Description

Just in time for back to school we present K12 (LRN) as a long.  In this report we will begin with a brief description of the business (it’s nuanced), address the  short thesis, and articulate why we think this is a great investment.  Basically we think the bears are missing the forests for the trees, most notably the fact that the fundamentals in K12’s core managed public school business are, in fact, stable and getting better and the fact that in May of this year  the company purchased 1.83 million shares at $15 from a end-of-life VC fund which was a big overhang for the stock. To put this in context, the company has been sitting with an overcapitalized balance sheet for years and only recently took these shares out which we think hints to  increased confidence in their future. In spite of all the negativity surrounding the company, primarily funded by teacher unions, K12 has a recession resistant business model with substantial barriers to entry that generates solid free cash. Importantly, K12 only has ~100,000 students enrolled out of a TAM of 50mm students enrolled in  K-12 public school and 5mm students enrolled in private schools so it’s not a tremendous leap of faith to project that this company has years of growth ahead of them. Trading at 3.5x EV /EBITDA, we think you get the Managed Public School and Non-Managed Public School Business at a fair price and are getting their Institutional Software business for free.                                            

Background

What does K12 do and where is the confusion surrounding their business model?

K12 breaks down their revenue into four discrete categories and the short thesis primarily focuses on the Non-managed Public School Programs which was $57mm/ $918mm in total revenue for FY18.  Rather than cut and paste the language from the 10K, here is the plain english description of each line item:

Managed Public Schools - K12 provides a virtual public school education where local districts contract with K12 to provide full-time education. Students receive online lessons over the internet or through apps that are monitored remotely by teachers/ administrators. K12 is responsible for all aspects of the school - curriculum, marketing, budgeting, staff recruitment, etc. K12 is paid on a six month lag from the start of the school year (this is one of the barriers to entry and another source of misunderstanding as there are working capital drawdowns at the beginning of the year but it also keeps out competitors who lack capital).  Basically Managed Public Schools is a turnkey, soup- to- nuts offering where K12 takes the place of a regular school. The only other scale player is Pearson, who runs a competing offering called Connections.

Non-managed Public School Programs - Unlike Managed Public Schools, the non-managed public school program does not offer primary administrative support services i.e hiring teachers and administrators but it does offer some of the managed school services. Importantly this business is more than just software as K12 acts in a consultative  capacity with school districts to help them set up their own virtual or blended programs.

Institutional Software and Services and Private Pay - Going to market under the “FuelEd” brand, the best way to think about this business is “build once sell twice.” This is a totally ala carte offering where K12 sells its curriculum from its Managed and Non -Managed Public School offering  on a subscription basis to public and private schools. This business competes with some of the more well known publicly traded education companies like Rosetta Stone and Cambium Learning.

Rebuttal to Short Report:

The reason it’s critical to understand these different components is that it makes it easier to put the bear case into context. The July 31st report on VIC primarily focused on K12 losing Texas Virtual Academy (TVA). The report makes several bearish claims to which we provide rebuttals:

Claim 1:  For 2018-2019 school year K12 is losing a major Non-Managed school (TVA in Texas) as a client whose loss will have a disproportionate negative effect on K12’s operating income. The effect will be disproportionate because Non-Managed Public school revenue is primarily the licensing of software vs. the lower margin revenue that accompanies the Managed Public School revenue.

Rebuttal of Claim 1:  First, it is true that K12 managed a school in Texas called TXVA which will close for the 2018-2019 school year. However, this is not news. K12 loses customers here and there but also adds new customers nearly every quarter. The critical point is that over time  it gains more than it loses (they now have over 77 schools in Managed- Public Schools). Management claims that TVA wasn’t even a Non Managed Public School. The big takeaway relates to K12’s degree of diversification/lack of concentration among their various contracts  and the durability of their current book of business. No contract is over 10% of revenues and K12’s schools are funded at each individual district, i.e., each contract is discrete and separate.

Claim 2: Non managed public schools are 100% of the $91mm in Q318 run rate revenue from the Institutional business.

Rebuttal of Claim 2: K12 combines it Non Managed Public Schools with its Institutional Software and Services business into one category called Institutional Sales and Services. As of the end of Q418, Non Managed was only 56% of Institutional so even if the claim was true the impact would be much less than the $17mm hit to EBITDA projected in the July 31st bearish write-up.

Claim 3: The gross margin profile in Non Managed Public Schools is 60-80%.

Rebuttal of Claim 3: - The company does not break out gross margins but refer to the description above and the 10K which clearly shows that this is more than just software. Yes it might be higher margin than Managed Public School but not anywhere close to the 70% claimed in the report.

Claim 4 - K12 provides a low quality education that is worse than traditional brick and mortar schools.

Rebuttal of Claim 4 -  A lot of ink has been spilled on both sides arguing for and against the model and a simple Google search will produce both sides of the argument.  K12’s basic response is their offering is for a niche population - the total enrollment for online public school is around 300k students out of 50mm total. As might be imagined, the students enrolling in these programs are self selected because the traditional brick and mortar  model did not work out for them. Therefore, it’s very challenging to make genuine apples to apples comparisons. Just to share a few statistics:

• Over 50% of K12’s students are eligible for free and reduced lunch (FRL) which is an indicator of lower economic status and  lower baseline academic performance.

• Of the new students who joined K12 last year, only 11%  were at grade level for the start of school so it’s unreasonable to expect them to compare on standardized tests.

