Whitney R. Tilson phone: 212 277 5606

Managing Partner WTilson@KaseCapital.com

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 is

up 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 we

own (our average long is up nearly 30%), offset by the headwinds of cash and the short book.

I’ve been doing a great deal of thinking and been having many discussions with the smartest

people I know in this business about these two headwinds and what, if anything, I should do

differently. I’ve reached a number of conclusions.

Holding cash and long exposure

My biggest mistake since I started managing the fund myself 15 months ago has been

underexposure on the long side. I’ve been holding 20-40% cash during most of this period,

positioning our fund conservatively – practicing the principle of “be fearful when others are

greedy and greedy when others are fearful” – in light of the widespread complacency in the

equity markets and the fact that the major indices have regularly been hitting multi-year or even

all-time highs. I let my concerns about the market affect how I positioned our fund, with the

result that instead of being at my target exposure of 100% long by 30% short, I was typically

closer to 70% long by 30% short, which has been costly in light of the market’s strong upward

move.

Holding such a large amount of cash can make sense for a long-only fund but, when combined

with a substantial short book, is overly conservative in the absence of great conviction that the

market is about to implode. In the nearly 15 years that I’ve been managing money professionally,

I’ve only twice felt this way: in late 1999/early 2000 at the peak of the internet bubble, and in

early 2008 when my research led me to believe that the consequences of the bursting of the

housing bubble would be much worse than nearly anyone believed at that time.

Today, I don’t have this feeling. While there are plenty of things that could upset the current

complacency in the markets – for instance, the current government shutdown continuing;

Congress failing to raise the debt ceiling; unexpected consequences from the recent jump in

interest rates; and/or a sharp economic downturn in Europe, China, Japan, or emerging markets –

my best guess is that the U.S. economy will continue to muddle along, as it has been doing for

the past few years.

As such, going forward I plan to be more disciplined about maintaining my target exposures on

both the long and short sides, but also to, on rare occasions, hold more cash and/or increase the

fund’s short exposure.

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

future.

Casting a wider net

I’ve 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 experience

here, shareholders are well protected, and I have always been fearful of straying outside my

circle of competence and being the proverbial sucker at the poker table were I to invest

elsewhere.

I think I’ve been too dogmatic about this, however, and over time plan to invest some time and

energy into becoming familiar with foreign companies and markets. I don’t expect to become a

truly global investor anytime soon (if ever), but there are great investment opportunities all over

the 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 hear

you thinking: “A Korean automaker? What are you thinking???” The simple answer is that this is

an excellent company with bright future prospects, and I was able to purchase it – through the

preferred stock – at a ridiculously cheap price: 3.4x trailing earnings (not EBITDA, but real

earnings).

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 third‐tier industry laggard into the

world’s third largest automaker, and has been steadily gaining share, as this chart shows:

Hyundai’s Global Market Share

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Remarkably, the company hasn’t gained share by sacrificing profits – in fact, it has consistently

had the highest profit margins among the largest global automakers, as this chart shows:

Consolidated Operating Margin, 2009-Q2 2013

Ah, but it’s an automaker, so the balance sheet must be a mess, right? Nope. The company has

$20.7 billion in cash (43% of the company’s market cap of $48.3 billion), its debt is tied to its

finance arm and more than offset by associated assets, and there are no long-tailed pension and

healthcare liabilities that crippled the U.S. automakers (“net defined benefit liabilities” are a

mere $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 very

well in recent years – and the stock has responded, rising more than 6x from its late-2008 lows.

Nevertheless, today it trades at a mere 8.4x trailing earnings – and pays a small 0.8% dividend to

boot. That’s cheap and I might be tempted to buy it – but not when I can instead own it through

Hyundai’s 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 shares

Korean 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 didn’t wish to dilute their

control, to issue equity in the form of preferred shares, which typically had the same economic

rights as the common stock, but few or no voting rights. Nearly 150 companies issued preferred

shares before the law was changed long ago.

