Is K-12 Inc. The Future Of Education? Here's Why I'm Skeptical

| About: K12 Inc. (LRN)

The internet has radically altered the media, financial markets, retail, and service industries to improve their services at a lower cost. Can the same be done to primary and secondary education?

K12 Inc. (NYSE:LRN) is a company that is trying to do that by using the internet to customize the learning experience for students, while lowering the cost below the expenses incurred by brick and mortar public and private schools. Despite its rapid revenues and earnings growth, cash flow issues and societal pressures make me skeptical of K-12's performance over the next 1-2 years.

Financially K-12 is a mixed bag. The company is growing rapidly, with an average of 34% revenue growth and 24% earnings growth over the past five years. Due to a low base of students and state governments' continuous need to cut costs, growth is expected to continue to exceed 20% for the next five years as well. With a 7% debt to equity ratio, K-12 also has low debt levels. K-12 is growing rapidly, but its failure to reach profitability undermines this. Even with high growth, the company still has a poor return on investment capital at 3.4%, and has a negative free cash flow of -$1.5 million on $15 million in net income over twelve trailing months. Part of this shortfall is due to the need to finance growth. However, by this stage of the company's life cycle, investors should expect profitability from low cost online education company.

Societal issues and the skepticism of current online education are also an anchor to K-12's performance. For-profit education in post secondary education has been highly profitable. However, companies such as Apollo Group (NASDAQ:APOL), DeVry (NYSE:DV), and ITT Educational Services (NYSE:ESI) have not been able to translate this to improve the quality of their products. Their degrees lack any significant value in the private sector job market, and K-12 faces the same problem with its degree's credibility to the admission departments of major universities. K-12 lacks a substantial track record of placing its students in prestigious universities. Until K-12 has successive classes of college placement on par with top public schools, ambitious and diligent parents / students will not allow their child (or choose to attend themselves) to opt out of traditional school.

Based on the schooling experience of both myself and younger family members, online classes are still largely regarded as an easy way out of regular classes. The primary reason this stigma remains is that there is no way to prevent cheating (which is significantly easier online) through the online model. It is too easy to look up Wikipedia or Yahoo Answers during a test. Since parents are usually the "learning coach", students can either take the tests when the parents are at work, or the parent may even comply to help their student gain an edge in a intensely competitive college placement market. K-12 does not have any legitimate method in its curriculum to prevent this type of cheating from happening. The result can the be the graduation of even less educated kids than from the already weak public educational system. The ease of academic dishonesty and the lack of a college placement track record will keep skepticism of online education alive and hurt the long term outlook of K-12 Inc. until the company remedies these concerns.

Overall, due to its lack of a track record of college placement, society's skepticism of homeschooling, a high valuation in a bear market, and negative free cash flows, I expect K12, Inc. to underperform for the next 1-2 years. Credibility is K-12's major concern and the negative perception of for profit colleges does not help its case. The company has longer term potential due to the economic pressures on state governments and the cultural shift towards embracing technology, but it needs to fix structural issues within its curriculum first.

Due to the stock's most recent freefall, I would not initiate a short position here, as it is technically oversold. However, I would not recommend buying here and would short if the stock breaks above $30 again.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.