• Studies of graduation rates are nuanced because K12 students are highly mobile unlike  regular students that stay in the same high school for 4 years. If a K12 students stays for 4 years, graduation rates are similar to the national average.

In spite of all the bad press, online-only public school education has been around for almost two decades.  So there is already a solid precedent for its existence and we think it continues to gain in acceptance as more students and parents become increasingly comfortable with alternative educational models.  

Long Thesis:

Some of the reasons we like K12 were touched upon in the response to the bearish report, but we want to dig in a little deeper into why we think K12 is underappreciated and has asymmetric upside from these levels.  To sum it up: The core Managed Public School segment which generated $781mm in revenue and virtually all of the company’s $121mm in Adj. EBITDA in FY 2018 more than justifies the current EV of $422mm. But we think growth could actually begin accelerating from the current mid single digits level. By way of background K12 has been investing aggressively in their software and  curriculum over the last three years and finished a multi year refresh of their offering in FY2018. At the heart of this upgrade is moving their offering away from a more laptop centered world over to smartphones and improving student retention, which is a critical requirement for state funding (smartphones have the advantage of always being tethered to students so it’s easier to check in for the purpose of truancy).

While skeptics extrapolate more bad news from isolated school closings, management is as bullish as ever as evidenced in their Q4 conference call which was held on Aug. 2nd.

https://seekingalpha.com/article/4197979-k12-inc-lrn-ceo-nate-davis-q4-2018-results-earnings-call-transcript?part=single

The main takeaway is that the CEO believes  momentum in Managed Public Schools is accelerating off current levels:

“I believe and all indicators tell me that growth in our managed public school program is likely to be stronger in the upcoming fiscal year than it has been in the last 2 to 3 years. What indication gives me optimism, it’s the new K12 app we just introduced. The K12 app guides families through the process of identifying potential schools and enrolling and is steadily gaining users and receiving strong reviews.”

One of the areas that is most exciting is the move towards online-only vocational offerings.  K12 has a new curriculum called Career Technical Education (CTE) which has 180 courses across 30 career pathways. We don’t think the market is giving K12 credit for the potential here, as this offering is very timely given trends in secondary education and the desire to promote more technical skills and prepare graduating seniors for immediate entry into the labor force . This product has the potential to introduce new demographics to K12 that previously might not have considered online education . From the Q4 call:

A recent independent survey of parents supported our enthusiasm around CTE. The survey found that 12% of prospective parents would choose a full-time online school with CTE for their student if it was available,. Additionally, it found that 27% of perspective parents in this study would choose an online CTE course for their student, if it were offered in conjunction with their normal brick-and-mortar charter school. That means 40% of families would be receptive to a full-time or part-time online or blended CTE program

Granted this is a company funded study and needs to be taken with a grain of salt but the key is to focus on the size of the opportunity. Just to reiterate the size of the market: even if only 2% of parents embrace online-only ,the market opportunity for K12 jumps by 3x.  We don’t need this to happen for our thesis to work but it’s not unreasonable to believe that education will eventually catch up with the rest of the economy and see more digital adoption.

The cherry on top is that you get a prospective turnaround in  Institutional Software (FuelEd) for free. As was mentioned above,  K12 repackages its curriculum and sells it on a subscription basis in its Institutional Software and Services Division.  The rationale behind the business makes sense given how much K12 is already spending on software development ($40-50mm/ year including capitalized software and curriculum) and the fact that they have ready-made distribution throughout the US.  Due to poor sales execution and stiff competition, primarily from venture backed startups, this business declined by 18% in FY2018 and is expected to decline again in FY19 albeit at a lower rate. This is the higher margin business which the bears perhaps confused with the Non Managed Public School.  As value investors, we see this not as a wart but as an opportunity-- as this division is currently not contributing anything to operating income. K12 could turn this unit profitable by increasing revenues. This could be accomplished by merging this unit with another subscale competitor -- either through cash acquisition or by folding the two units into a JV.  

Valuation

Accounting for the buyback, K12 has 39mm shares and $233mm in cash on their balance sheet ($6/ share)  which results in a Market Cap of $655mm and an EV of $422mm at current prices. In FY 2018 K12 generated $121mm in Adjusted  EBITDA and $60mm in free cash flow per management’s calculation [this number excludes $13mm in repayments on capital lease obligations related to laptops that K12 provides but as laptops become cheaper and students choose to use their smartphones this line item is expected to decrease]  for a EV / EBITDA of 3.5x and FCF / EV of 14% or 11% if you ding them for the laptops, compelling for a for a business with K12’s dominant position and wide-open market opportunity. At a 10% fcf / EV the stock is worth over $21 but we think upside could be greater given the Institutional Business is not contributing and Managed Public Schools is projected to grow at a faster pace than the past.

In summary, the system simply doesn’t work for everyone and there’s room for variations on the traditional model. Whether it’s a pre Olympian or a musician that needs a more flexible schedule to accommodate a rigorous training schedule, a student with a mental or physical disability, or even a paranoid parent that is concerned about school violence, K12 is offering a viable option for a subset of the population at a cheaper price than the brick and mortar alternative.  Should we enter a recession, we think K12’s current revenue stream will be relatively immune as public education is about as non- discretionary an expense as you can find and it’s even possible they gain share as municipalities and districts looks for ways to cut costs.

Catalyst

-Q1 Conference Call in October where K12 reports enrollment for 2018/2019 year

-Any sign of stability or improvement in Institutional Software and Sales