| 2018 | 2019 | ||||||
| Price: | 16.50 | EPS | 0 | 0 | |||
| Shares Out. (in M): | 41 | P/E | 0 | 0 | |||
| Market Cap (in $M): | 677 | P/FCF | 0 | 0 | |||
| Net Debt (in $M): | -227 | EBIT | 0 | 0 | |||
| TEV (in $M): | 450 | TEV/EBIT | 0 | 0 | |||
| Borrow Cost: | General Collateral | ||||||
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Description
Possible SAT words/concepts/foreign language in italics for your test prep benefit. Sorry in advance, Ms. Palmisatto, for any grammar or spelling errors.
Summary
While K12 (LRN) screens very cheap, there are some major problems with their business that should begin to manifest in results in 2019 (fiscal year = school year, ends in June). Notably, the market is unaware of a major contract loss in Texas that will have a substantial earnings impact.
Company Background
LRN is an early pioneer in delivering online education, serving public school systems up through grade 12. They operate through various brands including “Virtual Academy” and “Insight Schools” to provide primary and secondary education to students in most states in the US.
~80% of their revenue comes from their Managed segment, through which they partner with a local non-profit entity to set up and register an online school. (For profit entities cannot run schools directly.) Managed schools are mostly shells through which LRN employees operate every aspect from marketing to admin to teaching to lobbying. These schools are public charters, meaning the state gives them taxpayers dollars for every head they teach and tuition is completely free to the parents, as if the kids were going to the local school.
The remainder of their business is Non-Managed, where the non-profit school simply buys the curriculum and consulting services from LRN, but manages everything else themselves. They also have an insignificant private online school offering.
LRN schools are predominantly 100% online, with teaching done through electronic coursework and video (along with a crate of art supplies, etc.), although some are “blended”, meaning some mix of in-person activities.
LRN has an inglorious history of poor academic outcomes, weak shareholder disclosure and questionable operating practices. Whitney Tilson even published a well timed short report in 2013. https://www.tilsonfunds.com/K12-Tilson-9-17-13.pdf
Industry Background
Virtual schooling started taking off around the time of the Internet revolution and is continuing to grow today. However, LRN and Pearson (which owns Connections), began to taper off in the past few years. Let’s come back to why in a bit.
http://nepc.colorado.edu/publication/virtual-schools-annual-2018
First, why does the business exist? Basically, we view LRN and Connections as weapons dealers to the various school districts that are fighting a perpetual arms race to grab the greatest share of the state educational dollars. A school district which runs a virtual school can enroll students from anywhere in the state, and they are allocated tax dollars for every student they serve. So, it is a rational response for underserved communities in particular to pull in more resources to help their kids. Understandable behavior, but a societal zero sum game at best, and a dead loss game if the academic report cards are accurate. There are plenty of less savory reasons for this investment by the various players involved as well. It is disturbing when you read about how these virtual schools can spend 50% of the state average per student and still get paid exactly the same stipend per head.
While the idea of virtual education sounds wonderful, educational outcomes have been uniformly bad, and most of the schools are playing a cat-and-mouse game with state policymakers to try to avoid getting shut down or sanctioned. This game has creative rule-bending that reminds us of the good ol’ Financial Crisis days, such as changing authorizers, bifurcating students into a good school/bad school and shutting down the old school and then starting up exactly the same new school with a new coat of paint.
So why are LRN and Pearson not growing with the market? While it is hard to make generalizations, given how Balkanized the state systems are, it does seem like school districts themselves are climbing the learning curve on how to run their own schools. Numerous charter school networks are moving into online. LRN has been hit by some large defections, such as Agora in PA. There are also a litany of private competitors, including one run by LRN’s founder/ex-CEO. In other words, the space just looks a lot more sophisticated and competitive than before, when nobody knew how to do online education.
On top of all that, some high profile virtual frauds have come to light. Reading up on Ohio’s ECOT scandal might make your blood boil. A PA charter executive was just sentenced. LRN itself was dragged through the mud in California in 2016.
To be fair, these are subjective views, and when idealism meets greed in the arena of public policy, the good guy usually goes to the ICU.
Texas Virtual Academy Closure
For the 2018-2019 academic year, LRN will lose the Texas Virtual Academy (TVA) contract. TVA is operated by the Texas-based non-profit, ResponsiveEd, and its affiliate, Premier High School. https://www.guidestar.org/profile/75-2748762
TVA historically used LRN’s curriculum and other services as a Non-Managed client, and enrollment was even done through LRN’s website as recently as May. Our (imperfect) understanding is that ResponsiveEd, which runs a network or brick-and-mortar charter schools, decided to take the curriculum in-house. For the upcoming year, they have rebranded to iSchool Virtual and are marketing furiously. https://ischoolvirtual.com/
But wait, LRN still runs the Texas Virtual Academy at Hallsville and is enrolling grades 3-12? https://www.k12.com/participating-schools.html?state=texas
This is a diversion. Hallsville was a nonentity that served a total of 7 students in the ’15-’16 school year. LRN simply pulled out the old industry trick of swapping the school’s nonprofit sponsor with a district eager to bump up its education dollar intake. We know Hallsville was not up and running as of May, because at that time their enrollment specialist confirmed TVA was shut down and sent us to TOPS, LRN’s other virtual school in Texas.
