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K12 Inc. (LRN)

Overall Short Opinion (1 to 10, 1 is a bad short idea, 10 is the best): 9

Price: $22.18

Shares Outstanding: 36.8 Million

Market Cap: $843 Million

Short Interest as % Float: 33.7% -- Short Interest up by 21% over the past three months

Upcoming Catalysts: Management expects to release formal FY/13 guidance the week of October 8. However, management did comment that FY/13 consensus estimates are "comfortable" with management (revenue of $854.7 million; +21%, EBITDA of $109.7 million; +26%, and EPS of $0.69; +53%).

Ownership: Delaware Investment Management owns roughly 14%, William Blair owns 11%, Technology Crossover Ventures owns 11% (invested via private placement in April 2011 at $31.58 per share -- TCV also got a board seat in the deal), Fidelity owns roughly 9%.

Business: From their 10-K: "We are a technology based education company. We offer proprietary curriculum, software systems, and educational services designed to facilitate individualized learning for students primarily in kindergarten through 12th grade (K-12). K12 provides a continuum of technology-based educational products and solutions to districts, public schools, private schools, charter schools, and families as we strive to transform the educational experience into one that delivers individualized education on a highly scalable basis."

K12 goes on to state that their core competencies include the "ability to create engaging curriculum, train teachers to be effective in online instruction, provide turn-key management services to online schools, customize online learning programs for school districts, develop innovative new offerings."

In the past three years, the company has been on a spending binge-with several key acquisitions, including the following:

July 2010: Acquire KC Distance Learning (KCDL), provider of online curriculum and private virtual education

July 2010: Acquire Capital Education LLC

December 2010: Acquire American Education Company (AEC)

April 2011: Acquire International School of Berne

July 2011: Acquire Assets from Kaplan Virtual Education (KVE and Insight Assets)

K12 has three main business lines: Managed Public Schools, Institutional Business, and International and Private Pay.

The Managed Public Schools segment consists of "Virtual Public Schools," which is where the majority of revenue for K12 is generated; roughly 84% in 2012. K12 provides the course materials, management, technology and support services. These online schools managed by K12, also known as "Virtual Academies" serve K-8 and some high school students. K12 also manages Insight schools, which serve middle school and high school and these schools utilize the Aventa curriculum. iQ Academies serve middle school and high school students as well. K12 also sells products and services to Blended or Hybrid public schools, those that rely on face to face and online (expect to manage schools in CA, Hawaii, Illinois, Indiana and NJ in 2012-2013).

The Institutional Business consists of public schools, school districts, private schools, charter schools that need assistance with virtual systems, curriculum and teaching services. Also operates a joint venture with Middlebury College known as Middlebury Interactive Languages LLC.

The International and Private Pay Business consists of three online private schools managed by K12-The Keystone School, the K12 International Academy and the GW University Online High School. Also manage a foreign brick and mortar private school (Int'l School of Berne).

The company is highly dependent on state funding -- Today, K12 receives an average of $5,500 to $6,000 per student from state and local governments. The schools also receive money for federal programs.

The company is also highly dependent on two virtual public schools-Ohio Virtual Academy and the Agora Cyber Charter School of Pennsylvania which produce 12% and 13% of overall revenues (based on FY 2012 Totals).

For the Managed Public Schools division, funding is provided primarily by state governments. For the 2012-2013 school year, the company is providing services to schools in 32 states and the District of Columbia, marking another year of consistent progress as the company continues to expand its reach to other states in the U.S. (see table below)

Future progress may be harder to come by as many of the remaining states might not be so keen on the idea of forking over taxpayer dollars to a for-profit education company with questionable student performance statistics. This was in fact the case in June of 2012, when the company was denied entrance into North Carolina.

However, money talks and K12 has indeed spent significant amounts of money in lobbying for state approval. The Washington Post notes that K12 has spent over $500,000 (from 2004 to 2010) in "direct contributions to state politicians across the country, with three-quarters going to Republicans, according to the National Institute on Money in State Politics." And according to the New York Times, Ronald J. Packard, chief executive of K12, has called Lobbying a "core competency" of the company.

Notable News/Events:

In July 2009, the Pennsylvania Department of Education instituted charter revocation proceedings against the Agora Cyber Charter School based on allegations of charter violations and non-compliance with state charter school and other laws by the independent charter board. However, the charter was renewed for five years on June 30, 2010, following PDE approval of a new board and management contract with K12.

