K12, Inc. LRN S
June 02, 2008 - 2:28pm EST by
britt12
2008 2009
Price: 26.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 800 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT
Borrow Cost: NA

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Description

Introduction/Thesis:

At its current price, we believe that K12 Inc. is being priced as if their highly regulated, highly competitive, and largely unproven business model will work to perfection in the coming years. We believe that an aggressive DCF yields a fair value of no more than $14 per share, substantially less than today’s price. While we believe the fundamental thesis stands up on its own merit, we are also encouraged by certain technical factors. In mid June, roughly 70% of the shares that are currently locked post IPO become freely tradable, and following the stock’s ~50% appreciation post IPO in a very difficult market overall and for the education space in particular, we believe that some of these shares will be for sale, including the roughly 12% owned by Bear Stearns Asset Management subsidiary Constellation Ventures. We are recommending a short position in K12.

 

Company background:

K12 was founded in 2000 with the mandate to develop a web-based/virtual for-profit public education platform for K-12 as an alternative to traditional brick and mortar public schools. After 18 months of research and development, the Company launched its K-2 product in Pennsylvania and Colorado, and each year thereafter the Company added additional grades and states in which it offered its curriculum. Today, the Company has a full K-12 offering serving over 42,000 students in 18 states (with two more recently approved – Hawaii and South Carolina), having spent over $120 million on its own proprietary curriculum since inception, garnering ~45% of the market share in virtual K-12 education. The Company’s target student typically fits into one of six profiles: 1. children who face learning disabilities, 2. have physical disabilities, 3. are gifted and bored of traditional school, 4. live in rural communities and don’t want to travel long distances for school, 5. play elite sports or are in the entertainment business, or 6. seek to retake classes to fulfill graduation requirements. The Company relies on state funded education budgets as its primary source of revenue, and in fiscal year 2007, generated approximately $5,200 in revenue per student. 83% of the Company’s revenue is derived from turnkey management services, where K12 is responsible for the complete management of these schools. Under these arrangements, K12 typically works under 3-10 year contracts, and generates revenue from state mandated compensation per pupil (typically no local funding unlike most public schools), in turn offering each student access to their curriculum, textbooks, and other materials, which typically includes a computer. Approximately 15% of the Company’s revenue is derived from schools services where K12 does not have management contracts. In these situations, the Company’s revenue is limited to direct invoices (primarily sales of their materials/curriculum), which are independent of the total funds received by the school from a state or district, and revenue per student is lower at an average of ~$2,500. Finally, the Company has a small (2%) portion of its revenue derived from curriculum sales to private payers, and this distribution channel has not seen much growth, if any, in recent years.  

 

K12 went public on December 18th, 2007 at $18 per share, with 6 million total shares offered (4.5 million new shares, and 1.5 million by selling shareholders). The Company now has a total of 30.6 million fully diluted shares outstanding, and trading at $26.13 per share, has a market capitalization of approximately $800 million. The Company is well capitalized with a net cash position of $53 million, making the enterprise value $747 million. In 2007, on $184 million in revenue, the Company generated $7 million in EBIT and $5.6 million in operating cash flow, and after spending approximately $14 million in capitalized curriculum and PP&E (mostly computers), had negative free cash flow.

 
There are a number of both fundamental and technical reasons why we believe that LRN is a compelling short opportunity:

 

K12 operates in a highly regulated space and is exposed to state budgetary spending pressure from large deficit balances: K12 relies primarily on state funded education plans/budgets that are driven more by available resources than demand for their product and therefore they have essentially no bargaining power and openly admit to being ‘price takers’. Recent historical growth rates in per pupil funding have significantly trailed inflation, and there is little reason to believe that this trend will reverse in the coming years as many states available resources have diminished to dangerously low levels from massive budget deficits. According to the Center on Budget and Policy Priorities, at least 27 states are facing an estimated $47 billion in combined shortfalls for fiscal year 2009. After drawing down substantial portions of reserves, states are left with only two primary options to help cover this shortfall: raise taxes or cut expenditures. As consumption has weakened and tax revenue collections have declined, many states are starting to look toward significant spending cuts, and education spending is not immune to these plans.  Three of LRN’s largest grossing states, including Arizona, Ohio, and California (which collectively represent at least 25% of revenue) are among states that face the largest shortfalls, and in each case, the possibility exists (as the Company openly admits) that they will cut per pupil funding, delay certain payments, and take other measures to cut education expenditures. Though the Company would not provide much commentary on this, it was interesting that in the quarter ended March 31, receivables tripled, growing at a much faster clip than the 60% growth rate in revenue.

