Virtual School Meanderings

April 19, 2018

18 April 2018: Google Alert – LRN

The corporate alert for K12, Inc. from yesterday.

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As-it-happens update ⋅ April 18, 2018
NEWS

Cornerstone Capital Management Holdings LLC. Reduces Position in K12 (LRN)

Cornerstone Capital Management Holdings LLC. decreased its position in shares of K12 (NYSE:LRN) by 21.4% during the 4th quarter, according to the company in its most recent 13F filing with the Securities and Exchange Commission. The institutional investor owned 204,953 shares of the company’s …
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LRN

As-it-happens update ⋅ April 18, 2018
NEWS

K12 (NYSE:LRN) Shares Sold by Axa

AXA lessened its holdings in shares of K12 (NYSE:LRN) by 39.7% in the fourth quarter, according to its most recent 13F filing with the Securities and Exchange Commission. The institutional investor owned 21,300 shares of the company’s stock after selling 14,000 shares during the quarter. AXA owned …
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As-it-happens update ⋅ April 18, 2018
NEWS

K12 Inc. (LRN) EPS Estimated At $0.34; 4 Analysts Are Bullish JinkoSolar Holding Co., Ltd. (JKS …

Analysts expect K12 Inc. (NYSE:LRN) to report $0.34 EPS on April, 24 after the close.They anticipate $0.08 EPS change or 19.05% from last quarter’s $0.42 EPS. LRN’s profit would be $14.08 million giving it 10.24 P/E if the $0.34 EPS is correct. After having $0.33 EPS previously, K12 Inc.’s analysts see …
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LRN

As-it-happens update ⋅ April 18, 2018
NEWS

K12 (NYSE:LRN) Holdings Boosted by Geode Capital Management LLC

Geode Capital Management LLC lifted its stake in K12 (NYSE:LRN) by 12.4% during the fourth quarter, according to its most recent 13F filing with the Securities and Exchange Commission (SEC). The fund owned 590,068 shares of the company’s stock after buying an additional 64,885 shares during …
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Services Stock in Focus: K12 Inc. (LRN)

K12 Inc. (LRN):. Share of K12 Inc. (LRN) have caught the attention of the Wall Street community. The stock price is settled at $13.92 after trading hours. Taking a look at the daily price change trend and size of price movement it is recorded that LRN spotted a positive behavior with drift of 2.96%.
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LRN

As-it-happens update ⋅ April 18, 2018
NEWS

MGIC Investment (MTG) Reaches $10.42 After 4.00% Down Move; K12 (LRN) Sellers Decreased …

K12 Inc (NYSE:LRN) had a decrease of 9.65% in short interest. LRN’s SI was 735,900 shares in April as released by FINRA. Its down 9.65% from 814,500 shares previously. With 183,100 avg volume, 4 days are for K12 Inc (NYSE:LRN)’s short sellers to cover LRN’s short positions. The SI to K12 Inc’s …
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LRN

As-it-happens update ⋅ April 18, 2018
NEWS
As of April, 24 K12 Inc. (LRN) Analysts See $0.34 EPS

Zacks Inv Mgmt stated it has 0.04% of its capital in K12 Inc. (NYSE:LRN). Citigroup owns 77,363 shs or 0% of their US capital. Acadian Asset Mgmt Ltd Co has invested 0.06% in K12 Inc. (NYSE:LRN). Dimensional Fund Advisors Limited Partnership reported 0.02% stake. California State Teachers …
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$0.34 EPS Expected for K12 Inc. (LRN) on April, 24

Principal Gru owns 0.01% invested in K12 Inc. (NYSE:LRN) for 431,201 shs. Federated Invsts Incorporated Pa holds 0% of its capital in K12 Inc. (NYSE:LRN) for 89,437 shs. Zacks Inv Management reported 112,142 shs or 0.04% of all its holdings. Goldman Sachs reported 0% in K12 Inc. (NYSE:LRN).
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K12 Inc. (LRN) Analysts See $0.34 EPS on April, 24

Investors wait K12 Inc. (NYSE:LRN)’s quarterly earnings on April, 24 after the close., according to RTT. Analysts forecast $0.34 earnings per share. That’s $0.08 down or 19.05 % from 2017’s earnings of $0.42. If LRN’s EPS is $0.34 the profit will reach $14.08M for 10.18 P/E. Last quarter $0.33 earnings …
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LRN

As-it-happens update ⋅ April 18, 2018
NEWS

K12 Inc. (LRN) Analysts See $0.34 EPS

Alliancebernstein Lp has invested 0% in K12 Inc. (NYSE:LRN). Metropolitan Life Company Ny reported 12,424 shares. Geode Capital Mgmt Ltd reported 0% stake. Wedge Cap Mngmt L Limited Partnership Nc holds 0% of its portfolio in K12 Inc. (NYSE:LRN) for 10,817 shares. Schwab Charles …
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Pulling Back the Curtain on These Stocks: Tamarack Valley Energy Ltd (TSX:TVE), K12 Inc. (NYSE …

K12 Inc. (NYSE:LRN) has a Price to Book ratio of 0.984044. This ratio is calculated by dividing the current share price by the book value per share. Investors may use Price to Book to display how the market portrays the value of a stock. Checking in on some other ratios, the company has a Price to Cash …
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LRN

