kase quarterly letter q3 2013

8/22/2019 Kase Quarterly Letter Q3 2013

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Whitney R. Tilson phone: 212 277 5606

Managing Partner [email protected]

Carnegie Hall Tower, 152 West 57th Street, 46th Floor, New York, NY 10019

October 10, 2013

Dear Partner:

Our fund rose 3.9% in September vs. 3.1% for the S&P. For the quarter, it declined 2.3% and isup 6.3% year to date vs. 5.2% and 19.8%, respectively, for the S&P.

The story in Q3 mirrored the story of the year so far: solid performance among the stocks weown (our average long is up nearly 30%), offset by the headwinds of cash and the short book.

Ive been doing a great deal of thinking and been having many discussions with the smartestpeople I know in this business about these two headwinds and what, if anything, I should do

differently. Ive reached a number of conclusions.

Holding cash and long exposure

My biggest mistake since I started managing the fund myself 15 months ago has beenunderexposure on the long side. Ive been holding 20-40% cash during most of this period,positioning our fund conservativelypracticing the principle of be fearful when others aregreedy and greedy when others are fearful in light of the widespread complacency in theequity markets and the fact that the major indices have regularly been hitting multi-year or evenall-time highs. I let my concerns about the market affect how I positioned our fund, with theresult that instead of being at my target exposure of 100% long by 30% short, I was typicallycloser to 70% long by 30% short, which has been costly in light of the markets strong upward

move.

Holding such a large amount of cash can make sense for a long-only fund but, when combinedwith a substantial short book, is overly conservative in the absence of great conviction that themarket is about to implode. In the nearly 15 years that Ive been managing money professionally,Ive only twice felt this way: in late 1999/early 2000 at the peak of the internet bubble, and inearly 2008 when my research led me to believe that the consequences of the bursting of thehousing bubble would be much worse than nearly anyone believed at that time.

Today, I dont have this feeling. While there are plenty of things that could upset the currentcomplacency in the marketsfor instance, the current government shutdown continuing;

Congress failing to raise the debt ceiling; unexpected consequences from the recent jump ininterest rates; and/or a sharp economic downturn in Europe, China, Japan, or emerging marketsmy best guess is that the U.S. economy will continue to muddle along, as it has been doing forthe past few years.

As such, going forward I plan to be more disciplined about maintaining my target exposures onboth the long and short sides, but also to, on rare occasions, hold more cash and/or increase thefunds short exposure.


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The fund is currently 86% long and 22% short, both of which I plan to increase in the nearfuture.

Casting a wider netIve historically invested almost exclusively in American companies that are subject to U.S.

auditing and filing rules and trade on one of the major U.S. exchanges. I have deep experiencehere, shareholders are well protected, and I have always been fearful of straying outside mycircle of competence and being the proverbial sucker at the poker table were I to investelsewhere.

I think Ive been too dogmatic about this, however, and over time plan to invest some time andenergy into becoming familiar with foreign companies and markets. I dont expect to become atruly global investor anytime soon (if ever), but there are great investment opportunities all overthe world and I think expanding my investment horizons will serve us well over time.

To date, I have many only one investment in a foreign company, Hyundai Motors preferred

stock.

Hyundai Motors preferred stock

I recently established a nearly 2% position in the preferred stock of Hyundai Motors. I can hearyou thinking: A Korean automaker? What are you thinking??? The simple answer is that this isan excellent company with bright future prospects, and I was able to purchase itthrough thepreferred stockat a ridiculously cheap price: 3.4x trailing earnings (not EBITDA, but realearnings).

Over the past 15 years, Hyundai, under the leadership of M. K. Chung (whose family owns more

than 20% of the company), has transformed itself from a thirdtier industry laggard into theworlds third largest automaker, and has been steadily gaining share, as this chart shows:

Hyundais Global Market Share


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Remarkably, the company hasnt gained share by sacrificing profits in fact, it has consistentlyhad the highest profit margins among the largest global automakers, as this chart shows:

Consolidated Operating Margin, 2009-Q2 2013

Ah, but its an automaker, so the balance sheet must be a mess, right? Nope. The company has$20.7 billion in cash (43% of the companys market cap of $48.3 billion), its debt is tied to itsfinance arm and more than offset by associated assets, and there are no long-tailed pension andhealthcare liabilities that crippled the U.S. automakers (net defined benefit liabilities are amere $906 million).

Even without adjusting for the excess cash, the company has generated a high-teens to low-20%

return on equity for a number of years.

To summarize, this is a good business (albeit in an admittedly lousy industry) that has done verywell in recent yearsand the stock has responded, rising more than 6x from its late-2008 lows.Nevertheless, today it trades at a mere 8.4x trailing earningsand pays a small 0.8% dividend toboot. Thats cheap and I might be tempted to buy it but not when I can instead own it throughHyundais Series 3 preferred shares, which trade at a 59% discount to the common stock,meaning we own it today at 3.4x earnings (and will receive a 2% dividend as well).

Korean preferred sharesKorean preferred shares came into existence in the mid-1980s thanks to a favorable law that

allowed Korean companies, many of which are run by families that didnt wish to dilute theircontrol, to issue equity in the form of preferred shares, which typically had the same economicrights as the common stock, but few or no voting rights. Nearly 150 companies issued preferredshares before the law was changed long ago.

For many years, the preferred shares traded at around a 20% discount to their associated commonstocks, but during the panic of the Asian financial crisis in 1997, they traded down to more than a


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70% discount and, since then, have traded at a 40-70% discount. The current discount is around60%.

I can find no good reason for such a large discount, especially in light of the fact that the Koreanmarket is steadily becoming more shareholder friendly. Obviously, some discount is warranted,

but as this chart shows, the preferred stock discount in Korea far exceeds that of other countries:

Preferred Stocks Discount By Country

I believe that this is one of those market anomalies in which something is mispriced primarilybecause its always been mispriced. I have no idea when this discount will close, but myexperience, to paraphrase Ben Graham, is that while in the short run the market is a votingmachine, in the long run its a weighing machine. As Korea continues to become more investor

friendly, I think the preferred share discount is likely to close over time, which gives me asecond way to win on this investment (the first being that Hyundai continues to do well and itscommon stock rises over time).

A final thought: I take some comfort investing in Korea after reading thistranscriptof a Q&ABuffett did in April 2009 with University of Kansas students:

[Buffett then pulled out the 2004 Korean Stock Guide compiled by Citigroup]. My broker atCitigroup told me to look through this Korean version of the Moodys guide. He said it wouldlook just like 1951. He was right. I began flipping through the pages and found a lot of goodcompanies trading at very low multiples. In 5-6 hours I put together a small portfolio of 20-25

stocksabout $100 million total. One example was DaeHan Flour Mills. It has a 25% marketshare in wheat flour in South Korea . Book value was 206,000 Won and the company had201,000 Won in marketable securities and was trading at 2x earnings. The market is clearly notefficient all the time. There are certain opportunities that can make you fabulously rich.

Shorting

I have two strong feelings about shorting right now:
http://www.stocksavenue.com/2009/04/14/some-q-a-university-of-kansas-with-warren-buffett/http://www.stocksavenue.com/2009/04/14/some-q-a-university-of-kansas-with-warren-buffett/http://www.stocksavenue.com/2009/04/14/some-q-a-university-of-kansas-with-warren-buffett/http://www.stocksavenue.com/2009/04/14/some-q-a-university-of-kansas-with-warren-buffett/


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1) Its a horrible business, its cost all of us dearly over the past 4 years, I wish Id neverheard of it, and every bone in my body wants to cover every stock Im short and nevershort another stock again; and

2) In my nearly 15-year career of professional investing, the only other times that have beenas target-rich in terms of juicy, obvious shorts are late 1999/early 2000 and late2007/early 2008 (and we all know how those ended).

So which feeling am I going to follow? The latter. Not because I am unreasonable, stubborn anda glutton for punishment, but because I am convinced that I can make a lot of money on the shortside going forward.

The only other time in my investing career in which I seriously considered covering every shortand becoming a long-only manager was October 2007. At that time, I went through my shortbook, stock by stock, and said, OK, am I willing to cover MBIA at $70? Hell no, not a singleshare! Allied Capital at $30? Hell no, not a single share! Farmer Mac at $30? Hell no, not a

single share!And on it went I couldnt bring myself to cover a single share of any stock I wasshortthey were all trembling-with-greedshorts. And thats exactly how I feel today.

Let me be clear: I have no illusions about what a tough business shorting is. In most years, infact, I expect that it will detract slightly from our returns. But thats a price Im willing to pay fora number of reasons:

1) Having a short book allows me to invest more aggressively on the long side, both in terms ofoverall portfolio positioning, individual position sizes, and willingness to take risks in certainstocks. Here are some examples of what I mean:

I wouldnt be comfortable taking our funds exposure up to 100% in the current market if it didnthave meaningful long exposure;

I wouldnt have held onto my position in Netflix as its risen from just above $50 to more than$300 over the past year if our fund wasnt short a number of similarly volatile, speculative stocks;

I wouldnt hold such a large position in Howard Hughes (9.5%), another huge winner for us, ifour fund werent short St. Joe, which is also closely tied to the real estate/housing market; and

Im not sure I would feel comfortable owning economically sensitive stocks like Hertz and Avisif our fund werent short many stocks that I expect would do very poorly if the economyweakens.