The Company is facing increased competition from much larger competitors: While LRN has been one of the first movers in the niche online education for K-12 space and has garnered 45% of the market share, larger, more powerful businesses such as Apollo Group and Devry have entered the space through acquisitions and are attempting to expand at a relatively aggressive pace. This may add pricing pressure to a business that already has minimal pricing power. Additionally, there is limited evidence to suggest the K12’s ‘proprietary’ curriculum is more effective than the alternatives/competitors. The Company prospectus and marketing material is carefully worded to say that their students on average test ‘near or above’ state averages, but there is little evidence to suggest that their platform is conclusively more effective than the online competitors or from traditional brick and mortar education and relative to other online competitors. We also anticipate that whatever advantage the company has by being one of the first movers and through developing its own ‘proprietary’ curriculum will decrease substantially as their larger competitors gain market share in the industry.

The economics of LRN’s business are not particularly attractive: With the exception of 2005 when the Company generated approximately $1 million in free cash flow (due to an unusual decline in working capital), the Company has never generated positive free cash flow, and is not expected to do so until 2010 at the earliest. Since inception, K12 has had an accumulated deficit of $190 million. After capitalizing some of its curriculum development (which is aggressive given the intangible nature of these costs and the Company’s historical write downs of some of these assets), K12 operates with thin EBIT margins of less than 5% today. We believe that it will be difficult for the Company to ever exceed 10% margins because for-profit public education businesses have little economies of scale, if any, and a report put out by BellSouth entitled 20/20 Vision for Education suggests that operating costs are essentially the same whether brick and mortar or online education. Instructional costs, which comprise roughly 60% of total costs, primarily consist of teacher and administrator salaries, textbooks and materials, and typically remain the same with each incremental student. In K12’s case, instructional costs have actually risen faster than revenue in recent quarters (from roughly 54% of sales to 58% of sales year over year), primarily related to the introduction of their high school offering, which has lower margins due to higher teacher-student ratios and more materials and textbooks. This increase has nearly offset decreases in SG&A and product development expenses as a percentage of sales, where the Company has been able to realize some economies of scale. Going forward, instructional costs as a percentage of sales should continue to rise as the Company expands its high school offering, but more importantly, as inflation affects materials costs to a much greater degree than inflation will be passed through to the highly regulated and pricing constrained top line. This could particularly affect the Company’s managed contracts, where if costs outweigh revenue for a given school, the Company must absorb operating deficits, in which case they adjust their revenue downward by this deficit. As of the end of fiscal year 2007, operating deficits totaled $14 million. Operating deficits have grown faster than revenue and the Company has forecasted that this trend will continue.

No Company that caters to for profit K-12 education has succeeded to any large degree historically: Largely as a result of some of the economic factors mentioned above, there are a handful of historical examples of Companies that operate in K-12 for profit education that have either failed completely or failed to create substantial equity value for shareholders. Edison Schools is perhaps the best example.   Once a high flying stock that reached a market capitalization of nearly $2 billion, Edison was hailed as the salvation of public education, offering a charter school concept they claimed could run public schools for less money than school districts. The model ultimately failed and the Company was acquired in 2003 for $130 million (or $1.75 per share), far less than the $600 million that had been invested into the Company. Like K12, Nobel Learning Communities is another Milken/Ellison backed company that participates in the for-profit, K-12 space, only they operate private, traditional brick and mortar schools. Since inception, the Company has only had modest success at best having just moved from an accumulated deficit to retained earnings with its minimal profitability in recent years. Since going public in 1993, the stock has been largely forgotten and trades less than $200,000 worth of stock per day. While both Edison and Nobel operate in the traditional brick and mortar school space rather than online, their lack of success is indicative of the difficult economics associated with all for-profit K-12 education.