As-it-happens update ⋅ April 18, 2018
NEWS

EPS for K12 Inc. (LRN) forecasted at $0.34

Moreover, Matarin Mgmt Ltd Liability has 0.46% invested in K12 Inc. (NYSE:LRN). Century Companies holds 39,941 shs. Acadian Asset Lc has 0.06% invested in K12 Inc. (NYSE:LRN) for 917,681 shs. Balyasny Asset Management Ltd Liability Company holds 37,472 shs or 0% of its capital. Bancshares …
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As of April, 24 K12 Inc. (LRN) EPS Estimated At $0.34

Brandywine Glob Invest Mgmt Limited stated it has 0.01% of its capital in K12 Inc. (NYSE:LRN). Matarin Cap Ltd Co, Connecticut-based fund reported 375,035 shs. American Intl Gp, New York-based fund reported 25,928 shs. Hennessy Advisors Inc reported 211,400 shs. Metropolitan Life Insurance …
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As of April, 24 The EPS for K12 Inc. (LRN) Expected At $0.34

Cornerstone Holdg Ltd reported 0.02% in K12 Inc. (NYSE:LRN). Blackrock holds 2.57M shs or 0% of its capital. Citigroup Incorporated owns 77,363 shs. Macquarie Gp Limited holds 0% of its capital in K12 Inc. (NYSE:LRN) for 12,912 shs. Zacks Invest accumulated 0.04% or 112,142 shs. Wedge Capital …
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Analysts See $0.34 EPS for K12 Inc. (LRN) as of April, 24

James holds 0.04% in K12 Inc. (NYSE:LRN) or 66,220 shs. Balyasny Asset Management Ltd Company, a Illinois-based fund reported 37,472 shs. Shell Asset Management Com reported 56,636 shs or 0.02% of all its holdings. Tower Lc (Trc) has invested 0% in K12 Inc. (NYSE:LRN). Goldman Sachs …
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BMO Capital Markets Set “Purchase” Rating for K12 Inc. (LRN)

Other research analysts have also recently issued research reports about the company. TheStreet upgraded K12 from a c+ rating to a b- rating in a research note on Monday, April 3rd. Zacks Investment Research cut K12 from a hold rating to a sell rating in a research note on Monday, January 30th.
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MarketBeat Daily: Headlines and Analysts’ Updates for 4/18/2018

The MarketBeat update for K12, Inc. and Pearson Education from yesterday.

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April 18, 2018
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April 18, 2018

LRN: K12 Inc.’s Crony Capitalist Profit Machine Looks Like It’s Finally Dying – 50% Downside

Note this K12, Inc. update from Seeking Alpha that I received two or three days ago.

K12 Inc.’s Crony Capitalist Profit Machine Looks Like It’s Finally Dying – 50% Downside 
8:33 am, Mon, Apr. 16, 2018, by Rota Fortunae

Read now »


Normally I just post the update, but in this instance I feel I need to copy and paste the article below.

Summary

For years, K12 has profited off of public school funding while producing poor academic outcomes and employing allegedly fraudulent tactics to mask turnover and inflate enrollment.

Politics has kept K12 alive, but incremental regulation has caused revenues to stagnate and free cash flow to decline 75%, and we think K12’s financial decline is about to accelerate.

Analysts have yet to address the recent avalanche of negative news regarding school closings, teacher unionization and the loss of key political support. We estimate earnings turn negative in FY2019.

K12 touts $5/share in receivables as positive, but the audit committee chair has been accused of failing to ensure proper reporting systems and we estimate $1.55/share in uncollectible receivables.

Setting aside our concerns, K12’s stock is still 50% overvalued; the company doesn’t earn cost of capital and should trade at 0.5x book value.

“The future of our country is not found in our boardrooms, but in our classrooms.”

– Michael Milken

Please read the full disclaimer at the end of the report before reading further. This report represents the opinion of the author. Investors should do their own due diligence and come to their own conclusions.

Introduction

After years of using allegedly fraudulent tactics to reap profits off of public school funding, it looks like K12 Inc.’s (NYSE:LRNcrony capitalist profit machine is finally dying. Margins are declining, receivables are piling up, management altered its calculation for free cash flow and removed growth predictions from the most recent 10-Q, teachers are unionizing, schools are closing, politicians are pulling support, execs are leaving and the largest shareholder has been selling. We think K12’s stock will fall 50% in the next six months.

K-12 is the largest operator of virtual charter schools, an industry that has been criticized for its aggressive sales tacticsfraudulent enrollment reportingand horrible academic outcomes. While the issues have been well publicized, K12’s heavy political influence has, in our opinion, stalled the company’s demise. But incremental regulation has increasingly taken its toll. Revenues are stagnant, gross margins have declined 590 basis points from their peak and free cash flow has declined 75% over the past four years.

And we think K12’s financial decline is about to kick into overdrive. Since reporting in January, K12 has been party to an avalanche of negative press regarding school closures, teacher unionization and lost political support. Despite significant earnings implications, the analysts appear to be asleep at the wheel. The three left covering K12 have yet to update estimates or even acknowledged the onslaught of negative events unfolding.

We found reports that show several K12 schools will close or are at risk of closing after the 2017/2018 school year. We estimate fiscal 2019 revenues will decline as much as 4.8% (vs. estimates of +1%), which by itself would be enough to turn operating income negative, but it’s just the tip of the iceberg.

