A Lesson in Corporate Values for Edison Schools
Last week, the cranks here at Eye to the Keyhole had an uncharacteristically nice word or two to say regarding Martha Stewart and the pending public stock offering for her extraordinarily profitable company, Martha Stewart Living Omnimedia. The result was an unusually large volume of mail from readers. Some wondered whether I'd forgotten to take my medicine before writing the column, and at least one reader asked whether I was angling for a date with Stewart.
Sorry to disappoint, folks, but the only reason we had anything nice to say about the offering was that Stewart and her company represent that rarest of commodities in this wildly overextended bull market: a profitable enterprise being run by a talented chief executive. Both of these attributes should be, but rarely if ever are anymore, qualities a company ought properly to possess before any self-respecting underwriter takes the deal to market in the first place.
So, would you like to review an example of what's wrong with the market today and why Stewart's deal stands out as such an obvious exception to the rule? Then look no further than Edison Schools (EDSN:Nasdaq), a deal underwritten by Merrill Lynch that seeks to raise as much as $172.5 million so that a smooth-talking media hustler named Christopher Whittle won't have to throw in the towel on his latest backfiring business-world jalopy -- a scheme to make money by running a network of so-called "for-profit" private schools.
In case you've forgotten, Whittle is the aging boy genius who took the New York media world by storm back in 1979 when he and a pal, Phillip Moffitt, bought Esquire magazine and, over time, drove it nearly to ruin.Possessed of his own sense of visionary infallibility -- and the baloney-spouting skills of a Harold Hill -- Whittle soon had individuals ranging from Yale University President Benno Schmidt to President Jimmy Carter's top White House aide Hamilton Jordan to Fortune magazine editor William Rukeyser coming to work for him. Suitably adorned with such names all around him, Whittle thereafter went on to start up one wacky venture after the next. They ranged from a scheme for publishing books with ads in them, to piping advertiser-supported medical news into doctors' offices via cable TV, to the same basic idea for ad-supported news for kids in the classroom. The latter clunker, dubbed Channel One, was eventually sold to a Henry Kravis brainstorm called KIII Communications that is now spewing losses in all directions under the name Primedia (PRM) So what's the problem with Whittle's latest Big Idea, Edison Schools? Basically, it comes down to this, at least so far as Whittle himself is concerned: The Edison business has been losing money from day one -- gobs of it -- yet along the way Whittle seems to have found an apparently none-too-bright banker at Morgan Guaranty Trust Co. of New York who has gone ahead and extended him what is apparently a quite sizable personal loan, taking back Whittle's stock in the business as collateral. Exactly how much stock Whittle actually has in Edison is not clear from the registration statement, which reveals a capital structure that's about as tidy as a bucket of eels. There are two classes of stock ("A" shares and "B" shares), a tranche of convertible preferred shares and all sorts of promissory notes. Holders of one or another of these securities include investment groups affiliated with Microsoft (MSFT) co-founder Paul Allen, with Donaldson Lufkin & Jenrette (DLJ) , with J.P. Morgan (JPM) and who knows what else. All seem to have kicked in money, and taken back stock, as the Edison business itself began to flounder. As a result, it is hard to say exactly how big a stake Whittle himself still has in the business, but it does seem to be substantial. One bit of evidence has to do with the aforementioned loan from Morgan Guaranty. According to the registration statement, the loan comes due this month, and if Whittle defaults, the bank can seize his stock and thereby become able to "exercise substantial influence over corporate matters." More important, from Whittle's perspective with the loan now coming due, he needs to restore Edison's cash drawer quickly. The company is now down to less than $8 million of ready money, and its working capital will almost certainly be gone before year-end. As a result, Morgan Guaranty could soon be asking him for more and better collateral than his worthless stock in a privately held company that would no longer be able to pay its bills -- a problem that would at least be postponed by a public stock offering and $172.5 million capital infusion. Unfortunately for Whittle and his company's other investors, to get that $172.5 million they have to draw back the curtain on the company's financial affairs. And bluntly put, they're a mess. Let us start with the sweetheart deal the books disclose concerning the company's current chairman of the board, Benno Schmidt, the ex-president of Yale. As an apparent inducement to help lure Schmidt away from Yale and sign him on as Edison's first chief executive when the company was still a development-stage operation back in 1992, Whittle arranged to have the company extend Schmidt a $1.6 million personal loan at 5.83%. This occurred in June 1992, when the prime rate for bank loans to their most creditworthy corporate borrowers stood at 6.50% and personal loan rates were much higher even than that. But wait, it gets better, for in January 1996 the company extended Schmidt yet another loan for $200,000 -- once again at 5.83% -- only by then, the prime rate had climbed to 8.50%. Interest and principal on both loans become due and payable this coming February, with the total to date (interest and principal combined) equaling $2.4 million due back to the company. But during the whole of this period, Schmidt has had, we may assume, unrestricted use of the money. Thus, had he simply invested it in a low-risk, broad-market index fund like the S&P 500, Schmidt's bonanza today would approach $8.5 million in value, meaning a $6 million windfall for doing