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Wall Street Roundup: A Look at Baird’s Bullish View on K12 Inc. (LRN)

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Analyst Amy Junker over at Baird Equity Research updated her research on K12 Inc. (LRN) recently, adjusting 2011 earnings per share to .91 cent for Fiscal 2012. She predicts the stock, currently priced around $26 per share, will rise to $34 per share, driving the market capitalization for K12.Inc beyond its current value of $817 million.

K12 Inc., founded in 2000 and headquartered in Herndon, Virginia, is a technology-based education company that offers proprietary curriculum, software, and management services for online delivery to students in kindergarten through 12th grade, or K-12. The company’s primary market focus is the virtual or online public school industry. K12 also sells its proprietary curriculum to schools and home school families. As of December 31, the K12 school system had an average enrollment of 83,320 students in 27 states and D.C as well as nearly 14,980 students from the KC Distance Learning acquisition.

Here’s some key reasons for her thesis on the stock, which provide some excellent background on the market:

Large market opportunity. According to the National Center for Education Statistics (NCES), there were 50 million students in K-12 public schools during the 2008-09 school year. In addition, approximately two million students are home schooled and approximately six million students are enrolled in private schools. Capturing just two million (3.5%) of the addressable market yields a market opportunity of approximately $12 billion.

Solid growth opportunity. K12 expects to drive growth through enrollment growth at existing schools, expanding to new states, selling curriculum to schools for in-class use, and increasing direct-to-consumer sales. Over the next three to five years, the company anticipates revenue to grow in excess of 20% and earnings growth to exceed revenue growth.

Market leader. K12 enrolled its first students in September 2001 and currently enrolls over 83,000 students in its core virtual academies, which is more than K12′s three largest competitors combined. According to the Center for Education Reform, as of January 2007, there were over 92,000 students enrolled in 173 virtual schools.

Attractive financial model. K12 generates a high level of recurring revenues due to the long-term nature of the contracts with schools (usually five years) as well as high degree of customer satisfaction. According to an internal survey, 97% of families are either satisfied or very satisfied with K12′s curriculum and 95% would recommend K12 to other families. The business is also highly scalable, which we believe will lead to significant margin expansion over the next several years as the student body grows.

Proprietary curriculum and technology. We believe K12′s proprietary curriculum and technology are a key point of differentiation for the company. Approximately 90% of K12′s curriculum was developed in-house and contains more than 11,000 lessons, which combine technology, such as flash animation and interactivity, with text books and other offline course materials. K12 has invested over $200 million in the development of its curriculum and systems.
Strength in lobbying in new states. Another key point of differentiation is K12′s success in working closely with state policymakers and school districts to enable the expansion of virtual schools into new states or districts. The company has years of experience in successfully lobbying to get legislation passed to allow virtual schools to operate.
Junker also lays out the following Risks & Caveats:
Competition. The market for primary and secondary education is highly competitive. K12 competes against other virtual schools, charter schools, and public schools as well as private schools and home schooling. We believe the high school market is the most competitive.Delay in opening new states. K12 spends time and money lobbying state legislators to create and vote for bills that would permit and fund the virtual charter schools. Delays in opening new states could impact margins and slow potential growth.The K-12 market is cyclical. K-12 funding is tied to state budgets and tax revenues, which are impacted by economic cycles. Funding generally has a one-year lag to an economic slowdown. A downturn could decrease the amount of funding the company receives from the state.

Regulatory issues. K12′s schools are subject to state government regulations and licensing requirements. Failure of any school to comply with the requirements could result in sanctions, fines, probations, or in severe cases, revocation of the license to operate.

High school growth negatively impacts margins. The newer high school offering generates a lower margin than the K-8 business due to differences in scale and higher teacher pay. While management expects the gap to close, the faster growth in high school could lower margins in the near term.

Teacher unions. K12 has faced opposition from unions while lobbying for legislation that would create virtual public schools. The company was previously involved in two lawsuits concerning virtual charter school laws, both involving teachers unions, which were resolved in favor of the company. We expect teacher unions to continue to resist the company’s efforts to expand.

Revenue concentration. Two schools (Ohio Virtual Academy and the Pennsylvania Virtual Charter School) each contributed over 10% of revenue, and together generated 28% of K12′s F2010 revenue. Future revenue could be significantly impacted by any decline in the funding levels or in enrollment, the loss of a contract, or a legal challenge to the status to the two schools.

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