Last week, the California Virtual Educators United Union announced a tentative agreement with the California Virtual Academies to increase pay and lower student-teacher ratios. We estimate the contract will erase nearly 40% of K12’s operating income. Worse yet, the high profile news of K12’s first union contract risks setting in motion a domino effect of unionization at virtual schools across the county.

But perhaps the greatest risk lurks in Ohio where the high-profile closure of the state’s largest virtual school has brought a crescendo of political backlash. K12’s largest school will see a near-term benefit in enrollments, but Ohio Republicans are pulling support and proposing funding reform that would significantly reduce K12’s revenues. If the school is eventually shut, we estimate K12 will lose over $100 Million in revenue. And Ohio is not the only state where the political winds are shifting. Pennsylvania, Colorado, California, South Carolina, Florida, Minnesota and Utah all have policies that negatively affect K12.

The pressure being exerted on K12 is evident in its rising receivables. Days sales outstanding (DSOs) are up 67% since 2011. Management says the increase is not the result of structural issues and even points to the $5 per share in receivables as a positive for valuation. We caution investors not to fall prey to the allure of K12’s purportedly strong balance sheet. We found that K12 has a history of delaying write-offs for uncollectible debts and its contracts contain a clause that permits it to advance money to struggling schools. Based on historic DSOs, we think K12 has at least $63 Million ($1.55 per share) in uncollectible receivables.

And we have very little faith in the company’s willingness to openly address these issues with shareholders. K12 has been party to four separate shareholder lawsuits ( 1234) in the last seven years, all of which alleged management made false and misleading statements and one which alleged the current chair of the audit committee failed to ensure proper reporting systems.

In the end, we think the freewheeling days of aggressive sales tactics, loose regulation and poor academic outcomes are over. We believe this is why management recently changed the way it calculates free cash flow and removed growth projections from the 10-Q. We also note that the CEO departed shortly after the earnings release and the largest shareholder began selling.

Setting aside our concerns, K12 shares still hold significant risk. The stock doubled after the appointment of school choice advocate and early K12 investor Betsy DeVos as Secretary of Education. The run up was a knee jerk reaction to an appointment that has little significance. And while shares have since fallen 30%, they still trade at 1.0x book value, a level that is not supported by historical returns. K12 pays no dividend and has shown no ability to earn its cost of capital. Book value per share has grown a paltry 3.3% compounded over the last five years. Our price target is $7.00 or 0.5x book value.

What Is A Charter School

Charter schools is a public, tuition-free school funded with public school dollars and overseen by an authorizer. An authorizer is an entity approved by state legislature to approve new charter schools and monitor their academic record. Authorizers can be a school district, state board of education or independent entity.

A key element to understanding this article is to understand that public school funding follows the student. In other words, when a student leaves one school for another, the funds go with her. This system creates a fight for funding and makes virtual charter schools and their history of poor academic results a political target for supporters of brick and mortar schools (whether traditional or charter).

K12’s Beginnings

K12 is a vestige of Michael Milken’s Knowledge Universe, a holding company that once oversaw nearly $2 Billion in for-profit education investments. Milken, a billionaire and convicted felon, began investing in education after his release from prison. Other publicly traded offshoots of Knowledge Universe include Leapfrog, which at its height traded for $38 per share but in 2016 sold to VTech for $1 per share.

K12 was founded by former CEO Ron Packard, a Goldman Sachs alumni who persuaded Milken to invest $10 Million (paywall) in 1999. Packard’s idea was to offer a K-12 education completely online. The best part, K12 would be funded through local, state and federal funding. Public school funding not only provided huge revenue potential but state laws prohibit public schools from turning away students, so if K12 could sell them, at any cost, it could tap into the funds.

And K12 had an immediate advantage. Often its schools collected the same per-student funding as traditional public schools, but they did not have to spend on costly facilities and transportation. This meant that K12 could spend heavily where traditional schools could not, namely marketing, lobbying (discussed later) and executive pay.

K12’s Business Model

K12 generates 83% of its revenue from managing virtual (completely online) and blended (online with some face-to-face instruction) charter schools. Through its managed school programs, K12 provides substantially all of its school’s administrative (e.g. budget proposals, financing reporting and staff recruitment), information technology, academic support services, curriculum, learning systems and instructional services.

Because state laws prohibit profiting from public education, K12 contracts with its schools’ “independent” non-profit boards to earn a percentage (15-22%) of the schools’ revenues. We highlight independent because K12 has been accused of having de facto control of its schools’ boards and finances.

The remainder of K12’s revenue is generated from non-managed school programs in which K12 offers online education solutions (e.g. curriculum) to schools. The chart below shows K12’s key financial data.

Source: Chart By Author, Using K12 Financial Data

K12’s History Of Poor Academics & Alleged Misconduct

A history of K12’s academic record and alleged misconduct can be told through the litany of shareholder lawsuits brought over the past seven years. The first class action suit (settled for $6.8 Million in 2013) came in 2012 after a NY Times article revealed K12’s excessive churn rates, improper sales tactics, enrollment inflation and poor academic performance.

Up until this point, K12 was reporting 30% revenue growth led by strong enrollment. The lawsuit accused management of misleading investors by claiming enrollment gains were due to offering academic outcomes that are as good or better than brick and mortar schools at a lower cost. The allegations, which are too numerous to reproduce here, include:

  1. Advertising misleading or non-existent academic statistics;
  2. Targeting high truancy students because K12 could collect full funding but the students required less of K12’s education and teaching resources;
  3. Instructing teachers to coach parents to retroactively log student’s attendance for missed days;
  4. Misrepresenting special education requirements to collect higher per student funding.

