: The vision for personalized learning through AI may not materialize, as customers are not sufficiently open to this change.

• Limited Track Record: PowerSchool is a relatively small company with limited historical performance.

• Long Sales Cycles: Sales processes can extend up to 30 months.

In Summary

PowerSchool presents an interesting GARP opportunity, as it possesses what we look for in a business: long growth runway, a wide moat, mission-critical services, improving cash flow profitability and ROIC, competent management, and reasonable valuation. This is the kind of business we seek for long-term partnerships.

Today (October 24')

A few factors helped us build a strong position and conviction here. While the market assumed the business would grow at high single digits, we believed it would exceed that. A weak short thesis raised several key concerns about PowerSchool, including potential violations of state student privacy laws, inflated revenue and adjusted financials, higher leverage than reported, management and Board concerns, and unsustainable growth prospects. This helped us better understand the risks in the business and recognize it as an opportunity, as we were closely familiar with the company's quality and could counter the report's arguments. The company was largely under the radar, to the point that even when they updated guidance to 12% growth, it went unnoticed.

In June 2024, the company was acquired by Bain Capital at a premium of around 40% above our purchase price. While securing a profit is always positive, we were not pleased with the acquisition, as we believe PowerSchool has long-term compounding potential that could exceed a 40% premium. Nevertheless, we have written this article to highlight the types of businesses we aim to partner with—those that can deliver shareholder value over the long term, with wide moats and extended growth runways.

(Media: PWSC IR)

Disclaimer: This article is for informational purposes only and should not be considered financial advice. Our hedge fund may hold positions in the companies discussed and may actively trade in these securities. Our views are based on publicly available information and our internal analysis, which are subject to change without notice. We encourage readers to perform their own research or consult with a professional financial advisor before making any investment decisions. We assume no responsibility or liability for any errors or omissions in the content.