2) A short book typically pays off just when you need it, during severe market declines,providing cash to invest on the long side when its most attractive. This is exactly what happenedin 2008 and early 2009. After inflicting losses as the market rose from early 2003 throughOctober 2007 (the same length of time as the current bull market), our substantial short bookcushioned the downturnour fund was down approximately half the market in 2008andallowed me to invest aggressively on the long side, which translated into big gains after themarket bottomed in March 2009.


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3) I sleep better at night with insurance. At the beginning of every year, I write a check forhomeowners insurance and at the end of the year, when my apartment hasnt suffered from aflood or fire, my insurance expires worthless and I have to buy it again. Is it a mistake to buyinsurance that turns out to be worthless almost every year? Of course not.

I suspect most people wouldnt quarrel with buying cheap insurancebut it hasnt been cheap!Over the past 15 months, losses on the short side have offset most of the funds gains on the longside, despite long exposure being at least twice as large as short exposure. In other words, ourfundsshort book has performed unusually badly.

So is the problem that Im simply uniquely bad at shorting (in which case, I should just stick tothe long side)? I think not. I know, talk to, and read the investor letters of dozens of value-oriented long-short fund managers like me and pretty much to a person they report carnage intheir short books. One can see this reflected in the HFRX Equity Hedge Fund Index, which wasup 6.7% year to date through Septemberless than half the return of the S&P 500, due largely tolosses on the short side I have no doubt.

In the past year, Ive seen more pain inflicted upon short sellers than at any point since theinternet bubble in 1999 and early 2000. One 20+ year veteran said it well when he told me:

I dont have the antidote to your pain. Weve been bludgeoned by this melt-up as well. Itsunbelievably unpleasant.

Ive never seen such widespread capitulation among seasoned short sellers. Many are out ofbusiness.

This stretch is worse than the internet bubble for me. Its constant pain across my entire shortbook, whereas the internet was isolated to one industryand then you got relief when the bubble

burst.

So while its been painful, this is the kind of environment, I believe, in which those with thecourage to maintain a short book will be well rewarded.

Adjustments to my short strategyThis isnt to say that there isnt room for improvement. There is. Specifically, I plan to make thefollowing adjustments:

1) Smaller positions. Over the last 15 months, Ive been managing the funds short bookidentically to its long book in terms of the number of positionsabout a dozen exceptionally-

high-conviction positionsbut roughly half the size. Thus, the average long position has beenaround 5-6% whereas the average short was in the 2-3% range.

Ive learned the hard way the perils of sizing too many short positions above 2%. Every five orten years, the market goes through periods like the current one in which overvalued stocks canbecome even more overvalued, rising 50-100% or more, which causes a lot of pain andsometimes forces me to cover some of the positions to manage risk.


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Going forward, I plan to size new short positions around 1% rather than 2%, which I expect willenable our fund to better weather the markets periodic bouts of foolishness.

This means, of course, that the funds short book will be comprised of more positions, but Ibelieve I can manage this, especially in light of todays incredibly target-rich environment.

2) Better match the funds long and short positions. A meaningful percentage of the funds longexposure over the past year has been in large-cap stocks like Berkshire Hathaway, AIG,Citigroup and Goldman Sachs, whereas the short positions have tended to be in smaller, morevolatile, heavily shorted, battleground stocks. These stocks tend to be the most overvalued andhave the potential to fall the furthestoften, I believe, 100%but they can also rise the mostduring periods of excess liquidity and complacency. (It hasnt been a complete mismatch, as thefunds long book has some similarly volatile stocks like Netflix, Spark Networks, and Deckers,all of which have performed beautifully.)

Going forward I plan to better balance the funds long and short positions by having a wider mix

of stocks on the short side. Among my three favorite types of shorts, fads, frauds and failures,Ive had too many of the first two and not enough of the letterwhat one friend called reversecompounders.A good example in our short book today is St. Joe, a stock Ive writtenextensively about in past letters, where very little is happening and I see minimal value beyondthe timberland.

3) Be more patient. Ive been reasonably successful over the years in being able to identifyhugely overvalued stocks, but have been less successful in getting the timing right. I find that Ican frequently correctly foresee whats going to happen a year or two in the futurebut am oftenamazed at how the marketespecially this marketignores huge red flags at certain companiesand runs their stocks up further in the short term. Ive certainly gained a greater appreciation forthe power of short-term stock price momentum and am going to make more of an effort to bepatient, stay out of the way of freight trains on the way up, and make money shorting these typesof stocks on the way down. Allow me to illustrate this with two examples.

First, Ive recently cut our funds short position in World Acceptance, which I discussed atlength in my Q2 letter, from a bit over 2% to 0.5%not because Ive lost any degree ofconviction in investment thesis, but rather because I recognize that it might take some time,perhaps even years, for regulators to act to rein in this company. In the meantime, exploiting thevast majority of its customers is a heck of a good business, so I expect the company will continueto growand its share price will continue to riseso Ill patiently wait with a toe-hold positionuntil theres clear evidence that regulators are taking action and only then size up the position.Sure, Ill miss the peak and the stock might be down 10-20% before I act with conviction, but Ithink the downside here is 70-100%.

Another example of the need for me to be more patient is Green Mountain Coffee Roasters,where Ive twice been too early. Here is the stock chart over the past five years:


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I shorted the stock much too early in 2010, took a lot of pain as it skyrocketed during most of2011, and then made it all back and then some as it collapsed in late 2011 and early 2012. But Iwould have made more if Id waited until after the company missed expectations and loweredguidance to short it. Even though the stock had fallen 20% at that point, it was still a great shortbecause the momentum was broken yet the valuation remained extreme (it ultimately ended upcollapsing by more than 80%).

I then covered the position and waited to see if I might get another opportunity to short it, as the

two patents that gave the company monopolistic pricing and market share for its K-cups expiredin September 2012. My research led me to believe that numerous competitors would then enterthe market and both take market share and force Green Mountain to reduce pricing, severelyimpacting Green Mountains profitability, especially since its a high-cost producer.

Sure enough, the stock more than doubled off its lows and I reestablished the short position fromJanuary through April of this year at prices ranging from $40 to $55and got run over as thestock rocketed to nearly $90 by the end of August (it has since pulled back to around $67).

My mistake earlier this year was that, while I was confident that new competitors would emergesoon after Green Mountains patent expired, they had not yet done so to any material degree.

Thus, the company was able to report a couple of strong quarters, pooh-pooh competitive threats,and give rosy guidance, which led to the stock doubling. Shame on me for not recognizing that itwould take time for competitors to ramp up K-cup production and win shelf space among thenations retailers.

But today, the evidence is clear that a competitive tsunami is hitting Green Mountain. As you cansee in this chart, competitors already have approximately 20% of the market and are gainingmore than one percentage pointper month(as shown by the green line):


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Nielsen Single Serve Data ($ Market Share)

The latest Neilsen data out yesterday revealed even worse news: K-cup unit sales for GreenMountain owned and licensed brands rose a mere 4.5% year-over-year in September whileaverage pricing fell 3.3%, resulting in tepid 1.1% dollar sales growthall terrible numbers thatare far below the companys guidance and analyst estimates, so its not surprising that the stockfell 7% yesterday (and its down again today on news that Whole Foods is now selling privatelabel K-cups).

Some savvy investors are starting to realize what is happening, as the stock is now down 25%

from its recent high, but most investors and analysts still appear to be in the darkand GreenMountain is, of course, trying to keep them there: at its analyst day last month, it presented aslide with old data showing that non-licensed K-cups had only 8% of the market.

Another important data point is a recent survey of buyers and store managers at leading retailersnationwide. A majority of the respondents said that while K-cup sales are still rising, GMCR K-Cup growth rates decelerated, compared with early 2013, and GMCR lost market share.Hereare some quotes:

Green Mountains rate of growth is decelerating because there is so much more competition outthere, and private label is giving them a run for their money. Everyone is getting into the [pods]business.

The K-Cup people are coming out of the woodwork. In a way, it reminds me of craft beerslotsof local brands. It is open season right now.

Theyre all discounting now, trying to compete with each other and with private label. We pulled a couple of Green Mountain ads because we did not want to go out there at $6.99

after the competitions $4.99 ad.

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Jul-09 Nov-09Mar-10 Jul-10 Nov-10Mar-11 Jul-11 Nov-11 Mar-12 Jul-12 Nov-12Mar-13 Jul-13

GMCR Owned GMCR Licensed Non-Licensed


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Discounting is much more aggressive now due to competition; thats what is driving the prices.Green Mountain hasnt been as aggressive and thats why theyre in so much trouble right now.

A small anecdote that supports my thesisthis is what I saw when I visited Costco yesterday:

Costco is selling four brands of K-cups: (from left to right) Starbucks, Green Mountain,Newmans Own, and Kirkland. Starbucks and Newmans Own are both licensees of GreenMountain, whereas Kirkland is the Costco store brand, so in terms of shelf space, the non-licensed brand has 25% share. I dont know actual sales of course, but note the pricing: at first

glance, it appears to be identical: $37.99/box for each brand. But look closer: the Kirkland boxhas 100 K-cups whereas the others only have 80in other words, Green Mountains K-cups are25% more expensive. In this hyper-competitive world, I dont think that kind of pricediscrepancy is sustainable.