Despite the criticism, management continued to promote its growth story. And the stock, which had fallen over 30% from its peak, moved higher. That is until September 2013 when Whitney Tilson presented a 133-page short thesisthat called K12’s growth unsustainable.

Tilson’s report proved prescient. On October 8th, 2013, K12 pre-announced guidance that was significantly below that provided just two months earlier. Another class action lawsuit followed in January 2014. The same month, founder Ron Packard announced he was resigning as CEO and Chairman Nate Davis was named K12’s new CEO.

This suit alleged a fraudulent scheme to conceal K12’s financial performance when management knew enrollment figures were significantly lower than the year before. Furthermore, it claimed insiders reaped millions from advantageous stock sales. The suit was ultimately dismissed, but the judge stated: “The impact on investors of [K12’s] lack of managerial competence cannot be minimized…”

In order to address the mounting criticism, K12 began publishing Annual Academic Reports based on self-administered Scantron tests. From 2013 to 2015, management highlighted its continued investment in academics and touted the results of the Scantron tests as proof of positive headway.

But trouble hit again in August 2014 when K12 announced that the Agora Charter School, representing 13% of revenues, was terminating its management contract with K12. The decision to terminate was allegedly related to the lack of improved academic performance (see the related lawsuit discussed below).

In January 2016, K12 announced Stuart Udell would replace Nate Davis as CEO and stated his experience uniquely qualifies him to “continue the progress we’ve made improving academic outcomes.” But by mid-2016, new allegations were coming out of California.

two-part investigation published by The Mercury News revealed allegations of dismal academic records, exploitation of charity laws and enrollment inflation. Then in its fiscal 1Q2016 10-Q, K12 disclosed that it had received a subpoena from the attorney general of California on September 24, 2015. In July of 2016, K12 announced a settlement with the attorney general. The settlement, which we detail later, required K12 to correct errors reported in past Scantron tests and completely remove the 2015 Annual Academic Report from its website. This is notable because K12 was compensating executives based on the Scantron test results.

Concurrent with the settlement, files from the investigation were released, including the existence of a qui-tam case alleging violations of the False Claims Act and a non-disclosure agreement that noted K12 was served with a subpoena on January 17, 2013, two and a half-years before K12 made any disclosure (see amended complaint below).

By September 2016, another shareholder lawsuit was filed in response to the matters in California. In December 2016, an updated complaint was filed that offers the most comprehensive set of allegations against K12 dating from October 2013 through October 2015. Investors interested in a comprehensive review of K12’s legal and academic troubles should read the entire complaint.Included in the updated complaint are new allegations that K12 made false statements and/or omissions concerning students’ academic and Scantron test results.

The complaint also alleged (pg. 41) that Agora’s board had provided K12 a written notice of non-renewal eighteen months before the contract expired on June 30, 2015 (approximately late 2013). Despite this knowledge, management told investors in April 2014 that it was in negotiations for the renewal and only admitted in August 2014 that Agora’s board had indicated a “clear interest to be self-managed.”

The last thing we note in this section is that K12 reached what we believe is the appropriate near-term price of $7.00 per share shortly after it lost the Agora contract. The stock then shot up above $20 after President Trump was elected and Betsy DeVos, a billionaire school choice advocate and early K12 investor, was nominated as Secretary of Education. Devos has since been coined “ the most hated cabinet member” and Congress recently rejected her attempt to spend more than $1 Billion promoting school choice policies.

Below is K12’s historical stock chart marked with the events discussed herein.

Source: Chart By Author

The last piece of background information required to understand our thesis is K12’s political influence, which we believe is the reason that K12 has remained in business despite its academic record and years of alleged misconduct.

The Virtual Charter School Money Cycle

One of the biggest criticism against for-profit charter schools is the circuitous cycle of money from state coffers to the schools, to the corporations who donate heavily to politicians and lobbyist to influence education policy.

This system in which business leaders and government officials enjoy mutually advantageous relationships using taxpayer dollars is the Oxford Dictionary definition of crony capitalism. We call it the Virtual Charter School Money Cycle.

Source: Chart Created By Author

K12’s political donations are well-chronicled. In fact, Ron Packard once called its lobbying efforts a “core competency.” According to an article by Education Weekly (freemium paywall), K12 spent at least $10.5 Million on lobbyist and $1.8 Million on political contributions over the last decade (this represents over 8% of K12’s cumulative profits between 2008 and 2017).

In the early days, K12 used its political influence to open new states to virtual charter school funding. Growth from new states has stalled, but the money cycle continues. We found K12’s political influence is being used to grow enrollment in existing states and to keep open poorly performing schools.

The August 2017 board minutes from K12’s Ohio Virtual Academy show that the school’s independent board was coached by a longtime K12 lobbyist on the ability to bifurcate schools to improve the appearance of a schools report card.

Source: Ohio Virtual Academy Board Minutes

This practice of quartering off the poor performing students into a new school to improve the existing school’s appearance has been used before. According to this article, the Hoosier Academy did just that when the charter authorizer permitted the new Indiana Insight Academy. The Hoosier Academy announced in September 2017 that it would close at the end of the school year. The Insight Academy is still open.

