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July 23, 2009

The Long-biased Forensic Analysis is Now Available to the Public
by Reggie Middleton

This blog's first long biased forensic analysis is now available, and I am releasing it to the public (this one time) to illustrate the depth of the work that is put into these efforts.

This is the first of several long-biased research reports. I would like to make clear from the start - this is not investment advice. This is the result of my search for a company that has high growth potential, healthy metrics and is underpriced. I have a 6 to 18 month investment horizon. This research is for use in my own investment operations and is presented to subscribers and (for this instance) blog readers for illustrative purposes only. Althoug this is long-biased research, I am still bearish on the US equity market in general. This also serves as an opportunity for me to highlight a company that makes a tangible product that actually helps society (educates children), and exhibits rapid growth without bankrupting state governments, requiring billions in federal bailout funds, or having to resort in paying 50% of its net revenues to its employees after accepting said federal bailouts. I, of course, am not naming any names (but if I were to do so, here is where the names would be). I'm sorry, but the record bonuses generated from taxpayer funds really grates my nerves.

There are two things that will really stand out about the analysis and opinion that comes out of this site. For one, the team that generates it is very smart, with both a deep and broad knowledge base and skill set. They are not amateurs. The second thing is increasingly difficult to find in the investment world today - I/we are BRUTALLY honest. There are no big client's asses to kiss, there is no advertisers to be beholden to, and I have been a Wall Street outsider my whole life. I call it as I see it. The good, the bad, and the ugly. This has pissed off the management of General Growth Properties (who are now bankrupt - see GGP and the type of investigative analysis you will not get from your brokerage house), Lehman ("Is Lehman really a lemming in disguise?") and Bear Stearns (Is this the Breaking of the Bear?) also both also bankrupt, or the equivalent thereof, MBIA and ABK (effectively in runoff mode, aka bankrupt - see A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton, Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion, Follow up to the Ambac Analysis, and Monolines swoon, CDOs go boom & I really wonder why the ratings agencies are given any credibility), and a whole host of other companies. Well, now I have some nice things to say, and I hope corporate management can be as sweet to me as they have been mean. If not, well, you know what I'll say...

I invite all to learn more about virtual schools, and the potential growth opportunity. I also welcome all to peruse and participate in the bear debate published in the Wall Street Journal concerning the subject of the long biased report. Of course, I feel that we have performed superior research, but sometimes one needs to hear the opposing argument to truly appreciate the quality of the extant argument. Feel free to download the professional version of the forensic analysis here: K12 Forensic Analysis (ticker:LRN) 2009-07-20 07:54:32 619.70 Kb. Those who wish to subscribe to the research may do so by clicking here.

The Bear Argument

Barron's recently ran an article citing LRN as short candidate. Obviously, their viewpoint is diametrically opposed to mine. I have excerpted a portion of that article here, and have offered a rebuttal to it, which is also available in verbose, long form via the forensic analysis download. From the Barron's article:

"K12 is viewed by Guild as a "limited-market" story. "When Wall Street gets excited by a new product," he remarks, "it overestimates the size of the market." K12's product is an online educational package for home-based students from kindergarten through high school. The company can also provide live teachers for students who really need help.

Guild cites research showing that on-line learning has clear benefits for a very limited number of students, and he adds that state and local budget cuts threaten to reduce per-student support. K12 Chief Financial Officer John Baule notes that the company's market is now quite small and has lots of room to grow. The key question, however, is whether the stock deserves a price/earnings multiple of 50. If its earnings growth slows and its P/E shrinks to, say, 25, the stock, recently in the low 20s, could fall sharply."

The Counter to the Bear Argument

We agree that growth stocks such as LRN tend to have an inherent risk of contraction in valuation multiple due to decline in near-term decline earnings. However, we have looked at the company's potential from medium-to-long-term perspective, which draws quite a favourable scenario. Based on our DCF valuation, which takes into consideration long-term potential and variability in earnings growth and margin expansion, we determined that the stock presented upside potential at its then listed price. We believe valuing this company based on a P/E multiple alone would not be appropriate as it is important to reflect an element of future potential growth in the price, which unfortunately gets ignored if P/E is used standalone for valuation. This is the reason why practically all successful growth companies trade at high P/E's!