The Company faces considerable opposition from teachers unions throughout the country: The Company has significant opposition from teachers unions throughout the country that view the move to a less labor intensive, online model as a threat to their existence. The Company has faced litigation in a number of states since their inception from teachers unions seeking the closure of the virtual public schools they serve. Most recently, the Company was able to prevail in Wisconsin and the state amended certain charter school, open enrollment and teacher licensure laws. They do, however, continue to face an enrollment cap of 5,280 students in Wisconsin, and face these caps in a number of other states in which they operate. Similar to Wisconsin, the Company faces ongoing litigation in Chicago where the Chicago Teachers Union has filed a lawsuit challenging the decision to certify the Chicago Virtual Charter School. It remains to be seen how effectively the teachers unions will be able to challenge the growth of virtual public schools, but it’s clear that they are vehemently opposed to virtual schooling and will do all they can to slow the development of these schools. Even if they do not succeed in eliminating or preventing virtual schools from gaining acceptance in certain states, they will clearly have some influence and may be able to maintain strict enrollment caps, as they’ve done in Wisconsin.

Not surprisingly, Sell Side Models contain aggressive/ridiculous assumptions and are driven/biased by significant conflicts of interest rather than reality: Following the Company’s IPO in December, the six investment banks that underwrote the IPO initiated coverage (what a coincidence!), all with buy recommendations and target prices between $29 and $32 per share. Projecting cash flows for this Company is obviously extremely difficult for this business given that the major assumptions are dependent on highly variable long term enrollment growth, state education funding legislation, and new state acceptance of virtual public schools, to name a few, so any DCF model of LRN faces significant uncertainties in the first place. A closer look at some of the sell side models yield some of the more insanely aggressive, and in some cases, next to impossible assumptions that we’ve ever encountered. This example is no different from most, but is particularly fishy given the obvious conflicts of interest from the investment banking dollars driven from the IPO and probable near to mid term secondary offerings by insiders, potential investment banking dollars from other businesses owned/managed by K12 shareholders, in addition to the lock up expiration of K12 shares owned by the underwriter. We will spare everyone from too much commentary on meaningless sell side models, but for comedy’s sake, we thought we’d share a few of the more ridiculous assumptions from Morgan Stanley’s model:

o       Before getting into input assumptions, we thought we’d point out that Morgan derives their target valuation from a 100 year DCF. It’s hard enough to predict the growth trajectory of this (or really any) business in the next 5 years, but for an analyst to build a 100 model is just irresponsible.

o       If all does not go as planned, Morgan’s ‘bear case’ model assumes enrollment CAGR of 22% in the next 5 years, EBITDA CAGR of 28% in the next 10 years, EBITDA margins increasing from ~10% today to 17% in 2012 and 20+% in 2017, with a 6% growth rate income statement line items for years 11-100. These are ‘bear’ case assumptions?!!!

o       The base case model, which has an 8% growth rate in years 11-100, assumes that the Company will generate revenue in 100 years of over $1 trillion and have over 76 million students in its program. To put this into perspective, there isn’t a single company in the world today that generates $1 trillion in revenue, total spending in the public K-12 market is approximately $500 billion, and there are only 55 million students in total K-12 in the US today, including all public, private, and home schooled.

o       If the Company exceeds Morgan’s base growth assumptions, then the bull case models suggest they will have over 200 million students in 100 years! Instead of ‘No Child Left Behind’, Morgan’s long term financial model implies ‘No Child Left Without K12, inc. virtual education’!

o       Morgan Stanley’s long term projections are especially suspect given that Years 2008-2012 contribute a meaningless amount of cash flow if any in all of their scenarios, and over 80% of the NPV comes from years 2018-2107.

