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Learning to Profit: K12 Inc. (NYSE:LRN) Flagged For Breakout

Companies / Investing 2009 Apr 07, 2009 - 12:47 AM GMT

By: Oxbury_Research

Companies Best Financial Markets Analysis ArticleK12 Inc. (LRN) is one of those companies you salivate over. It's a beaten down stock with fundamental attributes that just make sense. Even the technical crowd would like a piece of the action. But before we get into the nitty gritty details, it would probably serve you well to tell you a bit about the company itself in case you've never heard of it before.

Personally, I'd rather hear about a hidden gem than to latch on recommendations that have already been spotted by the fund manager and media types who are likely to leave you hanging onto an expensive stock near the peak. This is not the case with K12.

As it turns out, K12 has its fingers in the educational space. It sells on-line curriculum and educational books/materials targeted toward those in grades Kindergarten through 12 th grade. As you can tell, the name is fairly straight-forward. In addition to this, the firm is also known for providing management and technology services to virtual public schools. This means that students can absorb information anywhere, whether it's via online portal or from an offline learning kit -- all of this done through direct sale to the consumer.

My job here is not to tell you the story or how this particular company is only worthwhile because of some political policy or global event. Instead, I will look to both fundamental and technical analysis to make my bullish analysis.

K12 Fundamentals

For starters, K12 is an “uber” small cap stock. It only has a market capitalization of approximately $455M, so you can be sure that mob has yet to discover it. Now, most of us have our favorite fundamental characteristics that we utilize. For me, there are some key questions that I need answered first:

•  Is the company profitable?

•  Is there growth and improving financials?

•  Does the company take on a lot of debt?

•  Is it liquid, meaning is there enough shares trading hands on any given day that I will have no problem getting into and out of the stock?

•  Is management being effective with shareholder dollars?

•  How is the company valued in comparison with the peers in its industry?

•  Is there enough cash on hand to pay its short-term obligations?

This probably isn't the list among lists -- and it does get tweaked from time to time. But more importantly, I'm looking for value, financial solvency, stability (especially in this type of economic environment) and growth. Specific buy and sell points come through the use of technical analysis which we'll get to in a moment.

Why did I choose K12 Inc. (LRN)?

Simple, it's one of the strongest equity plays in the market right now. I'm not just saying that because I have to. You see, given my specific set of investment screening criteria, I have been able to effectively filter out the garbage that just doesn't make the investment grade. For discussion sake, here's a quick list of my top five stocks according to fundamentals:

  1. LRN – K12 Inc.
  2. SOHU –
  3. ALKS – Alkermes
  4. QCOR – Questcor Pharmaceuticals
  5. CSR – China Security & Surveillance Technology

Just because a stock makes the fundamental list doesn't mean you should be throwing every penny at it. The rest of the stocks on this list do not appear to be set up for a technical breakout anytime soon. As luck would have it, K12 is tops on both analytical fronts.

Okay, so here's the beef…

K12 has traded a daily average of 329,424 shares over the past month which is more than enough to meet our needs since the stock still trades at a respectable $15.78/share at the time this article is being written. So, you should have no problem acquiring your intended amount of shares.

Revenue figures are strong as well. The company is experiencing revenue growth year over year of 61% and EPS growth comes in at 45% -- which is great. And get this; next year's growth rate of 182.67% will eclipse this year's already stellar 150%.

How about the company's profitability? Well, as you can imagine, I'm very pleased with K12's return on equity (ROE) of 19.32%. Anything over 10% is generally worth crowing about. Just in case you were curious, return on equity reveals how much profit a company generates with the monies that shareholders have invested. It's a great tool to use because it casts a wide net with regards to corporate management. Specifically, I'm referring to profitability, asset management and financial leverage. All in all, we're grading management on whether or not they have the ability to get the job done. Who wants to invest in an incompetent management team running the show – not me!

Next, we'll look to see if price is trading at a premium or at a discount. For this, we'll go with the infamous price-to-earnings ratio (P/E). As an investor it is important to realize that this ratio is only useful if you compare it to peers within a company's industry. Otherwise, you'll get a false signal in comparing apples to oranges – and we certainly don't need any conflicting data. Some companies can justify high P/E ratios (think Internet highflyers) while other companies lack the growth, imagination and interest from investors to warrant unchecked valuation (utility companies come to mind).

