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A Case Against K12

NEW YORK ( TheStreet) -- Some of the most widely reported presentations from past Value Investing Congress sessions have been the short-selling ideas. Who can forget hedge fund manager David Einhorn's presentations that made the short cases for Florida land company St. Joe's Corp. (JOE) in 2010 and Green Mountain Coffee (GMCR) in 2011? Both raised serious questions and had a material impact on the stocks.

During yesterday's conference, Kase Capital's Whitney Tilson -- also co-founder and chairman emeritus of the Value Investing Congress -- presented his short thesis for K12 (LRN), a kindergarten through 12th grade for-profit education company.

Tilson believes that despite K12's rapid revenue growth of 32% annually over the past 10 years, there are several issues brewing that haven't been recognized by investors. He noted that profit margins are low and the company has generated just $11 million in free cash flow over the past decade. LRN Revenue TTM Chart LRN Revenue TTM data by YCharts

Tilson also questioned the company's accounting practices: K12 capitalizes certain costs instead of expensing them, which increases reported income. He is also curious about why K12 doesn't use a Big Four accounting firm as its auditor.

What seems to bother him most is that K12 isn't effective in educating students. He points to high dropout rates and poor academic results. Tilson presented several case studies from various states that demonstrate K12's difficulties, and said K12 is targeting at-risk students who the company knows are unlikely to succeed.

Tilson interviewed former employees, who lamented K12's "growth at any cost" strategy, and what he termed "high-pressure, misleading sales tactics."

Now trading at 48 times trailing earnings, and 37 times the 2014 average earnings estimate, Tilson said that K12 is priced for perfection, and asserted that the company's true results and tactics will become well-known, curtailing growth and causing K12 to miss revenue and earnings expectations, perhaps as early as next month when the company gives its projections for 2014, or in November when it reports first-quarter results. Analysts expect revenue of $257 million, and earnings per share of 17 cents for that quarter.

Ultimately, Tilson says that the company will have to shrink to better serve students. Stay tuned to see how this plays out.

While I am not a big proponent of shorting stocks, given the risks of being wrong, there is much to be learned from those who do short, and the theses that they build in order to back up their positions.

As long investors, we build our own cases about why we are buying certain stocks, but these cases are often very thin. The attention to detail used in building the negative case for a stock, such as the one Tilson presented, should also be used for building a positive case before we buy.

At the time of publication, the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
At the time of publication, Heller was long XXXX.

Jonathan Heller, CFA, is president of KEJ Financial Advisors, his fee-only financial planning company. Jon spent 17 years at Bloomberg Financial Markets in various roles, from 1989 until 2005. He ran Bloomberg's Equity Fundamental Research Department from 1994 until 1998, when he assumed responsibility for Bloomberg's Equity Data Research Department. In 2001, he joined Bloomberg's Publishing group as senior markets editor and writer for Bloomberg Personal Finance Magazine, and an associate editor and contributor for Bloomberg Markets Magazine. In 2005, he joined SEI Investments as director of investment communications within SEI's Investment Management Unit.

Jon is also the founder of the Cheap Stocks Web site, a site dedicated to deep-value investing. He has an undergraduate degree from Grove City College and an MBA from Rider University, where he has also served on the adjunct faculty; he is also a CFA charter holder.

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