Spruce Point Capital Management Announces Investment Opinion: Releases Report and Strong Sell Research Opinion on PowerSchool Holdings, Inc. (NYSE: PWSC)
NOTE TO EDITORS: The Following is an Investment Opinion Issued by Spruce Point Capital Management
Provides Evidence That PowerSchool May Be Potentially Violating Student Data Privacy Laws
Expresses Concerns with Reported Revenue Quality Given Conflicting Customer References, Changes to Revenue Recognition Policy Language, Abnormally High Bad Debt Reserves, and Rising Days Sales Outstanding
Believes That PowerSchool’s Financial Reporting Has Become More Opaque and That its Adjusted Financial Reporting is Highly Embellished with Liberal Cost Capitalization and Amortization Practices Which are 2x to 3x Industry Peers
Believes That PowerSchool’s Strains From its Growth by Acquisition Strategy Will Only be Compounded with Surplus COVID-19 Stimulus Spending Winding Down
Questions the Independence and Ability of the Board to Hold Management Accountable While Top Executives and Controlling Shareholders Sell Millions Worth of Stock 25% Below What Promotional Analysts Claim the Shares are Worth
Sees 30% to 60% Long-Term Downside Risk to PowerSchool’s Share Price and Expects the Price to Underperform the Broader Technology and Education Sector
April 17, 2024 09:00 AM Eastern Daylight Time
NEW YORK--(BUSINESS WIRE)--Spruce Point Capital Management, LLC (“Spruce Point” or “we” or “us”), a New York-based investment management firm that focuses on forensic research and short-selling, today issued a detailed report entitled “Schooling Investors With Powerful Accounting” that outlines why we believe shares of PowerSchool Holdings, Inc. (NYSE: PWSC) ("PowerSchool" or the "Company") face up to 30% to 60% long-term downside risk, or $8.00 – $14.00 per share. Download and view the report by visiting www.SprucePointCap.com for additional information and exclusive updates.
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Spruce Point Report Overview
PowerSchool is a K-12-oriented educational technology (edtech) software provider based in Folsom, CA. The Company’s origins date back to 1997 and the business has grown through private equity backing and over a dozen acquisitions. The Company has a portfolio of more than 20 software solutions, virtually all geared toward K-12 district and school customers. Its Student Information System solution has an estimated market share of over 20%. In total, PowerSchool claims to reach more than 50 million students, equating to over 80% of the K-12 population in the U.S. and Canada, through its more than 17,000 customers. PowerSchool IPO’ed in 2021 during a period of unprecedented funding and demand for edtech solutions. As of year-end 2023, PowerSchool reported $697.7 million and $231.9 million of revenues and Adjusted EBITDA, respectively.
The concerns we outline in our report include:
- We believe K-12 school districts across the U.S. are staring down an impending fiscal cliff. We believe this will significantly pressure contract renewals for K-12 vendors such as PowerSchool. In response to COVID-19 in 2020, federal, state and local legislatures passed a series of spending bills aimed at supporting K-12 districts through the pandemic. The U.S. federal government passed three emergency spending bills, collectively known as the Elementary and Secondary Emergency Relief Funds (“ESSER Funds”), which provided nearly $200 billion in direct aid to K-12 districts and gave little stipulation on how to spend it. ESSER represented the largest single federal investment in primary and secondary education in history, providing roughly double the appropriations given under the American Recovery and Reinvestment Act of 2009. With this newfound funding, districts had to balance immediate needs with long-term priorities. For many schools, spending was initially focused on finding solutions to needs created by the pandemic such as virtual learning, student health services, and addressing learning loss. Now, as the pandemic has subsided and ESSER Funds have begun to expire (the last of the ESSER Funds must be obligated by September 2024), districts have generally shifted spending towards operational expenses such as increased headcount, higher salaries and benefits for teachers and staff. This thesis has already started to play itself out. Our analysis of the fiscal year 2023-24 budgets of the 50 largest school districts in the country reveals that, on average, school districts are budgeting for reductions in technology spend in 2023-24 vs. 2022-23. This impact is even more severe in districts facing declining enrollments. We see this as only the beginning as ESSER Funds do not actually run out until September 2024, making 2025 the first year that most school districts will be without emergency COVID-19 funding since 2019.