Why Should Investors Care Now?

If all of K12’s issues are well publicized, why should investors care now? First, we think that K12 has fallen off investors’ radar and therefore the continuous decline in K12 financials has been largely unquestioned. Second, we do not think investors or analysts have priced in the avalanche of bad news that has hit since reporting in January.

K12’s Continuous Decline

Below is a historical chart of K12’s gross margins and free cash flow. Note free cash flow is calculated as operating cash flow minus capex (including capitalized software and curriculum costs) minus financing for capital leases (the financing of computers that are provided to K12 students, which although a financing cash flow is very much part of operations).

Source: Chart By Author, Using K12 Financials

We believe the decline in K12’s profitability is the result of costly regulatory actions. The 2016 California settlement is the perfect example. The settlement contains over 60 corrective actions, including: ensuring the accuracy of advertisements, training teachers to improve attendance claims, providing all students computers and subsidies of at least $20 per month for high-speed internet, and increasing audit sampling.

While management does not specifically call out regulation as the problem, our thesis is supported by its commentary. On the fiscal 1Q2015 conference call, management explained that the decrease in gross margins was due to continuing “to invest in teachers and academic programs.” More recently, on the fiscal 3Q2017 call, management stated:

we expect gross margins to contract marginally… this is really driven by the result of increased amortization for some curriculum we recently put in service as well as an ongoing investment in driving stronger student outcomes…

K12 has been able to offset some of the margin degradation with cuts in SG&A, which has declined $17 Million since fiscal 2014. However, on the fiscal 4Q2017 call management said future SG&A inflation is expected:

we face a number of inflationary pressures on third-party costs in such areas as our enrollment center, product development and IT that we will continue to try and minimize, but may put some upward pressure on these costs that we have not seen in the past few years.

Despite its efforts towards improvement, we think K12’s financial decline is about to kick into overdrive. Since reporting in January, K12 has been party to an avalanche of negative press regarding school closures, teacher unionization and lost political support.

Schools Closing

In addition to the closing of the Hoosier Academy (which was discussed on the October 2017 call), five K12 schools are closing or at risk of closing at the end of this school year. Details and links are below.

Hoosier Academy – 2,065 Students – Closing June 2017

Insight School of Ohio – 1,300 Students – Closing June 2017

South Carolina Virtual School & Cyber Academy of South Carolina – 3,000 Students

K12 has two schools in South Carolina that are tied up in a public feud with the current authorizer. As detailed in this opinion piece, nine schools requested to transfer their charter from the South Carolina Public Charter School District to the financially struggling Erskine College Charter Institute. Four schools, including K12’s, were denied because they were underperforming and the district thought they were trying to escape accountability by moving to a new sponsor.

Threats of lawsuits and mediation followed, and now the schools are leaving for Erskine anyway. But that is not the end of the story. Representatives Raye Felder, Merita Allison and Gary Clary (notably all Republicans) introduced Bill 5018 in a blatant attempt to stop the transfer. The bill introduces two key changes to the existing charter school legislation:

First, it limits public or independent institutions of higher learning (i.e. Erskine College) from sponsoring more than three charter schools. The presumption is that Erskine will end up sponsoring the higher performing schools that the district already approved for transfer. Second, public or independent institution of higher learning are not permitted to retain the administrative fee that is usually paid by the school to the charter authorizer. The bill is currently in house committee.

Nevada Virtual Academy – 2,000 Students

Nevada’s State Public Charter School Authority issued the school a notice of intent to terminate. The school has until April to present a turnaround plan. If that plan is not submitted or not accepted, the school will but shut down.

Florida Cyber Charter Academy (Pasco County) – 348 Students

K12’s Florida Cyber Charter Academy is abandoning its charter contract with Pasco County at the end of the year. It is unclear how many students will be affected as Florida law allows students from any county to attend virtual schools in other counties; however, this is now the third county in Florida (pg. 30) that K12 has severed ties with.

Below we provide our estimates for the revenue and operating income effects based on the school closures. We estimate minimum, median and maximum enrollment effects based on the unknowns surrounding the closures in South Carolina, Nevada and Florida. We also adjust for the enrollment gains the Ohio Virtual Academy is likely to get from the closure of ECOT Virtual Academy(discussed below).

Source: Chart By Author, Using Reported Data and Author Estimates

We estimate fiscal 2019 revenues will decline as much as 4.8% (vs. estimates of +1%), which by itself would be enough to turn operating income negative, but is just the tip of the iceberg.

California Teacher’s Win Union Contract

In 2014 educators from the California Virtual Academies (CAVA – 12,000 students or 11% of K12’s total enrollment), unionized. In 2016, CAVA recognized the union and began negotiations. The main arguments were for higher teacher pay and lower student/teacher ratios. The chart below shows the enormous spread between the salaries of K12 administrators and teachers vs. traditional school districts. The chart highlights both how overpaid K12 administrators are and how underpaid K12 teachers are, as compared to peers.

Source: In The Public Interest Report February 2015 Report

Last week news came that CAVA reached a tentative agreement to increase average teacher pay 17.6% and reduce the student-to-home room teacher ratio to 30:1. Based on this article which states some home rooms have ratios as high as 40:1, we estimate that the current ratio is 35:1. We estimate that the increase in pay from raises and new hires is an additional $5.4 Million. Our math is detailed below.