Based on DCF based valuation we had arrived at a valuation of $30.71 per share. Also, if end users review the assumptions we used in our LRN modelling (available in the professional edition of the LRN Forensic Anlalysis, you would find that most of the assumptions that we took are far more conservative compared to the performance of the company in the past few years.

Enrollment growth: We applied reasonable enrollment growth rates of 24% and 23% for 2010 and 2011, respectively against y-o-y enrollment growth of 51% and 37% in 2008 and 9 months ending 2009, respectively. Considering the historical performance, the above enrollments growths seem to be based on a very conservative stance with an expected addition of just 4 states over the next couple of years (K12 has actually added 4 states this fiscal year, alone), and 26% and 23% increase in same state enrollment growth in 2010 and 2011, respectively compared with 29.7% and 30.8% for 2008 and nine months ended March 2009, respectively. Our growth estimates are very, very conservative.

Market Share growth: We have already taken into consideration the "limited" market perspective of K12 and incorporated that into the model by limiting K12's total enrollments to just 0.20% and 0.28% of total U.S enrollments by 2012 and 2017, respectively from 0.11% presently. We agree that there could be short term risks in the form of budget cuts which we highlighted in the investment risks section of the forensic analysis and report. However, we do not foresee a decline in education budget spending that is large enough to pose a key risk from an investment perspective. Also, for K12's revenues growth, enrollment growth tends to be a more important driver than growth in revenue per enrollment, and any slowdown in revenue per enrollment would be more than offset by higher enrollment growth without impacting revenues growth by a material percentage from our assumptions.

Reggie Middleton
Reggie Middleton, LLC
Perpetual Interests, LLCTM
http://boombustblog.com/

Who am I?

Well, I fancy myself the personification of the free thinking maverick, the ultimate non-conformist as it applies to investment and analysis. I am definitively outside the box - not your typical or stereotypical Wall Street investor. I work out of my home, not a Manhattan office. I build my own technology and perform my own research - in lieu of buying it or following the crowd. I create and follow my own macro strategies and am by definition, a contrarian to the nth degree.

Since I use my research as a tool for my own investing to actually put food on my table, I can stand behind it as doing what it is supposed too - educate, illustrate and elucidate. I do not sell advice, I am not a reporter hence do not sell stories, and I do not sell research. I am an entrepreneur who exists just outside of mainstream corporate America and Wall Street. This allows me freedom to do things that many can not. For instance, I pride myself on developing some of the highest quality research available, regardless of price. No conflicts of interest, no corporate politics, no special favors. Just the hard truth as I have found it - and believe me, my team and I do find it! I welcome any and all to peruse my blog, use my custom hacked collaborative social tools, read the articles, download the files, and make a critical comparison of the opinion referencing the situation at hand and the time stamp on the blog post to the reality both at the time of the post and the present. Hopefully, you will be as impressed with the Boom Bust as I am and our constituency.

I pay for significant information and data, and am well aware of the value of quality research. I find most currently available research lacking, in both quality and quantity. The reason why I had to create my own research staff was due to my dissatisfaction with what was currently available - to both individuals and institutions.

So here I am, creating my own research for my own investment activity. What really sets my actions apart is that I offer much of what I produce to the public without charge - free to distribute and redistribute, as long as it is left unaltered and full attribution is given to the author and owner. Why would I do such a thing when others easily charge 5 and 6 digits annually for what some may consider a lesser product? It is akin to open source analysis! My ideas and implementations are actually improved and fine tuned when bounced off of the collective intellect of the many, in lieu of that of the few - no matter how smart those few may believe themselves to be.

Very recently, I have started charging for the forensics portion of my work, which has freed up the resources to develop the site to deliver even more research for free, particularly on the global macro and opinion front. This move has allowed me to serve an more diverse constituency, which now includes the institutional consumer (ie., investment turned consumer banks, hedge funds, pensions, etc,) as well as the newbie individual investor who is just getting started - basically the two polar opposites of the investing spectrum. I am proud to announce major banks as paying clients, and brand new investors who take my book recommendations and opinions on true wealth and success to heart.

So, this is how I use my background and knowledge in new media, distributed computing, risk management, insurance, financial engineering, real estate, corporate valuation and financial analysis to pursue, analyze and capitalize on global macroeconomic opportunities. I have included a more in depth bio at the bottom of the page for those who really, really need to know more about me.

Visit his blog Boom Bust Blog.

Copyright © 2007-2009 Reggie Middleton

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