Meanwhile, TVA served ~6,300 students in the ’16-’17 school year.
TVA Hallsville will likely be an institution that is similar but not congruent with old TVA – in other words much, much smaller. The problem here for LRN is that current students will have been inculcated in the ResponsiveEd paradigm and ResponsiveEd owns the student dossier. The old trick of swapping districts probably doesn’t work when there is incumbent competition.
So, what’s the plausible financial impact? Comparing the data for last nine months of 2018 vs. 2017 is instructive. Note Gross Margin below treats only Instructional Costs and Services as COGS. Although LRN arranges SG&A and Product Development in their filings so there is no true COGS entry, these two line items should be treated as fixed costs other than to the extent SG&A includes lobbying dollars tied to specific schools.
Growth in Managed enrollment paired with declines in Non-managed enrollment results in a small revenue increase, but substantial gross margin contraction. Sixth grade mathematical reasoning should lead one to the conclusion that the Non-Managed business is more profitable by far. While the data isn’t perfect and sixth grade algebra doesn’t provide a clean solution (implies Non-Managed GM > 100% #UNSOLVABLE PRESS C TO RESET#), likely due to various cost rationalization measures LRN has taken and some other data issues, it is not unreasonable to believe that GMs for serving up an online software curriculum without all the pesky costs of hiring humans to teach/market/administer are in the 60-80% range vs. something below 30% for the Managed business.
A look at the Agora loss in 2016 is not clear cut due to a major revenue hit the same year, but provides support for this hypothesis as well. When the Agora contract was revised, margins went up, not down.
So what happens when Texas Virtual Academy drops off for the 2019 school year? It may not a 100% enrollment loss, as LRN might recapture some students, so the below is simply illustrative. Furthermore, any recapture by TOPS or TVA Hallsville will have an indutibly lower margin, as they are Managed schools.
While revenue doesn’t see much impact, since a fraction multiplied by a fraction is smaller than either fraction, the bottom line impact could be repugnant. The implications of a declining Non-Managed business are nicht gut, no bueno, pas bon, ä¸å¥½.
Back to Hallsville for a moment. Hallsville projects they could serve 2,000 students in year 1: https://www.news-journal.com/news/county/gregg/hallsville-isd-signs-manufacturing-academy-virtual-school-agreements/article_ad203372-5d18-11e8-b6ad-37f787fe688d.html. We are skeptical, but even if they succeed, LRN will “front all the costs for a year” per the article. Per SEC filings, LRN takes a hit if the school is running at a deficit (see below). At best, we will see recapture at a sub-30% margin, but more likely, we believe Hallsville is breakeven in ’18-’19.
Generally, Non-Managed enrollment is finally starting to show some real wear after peaking in 2017:
Both LRN’s and Pearson’s commentary are very clear that the Non-Managed business is not doing well, even if the Managed business is hanging on. Pearson highlights 3% enrollment growth in 2018 H1 off of a big school closure in the prior year comp, but forecasts a decline in H2 enrollment off of an upcoming school closure. Pearson was strangely excited to tell us that, even though enrollment will decline, the hit to revenue will not be proportionate because these are equivalent to Non-Managed businesses. However, when asked about whether operating income might fall even as revenues rose, they demurred. While some of the other closures (discussed below) are known, we believe the market hasn’t identified the Texas Virtual Academy loss yet and will underestimate how significant the impact is when they do.
Other Stuff that Could Be Really Bad
We like to focus on one crux issue in our posts, but there is a litany of other quandries with LRN. These are well covered by a short activist on Seeking Alpha, so we will point you there.
We disagree with some of their numbers of course, such as our research showing they lost all of TVA not just grades 3-8, but we end up in roughly the same bearish place. Just to list some of the issues they raised and some of our own:
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Other school closures in ‘19: Probably well digested by the market, and these are Managed schools, meaning the bottom line impact is less. The closures of Hoosier Academy and Insight Ohio are probably going to be balanced out by growth in some other regions, particularly Ohio where the massive ECOT closure will be a gift to LRN. South Carolina and Nevada looked dicey earlier in the year, but have been given a reprieve from getting shut down. It isn’t clear that the Managed business is going out of style though—there seems to be no shortage of districts willing to sign the Faustian bargain or scumbags politicians willing to push special interests, such as https://edscoop.com/virtual-schools-bill-missouri-eric-greitens-resigns-scandal
The above estimates are likely to be wildly off, but it is there to highlight some growth regions that should counteract known losses. Our checks suggest there will be other gives/takes, but the above was our best guess at some of the more transparent enrollment changes. In any case, Managed growth is real.
