K12 INC LRN S
July 31, 2018 - 11:44am EST by
zipper
2018 2019
Price: 16.50 EPS 0 0
Shares Out. (in M): 41 P/E 0 0
Market Cap (in $M): 677 P/FCF 0 0
Net Debt (in $M): -227 EBIT 0 0
TEV ($): 450 TEV/EBIT 0 0
Borrow Cost: General Collateral

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Description

Possible SAT words/concepts/foreign language in italics for your test prep benefit. Sorry in advance, Ms. Palmisatto, for any grammar or spelling errors.

Summary

While K12 (LRN) screens very cheap, there are some major problems with their business that should begin to manifest in results in 2019 (fiscal year = school year, ends in June). Notably, the market is unaware of a major contract loss in Texas that will have a substantial earnings impact.

Company Background

LRN is an early pioneer in delivering online education, serving public school systems up through grade 12. They operate through various brands including “Virtual Academy” and “Insight Schools” to provide primary and secondary education to students in most states in the US.

~80% of their revenue comes from their Managed segment, through which they partner with a local non-profit entity to set up and register an online school. (For profit entities cannot run schools directly.) Managed schools are mostly shells through which LRN employees operate every aspect from marketing to admin to teaching to lobbying. These schools are public charters, meaning the state gives them taxpayers dollars for every head they teach and tuition is completely free to the parents, as if the kids were going to the local school.

The remainder of their business is Non-Managed, where the non-profit school simply buys the curriculum and consulting services from LRN, but manages everything else themselves. They also have an insignificant private online school offering.

LRN schools are predominantly 100% online, with teaching done through electronic coursework and video (along with a crate of art supplies, etc.), although some are “blended”, meaning some mix of in-person activities.

LRN has an inglorious history of poor academic outcomes, weak shareholder disclosure and questionable operating practices. Whitney Tilson even published a well timed short report in 2013. https://www.tilsonfunds.com/K12-Tilson-9-17-13.pdf

Industry Background

Virtual schooling started taking off around the time of the Internet revolution and is continuing to grow today. However, LRN and Pearson (which owns Connections), began to taper off in the past few years. Let’s come back to why in a bit.

http://nepc.colorado.edu/publication/virtual-schools-annual-2018

First, why does the business exist? Basically, we view LRN and Connections as weapons dealers to the various school districts that are fighting a perpetual arms race to grab the greatest share of the state educational dollars. A school district which runs a virtual school can enroll students from anywhere in the state, and they are allocated tax dollars for every student they serve. So, it is a rational response for underserved communities in particular to pull in more resources to help their kids. Understandable behavior, but a societal zero sum game at best, and a dead loss game if the academic report cards are accurate. There are plenty of less savory reasons for this investment by the various players involved as well. It is disturbing when you read about how these virtual schools can spend 50% of the state average per student and still get paid exactly the same stipend per head.

While the idea of virtual education sounds wonderful, educational outcomes have been uniformly bad, and most of the schools are playing a cat-and-mouse game with state policymakers to try to avoid getting shut down or sanctioned. This game has creative rule-bending that reminds us of the good ol’ Financial Crisis days, such as changing authorizers, bifurcating students into a good school/bad school and shutting down the old school and then starting up exactly the same new school with a new coat of paint.

So why are LRN and Pearson not growing with the market? While it is hard to make generalizations, given how Balkanized the state systems are, it does seem like school districts themselves are climbing the learning curve on how to run their own schools. Numerous charter school networks are moving into online. LRN has been hit by some large defections, such as Agora in PA. There are also a litany of private competitors, including one run by LRN’s founder/ex-CEO. In other words, the space just looks a lot more sophisticated and competitive than before, when nobody knew how to do online education.

On top of all that, some high profile virtual frauds have come to light. Reading up on Ohio’s ECOT scandal might make your blood boil. A PA charter executive was just sentenced. LRN itself was dragged through the mud in California in 2016.

To be fair, these are subjective views, and when idealism meets greed in the arena of public policy, the good guy usually goes to the ICU.