I think it is highly likely that Green Mountain and its licensees continue to lose unit market shareat a rapid rate and will be forced to continue cutting pricing as well, which will severely impact


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Green Mountains earningsand its richly valued stock, currently trading at 24x trailingearnings.

As an added bonus, the numbers Green Mountain is reporting dont make sense to me, whichmakes me suspicious that, at the very least, the company has too much inventory and/or is

stuffing the channel, which I discuss in an article I published a few weeks ago, Green MountainCoffee: One Of My Favorite Shorts(see Appendix A).

In summary, while I was too early in getting back into the GMCR short, Im convinced that thestock is a fantastic short today and hence its among my largest at 2.2%.

K12

I gave a detailed presentation on why K12 was our funds largest short position at the ValueInvesting Congress three weeks ago (I emailed you the slides the following day; the latestversion is postedhere). At the time, the stock was at $35.15. In the following weeks, the stocktrickled down to around $28and then the company gave weak guidance after the close on

Tuesday and the stock crashed 38% yesterday to $17.60, down by nearly half since I went publicwith my concerns.

Here is page 8 of my presentation, which summarizes my investment thesis:

K12s aggressive student recruitment has led to dismal academic results by students and sky-highdropout rates, in some cases more than 50% annually I wouldnt be short K12 if it were carefully targeting students who were likely to benefit from its

schoolstypically those who have a high degree of self-motivation and strong parental commitment But K12 is instead doing the opposite; numerous former employees say that K12 accepts any

student and actually targets at-risk students, who are least likely to succeed in an online school

There have been so many regulatory issues and accusations of malfeasance that Im convincedthe problems are endemic

Enrollment violations, uncertified teachers, illegally siphoning profits from nonprofit entities States (and the IRS) are waking up to what K12 is doing and the company is coming under

increased scrutiny, which is beginning to impair K12s growthand I believe this trend willaccelerate

K12s founder, Knowledge Universe, distributed its entire stake to its investors earlier this month Yet the stock, trading at nearly 50x trailing earnings, is priced as if K12 will continue to grow at

high rates for the foreseeable future and also improve on its persistently low margins and freecash flow

Like subprime lending and for-profit colleges, the business makes sense on a small scale but, fueledby lax regulation and easy government money, the sector, led by K12, has run amok

For more on K12, see my article,An Analysis of K12 and Why It Is My Largest Short Position,published on September 22nd(Appendix B) and the article I just published today, Why Im NotCovering My K12 Short(Appendix C).
http://www.tilsonfunds.com/K12-Tilson-9-17-13.pdfhttp://www.tilsonfunds.com/K12-Tilson-9-17-13.pdfhttp://www.tilsonfunds.com/K12-Tilson-9-17-13.pdfhttp://www.tilsonfunds.com/K12-Tilson-9-17-13.pdf


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Conclusion

Thank you for your confidence and support. If you have any comments or questions, please callme anytime at (212) 277-5606.

Sincerely yours,

Whitney Tilson

The unaudited return for the Kase Fund versus major benchmarks (including reinvesteddividends) is:

September Q3 YTD Since Inception

Kase Fundnet 3.9% -2.3% 6.3% 123.9%

S&P 500 3.1% 5.2% 19.8% 79.4%

HFRX Equity Hedge Fund

Index

1.4% n/a 6.7% n/a

Past performance is not indicative of future results. Please refer to the disclosure section at the end of this letter. The Kase Fundwas launched on 1/1/99.

Kase Fund Performance (Net) Since Inception

Past performance is not indicative of future results.

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Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

(%)

Kase Fund S&P 500


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Kase Fund Monthly Performance (Net) Since Inception

Past performance is not indicative of future results. Note: Returns in 2001, 2003, and 2009 reflect the benefit of the high-water mark, assuming an investor at inception.

Kase S&P Kase S&P Kase S&P Kase S&P Kase S&P Kase S&P Kase S&P Kase S&P Kase S&P Kase S&P Kase S&P Kase S&P Kase S&P Kase S&P Kase S&P

Fund 500 Fund 500 Fund 500 Fund 500 Fund 500 Fund 500 Fund 500 Fund 500 Fund 500 Fund 500 Fund 500 Fund 500 Fund 500 Fund 500 Fund 500

January 7.8 4.1 -6.3 -5.0 4.4 3.6 -1.8 -1.5 -5.5 -2.6 4.7 1.8 1.1 -2.4 1.9 2.7 2.4 1.7 1.9 -5.9 -3.6 -8.4 -1.6 -3.6 -2.8 2.4 12.6 4.5 4.5 5.2

February -2.9 -3.1 6.2 -1.9 -0.6 -9.2 -1.1 -2.0 2.9 -1.6 7.0 1.5 2.1 2.0 -3.1 0.2 -3.3 -2.1 -6.9 -3.3 -8.9 -10.8 7.3 3.1 4.1 3.4 -0.8 4.3 0.8 1.4

March 4.1 4.0 10.3 9.8 -2.6 -6.4 3.0 3.7 1.4 0.9 3.9 -1.5 3.9 -1.7 3.9 1.3 -0.8 1.1 -2.3 -0.5 2.9 9.0 4.6 6.0 -4.1 0.0 10.9 3.3 1.3 3.8

April 2.1 3.7 -5.1 -3.0 5.1 7.8 -0.2 -6.0 10.5 8.2 2.4 -1.5 0.6 -1.9 2.2 1.4 4.4 4.6 -0.9 4.9 20.1 9.6 -2.1 1.6 1.9 3.0 1.3 -0.6 0.1 1.9

May -5.7 -2.5 -2.8 -2.0 1.8 0.6 0.0 -0.8 6.6 5.3 -1.4 1.4 -2.6 3.2 1.8 -2.9 2.5 3.3 7.9 1.2 8.1 5.5 -2.6 -8.0 -1.9 -1.1 -13.6 -6.0 2.8 2.3

June 2.2 5.8 4.1 2.4 4.6 -2.4 -7.3 -7.1 2.9 1.3 0.1 1.9 -3.1 0.1 -0.2 0.2 -3.0 -1.5 -1.2 -8.4 -5.0 0.2 4.5 -5.2 -2.4 -1.7 0.5 4.1 -1.0 -1.3

July -0.7 -3.2 -3.6 -1.6 -1.1 -1.0 -5.0 -7.9 2.3 1.7 4.6 -3.4 0.5 3.7 -0.9 0.7 -5.4 -3.0 -2.5 -0.9 6.8 7.6 3.5 7.0 -4.6 -2.0 0.2 1.4 -0.1 5.1

Aug us t 4 .1 -0.4 5.4 6.1 2.5 -6.3 -4.3 0.5 0.4 1.9 -0.9 0.4 -3.2 -1.0 2.9 2.3 1.7 1.5 -3.3 1.3 6.3 3.6 -1.5 -4.5 -13.9 -5.4 -7.2 2.3 -5.8 -2.9

September -3.3 -2.7 -7.2 -5.3 -6.1 -8.1 -5.4 -10.9 1.7 -1.0 -1.6 1.1 -1.5 0.8 5.0 2.6 -1.1 3.6 15.9 -9.1 5.9 3.7 1.7 8.9 -9.3 -7.0 0.0 2.6 3.9 3.1

October 8 .1 6.4 -4.5 -0.3 -0.8 1.9 2.8 8.8 6.2 5.6 -0.4 1.5 3.5 -1.6 6.3 3.5 8.2 1.7 -12.5 -16.8 -1.9 -1.8 -1.7 3.8 7.0 10.9 1.6 -1.9

November 2.8 2.0 -1.5 -7.9 2.3 7.6 4.1 5.8 2.2 0.8 0.8 4.0 3.1 3.7 1.9 1.7 -3.6 -4.2 -8.9 -7.1 -1.2 6.0 -1.9 0.0 -0.6 -0.2 -4.5 0.6

December 9.8 5.9 2.3 0.5 6.5 0.9 -7.4 -5.8 -0.4 5.3 -0.2 3.4 -1.3 0.0 1.4 1.4 -4.3 -0.7 -4.0 1.1 5.5 1.9 0.5 6.7 0.1 1.0 0.1 0.9

YTD

TOTAL 31.0 21.0 -4.5 -9.1 16.5 -11.9 -22.2 -22.1 35.1 28.6 20.6 10.9 2.6 4.9 25.2 15.8 -3.2 5.5 -18.1 -37.0 37.1 26.5 10.5 15.1 -24.9 2.1 -1.7 16.0 6.3 19.8

20132012201120051999 2000 2001 2002 2003 2004 2006 2007 2008 2009 2010


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Appendix A

Green Mountain Coffee: One Of My Favorite

Shorts

Whitney Tilson2,017 FollowersSeptember 13, 2013http://seekingalpha.com/article/1690592-green-mountain-coffee-one-of-my-favorite-shorts

Jesse Eisinger, one of the best investigative journalists around, raises some very good questionsabout Green Mountain Coffee (GMCR)and its accounting in his column that ran in the NewYork Times earlier this week,Seeking Answers From Green Mountain Coffee,which begins:

Green Mountain Coffee Roastersfirst-ever investor day is Tuesday, and the company is flyinghigh.