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Virtual school teachers in California unionized and in April won a substantial pay raise plus other concessions such as more equitable student/teacher ratios. While California Virtual Academy is a Non-Managed customer and therefore the heightened expenses don’t necessarily hit LRN directly, they admitted on their last earnings call that there will be flowthrough to their P&L given how their contracts are written. Depending on how they machinate the accounting, this may or may not hit hard in 2019, but there could be real cash flow impacts.
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CEO turnover, most recently in February 2018. This is actually the old CEO taking back his seat after giving it up it in 2016... And their founder/ex-CEO was kicked out in 2014 and founded a competitor. Director resignations in 2017.
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Technology Crossover Ventures, big growth stage VC, began selling down this year. Trickle of insider sales, no buys.
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Lots of accounting and financial red flags. Ballooning DSOs. Risk of receivables writeoffs. Questionable pattern of delayed investor disclosure.
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Agora PA contract is up for renewal in June 2019. It is not unreasonable to assume that they represent a superlative chunk of the Non-Managed revenue at 1/3 the Non-Managed student count left after TVA leaves.
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Reasonable chance of litigation or regulatory risk down the line if they are committing ECOT-style fraud.
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New initiatives just to run in place will cost more money. Blended schools? Lower student/teacher ratios? Paying higher salaries to attract better teachers? If this market were forced to reach an equilibrium where results were palatable to regulators, we think the margins would be much thinner.
Summary, Risks and Valuation
LRN is a bad business with the bad kind of growth and no terminal value. The cash cow of the Non-Managed business is shriveling. But, valuation is tough to pin down, because LRN doesn’t trade on fundamentals.
Furthermore, they screen cheap as they are sitting on ~$5.50/share in cash, trade at 4x EV/EBITDA and ~10% FCF yield (on EV, not market cap, since you could just return the cash). The real FCF itself is debatable, depending on what you believe about their categorization of computer financings and capitalized software.
On the other hand, LRN does trade on news. TVA should be news. Analysts know Managed is growing and Non-Managed is performing poorly. But, consensus estimates imply 8% EBITDA growth for the next two years and higher bottom line growth, while we see major risk that EBITDA will be down 10%+. Perhaps a shock takes us back to $12, where it traded before the election?
We also estimate Non-Managed is where the operating leverage is, and it might even account for all of the proper free cash flow. If investors and analysts lose confidence in this segment and see FCF as heading to nil or negative, maybe this is an $8 stock, just for balance sheet, remaining cash steam and extrinsic value? The Agora contract renewal is a real risk, as numerous reports suggested they were ready to drop the LRN curriculum back in the 2015 negotiations. With a few more years under their belt and peer defections, the days may be numbered for Non-Managed’s fat profit margins.
Some risk areas:
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Valuation will also be impacted by how well management allocates capital. Although we don’t foresee a transformative M&A deal, the market may get excited about anything they announce. If they decide to offer a return of capital, that could also drive up the stock price, though management has been reluctant to do so in the past.
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The TVA contract may not be as profitable as our estimates suggest. LRN has been cutting expenses aggressively in a number of areas and might be able to soften any financial blows, while having some lag before clients and regulators see service level impacts.
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Stock traded up substantially on Trump/DeVos hope, and when it comes to public policy, who knows? They could turn this thesis upside-down with the stroke of a bear paw.
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It is also possible LRN has already incorporated all possible bad news, known and unknown, and the stock is marking the risk/reward properly. Maybe Vanguard really needs to own THE FUTURE OF EDUCATION and thinks it is cheap here. Tons of nonfundamental hedge funds in the mix
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The sheer moral turpitude of this business has blinded us to some obvious value proposition. Not joking. Push back appreciated.
As we just caught the TVA update prepping into Q4 earnings in a few days, we are posting this idea now even though there are some loose ends. They will not provide 2019 guidance until they report Q1, as by then they will have a firm grasp on enrollments for the upcoming school year. So, we might get an update soon, or we might get the full picture only with guidance. Or, we might got a ruler rap across our knuckles. Time will tell, but we probably won’t have to wait too long to know if this is working.
I and/or others I advise hold a material investment in the issuer's securities.
Catalyst
The TVA loss itself will probably be misunderstood as immaterial, but the ensuing financial impact will reverberate
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