Texas Virtual Academy Closure

For the 2018-2019 academic year, LRN will lose the Texas Virtual Academy (TVA) contract. TVA is operated by the Texas-based non-profit, ResponsiveEd, and its affiliate, Premier High School. https://www.guidestar.org/profile/75-2748762

TVA historically used LRN’s curriculum and other services as a Non-Managed client, and enrollment was even done through LRN’s website as recently as May. Our (imperfect) understanding is that ResponsiveEd, which runs a network or brick-and-mortar charter schools, decided to take the curriculum in-house. For the upcoming year, they have rebranded to iSchool Virtual and are marketing furiously. https://ischoolvirtual.com/

But wait, LRN still runs the Texas Virtual Academy at Hallsville and is enrolling grades 3-12? https://www.k12.com/participating-schools.html?state=texas

This is a diversion. Hallsville was a nonentity that served a total of 7 students in the ’15-’16 school year. LRN simply pulled out the old industry trick of swapping the school’s nonprofit sponsor with a district eager to bump up its education dollar intake. We know Hallsville was not up and running as of May, because at that time their enrollment specialist confirmed TVA was shut down and sent us to TOPS, LRN’s other virtual school in Texas.

Meanwhile, TVA served ~6,300 students in the ’16-’17 school year.

https://rptsvr1.tea.texas.gov/cgi/sas/broker?_service=marykay&year4=2017&year2=17&_debug=0&single=N&title=2017+School+Report+Card&_program=perfrept.perfmast.sas&prgopt=2017%2Fsrc%2Fsrc.sas&ptype=H&batch=N&level=campus&level=campus&search=campname&namenum=virtual&campus=221801022

https://rptsvr1.tea.texas.gov/cgi/sas/broker?_service=marykay&year4=2017&year2=17&_debug=0&single=N&title=2017+School+Report+Card&_program=perfrept.perfmast.sas&prgopt=2017%2Fsrc%2Fsrc.sas&ptype=H&batch=N&level=campus&level=campus&search=campname&namenum=virtual&campus=072801145

TVA Hallsville will likely be an institution that is similar but not congruent with old TVA – in other words much, much smaller. The problem here for LRN is that current students will have been inculcated in the ResponsiveEd paradigm and ResponsiveEd owns the student dossier. The old trick of swapping districts probably doesn’t work when there is incumbent competition.

So, what’s the plausible financial impact? Comparing the data for last nine months of 2018 vs. 2017 is instructive. Note Gross Margin below treats only Instructional Costs and Services as COGS. Although LRN arranges SG&A and Product Development in their filings so there is no true COGS entry, these two line items should be treated as fixed costs other than to the extent SG&A includes lobbying dollars tied to specific schools.

Growth in Managed enrollment paired with declines in Non-managed enrollment results in a small revenue increase, but substantial gross margin contraction. Sixth grade mathematical reasoning should lead one to the conclusion that the Non-Managed business is more profitable by far. While the data isn’t perfect and sixth grade algebra doesn’t provide a clean solution (implies Non-Managed GM > 100% #UNSOLVABLE PRESS C TO RESET#), likely due to various cost rationalization measures LRN has taken and some other data issues, it is not unreasonable to believe that GMs for serving up an online software curriculum without all the pesky costs of hiring humans to teach/market/administer are in the 60-80% range vs. something below 30% for the Managed business.

A look at the Agora loss in 2016 is not clear cut due to a major revenue hit the same year, but provides support for this hypothesis as well. When the Agora contract was revised, margins went up, not down.

So what happens when Texas Virtual Academy drops off for the 2019 school year? It may not a 100% enrollment loss, as LRN might recapture some students, so the below is simply illustrative. Furthermore, any recapture by TOPS or TVA Hallsville will have an indutibly lower margin, as they are Managed schools.

While revenue doesn’t see much impact, since a fraction multiplied by a fraction is smaller than either fraction, the bottom line impact could be repugnant. The implications of a declining Non-Managed business are nicht gut, no bueno, pas bon, 不好.

Back to Hallsville for a moment. Hallsville projects they could serve 2,000 students in year 1: https://www.news-journal.com/news/county/gregg/hallsville-isd-signs-manufacturing-academy-virtual-school-agreements/article_ad203372-5d18-11e8-b6ad-37f787fe688d.html. We are skeptical, but even if they succeed, LRN will “front all the costs for a year” per the article. Per SEC filings, LRN takes a hit if the school is running at a deficit (see below). At best, we will see recapture at a sub-30% margin, but more likely, we believe Hallsville is breakeven in ’18-’19.