The Agora School was also the focus of a 2011 investigation courtesy of the NY Times, which noted that nearly 60 percent of its students are behind grade level in math, with nearly 50 percent trailing in reading.

The Times figures, however, don't seem to really jive with what is advertised on the K12 website, which (as shown below) paints a story that looks a lot rosier The disparity comes from the fact that K12 utilizes its own 'internal' testing methodology.


(Click to enlarge)

The Times article also speaks of a high pressure sales environment where employees are paid bonuses based on the number of enrollments. I took a look at K12's reviews on the employment website Glass Door, and found that past and present employees didn't really have a lot of nice things to say about the company. One current employee sort of confirms what I might have pictured at a for-profit such as K12:

If you're in certain departments favored by the CEO, you can get away without working very hard. Go for the marketing department...it's rolling in money and employees.

And another speaks of a major concern with K12 (and other for-profits schools):

This company is driven by profits vs. providing a solid education to students. They are actively marketing to students who should not be schooled at home. Many students make little progress and have no learning coach supervision.

The Times article also discusses churn at K12 schools, which based on the levels, would seem to be a big problem -- especially at Agora, where 2688 students withdrew during the 2009-2010 school year or roughly 36% of the entire class.

This churn problem was a focus of The Financial investigator's Roddy Boyd who discovered that churn at both the Agora Cyber Charter School AND the Colorado Virtual Academy reached 36% in the school year 2010. Boyd also found that churn at Ohio Virtual Academy was even worse coming in at 51%. Boyd, noted that in calls to lower income 'brick and mortar' schools in his area, he found that churn of above 5% was typically a rare occurrence.

From Boyd:

Just as evident, however, is another reality: the fact that these cyber schools might as well have a turnstile as their logo for the volume of withdrawals they experience. The growth that has made the company's shareholders and founders-the Milken brothers, a fund capitalized by Oracle Corp. founder Larry Ellison, current chief executive Ron Packard, as well as former Reagan administration Education Secretary William Bennett-so happy is making many of the families whose kids attend the schools apparently much less so.

Boyd also came up with a comprehensive list of 10 Questions which he emailed to management which they refused to respond to. Of the Ten Questions asked by Boyd, these are the ones that I feel are the most important:

The churn rate, or turnover, in the virtual academies (Agora, OVA, COVA and CAVA) seems unusually high for any school (despite the impressive growth in students.) Does K12 see minimizing student turnover as in its best interests? If so, what steps does K12 take to increase retention?

Do you have a comment on Florida's rejecting K12's appeals in several counties to get more business?

I am confused why Agora is making such a huge push (~19% of students) in Special Ed? It is a high touch learning environment, where students have to be constantly observed, directed, and receive lots of direct input. Many learning challenges prevent, at least in the ages 14-18, the development of the traits necessary for the ideal Agora student, such as self-direction, willingness to face an intellectual challenge etc. ...

Florida DOE Investigation: On September 11, a story in The Ledger found that the state of Florida Department of Education was investigating K12, the nation's largest online educator, over allegations the company uses uncertified teachers and has asked employees to help cover up the practice.

According the Ledger, K12 was requesting teachers to put their name next to a list of students in order to say that they were taught by a qualified teacher. "The state investigation started in January, when a former K12 employee forwarded a series of emails to Seminole County Public Schools officials. In one email, K12's Florida project manager asked teachers to sign off on having taught students they may have never encountered."

Boyd was also all over this issue as well, so kudos to Mr. Boyd. In a story from September 4, Boyd discussed the matter in depth, as he presented documents he acquired via the Freedom of Information Act, which indeed show that teachers were signing for students which weren't theirs.

Boyd notes that K12 was continuing to use a "teacher of class" and a "teacher of record" framework even after the DOE told them that teachers had to be state-certified.

It's a simple concept: State-certified teachers sign the FTE, or full-time enrollment forms, showing the state that a student was enrolled full-time-thus satisfying Florida law-during the school year but the class instruction and grades were handled by a "teacher of class" who didn't have to be certified in the subject matter. [Though state certification naturally does not guarantee expertise in the subject matter, it does ensure working familiarity with it and at least some experience teaching it.]

Sally Roberts of the Florida DOE noted in the documents acquired by Boyd that:

"... using any teacher to teach the curriculum but using a certified teacher that has never worked with the student sign off as the teacher of record would be inaccurate and is not allowed."

Yet in typical sell-side fashion, the bulls were out to defend. Analysts at Wells Fargo say that the story was "dramatically overdone" and that Florida accounts for <$500K in revenues, with any fines to be "minor."