Source: Chart By Author, Using Quoted Figures and Author Estimates

We believe the entire $5.4 Million will come out of K12’s pocket. Our reasoning is based on a review of multiple CAVA school audits, which show that the schools lose money unless K12 provides “balanced budget credits” (pg. 12).The credits, which are disclosed in K12’s SEC filings (pg. 58), require the company to lower its bill when a school runs at a deficit, which in our opinion means that the only party with a piece of the pie to give up is K12. $5.4 Million is equal to 40% of K12’s trailing twelve month operating income.

Worse yet, the high profile news of K12’s first union contract risks setting in motion a domino effect of unionization of virtual schools across the country. In fact, the California union leaders stated: “they were inspired by teacher strikes in West Virginia and Oklahoma…”Imagine the financial impact if teachers in K12’s top five districts decided to go on a unified strike.

But perhaps the biggest risk to K12 lurks in Ohio.

Politicians Pulling Support In Ohio

The Electronic Classroom of Tomorrow (ECOT, not a K12 school) is Ohio’s largest virtual charter school. ECOT imploded after being embroiled in a legal battle with the state over a claim that it owes $60 Million for misrepresenting enrollment. Now Ohio democrats, who are using ECOT as a campaign issue, are pushing a legislative proposal to boost oversight and calling for the shutdown of failing charter schools.

The political heat has caused Republicans to pull support and propose restrictive new measures. The Ohio Republican Party returned $76,000 in political contributions to ECOT’s management company and Republican auditor Dave Yost has called for new compensation plans to reflect the differences between online and traditional schools. Examples would include funding schools based on academic completion instead of an enrollment count date.

The increased scrutiny could be a huge negative for K12’s Ohio Virtual Academy (OHVA), which we estimate after the near-term benefit of enrolling ECOT students is K12’s largest school with roughly 14% of total enrollment. As previously noted, OHVA board minutes already show that K12 is considering bifurcating the school to improve the appearance of its report card, which received D’s and F’s in five of six categories. Under the worst-case scenario, where OVHA is closed, we estimate K12 would lose over $100 Million in revenues.

Source: Ohio Department of Education

Restrictive Policies Emerge Nationwide

New funding policies to align enrollment and compensation with the realities of virtual schools are being enacted across the country. As noted in this June 2016 report from the National Alliance for Public Charter Schools, Florida, Minnesota, New Hampshire and Utah have enacted performance-based funding. All except N.H. are home to K12 schools, and we believe the policies have played a roll in K12’s stagnant revenues.

The alliance, while pro-charter schools, is also for more restrictive regulation on virtual charter schools. The concern is that virtual charter schools reflect poorly on their brick and mortar counterparts.

K12’s Ballooning Receivables

We think the pressure being exerted on K12 is evident in its increasing receivable balance. As shown in the chart below, days sales outstanding has ballooned over the past year and is up 67% since 2011.

Source: Chart by Author, Using K12 Financials

In the most recent conference call, management said DSOs were not a structural issue:

Our DSO’s have gotten a little bit behind on us. We have a couple of large customers that are I think not payment issue but funding, timing and things like that and just working through some of those logistics. But, largely I’d say a DSO driven issue which we expect to work through and not a long-term structural issue for us.

We caution investors to view this comment with an askance eye. The last time there was a major spike in DSOs in 2012, the company told the same story. The 2012 10-K (pg. 58) stated that higher accounts receivables were due to deferred payments that were expected to be collected in the first quarter of fiscal 2013.

But, DSOs got worse in 2013 as payment was deferred again. The 2013 10-K (pg. 58) stated that California delayed payment in 2012 and 2013, but this time there was no disclosure that they expected to collect.

Then in the fourth quarter of fiscal 2015, K12 recorded a $10.7 Million charge for receivables associated with school closures and “a funding issue in one state from a couple of years ago…”

The only longstanding funding issue we found discussed in filings or conference calls was California. If the write-offs indeed related to California, it would mean that K12 delayed charging a bad debt expense for three years from the initial collection concern!

And this is not the only bad debt K12 took years to recognize. In May 2013 (pg. 108), K12 exercised a put option to sell subsidiary Web International back to its original Chinese owner for $10 Million plus 8% interest. Collection had not occurred by June 2015 (pg. 119), so K12 wrote off $3.2 Million in accrued interest.

In 2017 (pg. 109), K12 finally wrote off the $10 Million sale price. In this case, K12 waited four years to deem the receivable uncollectible. The total $13.2 Million write off is equal to 19% of K12’s cumulative profits between 2013 and 2017!

And we think the write-offs K12 needs to take are much larger. Based on average DSOs between 2013 and 2017, we believe K12 has over $63 Million in uncollectible receivables that need to be written off. This would represent nearly all of the cumulative profit between 2013 and 2017.

Source: Chart By Author, Using K12 Financials

K12’s rising receivables are a particularly concerning red flag given the alleged control K12 has over its schools’ finances. School auditsdisclose that K12 can contractually “advance” money to its schools. Notably the money is due within thirty days of when K12 invoices, which technically could be an indefinite period of time. We also could not find that K12 disclosed these advances in its SEC filings.