- PowerSchool’s Intersect product may potentially be operating in direct violation of several states’ student privacy laws, which prohibit building profiles and targeting ads to K-12 students. In 2021, PowerSchool purchased Naviance and Intersect Solutions from Hobsons for $319 million, with management describing the purchase as giving PowerSchool “a deeper level of personalized insights to help middle and high school students prepare best for their future.” However, Spruce Point has multiple concerns that major aspects of the product may be potentially violating state student privacy laws. PowerSchool currently faces litigation related to the alleged illegal collection of student data through its Naviance platform. We also believe that the Company’s Intersect program may be potentially violating the Student Online Personal Information Protection Act (“SOPIPA”), which is a state law regulating K-12 student data that has been passed in nearly 30 states across the U.S.
California was the first state to pass SOPIPA, which was meant to address the shortcomings of the Family Educational Rights and Privacy Act (“FERPA”). FERPA has been the federal law regulating student privacy since 1974. Critics of FERPA say it is wildly outdated and new laws such as SOPIPA are needed to protect students in the digital age. A major shortcoming of FERPA is that vendors cannot be found liable for FERPA violations, instead liability can only fall on the school districts. SOPIPA addresses this directly, stating that vendors bear liability for violations of SOPIPA. California passed its SOPIPA law in 2014. Since then, roughly 30 states have passed some form of the bill. In states with SOPIPA laws, K-12 software vendors are generally prohibited from using data collected on their platform to build profiles or engage in targeted advertising to K-12 students.
While Naviance and Intersect may sound like two different programs, we believe they are essentially two sides to a single platform. Naviance is the side of the platform that K-12 students interact with by inputting information about themselves into its database. Student GPA, test scores, degree interests, extracurricular activities and more are all entered into the Naviance platform. In many districts, providing this information is required as a condition of graduation. After inputting their data, students receive information about colleges that align with their interests and background and can interact with colleges directly through the program. Intersect is the side of the platform that is used by college admissions offices as a lead-generation tool. Intersect connects to the Naviance database and gives admissions offices access to the data students enter into the Naviance platform. Our analysis shows that colleges using the Intersect platform can specifically target students of certain races, ethnicities, and class years, among other variables, and send them messages encouraging them to apply. We believe this system of essentially profiling students and targeting them through ads is a potential violation of SOPIPA laws. We believe that if regulators from states with active SOPIPA laws were made aware of PowerSchool’s activity, they could take punitive action against the Company, requiring it to significantly alter or even discontinue the Intersect software.
- We believe PowerSchool’s financial reporting and aggressive accounting practices signal growing strain and that financial leverage is understated. PowerSchool makes questionable references that confuse whether students or school districts are its ultimate customers. Revenue recognition depends on who exactly is the customer and when the service is delivered. This creates the potential for PowerSchool to recognize revenue before its products and services are fully implemented and usable for students. Furthermore, the Company recently changed revenue recognition language citing price discounts. In addition to signaling greater competitive pressures, this shift may also suggest that previously recognized revenue was inflated by ignoring discounts. Coincident with this recent change, we have determined that days sales outstanding (DSO) has been growing at a rate of 2x revenues while bad debt reserves against accounts receivables jumped to a multi-year high.
Between 2020 and 2023 PowerSchool reported a 71% increase in Adj. EBITDA. However, our analysis illustrates that ~100% of this reported Adj. EBITDA growth has come entirely from non-earnings growth. Between 2020 and 2023, the Company’s operating income has grown by just 8%, despite a series of major acquisitions and several strong years of reported organic growth. Over the same period, amortization and stock-based compensation grew by a combined $96.5 million, accounting for the entirety of the $96.3 million in reported Adj. EBITDA growth over the period. PowerSchool’s reported Adj. EBITDA calculation excludes the impact of ~$40 million in annual capitalized software development costs, a figure that has grown significantly since 2020. PowerSchool capitalizes software development costs at a greater rate than nearly all its peers, and when measured against a broader universe, its rate of capitalization still appears excessive. PowerSchool’s amortization expense schedule for these capitalized costs also indicates that a greater percentage each year is to be recorded beyond five years, which could serve to delay expense recognition.