The stock price of the company, which sells coffee machines under the Keurig brand and the littleK-Cups that go in them, has soared more than 260 percent in the last year.

Despite persistent questions, most of Wall Street remains resolutely bullish on Green Mountain,which has a market value of $12 billion.

In 2010, the company disclosed it was being investigated by the Securities and ExchangeCommission. In 2011, the hedge fund manager David Einhorn, who is betting against GreenMountains stock price, delivered a highly critical 110-slide speech at an investor conference,raising questions about the companys future prospects and, more seriously, its bookkeeping. Hefollowed up a year later with another one.

A class-action lawsuit, which was dismissed, quoted anonymous former employees aboutsuspicious activities. Green Mountain has said it conducted an internal investigation that cleared

the company.

Green Mountain operates on a razor/razor blade model - selling brewing machines but making itsreal money on the K-Cups. It used to disclose exactly how many K-Cups it sold but stoppeddoing so in 2010. Instead, it tells investors the year-over-year percentage growth. Wall Street hasdutifully plugged numbers in to estimate the unit sales.
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Last year, Green Mountain faced expirations of the patents that covered its brewing system. WallStreet has been monitoring whether Green Mountain will lose market share to new private-labelknockoffs. And indeed, a recent Barrons article suggested that it was losing share faster thanexpected.

A recent disclosure from the companys new chief executive, Brian Kelley, has revived the

questions about sales, as do on-the-ground accounts I have received from former factory andwarehouse workers.

Because Green Mountains investor day will give analysts and shareholders unusual access tocompany executives, it seems like an opportunity to ask them some hard questions.

Here are a few from me.

*Just how many K-Cups has Green Mountain sold year-to-date and is it less than the Streetunderstands?...

*How wide is the gap between how many K-Cups the company says it has sold and how manyhave ended up in customers hands? And why?...

*What explains the unusual movements of Green Mountain inventory described by some formercompany workers and associates?...

*What is happening with the SEC.s investigation of Green Mountain, which the company hassaid involves its accounting practices?...

Lets take a closer look at K-Cups, where the math just doesnt make sense - and the companyisnt helping with an explanation. At the analyst day earlier this week (see webcast and 188-slidepresentationhere), the company was asked to reconcile this estimate of K-Cups (since, as

Eisinger notes, the company stopped disclosing K-Cup sales in 2010): there are 16 millionbrewers, GMCR claims usage (an attachment rate) of 1.4 K-Cups per day x 365 days/year,which results in sales of 8.2 billion K-Cups per year (which doesnt even count maybe 15-20%additional consumption away from home).

But GMCR isnt selling anything close to this number of K-Cups, per both analysts and thecompany (see Eisingers article), so what gives? My answer: usage is declining. It makes sensethat the people who bought brewers first are likely to be the heaviest users, so the company andanalysts should be modeling declining attachment rates - but of course theyre not.

When Mark Astrachan, the Stifel Nicolausanalyst (and the only one with a sellrating on the

stock), asked about this at the analyst day, Green Mountains CEO Brian Kelley said: We dontmultiply it by 365. (inaudible) Youre applying straight math that we dont do.(Yes, he reallysaid that!) When Astrachan tried to follow up, Kelley said: Were not going to get into thathere. Thats not the intent and were not going to get into the model in that kind of detail here.(The detailhes referring to is the attachment rate of the brewers - one of the most importantmetrics there is!)
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An even greater concern is that 700-900 million K-Cups cant be accounted for. Eisinger writes:

Thats a far cry from 5.6 billion. There seems to be a gap in the United States of about 900million K-Cups.

Whats going on?

Mr. Brandt said the company declined to give its overall sales volume, but said the IRI numberthat I was furnished with was too low. He said a company analysis indicated that this portion ofGreen Mountains sales should be about 2.7 billion, not 2.6 billion.

Still, even if we use the companys figure of 2.7 billion, total sales in the United States would be4.9 billion, or about 700 million K-Cups short of what the company has said. Thats a lot of extraK-Cups sitting in the channel.

Maybe Im just being paranoid, but Ive seen this kind of thing before: in many of the Chinafrauds, companies were booking fake sales, resulting in fake profits. But that leads to a big

problem for the companies: its hard to fake all the cash that should be in the bank as a result ofthe supposed profits. The solution? Make overpriced/fraudulent acquisitions and/or fakeexcessive cap ex to reduce the cash (that was, of course, never there).

Now go back and read David Einhorns 110-slide presentation on GMCR at the Value InvestingCongress on Oct. 17, 2011 (postedhere)and look at the high-priced acquisitions on pages 50-53and pages 68-72 on cap ex. Einhorn estimated that $431 million (58%) of GMCRs 2012 cap exwas unexplainedand concluded:

Capital spending is growing much faster than the business Capital intensity should be getting more efficient as the company achieves scale The gap is so large and insufficiently explained that it raises questions about what is

being capitalized and casts doubt on the business model

Einhorn gave an update on GMCR in his presentation at the Value Investing Congress on Oct. 2,2012. He didnt release the slides, but here are my notes:

GMCRs cap ex as a percentage of sales was 11.0% in 2011, 13.1% (est.) in 2012, and 9.2%(guidance) in 2013. Compare this to the 3.3% average in the food products industry, with a rangeof 1.0% to 6.3%.

GMCRs cumulative cap ex from 2007-2012 was $1.043 billion and K-Cup shipments in 2012were 7.1 billion. Divide these two and you get 14.7 cents of cap ex over six years for each K-Cupproduced in 2012. Einhorn compared this to a competitor, which spent 3.8 cents for each K-Cupproduced (buying the same production equipment as GMCR). Again, massive unexplained capex.

Einhorn then turned to the production capacity that GMCRs competitors were bringing onlineand estimated that they would have enough capacity to take 19% market share by the end of 2012and 26% by the end of 2013.
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Lastly, Einhorn showed that competitors were already selling K-Cups for 22-39% less thanGMCR was, and highlighted price cuts GMCR had taken that would wipe out nearly all of itsprofit.

(Obviously these last two things havent occurred yet - but that doesnt mean they wont)

Is GMCR committing massive accounting fraud? I dont know - and I certainly cant prove it -but there are a number of warning flags, so I sure cant rule it out. The company could easily puta lot of these concerns to rest by providing some obvious disclosure - like number of K-Cupssold - but refuses to (despite providing highly granular disclosure on most other matters), whichmakes me all the more suspicious

The nice thing about GMCR as a short is that I think its a good one even if its accounting isclean because of its very high valuation (29x trailing EPS and 22x FYE 9/14 estimates (if youbelieve them)) combined with its patent loss a year ago, which is resulting in a ton of low-costcompetition entering the market (see page 44-48 of Einhorns 2011 presentation and my notesfrom his 2012 presentation above).

Its almost never pretty when a company with a monopoly market share and monopolistic pricingbegins to face competition from low-cost generic producers (think what happens when a druggoes off patent) - but it can take some time for the competition to emerge and impact themonopolists financials, during which time the monopolist can give whatever guidance it wants(and you can be sure that Wall St. analystswont question the pie-in-the-sky guidance).Witness this weeks analyst day


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Appendix B

An Analysis of K12 and Why It Is My Largest Short Position

Whitney Tilson2,017 FollowersSeptember 22, 2013http://seekingalpha.com/article/1707192-an-analysis-of-k12-and-why-it-is-my-largest-short-position

Last Tuesday at the Value Investing Congress, I gave a 123-slide presentation (postedhere)about my largest short position, K12 (ticker: LRN). In it, I shared the many reasons why I thinkthe company (and the entire sector) have run amok and why, at 46x earnings, I think the stock isa fantastic short.

The Bull Case for K12

There are many reasons that explain the bullishness of some investors and nearly all analysts(seven of the eight who follow the stock have a buy or strong buy on it). First, K12 has grown itsrevenue 32% annually over the past decade, as this chart shows:

Revenue ($M)

And analysts are projecting revenue and EPS growth of 16% and 32%, respectively, over thenext 12 months, fueled 10 new schools and enrollment cap expansion of 17,000 new seats. And

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K12 has less than $1 billion in revenue in a market that it says could become as large as $15billion annually.

Its also important to note that online schools sectorschools in which students are supposedlylearning by sitting at home all day in front of a computer, interacting with teachers almost

exclusively onlinecan be an excellent option for certain studentsfor example, childrenwhose pace is extremely accelerated, entertainers, solo athletes, teenage mothers who need tostay home with their babies, victims of bullying, children with cancer, seizure disorders, peanutallergies, etc.

K12 has a well-regarded curriculum, reports very high parental and student satisfaction, and hasstrong political support, especially among Republicans, for giving parents school choice. Finally,its operating in a space, online learning, that has enormous buzz (think MOOCs, etc.).

So whats not to like? Let me count the ways

(Note that my critique is specifically of K12, not all online charter schools, for-profit charterschools or blended learning schools. While I think the online charter school sector has, overall,run amok, there are a small number of good online schoolsand a few students at even the worstonline schools are doing well.)

