Description

Introduction

LRN has been a cheap stock for a long time. It has had fits and starts over the last number of years threatening to break out but we believe that now is the time that it will break out to new highs and change its profile from being a value stock to a growth company.

Business 

 LRN is broken into four segments with Managed Public Schools generating ~90% of revenue and the vast majority of operating income.  Managed Public Schools provides full time, tuition free online K-12 education in 30 states and over seventy school districts. Their next two largest segments are called Non Managed Public Schools and  Institutional (8% of revenue but carry higher gross margins). It’s best to think about non managed public schools and Institutional as  more ala carte offerings versus managed public schools where LRN provides everything from administrative support to the actual teachers.Lastly in January of 2020 K12 purchased a coding boot camp called Galvanize for $133mm which is  doing about $50mm in revenue. They hope is to cross sell some of the Galvanize offerings in managed public schools and market Galvanize to high school seniors enrolled in K12 programs. 

Recent History

We wrote up LRN  in Sept of 2018 (https://www.valueinvestorsclub.com/idea/K12_INC/0510609940#description ) on the premise that their valuation was too cheap relative to the emerging opportunity in their Managed Public School segment. 

Back in 2018 Managed Public Schools was rolling out a new offering at the high school level called Destination Career Academy (DCA) which focuses on serving high quality vocational education through an online channel.  The idea is that the average local school district  lacks the financial resources to invest in a  robust career training curriculum. Given the ever changing landscape of vocational education, there’s a great opportunity for a  national player to leverage a single curriculum across multiple schools throughout the country.  Though the company doesn’t break out DCA, we estimate that DCA has grown from a $50mm run rate in 2018 to $150-200mm in FY 20 out of  total Managed Public Revenues of ~$900mmm.

 On the anticipation of this new growth story, the stock ran to $35 in early 2019  but quickly retraced its lows when news broke that Georgia Cyber Academy was breaking their contract for the calendar year 2019 -2020 school year (K12 is now in arbitration and confident that they will open a new school in Georgia for the ‘21-22 school year).  Clearly losing a large customer is a negative, but the market missed the strong +10% underlying growth in enrollments in ‘19-20 excluding Georgia. In the absence of Georgia we believe the stock would have made new highs and demonstrated that it truly is a growth company. 

Enter coronavirus which changes everything….As we enter the seventh month of the pandemic, you might be thinking that all the “easy money” and obvious beneficiaries have already priced in the new reality. Due to a quirk in how they enroll students, we believe LRN is poised to report a dramatic acceleration in growth prospects for their FY21Q1 (September quarter).  In fact, outside of Zoom and other obvious coronavirus plays, it’s hard to think of a business that is better positioned than LRN. But unlike other virus plays that have already priced in revenue and earnings growth, LRN has yet to see the benefit of the virus in their numbers given they only enroll students once a year in the late summer and fall. It is possible that we might see an early indication of the strong growth when they report their fiscal fourth quarter (June) but in the past they have only provided enrollment guidance for the upcoming year after their fiscal Q1 (Sept.).

Going back to our original thesis, we were already expecting  a meaningful  inflection going into next year as we aniversary the loss of the Georgia Cyber Academy. This alone would have  taken revenue growth from low single digits to low double digits and potentially  brought the stock back to where it was trading before the loss of the Georgia Cyber Academy.  But now our due diligence (conducted over the last several weeks) indicates that LRN has an uncapped opportunity and corresponding demand  to grow enrollments in at least 4 of its top 5 states in addition to the steady growth they experienced last year.  In FY20 managed public school enrollments were 122,000 which was up modestly from 116,000 in FY19. Our baseline assumption before coronavirus was to see enrollments grow at least to 134,000 students for the upcoming year. However, we’ve heard from the company that they have capacity to add 40,000 new students which would take enrollments above 160,000 or 30% growth.  We don’ t need to rehash what is going on in the news but even without the current fear about a second wave,  full time online enrollments were only 375,000 to 400,000 out  of a total US  student population of over 50mm . Online school isn’t for everyone but whatever the TAM was before the virus hit,  it has expanded by a lot.

Valuation

LRN has a $1.4billion market cap and $50mm of net cash for an EV of around $1.35 billion. The company has always been a consistent generator or FCF albeit on a lag because they are only paid by the states after the school year has ended. Therefore,  LRN has to  finance all the marketing, enrollment, and instructional costs for at least half a year until they get paid. On the plus side they have a very high collection rate on their accounts receivables. Assuming revenue per student stays flat and  they grow enrollments by 30% for the upcoming year, we project revenue will grow to ~$1.4billion from $1billion this year and Adjusted EBITDA will expand from $135mm this year to $222mm next year per. Based upon management guidance, our assumption is that EBITDA will grow at 2x the rate of revenue. This guidance might prove to be conservative should K12 grow its non managed public school and institutional business which have higher margins.  

Bottom line: K12 is trading close to 1x EV / forward revenue and  5-6x EV /  FY ‘21 EBITDA despite having strong tailwinds. K12’s  President and Head of Corporate Strategy came from Match.com. He sees parallels between K-12 online schooling and online dating. It used to be that online dating was awkward and avoided but now it is normal. Full time K-12 online  schooling also has only managed to penetrate a very small niche at  less than <1% of total students. However, coronavirus has become a forcing function to bring it into the mainstream.

Conclusion

Maligned by short sellers and teacher’s unions, K12 has been an easy target for years which has led to the current mispricing. While the stock has had a nice move off its lows, it is only now trading where it was  before losing the Georgia Cyber Academy. Given the likelihood that they will announce strong growth trends for the upcoming year and beyond, we think LRN at its current valuation is highly asymmetric.

Catalyst

-Report enrollment numbers for '20-21 school year

-Demonstrate continued traction in Destination Career Academy