Okay, so this stock is definitely starting to heat up. The question of financial solvency should be a no-brainer, but it's an important one to address. I like to look at the Quick Ratio. In the case of K12, the ratio is 3.0. This tool measures the ability of a company to use its near cash/quick assets to retire current liabilities. In other words, can the company pay the bills? Any ratio over 1.0 indicates that it would have no problem accomplishing this feat.

Finally, we'll look at the debt/equity ratio, which is 0.15 for K12. The general rule of thumb is that the lower the debt-to-equity ratio, the less risky the investment. Although, if interest rates are low, as they are right now, the company may be able to justify taking on the debt if revenues from new investment projects materialize and go beyond covering the just the cost of principal and interest. Again, K12 is well positioned and seems to have its fundamental ducks lined up in a row.

But is it the right TIME to buy?

I don't care what the fundamentals say, if the equity, fund, ETF, or whatever is not technical aligned to move – it won't. I don't know about you, but I'd rather watch Curley, Larry and Moe smack each other around all day on the television than to jump headfirst into a long position and sit there for months or years as price either drifts sideways, or worst yet, against my intended position. Not only are you NOT making profits, but you'll be wasting precious time as well. We only live for so long. Why waste even one of those years? Technical charts and patterns occur on every time scale so make the most of your time and get crackin' away at it. If you're like me and you're busy with other projects during the day, there's no shame in taking an intermediate-term investing strategy. Not all of us have the time to necessarily become a day-trader. So, as a side note, pick your optimal trading time horizon and stick to it.

While fundamentals offer the comfort of quality, technicals can help you choose entry and exit points. I'm not exactly sure why this type of analysis is considered voodoo or some kind of weird science. Perhaps it is because some investors do not understand it, have the passion for the topic, or simply believe that the only thing a technical analyst does all day is plot historical lines and say, “Gee, I think it's going to continue in this direction because a certain pattern said so.”

Who says you can't use the best of both worlds? I take pride in knowing as much as I can about the different methodologies, because in the end it's about who is more efficient in scoring big profits.

Technical analysis can also be a wonderful tool to have when evaluating which price levels are optimal when setting a stop-loss. This is important because having the ability to manage both profits and losses is the key to winning in the long-run. It's about who can protect their cash reserves, limit losses and hang onto gains. Easier said than due, eh?

In getting back on topic, let's take a bird's eye view of K12 (LRN). I like to get a glimpse of the big picture first to help me understand the complexity of short-term movements. In my opinion, the best way to do this is to pull up a one-year weekly chart or a multi-year monthly chart if you're looking to hold a position much longer than six months. I do this because this particular view will smooth out the volatility and reduce trade signal noise. For example, when a buy or sell signal is given with the MACD and DMI indicators, you'll know it actually means something.

Below, I have plotted LRN on a six-month daily chart. This is where we focus in on the technical patterns and if there are any candlestick buying opportunities.

It just so happens that a symmetrical triangle pattern formed during March that under normal circumstances should have resulted in a breakdown to roughly $10 or so.

It didn't happen.

A seasoned chartist does not play the triangle itself, instead opting to wait for a breakout confirmation before initiating a position.

With this sudden show of bullish strength, and the resulting bullish consolidation flag under formation, it is probably safe to pull the buy trigger. I say this not just because of the short-term setup, but also due to the fact that in the first weekly chart I showed above, we saw bullish signals on display with not just the technical pattern itself, but the MACD and DMI indicators as well.

What happens if the stock goes against me?

This is where the practice of money management comes into play. In the short-term, I can easily see LRN hitting $20/share. In the weekly chart I drew a major head and shoulders neckline for you in green. It's the thick descending line, and you should be aware of this area of support. If the stock breaks down below this point, all bets are off and you should be stopped out of the entire position immediately. Specifically, I'm referring to a price in the neighborhood of $12.50-$13.50. Somewhere in this range you should place your stop. It really depends on your risk tolerance.

Our recommendation: Pick up shares of LRN near $15.78 and place a protective stop below support between $12.50 and $13.50/share.

Good investing,

Stanley Barnes
Analyst, Oxbury Research

Disclosure: no positions

Oxbury Research originally formed as an underground investment club, Oxbury Publishing is comprised of a wide variety of Wall Street professionals - from equity analysts to futures floor traders – all independent thinkers and all capital market veterans.

© 2009 Copyright Oxbury Research - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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