Weakening Financials and Aggressive Accounting

In my presentation, I show that K12s profit margins and free cash flows are low and erratic,days sales outstanding has doubled in the past five years, the company uses aggressiveaccounting techniques to inflate reported profits, and K12s founder, Knowledge Universe,distributed its entire stake to its investors only a few weeks ago. But I want to draw particularattention to this chart, which shows that year-over-year revenue growthcritical for a stocktrading at 46x earningshas been falling sharply over the past two years, and is projected to fallfurther in the next year (to 16%):

Year-Over-Year Revenue Growth

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Aggressive Recruitment Leads to Vast Numbers of Students Destined to Fail

While online schools can be an excellent option for certain students, it s a very small numbertypically those who have a high degree of self-motivation and strong parental commitment. Itssort of obvious if you think about it. Do you think you would have learned more during your K-12 educational experience if youd sat at home in front of a computer, or gone to school and had

daily face-to-face interaction with teachers? How many of todays youthin a world filled with500 TV channels, texting, video games, etc.do you think are better off at home rather thanbeing at school? Lastly, what do you think the answer is for the most at-risk kids, who typicallycome from poor, single-parent households, in which the parent has little time or ability to be theparent coachthats so critical to online education?

Tom Loveless, an education researcher at the Brookings Institution who did paid consulting forK12 in its early years,said:The enthusiasts for cyber learning have overstated the potential.What they keep forgetting is were not talking about college students here. Were talking abouthigh schoolers and young kids. The idea that parents go to work and leave their kids in front of acomputerits absurd.

In short, online schools are only educationally appropriate for a very small number of students,which means that K12 and its peers need to be highly selective in recruiting students, warningparents away whose kids are unlikely to succeed at an online school, especially at-risk youth.

So what does K12 do? Exactly the opposite. Since going public in late 2007, numerous formeremployees have told me that K12 has adopted a growth-at-any cost mentality in order to supportits richly priced stock. Jeff Shaw, the former Head of School of Ohio Virtual Academy (whichtoday accounts for 11% of K12s revenue), told me:

After the IPO, I got discouraged because the companys priority seemed to shift from academicsto growthit wasnt so much about academic achievement but on delivering the promised

enrollment numbers to shareholders.

[K12s] call centers that were encouraging enrollment and enrolling students who were obviouslyill-suited for learning in a virtual environment. It was apparent to those of us operating schoolsthat parents werent being given the whole story. K12 oversold studentspotential to besuccessful and obligated teachers to do things they wouldnt likely to be able to do.

Eventually, it seemed as though K12s enrollment strategy was to cast a wide net into the sea ofschool choice and keep whatever they caught regardless if the catch was appropriate for virtuallearning or not.

I am shocked that the stock continues to rise. I think its a house of cards that is going to

collapse. It boggles my mind when I read about and hear stories about whats going on in schoolsmanaged by K12.

Numerous other insiders confirm that what Shaw observed at his school was equally true acrossthe company (notes from these interviews as well as the entire interview with Shaw are includedin my presentation).
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Deliberately Targeting At-Risk Students

Worst of all, K12 in recent years has been deliberately targeting at-risk students, who are leastlikely to succeed at an online school. K12 CEO Ron Packard claims that its for noble reasons:

Its just K12s culture. We want to help kids. Its just so ingrained all the way through theorganization about helping as many kids, doing the right thing for kids.

At anothertime,he said:

We dont want to be recruiting kids who its not right for. That would be a disaster academically.It would be a disaster for the company economically.

This is nonsense. Luis Huerta, Associate Professor of Education & Public Policy at TeachersCollege, Columbia University, who has studied K12 carefully and published reports on virtualschools, told me:

The virtual providers like K12 are now mostly going after at-risk kids, kids on their last strawif

they didnt sign up, many would be dropouts or go back to juvenile court.

K12s phone banks have figured out a way to target dropouts and special ed kids. They will signup anyoneas long as that warm body signs in periodically, K12 can draw enrollment moneyfrom the district.

It isnt for some noble reasonits because these kids demand the least amount of education.These arent kids and parents who will be knocking on K12s doors saying, Hey, you need to domore for my kid.

K12 and Packard use this as an advertisement, saying theyre doing noble things and wonderingwhy theyre being criticized. Its almost comical. Its so misleading and conniving.

Again, numerous people confirm Huertas account. One person told me that online chartersknow that internet advertising leads to lots of students enrolling, but none succeed. Yet onlinecharters are spending big money on this.

And a former Employment Consultantwrotethe following on the web site, Glassdoor:

They push these quotes and true storiesabout all the children they have helped, but the truth is,this product is really only good for about 10% of the market that they target. The only successstories come from homes where there is a large parental support and willingness for the student tolearn. K12 markets to low income families who are oftentimes more interested in a free computer

and staying out of truancy court than anything else. Not only that, but the curriculum (which isactually very well developed) simply will not work for a low educated family who is having ahard time getting their child to go to a brick and mortar school, let [alone] apply themselves in ahome based environment. They push enrollments on families where the adult in the home cannoteven read, speak, or write in English, knowing that these students are destined to fail.
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While K12 celebrates how many at-risk students its serving, I view it as an educationalcatastrophe in light of the these studentsneed for intensive, personalized instruction and hencehow inappropriate online education is for most of them.

Low Spending on Teachers, Who Are Harried, Overworked and Unsupported

K12s online schools spend far less on teacher and administrator salaries than regular schools, asthis chart shows:

Per-Pupil Expenditures for Salaries, 2008-09

Source: Understanding and Improving Full-Time Virtual Schools: A Study of Student Characteristics, School Finance, and School Performancein Schools Operated by K12 Inc., National Education Policy Center, 7/12.

In light of such low spending, its not surprising that many teachers report excessive class sizesand feeling harried, overworked and unsupported. One teacher I spoke with, who taught English

from 2010-12 at Agora Cyber Charter School, K12s largest, accounting for 14% of thecompanys total revenues, told me:

It was a horrible experience. Every teacher had the same experience I did.

Before I started, I was told there would be a lot of support, a low student-teacher ratio, and that ifthere were students who didnt show up, theyd take them out and replace them with another. Butthey took everybody. There was no teacher to student ratio.

When I started, I was assigned 300 students, which was very, very overwhelming. I would try toread each of the essays students turned in a try to grade it and spend the appropriate time, but Iwas really struggling with that. I couldnt keep up. I was told to skim over the papers and grade

with a rubric.

For each class, Id have maybe seven out of 30 students in that particular section attendandeven among those seven, just because their name was there showing them present doesnt meanthey were at their computers.

A huge portion of my students never showed up or did anything. I have no clue what happened tothem, though I have no doubt Agora was charging the state for them.


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When it came time to give grades, I was told, whatever I had to do, I had to pass every student.

I would not say there was much learning going on. If students were doing the program like theywere supposed to, it could workbut the majority of students werent coming from a familywhere a parent would help them. (My notes from the entire interview are in my presentation.)

Again, numerous other former teachers confirm this account.

Horrific Educational OutcomesIn light of K12s growth-at-any-cost approach, targeting of at-risk students, and low spending onteachers, one would expect terrible educational outcomesbut theyre even worse than anyonecould imagine.

K12, of course, tries to hide this by producing a slick, colorful 132-page Academic Report(which you can downloadhere), which claims that for K12s students in reading, overallachievement was 196% of the norm group gainand in math, overall achievement was 97% ofthe norm group gain.

These results are virtually meaningless for a number of reasons:

1) K12 measures its studentsacademic growth using the Scantron test, which is not a state-adopted exam, but rather simply a diagnostic tool that is used by K12;

2) K12 has yet to allow independent external evaluators to both validate its data collectionefforts and more importantly evaluate its analysis of student achievement data, across allK12 schools;

3) The Scantron test is given in the home, unsupervised and untimed, making it easy forstudents to get help from a parent or the internet;

4) Only approximately 70% of eligible students take the test (likely to be the betterperforming ones of course); and

5) K12s purportedly strong Scantron results stand in stark contrast to K12 studentsdismalresults on state tests.

K12 now admits that the Scantron results cant be relied on (but that hasnt prevented thecompany from peddling them to shareholders, politicians, regulators, etc.). K12 ExecutiveChairman Nathaniel Davis said, The Scantron tests are optional for K12 students, and about 30

percent decline to take them. That means the company has been comparing a self-selected groupof K12 students to the national norm, which isnt appropriate.The company, he said, needs tofind a more honest assessmentof student progress.

Lets look at other, independent measures of K12s educational outcomes. There are variousways to measure them, so lets start with percentage of schools making AYP (Adequate Yearly
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Progress) under the No Child Left Behind Act. As this chart shows, barely a quarter of K12sschools made AYP vs. more than half of all schools:

Percent of Schools That Met AYP, 2010-11

Source: Understanding and Improving Full-Time Virtual Schools: A Study of Student Characteristics, School Finance, and School Performancein Schools Operated by K12 Inc., National Education Policy Center, 7/12

The same study also showed that 29 of 36 K12 schools (81%) that were assigned schoolperformance ratings by state education authorities failed to earn a rating that indicatedsatisfactory progress status in 2010-11. Finally, it showed that K12 students trailed state averagesfor the states in which K12 operates in both reading and math at every grade level (see charts inmy presentation).