Source: South Carolina Virtual Charter School Audit

The responsibility of overseeing K12’s financials falls on its audit committee, but we have serious concerns about its ability to do its job. The audit committee is chaired by Steven B. Fink. As a longtime member of the audit committee, Fink was party to a 2012 lawsuit that accused him and the other board members of failing to ensure that a proper financial reporting system was in place and turning a blind eye to obvious red flags.

Source: Staal vs. Tisch, et al

Other Red Flags

Removing Key Language

For years K12’s SEC filings contained a statement that management believes the acceptance of online education continues to grow and that it anticipates increased overall demand for virtual options in education will translate into increased demand for K12’s services. The company deleted this statement from its most recent 10-Q (vs. previous quarter 10-Q pg. 27)

Source: Factset Blackline Fiscal 2Q2018 10-Q

Changing Calculation For Free Cash Flow

Historically, K12 defined capital expenditures to include curriculum and software development, infrastructure and computer leases costs. Beginning in the fiscal 4Q2016, the company altered definition to exclude computer lease costs (which as discussed above is included in financing cash flows). The justification was that the expense used to run between $20 and $30 Million but now only runs about $10 Million.

The actual trailing twelve month expense was $14.5 Million, which is significant given that trailing twelve month free cash flow (using the new definition) was only $27.6 Million.

Executive & Board Departures

Executive and board level departures are classic red flags. Since 2016, the CEO, a senior vice president and four board members have resigned. Notably, Udell’s departure came just two weeks after the company reported the quarter and after the board requested he agreed to step down as CEO and step into a business development role.

We also note that with Nate Davis back as CEO, the top management team is the same as that when it allegedly failed to timely disclose the loss of the Agora contract.

Below is a table showing the departures we found.

Name Position Date Notes
Stuart Udell CEO February 2018 SEC Filing
Joseph Zarella EVP – Business Ops December 2017 LinkedIn
Andrew H. Tisch Director December 2017 Not Disclosed
Jon Reynolds, Jr. Director August 2017 SEC Filing
Fredda J. Cassell Director January 2017 SEC Filing
Adam Cohn Director December 2016 SEC Filing

It is also notable that K12 largest shareholder began selling after the quarter. Technology Crossover Ventures (TCV) sold 1.09 Million shares between January 26th and February 14th. The weighted average price on the days sold (using the closing price) was $15.98. TCV owned 4 Million shares that it purchased in a 2011 private placement at $31.00 share.

Notably, over 1 Million of the shares sold occurred on February 14th, the day after Udell resigned.

Conclusion

History shows that K12’s most profitable years lived in a bygone time when aggressive sales tactics, loose regulation, lax enrollment enforcement and poor academic outcomes were the norm. But, profitability has declined as regulation has caught up with the industry, and we believe the worst is yet to come.

Even setting aside the risks discussed in this report, the shares of K12 are mispriced. Having grown book value per share by a paltry 3.3% over the past 5 years, we believe the stock deserves to trade at 0.5x book or $7.00 per share.

Risks

We think the main risk to shorts in the near term is that the earnings impact from school closures and union contracts will not show up until fiscal 2019 (beginning July 2018). Earnings may hold up during the interim, but we think the news of the events will force management to address them.

The main mid-term risk to our thesis is that K12 makes a large accretive acquisition. It currently has $189 Million ($4.64 per share) in cash that is a significant drag on returns on equity. However, this risk has been present for several years and based on the small size of historical acquisitions, we think it would be very difficult to put anywhere close to $189 Million to work. Furthermore, we believe the longstanding cash balance supports the thesis that management is aware that the balance sheet is more stressed than it appears.

Disclosure: I am/we are short LRN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: IMPORTANT – Please read this Disclaimer in its entirety before continuing to read our research opinion. Investors are encouraged to conduct their own due diligence into these factors. This article represents the opinion of the author as of the date of this article. This article expresses the author’s investment opinions, which are based upon interpretation of certain facts and observations, all of which are based upon publicly available information. The information set forth in this article does not constitute a recommendation to buy or sell any security. This article contains certain “forward-looking statements,” which may be identified by the use of such words as “believe,” “think,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential,” “outlook,” “forecast,” “plan” and other similar terms. All are subject to various factors, any or all of which could cause actual events to differ materially from projected events. This article is based upon information reasonably available to the author and obtained from sources the author believes to be reliable; however, such information and sources cannot be guaranteed as to their accuracy or completeness. The author makes no representation as to the accuracy or completeness of the information set forth in this article and undertakes no duty to update its contents. You should assume that as of the publication date the author (possibly along with or through our members, partners, affiliates, employees, and/or consultants) and clients have a short position in all stocks (and are long/short combinations of puts and call options of the stock) covered herein, including without limitation K12, Inc. and therefore stand to realize significant gains in the event that the price of its stock declines. The author may also cover his/her short position at any point in time without providing notice. The author encourages all readers to do their own due diligence.

17 April 2018: Google Alert – LRN

The corporate alert for K12, Inc. from yesterday.