I beg to differ. While the revenues for Florida might represent a small piece of the pie, the facts are that if these allegations are true, then it just speaks of the character of the company. If they are using non-certified teachers to cut corners and then asking the certified teachers to cover up for their mistakes, what sort of penalty is really deserved, aside from complete removal from the Seminole Virtual School program?

And if it's true, which it certainly appears to be the case, what's to say it isn't happening in other states?

Poor Student Performance: A July 2012 study by the National Education Policy Center and the University of Colorado entitled "Understanding and Improving Full-Time Virtual Schools" examined the history of K12, its performance statistics, and overall effectiveness in providing a solid education for students. The results were not pretty, as the study outlined some inherent flaws in the full time pre-college "Virtual School" model. Some of the findings:

• Math scores for K12 Inc.'s students are 14 to 36 percent lower than scores for other students in the states in which the company operates schools.

• Only 27.7 percent of K12 Inc.'s schools reported meeting Adequate Yearly Progress (AYP) standards in 2010-11, compared to 52% for brick-and-mortar schools in the nation as a whole.

• Student attrition is exceptionally high in K12 Inc. and other virtual schools. Many families appear to approach the virtual schools as a temporary service: Data in K12 Inc.'s own school performance report indicate that 31% of parents intend to keep their students enrolled for a year or less, and more than half intend to keep their students enrolled for two years or less.

And as to recommended changes to improve the state of affairs at these Virtual Schools, the NEPC offered the following advice to legislators:

"'In the area of full-time virtual education, states should place their first priority on understanding why the performance of virtual schools suffers and how it can be improved before undertaking any measures or programs to expand this new model of schooling.'"

K12 as one might imagine wasn't thrilled with the results of the study and offered a rebuttal of their own, mostly referring to its own internal studies of student growth.

Funding For Schools: K12 is highly dependent on state and federal funding for its business. According to the company, they recognized a reduction in revenue of about 2% during fiscal year 2012, related to various state funding issues. They also note in the latest 10-K that several states are delaying payments to public schools as economic troubles continue to weigh on state budgets.

This means that accounts receivables are up -- in the most recent quarter, receivables totaled $161 Million, up from $96 Million in the fourth quarter of 2011, an increase of 67%, and nearly double the revenue increase over the same period of 33%.

Could K12 have trouble collecting on these debts? Management expects a good bulk of the payments to be paid in next quarter, yet with surmounting state budget issues; this could be considered a risk. And if the payments are extended even further, this could hamper the company from its growth via acquisition strategy over the past few years.

Fundamental Overview: Revenue Growth of approximately 36% in each of the past two years. No doubt that K12 is positioned to take advantage of a growing movement to online instruction; however a lot of the growth in recent years has been as a result of the company's many acquisitions, as opposed to true organic growth.

Therefore I am skeptical that these sorts of growth rates can be sustained without any further acquisitions. And given the headlines and increased focus on results at K12, my guess is that future state growth will be harder and harder to come by.

Operating margins have been fairly consistent over the past several quarters, averaging right around 40%, yet like many other online public education providers, most of the expense comes in the form of sales and marketing, with a teacher to student ratio that in most brick and mortar schools would be unsustainable.

Maybe expensive from a P/E perspective, trading at 31x forward EPS Estimates, yet if 36% growth can continue it might be reasonable.

However I would expect increasing costs relating to hiring more qualified teachers, more marketing expenses, and potential loss of state funding in current states where K12 currently operates. And also at risk for not achieving future state growth due to headline risks with various concerns keeping other states from moving on a full time virtual program.

Technical Views: We can see since the start of the year, after a big drop in November (following the NYT piece) the stock had rallied, reaching a high of near $27 in April, yet the stock has been in a near term downtrend since that point-as I've identified with a trend line.

I like the action here on the downside. Although the stock got a bit of a bounce following earnings this week, the stock still is in a downtrend.

I wouldn't expect a change in trend, unless the stock advanced back up over that line, which I would say now would be at right around $24, which is probably a good spot for a short term stop.


(Click to enlarge)

Conclusion: High student churn, questionable student performance, increased government and state scrutiny, growth via acquisition (non-organic growth), headline risk scaring other states away, state funding issues, poor technicals and questionable practices relating to using non-certified teachers (and covering up the fact). What's not to like as a short-seller? We're talking off the charts risk with this stock and one that deserves a place in an investor's short portfolio.

Source: K12 Inc.: School Might Be Out Of Session, This Is Why We're Short