Post IPO expiration of trading restriction on ~70% of  the shares: ~70% of the common shares are still locked up post IPO, but become free trading in June. On June 10th, the underwriters shares become free trading (of course they get to sell first!), and on June 16th, the remaining locked shares become free trading. While the majority of the 20 million shares that become free trading are held by well known family offices such as the Milken and Ellison families who presumably have a longer investment horizon, ~12% of total shares are held by Bear Stearns Asset Management subsidiary Constellation Ventures, who are likely to sell shares in the not so distant future. Constellation invested $20 million into the Company in 2003 at what we estimate to be around $5 per share, part of a $350 million fund they raised in 2000, which presumably doesn’t have much more than a 10 year total time horizon. Constellation is now struggling to raise assets for a third fund given their relationship with Bear Stearns, and may be compelled to book high IRRs (40+% by our estimate). Outside of the shareholders already mentioned, there are a handful of additional shareholders subject to the lock up, many of which sold some of their shares in the IPO at $18 per share.

Despite little in the way of meaningful news since the IPO at $18 in December, the stock has traded up 50+% overall (and nearly double its low just two months ago), while education companies (Morgan Stanley’s peer group) have traded down by an average of 15+%:

 

 

Risks and other commentary:

·        We have little doubt that the Company will continue to grow top line at a healthy clip in the next few years, and the Company will likely continue to underpromise and overdeliver as it relates to top line guidance. Longer term though, it is essentially impossible for them to deliver the ridiculous top line perpetuity assumptions used in Morgan’s model. More importantly, for all of the reasons mentioned above, we find it extremely unlikely that they will deliver margins anywhere near a figure that could justify today’s stock price.

·        The Company recently opened a beta program in Dubai and have signed on a ‘handful’ of students thus far. While industry sources and former employees have indicated the launch has not lived up to expectations, it’s possible that they could have some success in penetrating global education markets. We find it hard to believe, however, that they will generate significant overseas business given language and regulatory barriers.

·        There is a very small float now and relatively low trading volume. The stock is easily manipulated and has extremely high daily volatility relative to its trading volume. According to our prime broker though, there is a ‘decent amount of borrow’ available, priced at a full rebate.

·        There are some very powerful people behind this business, including the Milken, Ellison, and Tisch families, to name a few. We have a lot of respect for each of these families and they have made many multiples of their original investment in the Company, so this write up is in no way meant to discredit them. Like any investor though, they are capable of making bad investment decisions.

·        The Company is well capitalized with approximately $53 million in net cash and is not bleeding enough cash to where they will need to look to additional capital raises in the near future. The Company also has NOLs that total $59 million, which they may be able to utilize in the coming years.

 

Conclusion:

As we think about potential downside to our short thesis, outside of the possibility for pure manipulation of the stock by investment banks and/or the hype surrounding the story and sell side ‘bull case’ models, what does a more realistic ‘bull case’ look like? First, we must consider the potential market size for a Company like K12. We find it extremely unlikely that K12 will ever have more than 500,000 fully paid students. While it’s possible that the virtual education market can capture some portion of the 2 million home school market, it still will require continued acceptance of their product among home school parents in addition to the lifting of enrollment caps which they face in a number of states. It’s also hard to envision the possibility that the industry captures much more than a couple percentage points of the ~50 million traditional brick and mortar public school students, where the incumbent system is clearly entrenched and offers significant social benefits to the online model. As for a DCF model, Morgan’s ‘bear case’ is actually more in line with what we view as the true ‘bull case’. Although we think their assumptions in years 1-10 are aggressive, it is possible that K12 exceeds these, so we adjust these growth rates upward to reflect their base case adjustments. However, we adjust their 6% perpetuity growth rate downward to a more realistic 3%. The end result of our ‘bull case’ model is an NPV of $14 per share, still a substantial discount to today’s price. We find it extremely difficult to believe that LRN will ever grow into its current valuation.

 

Catalyst

1) Post IPO Share unlock in Mid June.
2) Increased competition from large industry players.
3) Education expenditure cuts in state budgets.
4) Litigation with teacher's unions.
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