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LRN

As-it-happens update ⋅ April 17, 2018
NEWS

Institutional Investor’s Pro-K12 Inc (NYSE:LRN) Sentiment In 2017 Q4

K12 Inc (NYSE:LRN) institutional sentiment increased to 1.43 in 2017 Q4. Its up 0.21, from 1.22 … K12 Inc. (NYSE:LRN) has declined 21.53% since April 16, 2017 and is downtrending. … The stock of K12 Inc. (NYSE:LRN) earned “Buy” rating by BMO Capital Markets on Wednesday, January 17. K12 Inc.
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K12 Inc 2017 Q4 Institutional Investor Sentiment Better Than Expected

K12 Inc (NYSE:LRN) institutional sentiment increased to 1.43 in 2017 Q4. Its up 0.21, from 1.22 in 2017Q3. The ratio has increased, as 66 institutional investors increased and started new holdings, while 46 sold and decreased equity positions in K12 Inc. The institutional investors in our partner’s …
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As-it-happens update ⋅ April 17, 2018
NEWS

K12 Inc (LRN) Moves Lower on Volume Spike for April 16

K12 Inc (LRN) traded on unusually high volume on Apr. 16, as the stock lost 1.46% to close at $13.52. On the day, K12 Inc saw 643,208 shares trade hands on 2,454 trades. Considering that the stock averages only a daily volume of 186,102 shares a day over the last month, this represents a pretty …
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Institutional Investors Are Betting On K12 Inc (NYSE:LRN)

K12 Inc (NYSE:LRN) institutional sentiment increased to 1.43 in Q4 2017. Its up 0.21, from 1.22 in 2017Q3. The ratio is better, as 66 hedge funds increased and opened new holdings, while 46 decreased and sold their stakes in K12 Inc. The hedge funds in our partner’s database reported: 33.03 million …
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LRN

As-it-happens update ⋅ April 17, 2018
NEWS

Have You Holding This Low Risky Stock?: K12 Inc. (LRN)

For this relative risk measurement, LRN has beta value of 0. A stock with a beta less than 1 is considered less volatile than the market; more than 1 means more volatile. If market is up, the stock should outperform by positive momentum and if the market heads lower, the stock should go down by same …
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Somewhat Positive Press Coverage Somewhat Unlikely to Affect K12 (LRN) Share Price

Media stories about K12 (NYSE:LRN) have trended somewhat positive this week, Accern reports. Accern ranks the sentiment of news coverage by monitoring more than twenty million blog and news sources in real time. Accern ranks coverage of publicly-traded companies on a scale of -1 to 1, with …
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LRN

As-it-happens update ⋅ April 17, 2018
NEWS

K12 (LRN) Scheduled to Post Earnings on Tuesday

K12 (NYSE:LRN) is set to release its earnings data after the market closes on Tuesday, April 24th. Analysts expect K12 to post earnings of $0.32 per share for the quarter. K12 (NYSE:LRN) last posted its earnings results on Thursday, January 25th. The company reported $0.33 earnings per share for the …
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Piper Jaffray Reaffirms a Buy Rating on Netflix (NFLX) and $367.0000 Target; K12 Has 1.43 …

K12 Inc (LRN) investors sentiment increased to 1.43 in 2017 Q4. It’s up 0.21, from 1.22 in 2017Q3. The ratio is better, as 66 funds increased and opened new stock positions, while 46 reduced and sold their holdings in K12 Inc. The funds in our database now hold: 33.03 million shares, up from 31.70 …
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LRN

As-it-happens update ⋅ April 17, 2018
NEWS

Two Sigma Advisers LP Sells 24800 Shares of K12 (LRN)

Two Sigma Advisers LP lessened its holdings in shares of K12 (NYSE:LRN) by 16.8% during the 4th quarter, according to its most recent filing with the Securities and Exchange Commission (SEC). The fund owned 122,668 shares of the company’s stock after selling 24,800 shares during the quarter.
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LRN

As-it-happens update ⋅ April 17, 2018
NEWS

Piper Jaffray Reaffirms a Buy Rating on Netflix (NFLX) and $367.0000 Target; K12 Has 1.43 …

Analysts await K12 Inc. (NYSE:LRN) to report earnings on April, 24 after the close. They expect $0.34 EPS, down 19.05% or $0.08 from last year’s $0.42 per share. LRN’s profit will be $14.08M for 9.94 P/E if the $0.34 EPS becomes a reality. After $0.33 actual EPS reported by K12 Inc. for the previous …
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LRN

As-it-happens update ⋅ April 17, 2018
NEWS

K12 (LRN) Shares Sold by Bank of New York Mellon Corp

Bank of New York Mellon Corp cut its holdings in K12 (NYSE:LRN) by 37.8% during the fourth quarter, according to the company in its most recent Form 13F filing with the SEC. The fund owned 292,432 shares of the company’s stock after selling 177,467 shares during the quarter. Bank of New York …
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K12 (LRN) Receives Daily Media Sentiment Rating of 0.14

News coverage about K12 (NYSE:LRN) has trended somewhat positive this week, Accern Sentiment reports. The research group rates the sentiment of news coverage by monitoring more than twenty million blog and news sources in real time. Accern ranks coverage of public companies on a scale of …
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LRN

As-it-happens update ⋅ April 17, 2018
NEWS

K12 (LRN) Receives $21.50 Average Target Price from Brokerages

K12 (NYSE:LRN) has been given a consensus rating of “Hold” by the six research firms that are currently covering the stock, MarketBeat Ratings reports. Two investment analysts have rated the stock with a sell rating, one has issued a hold rating and two have assigned a buy rating to the company.
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MarketBeat Daily: Headlines and Analysts’ Updates for 4/17/2018

The MarketBeat update for K12, Inc. and Pearson Education from yesterday.

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