VIC — Whitney Tilson’s Big Short

by Travis Johnson, Stock Gumshoe | September 17, 2013 4:29 pm

Final Notes from the Value Investing Congress on Tilson's Big Short Bet

Whitney Tilson sold his presentation big this year, saying he had put together a Einhorn-esque slide deck of 120 pages with a short argument about K12 (LRN).

On shorts in general, he said he has done awfully with shorts for a few years — but he sees a world that is so target-rich with crazy, juicy, obvious, shorts that he can’t capitulate …. even if stupidly overvalued stocks can certainly become more stupidly overvalued.

K12, with the cute ticker LRN, runs online charter schools in several states. It offers revenue growth of 32% annually for ten years, it is projecting 32% earnings per share growth, average revenue per student is growing, they have very high parent and student satisfaction, they have strong political support, the product is not completely illegitimate, it definitely works for at least some niches of students, and online learning has enormous buzz.

Why short?

Aggressive recruitment has led to dismal academic results and sky-high dropout rates, student turnover is more than 50% per year and they’ve been targeting increasingly inappropriate students to fuel growth. Recruitment of at-risk students makes them more money, because the parents tend to demand less.

There have been so many regulatory issues and accusations of malfeasance that he’s convinced the problems are endemic.

Similar to subprime lending or for-profit colleges, it makes sense on a small scale but the incentives and growth ambitious make it terrible and ripe for fraud.

He is a champion of charter schools, but is bearish on K12 because it’s a bad school and a bad stock.

Revenue has been growing dramatically, net income has risen but less dramatically. And that revenue growth is slowing, which is a big worry at 50X earnings. While revenue has slowed, the margins have also come down — that’s not supposed to happen.

Free cash flow has been about break even over ten years and has been aggressive. They capitalize their software and curriculum development instead of expensing it, which is very aggressive and even Salesforce.com doesn’t do it. Auditing and CFO don’t impress.

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Short interest is only 14% of the shares, because the stock has risen.

Tilson also interviewed several of the employees and teachers, all tell same story of “Growth at any cost” mentality — sign up as many students as you can using boiler room call centers, when they add a new school in a new state the enrollment all gets moved to these centralized call centers. In reality, the product is only good for perhaps 10% of the market they are targeting, they’re making inappropriate promises to bring in highly profitable students who demand little from the school.

And the academic results, though described glowingly in the company reports, are, says Tilson, completely bogus and not indicative of any real academic performance by their students. About half of public and charter schools make “adequate yearly progress” in helping students, which is a tough federal test — K12 is way below that at 27%. Where K12 students get regular state testing, they do much worse than other students. All the tests available indicate that they are completely failing almost all of their students and there is no learning going on in many of their schools. They trail online competitor schools when there are any — though most of those online schools are also doing terribly for most students — and dramatically trail the bricks and mortar schools.

Which is to say nothing of the fraud of the online school taking the money from the state and failing the kids, and then also having to pay to educate that kid in a regular bricks and mortar school, where they’ll need extra help to catch up, after they give up on the virtual school.

Dropout rates are sky-high even as K12 reports them, but the details they try not to disclose are even worse. Graduate rates are less than 50% (average is about 75% in those states).

And beyond that, even the business model is illegitimate — of the states that permit charter schools, almost all will grant charters only to nonprofits. Nonprofits who they work with are often established by K12 or are conflicted, and K12 manages them to break even and sucks the extra cash up into the corporate (also a violation of tax laws, so the IRS is looking at that too).

K12 says they help because the cost is only about 60% of the national average, they’re saving money — but that doesn’t really wash. Some students were home schoolers, some schools are set up in high reimbursement at-risk areas but take kids from low-reimbursement areas, etc. And of course, they don’t have facilities.

But they are excellent at lobbying — in their biggest state, Pennsylvania, they lobby aggressively and PA also pays far more than the national average per student. Horrific results led to almost shutting down the Pennsylvania Virtual Academy, but they got the legislature to extend it a year. They’re running into problems around the country and fighting them back with lobbying, and still winning some lobbying battles, but there are so many investigations and revelations that it’s finally building up to the point that even legislatures may not be able to ignore it anymore.

The company doesn’t need to go away, it may be useful for 10% or 20-30% of the current market … but it needs to shrink dramatically. He thinks they miss their growth projections by a lot, they may have bad numbers for enrollment this year


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