Overlooked Education Sector: K-12 Poised to Prosper

| About: K12 Inc. (LRN)

Education as an investment sector is often viewed as a safe, defensive play because education is, relatively speaking, a constant, and times of economic stress usually increase higher education enrollments as people seek to boost their job skills.

On a demographic basis, we believe that the U.S. education sector is overlooked as great long-term growth play, especially given that total enrollment in grades prekindergarten-12 is projected by the U.S. Department of Education’s statistics center to grow 10 percent (as of 2005) by 2017.

In particular we like innovative companies that harness technology as means to boost learning skills, with our personal favorite being K12 Inc. (NYSE:LRN).

K12 is a technology-based education company that offers proprietary curriculum and educational services to students in kindergarten through 12th grade who are being homeschooled, attending virtual public schools, attending a “blended” school, and to some in traditional classrooms.

The company offers its educational programs and services through online lessons, offline learning kits, and teacher’s guides; and provides a range of academic support services, such as scheduling tools, progress tracking tools, administration management, compliance tracking, technology support, special education support, to name a few.

K12 was founded in 1999 in Herndon, Virginia, and to date its curriculum is offered and accredited in 22 states, and the company expects to expand in at least seven to eight more states by 2012. According to the company, homeschooled and students in virtual schools who use K12’s curriculum consistently exceed state averages on standardized test scores and outperform virtual schools that use other curriculum.

As it has expanded during the past 10 years and student enrollment rapidly increased, its revenues have significantly jumped, with the company taking in $30.9 million in 2003, and estimating $315 million in 2009. The company IPOed in December 2007.

While the number of U.S. students is seeing 10 percent growth in the coming years, the growth of alternative forms of education, such as homeschooling and virtual public schools has been even more robust.

As of 2007 the Department of Education’s National Center for Educational Statistics estimated the number of home schooled children at 1.5 million, a 74 percent increase from 1999 when the department first started keeping track. While the center did not try to project future numbers, a statistician for the center said they believed the number of homeschoolers would continue to increase at a high level.

The number of students in virtual schools almost doubled between 2005, when there were 31,o00 students in 86 virtual schools in 13 states, and 2007, when there were 92,000 students attending 173 virtual schools in 18 states.

All of this bodes well for K12, which should see significant growth in the next few years, as more students continue to adopt alternative learning and the company expands into new states. If the company can continue its current pace of enrollment growth it will likely double its enrollment by 2012. And because the company’s fixed costs are basically stable, increasing enrollment means a nice boost to margins.

As of July 10 the short position in the stock was at 24.9 percent, reflecting what we believe to be the mistaken belief that state and federal funding will not continue to support the nascent virtual school movement, because they should not be considered true public schools.

However, recent court cases, as well as continued accreditation, belies this line of thinking. In the most recent court ruling a Cook County, Illinois court issued a summary judgement June 12, in favor of the Chicago Virtual Charter School, ruling that the school is in full compliance with the Illinois School Code, and ensuring its continued lawful operation and public funding.

K12 reported May 8, that for the three months ending March 31, quarterly revenue was up 38 percent on strong enrollment growth. K12 Chief Executive Officer Ron Packard was very positive about the group's long-term growth prospects:

We are pleased to be able to deliver these results, particularly in this environment, and we continue to see strong demand from state governments and students for our high quality offering.

The company also reconfirmed the earnings and revenue guidance issued on February 9, 2009 of full fiscal year 2009 revenues of approximately $310 million to $320 million versus last year’s $266 million.

We believe that, despite the company’s strong demographic tail wind, valuations still matter. On this basis the shares still offer excellent growth potential given its future growth prospects. The shares sell on an historic fully diluted price per earnings of 17.2 and a Price to sales of 1.7. Analysts are forecasting up to 50 percent plus growth this year, which leave the shares very attractively priced, particularly on a PEG (price/earnings to growth) ratio basis.

While there are no certainties in the investment business, our demographic, valuation and sentiment models suggest that K12 growth prospects are being undervalued by investors and earnings surprises should continue to be on the plus side over the next few years.

In addition, being an innovative company, we would not be surprised to see the company seek an alliance in the not-so-distant future with an e-book company – Amazon (NASDAQ:AMZN), with its Kindle; or Apple (NASDAQ:AAPL), with its highly anticipated iTablet – as a new medium for offering its curriculum.

Disclosure: No positions, but featured in our model portfolio