K12 claims that its dismal academic results are because it serves more at-risk students, but this is

questionable for two reasons:

1) Though its proportion of at-risk students has indeed risen in recent years, its from a lowbase so its not clear whether K12 is, in fact, serving a higher proportion of such studentsrelative to state averages; and

2) Even growth measures show dismal performance.K12 argues (correctly) that a more accurate method for measuring student performance is theprogress a student makes over the course of a school year, also known as a growth measure, solets look at these results.

Tennessee, which is well known for having a robust system for measuring student growth,tracked the growth of students in math, reading and science in the 2012-13 school year at all1,300 elementary and middle schools in the state, including K12s Tennessee Virtual Academy.As you can see from this scatter plot of math results, TVA students at the beginning of the schoolyear are slightly below the state average (x axis), but their academic growth (y axis) is by fartheworst of any school in the state (the results for reading and science are nearly identical, as youcan see in my presentation):


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Math

I think its safe to say that theres almost no learning at all going on at TVAand Im not awarethat TVA is much different from K12s other schools.

In Ohio, home to K12s second largest school, Ohio Virtual Academy, which accounts for 11%of K12s revenues, the state recently reported that the six biggest cyber schools in the state allgot Fs on their state progress reports, with OHVA doing worst of all. The state counts a progressscore of -2 as a complete failure for a schooland OHVAs score was -27!

Studies of growth metrics in Pennsylvania and Colorado show similar results, which I documentin my presentation.

Lastly, lets look at graduation rates. As this chart shows, the on-time graduation rate for the K12schools is 49.1%, compared with a rate of 79.4% for the states in which K12 operates schools:


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Graduation Rate

K12s Sky-High Student Dropout Rate

Another aspect of K12s horrific educational outcomes is the sky-high student dropout rate,which exceeds 50% annually at some schools. K12 has never released this datait is nowhere tobe found in its 132-pageAcademic Report,and in a conference call on November 16, 2011, CEO

Ron Packard, while admitting that [w]e track churn immensely,said that we havent chosentodisclose churn rates to investors. Instead, the company only acknowledges that onlineschools experience relatively high departure rates,but says that it has maintained consistentretention rates over the past five years.However, on that same conference call, Packer didreveal that about 60% of the kids who start with us in September are with us a year latermeaning a 40% churn rate!

This is consistent with other data that various researchers and journalists have been able to piecetogether on a school-by-school basis. For example, Journalist Roddy Boyd of The FinancialInvestigator, in an article entitled,K12: A Corporate Destiny Manifested,collected data for the2010 school year for four of K12s largest schools in Pennsylvania, Ohio, California and

Colorado and calculated that student churn ranged from 24-51%. Anotherstudyof online schoolsin Colorado, of which K12s is the largest, found that half the online students wind up leavingwithin a year.

Is K12 Defrauding States Via Lax Enrollment Policies?

In most states, K12 must stop charging states for students if they stop coming to school (i.e.,signing in) after a certain period of time, but there is significant anecdotal evidence that K12doesnt do this. Instead, it manipulates student counts and underreports student truancy andwithdrawals to increase its profits.

Astudyof 10 online schools in Colorado concluded that millions of dollars are going to virtual

schools for students who no longer attend online classes.And in Pennsylvania, anarticlein theNY Times reports:

Several current and former staff members said that a lax policy had allowed students to remain onthe rolls even when they failed to log in for days. Officials of the Elizabeth Forward SchoolDistrict in western Pennsylvania complained that Agora had billed the district for students whowere not attending.
http://www.k12.com/sites/default/files/pdf/2013-K12-Academic-Report-Feb6-2013.pdfhttp://www.k12.com/sites/default/files/pdf/2013-K12-Academic-Report-Feb6-2013.pdfhttp://www.k12.com/sites/default/files/pdf/2013-K12-Academic-Report-Feb6-2013.pdfhttp://www.thefinancialinvestigator.com/?p=649http://www.thefinancialinvestigator.com/?p=649http://www.thefinancialinvestigator.com/?p=649http://www.ednewscolorado.org/news/analysis-shows-half-of-online-students-leave-programs-within-a-year-but-funding-stayshttp://www.ednewscolorado.org/news/analysis-shows-half-of-online-students-leave-programs-within-a-year-but-funding-stayshttp://www.ednewscolorado.org/news/analysis-shows-half-of-online-students-leave-programs-within-a-year-but-funding-stayshttp://www.ednewscolorado.org/news/analysis-shows-half-of-online-students-leave-programs-within-a-year-but-funding-stayshttp://www.ednewscolorado.org/news/analysis-shows-half-of-online-students-leave-programs-within-a-year-but-funding-stayshttp://www.ednewscolorado.org/news/analysis-shows-half-of-online-students-leave-programs-within-a-year-but-funding-stayshttp://www.nytimes.com/2011/12/13/education/online-schools-score-better-on-wall-street-than-in-classrooms.htmlhttp://www.nytimes.com/2011/12/13/education/online-schools-score-better-on-wall-street-than-in-classrooms.htmlhttp://www.nytimes.com/2011/12/13/education/online-schools-score-better-on-wall-street-than-in-classrooms.htmlhttp://www.nytimes.com/2011/12/13/education/online-schools-score-better-on-wall-street-than-in-classrooms.htmlhttp://www.ednewscolorado.org/news/analysis-shows-half-of-online-students-leave-programs-within-a-year-but-funding-stayshttp://www.ednewscolorado.org/news/analysis-shows-half-of-online-students-leave-programs-within-a-year-but-funding-stayshttp://www.thefinancialinvestigator.com/?p=649http://www.k12.com/sites/default/files/pdf/2013-K12-Academic-Report-Feb6-2013.pdf


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One of them was a girl who had missed 55 days but was still on the schools roster, according toMargaret Boucher, assistant business manager at Elizabeth Forward

My presentation documents numerous similar reports.

K12 Appears to Be Violating State Laws and IRS Regulations Regarding Nonprofits

Of the 42 states (and DC) that permit charter schools, most will only grant charters to nonprofit501(c)(3) entities, for which the IRS code states: none of its earnings may inure to any privateshareholder and individual.This presents a vexing problem for K12, but it gets around this bysigning long-term contracts with local nonprofit entities to provide management and otherservices. While this type of arrangement doesnt technically violate IRS regulationsnonprofitscontact with for-profit businesses all the timeits critical that the nonprofit be a trulyindependent entity with an independent board of directors looking out solely for the nonprofitmission of the organization.

This doesnt appear to be happening with many of the nonprofit charter schools K12 contractswith. Rather, the relationship is often so rife with conflicts and self-dealing that K12 effectivelycontrols and operates the schoolsand siphons off all of the profits for itself. Consider that:

K12 employees sometimes serve on the board of the nonprofits and, worse yet, aresometimes involved with their very creation. (One person told me that Many of thesenonprofit boards are tiny, clueless, dysfunctional, and have K12 employees on them.)

Contracts are often awarded to K12 without competitive bidding. K12 usually directly or indirectly employs all key people, including the Treasurera

particularly blatant conflict of interest.

K12 often reviews its own billings and then fails to provide the boards with detailedaccounting for its expenditures.

The contract with K12 typically results in the nonprofit entity reporting minimal profitsor, often, a loss, which K12 then forgives(in its latest 10K, K12 notes that: We takeresponsibility for any operating deficits incurred at most of the Managed Public Schoolswe serve.).

Jeff Shaw of the Ohio Virtual Academy told me:

It was rather obvious to me as Head of School that K12 wasnt always interested in reducing thenon-profitsexpenses if those savings would impact the bottom line for K12.

K12 assumed control of most of the OHVA budget and a majority of any excess funds wassoaked up by the end of the year, often to the point where the school would show a loss. In this

case, the agreement with K12 required them to issue a credit for management fees so OHVAwould show a small surplus for the fiscal year.

The volunteer governing boards assume a limited role in the schools overall governance. Theboards tend to put their faith in K12 and count on it to do what is in the schools best interest. AHead of School walks a fine line in order to balance the best interests of both parties. In manycases, the boards know only what K12 wants them to know. Its like the fox guarding thehenhouse.


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For an in-depth expose of how this works at a K12-affiliated school in Newark, see this article inthe Newark Star-Ledger last week:Newark charter school contract with K12 Inc. showsinfluence of for-profit companies in public schools.

In summary, many of these nonprofits are a sham. For all intents and purposes, K12 controls,

operates, and profits from the supposedly nonprofit charter schools, in blatant violation of moststateslaws and IRS regulations.

The IRS appears to be looking into this (clickhere). If it acts, the consequences could be dire forK12.

K12s Political and Lobbying ProwessIn light of so many red flags around K12, one might ask why states havent acted more quicklyand forcefully to rein in the company. There are many answers, but the most important is moneyand politics. One person I spoke with told me that in many states, the Republican legislaturesare bought and paid forby K12. And the New York Timesreportedthat: An analysis by the

National Institute on Money in State Politics concluded that K12 and its employees contributednearly $500,000 to state political candidates across the country from 2004 to 2010.