We believe the Company’s Adj. EBITDA is also inflated by dubious restructuring add-backs. Despite telling the SEC in a letter in 2021 that it did not expect to incur meaningful restructuring expense adjustments post-IPO, the Company’s adjustments from restructuring expenses more than doubled in 2022, and then remained elevated over 2021 levels during 2023. PowerSchool appears to be delaying expense recognition to inflate earnings by amortizing its contract acquisition costs over seven years despite customer contracts typically lasting just three years. This seven-year period is the longest observed among peers with K-12 education customers. We believe this extended amortization schedule violates the spirit of GAAP’s matching principle, which requires expenses to be matched over the same period as revenues.
Our analysis also illustrates that PowerSchool’s true leverage is nearly 2x what it reports. We believe the Company’s Adj. EBITDA to be highly embellished, notably through large capitalized software development costs which are treated as non-cash add-backs to Adj. EBITDA. In addition, PowerSchool excludes a ~$420 million Tax Receivables Agreement (“TRA”) liability that must be paid in cash to its private equity sponsors, Vista Equity and Onex Corp. The net effect of these two adjustments brings PowerSchool’s leverage to 5.8x – a standout in the edtech industry where many companies have a net cash position.
- Spruce Point has several concerns with PowerSchool’s management team and board. We have identified at least seven senior-level executives who have departed post-IPO, including the Chief Revenue Officer, Chief Marketing Officer, Chief Operating Officer, Chief Accounting Officer, Chief Product Officer and the SVP of Corporate Development & IR. In departing so quickly post-IPO, the senior executives forfeited large RSU packages, the combined value of which is estimated to be over $17 million based on PowerSchool’s current stock price. We have concerns with the abrupt departure of PowerSchool’s Chief Accounting Officer (CAO) in 2023, who left with just one week’s notice. After her departure, the Company stopped referencing students as customers, which magnifies our earlier concern about potential revenue recognition issues. The CAO’s responsibilities were temporarily assumed by the CFO, who has a questionable past. CFO Eric Shander was terminated in 2019 by his former employer Red Hat over violations of workplace standards. His conduct was apparently egregious enough for Red Hat to dismiss him without the $4 million bonus he was due to receive. PowerSchool has had three independent directors. Independent director Amy McIntosh also serves as director of EAB Global, Inc., which is a software reseller representing 5%+ of PowerSchool revenue and portfolio company of controlling shareholder Vista Equity. Director Ronald McCray previously served as director of Career Education Corp., (now Perdoceo Education Corp.), which was fined $30 million by the FTC for improper collection of consumer data and forced to forgive nearly $500 million in student debt to settle similar claims levied by state regulators. Career Education Corp.’s alleged violations occurred while Ronald actively served as director, including a stint as Interim CEO in 2015.
- We estimate 30% – 60% downside risk to PowerSchool’s share price. PowerSchool is a unanimous “Buy” according to the sell-side with an average price target of $27.90/share which implies valuation multiples of ~9x and ~25x FY24 revenue and Adj. EBITDA, respectively. Despite the promoters’ aggressive share price targets, both PowerSchool’s management and private equity sponsors have been heavy sellers of stock at or below $21 per share or 25% below the consensus price target. Perhaps insiders are seeing what we observe which is that PowerSchool’s business is under growing pressure, operating on tenuous grounds in relation to student data privacy laws, being embellished with aggressive financial and accounting practices, and burdened with significant leverage. We value PowerSchool at 4x – 5x and 15x – 20x FY24 sales and Adj. EBITDA, in line with comparable companies, which implies 30% – 60% downside risk ($8.00 - $14.00/share). We expect the Company’s share price to underperform the broader education and technology industry sectors.