basically nothing at all. Had he been smart and invested in Microsoft, for example, he'd today be ahead more than $25 million. And that's just for Schmidt. Through it all, Whittle has had his own little side business going, called WSI Inc., of which he's the sole stockholder. Since March 1995, Whittle has had Edison fork over a cool $1.07 million in "professional services" fees to WSI, which is to say, to himself. On top of that, both men took home $296,636 in salaries for the year ended June 30, 1999, and have each so far accumulated in excess of 1.2 million fully vested options exercisable at around $1.50 per share or so. Assuming a $15 market price for the post-IPO shares, Whittle's stash will be worth nearly $22 million, and Schmidt's will be worth $18.5 million. In other words, since 1995, Whittle has paid himself alone perhaps as much as $23.3 million in compensation and fees -- which is to say, more than $5 million annually -- and is now hoping to set up a market on Wall Street through which he can begin cashing out the 94% of it that he took in the form of stock options. And what has he done in return for the money? From an outside investor's perspective, the answer is clear: Nuttin'. The company's registration statement for the IPO reveals, for example, that Whittle has been trying to wring a profit out of Edison since at least 1994, and in that time has taken in $215 million in revenue while running up operating costs of nearly $308 million. Since the registration statement plans to recognize more than $18 million in noncash stock compensation during the fourth quarter of 1999, we may properly add at least that much to the company's costs to date, boosting Edison's cumulative operating expenses to at least $326 million. Some business, huh? Take in $215 million and lose $326 million -- and there's not even a dot-com in the name to blame it all on. According to the registration statement, more such losses stretch out before the company for as far into the future as the mind can foresee. In fact, the overall financial situation at Edison is even worse than the operating numbers suggest. That's because, buried deep in the registration statement, can be found the astonishing news that this allegedly for-profit operation is actually taking handouts from various unnamed philanthropies to run the business. We'll just pass over the tax-related issues raised by such transactions and suggest that the acceptance of philanthropic aid to run a profit-making enterprise in fact amounts to nothing more than gussied-up begging, and that to get a true picture of the company's revenue-generating abilities as an actual business you've got to get the panhandling out of the numbers. Unfortunately, the registration statement conveniently sidesteps exactly how much panhandling is actually going on at Edison, vaguely mentioning only one unnamed charity outfit to which the company has extended an upturned palm. The registration statement says the organization has pledged $22.5 million to help Edison run certain schools it is operating in California, and that $4.6 million has already been spent. How many more such handouts are included in the numbers, the registration statement doesn't say. What exactly is this business that is attempting to sell stock on Wall Street while simultaneously holding itself out to be the moral equivalent of a public charity? According to the registration statement, Edison Schools is in the business of running public schools better and more efficiently than public school districts themselves can run them. The idea is, let's say you've got a typical middle school in Happy Valley. You know the place. It's filled with 12-year-old kids who can't read a damned thing, but can lock and load a Heckler & Koch MP5K semiautomatic machine pistol while simultaneously playing Area 51 Alien Killer, even as they watch South Park on Comedy Central, surf the Web for cool stuff and back-talk their teachers. So, what supposedly happens is, after years of pounding Happy Valley's tax dollars down this rat hole and getting nothing back but sullen 18-year-olds with pierced tongues and ambitions of someday owning their own Harley-Davidson Fat Boys, the Happy Valley Board of Education rises up in its righteous wrath and says, hey, let's get Edison Schools to turn this operation around (or words to that effect). And in comes Whittle and his sidekicks -- turnaround plans at the ready. Out comes the new, get-smart-quick curriculum, the new computers for the teachers and every kid above the second grade, the new books and study aids and the new "facilities upgrades." The IPO registration statement is overflowing with education bafflegab about "family and community partnerships" and that sort of thing. There's talk about "early learning" and "core values" and something called "norm-referenced tests" (beats me what that is). Yet in the entire 275-page document there's only a single paragraph purporting to show that the result of all the effort is really better educated, brighter kids. The graph in question says that kids in Edison schools score better on certain unnamed state and national tests than do kids nationwide on other kinds of tests. But the graph goes on to say that the two kinds of tests are not "strictly comparable." Now I will readily agree that any community that chooses to put its educational system in the hands of a private enterprise corporation ought to be able to decide for itself whether it is getting its money's worth. But investors in such a company must apply a different calculus, and even if Edison were to turn every schoolchild in America into norm-referenced geniuses quoting Ovid to each other instead of lines from that hideous Cartman character on South Park, it wouldn't mean anything if the bigger the company got, the more money it lost. And based on Edison's track record to date, that is exactly what is likely to happen. Bottom line? The deal's a dog, and the only investors who stand to come out ahead in it will be wily Whittle and his boola-boola buddy, Benno Schmidt.
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