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Instructure Inc Continues to Add to Its Sticky Revenue

Increasingly, we are seeing different software-as-a-service (SaaS) companies come to dominate their respective niches. Salesforce.com has conquered much of the sales world by giving companies a tool to track customer management. Veeva Systems -- an outgrowth of Salesforce -- is quickly capturing the cloud needs of big pharma.

And a tiny company started in Utah -- Instructure (NYSE: INST) -- has been winning over huge swaths of the education market. I make these comparisons because Instructure's most recent quarter reveals patterns that we've seen from the two aforementioned behemoths: winning over market share with high retention rates and evermore product offerings to raise switching costs.

Instructure reported third-quarter earnings on Monday. Let's take a look at what investors learned.

Image source: Getty Images.

Instructure earnings: The raw numbers

Before diving into the details, here are the headline numbers for Instructure:

Metric

Q3 2017

Q3 2016

Change

Revenue

$42.9 million

$30.1 million

42.5%

Non-GAAP EPS

($0.27)

($0.34)

N/A

Free cash flow

$39.7 million

$20.1 million

97.5%

Data source: Instructure.

The enormous gain in free cash flow is perhaps the biggest story. Management had promised this would be the case last quarter, and the company delivered. This tends to be the only quarter that's free-cash-flow-positive, as it marks the beginning of new contracts to coincide with the start of the new school year, with light capital spending to boot.

Perhaps more importantly, the company showed impressive leverage. Even when we include stock-based compensation, operating expenses grew 27% -- far slower than revenue growth. That translated to a 1,200-basis-point improvement in operating margins (non-GAAP), from -31.4% to -19.3%.

And while some investors may have fretted over gross margins contracting by 40 basis points to 71.8%, this was largely because of non-recurring service and support revenue that's associated with helping schools and businesses get started on the Canvas (for schools) or Bridge (for corporations) platform.

What else happened during the quarter?

The most important non-headline pieces of news from the earnings release were the following two tidbits: Revenue retention remained above 100%, and the company continues to come out with add-on services that not only add high-margin revenue to the bottom line, but create even higher switching costs, which work to keep customers with the company. In the most recent quarter, that was Bridge Perform, a tool to help employees and management communicate with one another.

In both the K-12 and higher education scene, a number of schools signed on to use Canvas, including:

  • The Utah Education Telehealth Network, with over 500,000 students.
  • A consortium of Wyoming schools, including 48 school districts, five community colleges, and the University of Wyoming, totaling 100,000 students.
  • Tufts (11,00 students), Georgia Institute of Technology (25,000), and the University of Colorado at Boulder (29,000).
  • Arlington, Virginia, public schools (25,000).

Internationally, a number of schools also signed on:

  • Swinburne University of Technology in Australia (24,000).
  • Catholic University of Minas Gerias in Brazil (16,000).
  • Centro de Integracao Empresa-Escola in Brazil (36,000).
  • International Institute for Management Development (IMD) in Switzerland (7,000).

And finally, the company also won over three big names with its Bridge solution for employee training and communication:

  • Discovery Communications, parent to the Discovery Channel and TLC (7,000 employees).
  • Banco PTG in Brazil (2,800).
  • Clemson University's faculty and staff (3,500).

Looking ahead

For the current quarter, management expects revenue to come in at a midpoint of $41.3 million, representing growth of 31% over the previous year. Non-GAAP earnings are expected to come in at a midpoint of -$0.28 -- a narrowing of 20% from the loss last year.

All things being equal, Instructure delivered on its promise of impressive cash flow growth. Shareholders now need to keep an eye on the company's ability to add on more programs for its customers, and leverage its network while winning over ever-more market share.

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Brian Stoffel owns shares of Veeva Systems. The Motley Fool owns shares of and recommends Veeva Systems. The Motley Fool recommends Instructure and Salesforce.com. The Motley Fool has a disclosure policy.