But this vastly understates what K12 is really spending. Consider Pennsylvania, home to K12sAgora Cyber Charter School and the nations largest online charter school sector, with 16schools and 35,000 students. The Auditor General has released two scathing reports (clickhereandhere), calling for a 35% funding cut, because PA spends about$3,500 more per student toeducate a child in a cyber charter school compared to the national average, which adds up to$315 million in annual savings.

Yet the legislature hasnt acted. Why? Perhaps its because, as the New York Timesreported,inPennsylvania K12:

Has spent $681,000 on lobbying since 2007. The company also has friends in high places.Charles Zogby, the states budget secretary, had been senior vice president of education andpolicy for K12. In a statement, Mr. Zogby said he still owned a small number of K12 shares, butdid not make decisions specifically affecting online schools.

However, increased scrutiny of PA online schools could result from a federal indictment of thefounder and former CEO of Pennsylvanias largest online charter school, who is alleged to havestolen nearly $1 million in public money and improperly diverted a total of $8 million to avoidfederal income taxes.

In my presentation, I document similar tales of K12s political influence in Tennessee, Ohio,Massachusetts, Idaho and Maine.

K12 Is Encountering Regulatory Problems Across the CountryDespite its political influence, however, K12 is increasingly unable to hide its bad acts andterrible results, so its beginning to encounter more and more regulatory problems across thecountry. In Tennessee, for example, after the off-the-charts-bad results noted above, state
http://www.nj.com/news/index.ssf/2013/09/newark_charter_school_contract_with_k12_inc_shows_influence_of_for-profit_companies_in_public_school.htmlhttp://www.nj.com/news/index.ssf/2013/09/newark_charter_school_contract_with_k12_inc_shows_influence_of_for-profit_companies_in_public_school.htmlhttp://www.nj.com/news/index.ssf/2013/09/newark_charter_school_contract_with_k12_inc_shows_influence_of_for-profit_companies_in_public_school.htmlhttp://www.nj.com/news/index.ssf/2013/09/newark_charter_school_contract_with_k12_inc_shows_influence_of_for-profit_companies_in_public_school.htmlhttp://www.lrrlaw.com/increased-irs-scrutiny-of-charter-schools-operated-by-for-profit-management-companies-06-18-2012/http://www.lrrlaw.com/increased-irs-scrutiny-of-charter-schools-operated-by-for-profit-management-companies-06-18-2012/http://www.lrrlaw.com/increased-irs-scrutiny-of-charter-schools-operated-by-for-profit-management-companies-06-18-2012/http://www.nytimes.com/2011/12/13/education/online-schools-score-better-on-wall-street-than-in-classrooms.htmlhttp://www.nytimes.com/2011/12/13/education/online-schools-score-better-on-wall-street-than-in-classrooms.htmlhttp://www.nytimes.com/2011/12/13/education/online-schools-score-better-on-wall-street-than-in-classrooms.htmlhttp://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&ved=0CC4QFjAA&url=http%3A%2F%2Fwww.auditorgen.state.pa.us%2Freports%2Fperformance%2Fspecial%2Fspecharterfundingreport100510.pdf&ei=JwY_Uu_qO5S44AODhYDYAQ&usg=AFQjCNFSLbyBRMRy7W6EbxtISYOPe6x4Zw&sig2=zsE0TDB-XInf3ubK3fyUkQ&bvm=bv.52434380,d.dmghttp://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&ved=0CC4QFjAA&url=http%3A%2F%2Fwww.auditorgen.state.pa.us%2Freports%2Fperformance%2Fspecial%2Fspecharterfundingreport100510.pdf&ei=JwY_Uu_qO5S44AODhYDYAQ&usg=AFQjCNFSLbyBRMRy7W6EbxtISYOPe6x4Zw&sig2=zsE0TDB-XInf3ubK3fyUkQ&bvm=bv.52434380,d.dmghttp://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&ved=0CC4QFjAA&url=http%3A%2F%2Fwww.auditorgen.state.pa.us%2Freports%2Fperformance%2Fspecial%2Fspecharterfundingreport100510.pdf&ei=JwY_Uu_qO5S44AODhYDYAQ&usg=AFQjCNFSLbyBRMRy7W6EbxtISYOPe6x4Zw&sig2=zsE0TDB-XInf3ubK3fyUkQ&bvm=bv.52434380,d.dmghttp://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&ved=0CC4QFjAA&url=http%3A%2F%2Fwww.auditorgen.state.pa.us%2FDepartment%2FPress%2FCyberCharterSpecialReport201206.pdf&ei=SwY_UpG_GI-24APs8oC4Bw&usg=AFQjCNFGfWnDDYjUAhb4Od4RDuj4t5a5mQ&sig2=qwoX1JCkXX3k7W_2FxzJog&bvm=bv.52434380,d.dmghttp://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&ved=0CC4QFjAA&url=http%3A%2F%2Fwww.auditorgen.state.pa.us%2FDepartment%2FPress%2FCyberCharterSpecialReport201206.pdf&ei=SwY_UpG_GI-24APs8oC4Bw&usg=AFQjCNFGfWnDDYjUAhb4Od4RDuj4t5a5mQ&sig2=qwoX1JCkXX3k7W_2FxzJog&bvm=bv.52434380,d.dmghttp://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&ved=0CC4QFjAA&url=http%3A%2F%2Fwww.auditorgen.state.pa.us%2FDepartment%2FPress%2FCyberCharterSpecialReport201206.pdf&ei=SwY_UpG_GI-24APs8oC4Bw&usg=AFQjCNFGfWnDDYjUAhb4Od4RDuj4t5a5mQ&sig2=qwoX1JCkXX3k7W_2FxzJog&bvm=bv.52434380,d.dmghttp://www.nytimes.com/2011/12/13/education/online-schools-score-better-on-wall-street-than-in-classrooms.htmlhttp://www.nytimes.com/2011/12/13/education/online-schools-score-better-on-wall-street-than-in-classrooms.htmlhttp://www.nytimes.com/2011/12/13/education/online-schools-score-better-on-wall-street-than-in-classrooms.htmlhttp://www.nytimes.com/2011/12/13/education/online-schools-score-better-on-wall-street-than-in-classrooms.htmlhttp://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&ved=0CC4QFjAA&url=http%3A%2F%2Fwww.auditorgen.state.pa.us%2FDepartment%2FPress%2FCyberCharterSpecialReport201206.pdf&ei=SwY_UpG_GI-24APs8oC4Bw&usg=AFQjCNFGfWnDDYjUAhb4Od4RDuj4t5a5mQ&sig2=qwoX1JCkXX3k7W_2FxzJog&bvm=bv.52434380,d.dmghttp://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&ved=0CC4QFjAA&url=http%3A%2F%2Fwww.auditorgen.state.pa.us%2Freports%2Fperformance%2Fspecial%2Fspecharterfundingreport100510.pdf&ei=JwY_Uu_qO5S44AODhYDYAQ&usg=AFQjCNFSLbyBRMRy7W6EbxtISYOPe6x4Zw&sig2=zsE0TDB-XInf3ubK3fyUkQ&bvm=bv.52434380,d.dmghttp://www.nytimes.com/2011/12/13/education/online-schools-score-better-on-wall-street-than-in-classrooms.htmlhttp://www.lrrlaw.com/increased-irs-scrutiny-of-charter-schools-operated-by-for-profit-management-companies-06-18-2012/http://www.nj.com/news/index.ssf/2013/09/newark_charter_school_contract_with_k12_inc_shows_influence_of_for-profit_companies_in_public_school.htmlhttp://www.nj.com/news/index.ssf/2013/09/newark_charter_school_contract_with_k12_inc_shows_influence_of_for-profit_companies_in_public_school.html


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Education Commissioner Kevin Huffman declared the Tennessee Virtual Academys resultsunacceptableand demanded an immediate turnaround, and the state turned down K12sapplication to open a second school in the state. And parents are figuring it out as well, asenrollment has plunged by two thirds.

K12 is also facing scrutiny in Florida and Georgia, where investigations (clickhereandhere)revealed K12 employees covering up the illegal use of uncertified teachers, and class sizes of upto 275 students. And in Colorado, K12 is scrambling to launch a new school after getting hit witha double whammy: the board of the Colorado Virtual Academy has fired K12, and the districtthat hosted the school has said it wont renew COVAs authorization. Local media (clickhereandhere)reported that the schools 22 percent graduation rate, high student turnover andquestions about COVAs management company, K12 Inc., originally led district staff torecommend denying the virtual schools multiyear charter application.

Lastly, K12 was denied online schools recently in New Jersey, North Carolina and Maine, whichmeans that K12 is not opening schools in any new states in the next year.

Thisis the growth story that justifies a 46x P/E on this stock???

