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.