Public Policy RecommendationsStates are responding to the online charter school sector having run amok by adopting one ormore of the following changes, none of which are aimed specifically at K12, but all of whichhave deleterious consequences for the company:

1) A full moratorium on any new cyber charters and/or cap limits on existing ones.2) Cut funding to cyber charters to levels below that of bricks-and-mortar charters.3) Improved accountability systems for all public schools (e.g., every school receives an A-

F grade).4) Default closure provisionsfor all charter schools so, for example, if a school is in the

bottom 25% of all charters in the state, it automatically wont get its charter renewed. Or,if a school gets an F for two or three consecutive years, its automatically closed (thoughtheres usually an appeals process). This applies to all charter schools, but woulddisproportionately affect the low-performing online schools.

5) Improved practices for charter school authorizers, especially getting rid of rogueauthorizers.

6) Prevent charters from district/authorizer shopping.I actually think the most elegant solution would be to let online charters pick and choose theirstudents, and then tie a meaningful portion of what they are paid to each students successfulcompletion of a course and demonstrating proficiency/growth. This would incent schools to helpstudents succeed and penalize them for enrolling those unlikely to succeed. (Note that stateswould have to change their rules to allow this, as most have laws that prevent any charter frombeing selective.)

The result would be online charters only serving a small fraction of the students they do nowwhich would be a very good thing.
http://www.miamiherald.com/2012/09/16/3005122/in-k12-courses-275-students-to.htmlhttp://www.miamiherald.com/2012/09/16/3005122/in-k12-courses-275-students-to.htmlhttp://www.miamiherald.com/2012/09/16/3005122/in-k12-courses-275-students-to.htmlhttp://www.thefinancialinvestigator.com/?p=816http://www.thefinancialinvestigator.com/?p=816http://www.thefinancialinvestigator.com/?p=816http://www.ednewscolorado.org/news/analysis-shows-half-of-online-students-leave-programs-within-a-year-but-funding-stayshttp://www.ednewscolorado.org/news/analysis-shows-half-of-online-students-leave-programs-within-a-year-but-funding-stayshttp://www.ednewscolorado.org/news/analysis-shows-half-of-online-students-leave-programs-within-a-year-but-funding-stayshttp://www.ednewscolorado.org/news/education-news/cova-charter-extended-by-adams-12http://www.ednewscolorado.org/news/education-news/cova-charter-extended-by-adams-12http://www.ednewscolorado.org/news/education-news/cova-charter-extended-by-adams-12http://www.ednewscolorado.org/news/education-news/cova-charter-extended-by-adams-12http://www.ednewscolorado.org/news/analysis-shows-half-of-online-students-leave-programs-within-a-year-but-funding-stayshttp://www.thefinancialinvestigator.com/?p=816http://www.miamiherald.com/2012/09/16/3005122/in-k12-courses-275-students-to.html


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K12 Needs to Shrink

I dont believe that K12 should go out of business. As I noted at the beginning of this article, thecompany has a strong curriculum and online schools can be appropriate for certain students. ButK12 clearly needs to shrink substantially in order to properly serve students and states/taxpayerswhich is exactly what happened to many for-profit colleges in recent years.

Jeff Shaw of the Ohio Virtual Academy said it well when he told me:

I cant see how K12 can get significant increases in student academic growth under their currentmodel. They need to say, Lets not focus on growthlets first get the academics right and thenlook into growing in a controlled fashion so as not to sacrifice student achievement for growth. Ifstudent really achieve, the company will grow for the right reasons.

Why would anyone in their right mind sacrifice student achievement for company growth? Thoseof us at the school level sometimes felt as though Ron Packard was charging ahead full speed togrow, grow, grow and not focusing on long-term sustainability and student achievement.

This kind of thinking hurts students. If you enroll students who clearly are not appropriate for thevirtual school setting, youre doing that student a terrible disservice. You have sacrificed a realperson for your own economic gain. And I think thats immoral and unethical.

K12s managed schools are public schools. Every student has a right to attend, but as educationprofessionals we have a responsibility to see that students are enrolled in a school mostappropriate for their needs. In the end, its the parents and students who make the ultimatedecision regarding what school they attend. Our obligation as professionals is to present themwith the realities of virtual schooling and how this school choice option may or may not be thebest choice. The profit motive should not guide this processbut at K12 it appeared to.

Theres a good case in Colorado of how shrinking a school can lead to better outcomes for

students, as thisarticledocuments:

One of Colorados oldest online programs, Branson Online School, is also its highest-performing.But to get there, the school had to cut back.

In 2005, the Branson school district on Colorados southeastern border with New Mexico ran thestates third-largest online school, enrolling more than 1,000 students. By 2010, the school haddropped back to sixth in size, enrolling 427 students.

Branson assistant superintendent Judith Stokes, who oversees the online school, said the growthand lagging scorescombined with a critical 2006 state audit of online programsprompted theranching communitys school board to slow down.

We had grown very, very rapidly at one time, before the audit, and at that point, we pulledback,she said.

Stokes said growth slowed when the school focused on ensuring families understood the onlineprogram before enrolling because, If youre looking for easy, its not us.
http://www.ednewscolorado.org/news/analysis-shows-half-of-online-students-leave-programs-within-a-year-but-funding-stayshttp://www.ednewscolorado.org/news/analysis-shows-half-of-online-students-leave-programs-within-a-year-but-funding-stayshttp://www.ednewscolorado.org/news/analysis-shows-half-of-online-students-leave-programs-within-a-year-but-funding-stayshttp://www.ednewscolorado.org/news/analysis-shows-half-of-online-students-leave-programs-within-a-year-but-funding-stays


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In spring 2011, Branson online students beat the statewide average in proficiency in reading andwere six percentage points short in math.

Conclusions and CatalystsK12 is pursuing a growth-at-any-cost strategy that is harming countless students, likely violatingnumerous state and federal laws and regulations, and wasting hundreds of millions of dollars oftaxpayer money every year.

What the company is doing is becoming increasingly well-known so states and possibly theIRSare waking up and thus the company faces increased regulatory risks. The likely result isthat K12 will not only miss its growth projections (analysts project that K12s revenues andprofits will grow 16% and 32%, respectively, in the next year), but will actually have to shrinksubstantially in order to properly serve students (and states/taxpayers).

A possible short-term catalyst is that the company could disappoint when it issues FY 2014guidance in mid-October and/or when it reports Q1 14 earnings in early November becausegrowth has been slowing, preliminary enrollment data Ive seen for a few schools are weak, andanalysts seem to be factoring in rising margins and continued growth in revenue per student, bothof which I think are unlikely.

Trading at 46x trailing earnings and 35x next years estimates, K12s stock is priced forperfection, yet its future is likely to be far from perfect.

AddendumSince I made my presentation public last week, I am even more certain that my analysis of K12is correct thanks to comments like these from people I know:

I met with Ron Packard years ago and could tell his motivations had little to do with kids,everything to do with manipulating state regulation to protect his interests. I started digging intothe results, the business model, the organization, and discovered much of what you lay out indetail in your presentation. As I said, they are terrible and epitomize everything that we should beworking against in the ed-reform movement.

I know the company very well and your presentation rings true. They have a well-deservedterrible reputation.

Youre totally right about K12 and, on top of it, they lie all the time. Its nave to trust anythingthey say. So Im not sure if their schools can be fixed, at least under the companys currentleadership. Theres no such thing as a successful online school in the entire country. To be sure, itworks well for some students, but Id guess only 15% of the ones cyber charters are currentlyserving.

Finally, lest you think Im just talking my book for a quick trade, it wont take you long to verifythats not how I operate. Agree or disagree with me, my views are based on the companysfundamentals and are genuinely held, irrespective of my fundsposition in the stock. Also notethat I am not short K12s stock because I oppose charter schools, online education, or for-profitschools. To the contrary, as you can see from mybio,Im a champion of new models ofeducation, whether for profit or nonprofit, as long as they work for kids.
http://www.tilsonfunds.com/TilsonEdBio.pdfhttp://www.tilsonfunds.com/TilsonEdBio.pdfhttp://www.tilsonfunds.com/TilsonEdBio.pdfhttp://www.tilsonfunds.com/TilsonEdBio.pdf


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Appendix C

Why Im Not Covering My K12 Short

Whitney Tilson2,017 FollowersOctober 10, 2013http://seekingalpha.com/article/1738982-why-im-not-covering-my-k12-short

My momma always said, Life was like a box of chocolates. You never know what youre

gonna get. Forrest Gump

That line came to mind as I was thinking about the wild turn of events the last few days vis--visK12. The stock fell 38% yesterday and has been cut in half since I went public with my concernsabout the company (and my fundsshort position) three weeks ago at theValue InvestingCongress(I also wrote about ithereon Seeking Alpha; the latest version of my K12 presentationis postedhere).

But let me start the story three days ago: on Monday night, I went to a dinner hosted MayorBloomberg at Gracie Mansion for folks attending the Education Nation conference that wasgoing on earlier this week in NYC. One of my friends came up to me and said, You know Ron

Packard [the founder and CEO of K12] is here. Let me introduce you.In light of what Ive saidand written very publicly about him and his company in the last three weeks, I feared an uglyconfrontation so I demurred.

But not long afterward, while I was talking to some other friends, she came over with Ron andintroduced us. We shook hands and he said hed read my presentation and thought I got somethings wrong. I said Id love to hear what and we started talking. And talking and talking...Somebody gave a speechand we kept talking. Then some performers sangand we moved to

kase quarterly letter q3 2013

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