For many years, the preferred shares traded at around a 20% discount to their associated common

stocks, 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 around

60%.

I can find no good reason for such a large discount, especially in light of the fact that the Korean

market 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 Stock’s Discount By Country

I believe that this is one of those market anomalies in which something is mispriced primarily

because it’s always been mispriced. I have no idea when this discount will close, but my

experience, to paraphrase Ben Graham, is that while in the short run the market is a voting

machine, in the long run it’s 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 a

second way to win on this investment (the first being that Hyundai continues to do well and its

common stock rises over time).

A final thought: I take some comfort investing in Korea after reading this transcript of a Q&A

Buffett did in April 2009 with University of Kansas students:

[Buffett then pulled out the 2004 Korean Stock Guide compiled by Citigroup]. My broker at

Citigroup told me to look through this Korean version of the Moody’s guide. He said it would

look just like 1951. He was right. I began flipping through the pages and found a lot of good

companies trading at very low multiples. In 5-6 hours I put together a small portfolio of 20-25

stocks – about $100 million total. One example was DaeHan Flour Mills. It has a 25% market

share in wheat flour in South Korea . Book value was 206,000 Won and the company had

201,000 Won in marketable securities and was trading at 2x earnings. The market is clearly not

efficient all the time. There are certain opportunities that can make you fabulously rich.

Shorting

I have two strong feelings about shorting right now:

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1) It’s a horrible business, it’s cost all of us dearly over the past 4½ years, I wish I’d never

heard of it, and every bone in my body wants to cover every stock I’m short and never

short another stock again; and

2) In my nearly 15-year career of professional investing, the only other times that have been

as target-rich in terms of juicy, obvious shorts are late 1999/early 2000 and late

2007/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 and

a glutton for punishment, but because I am convinced that I can make a lot of money on the short

side going forward.

The only other time in my investing career in which I seriously considered covering every short

and becoming a long-only manager was October 2007. At that time, I went through my short

book, stock by stock, and said, “OK, am I willing to cover MBIA at $70? Hell no, not a single

share! 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 couldn’t bring myself to cover a single share of any stock I was

short – they were all “trembling-with-greed” shorts. And that’s exactly how I feel today.

Let me be clear: I have no illusions about what a tough business shorting is. In most years, in

fact, I expect that it will detract slightly from our returns. But that’s a price I’m willing to pay for

a number of reasons:

1) Having a short book allows me to invest more aggressively on the long side, both in terms of

overall portfolio positioning, individual position sizes, and willingness to take risks in certain

stocks. Here are some examples of what I mean:

I wouldn’t be comfortable taking our fund’s exposure up to 100% in the current market if it didn’t

have meaningful long exposure;

I wouldn’t have held onto my position in Netflix as it’s risen from just above $50 to more than

$300 over the past year if our fund wasn’t short a number of similarly volatile, speculative stocks;

I wouldn’t hold such a large position in Howard Hughes (9.5%), another huge winner for us, if

our fund weren’t short St. Joe, which is also closely tied to the real estate/housing market; and

I’m not sure I would feel comfortable owning economically sensitive stocks like Hertz and Avis

if our fund weren’t short many stocks that I expect would do very poorly if the economy

weakens.

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 it’s most attractive. This is exactly what happened

in 2008 and early 2009. After inflicting losses as the market rose from early 2003 through

October 2007 (the same length of time as the current bull market), our substantial short book

cushioned the downturn – our fund was down approximately half the market in 2008 – and

allowed me to invest aggressively on the long side, which translated into big gains after the

market 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 for

homeowner’s insurance and at the end of the year, when my apartment hasn’t suffered from a

flood or fire, my insurance expires worthless and I have to buy it again. Is it a mistake to buy

insurance that turns out to be worthless almost every year? Of course not.

I suspect most people wouldn’t quarrel with buying cheap insurance – but it hasn’t been cheap!

Over the past 15 months, losses on the short side have offset most of the fund’s gains on the long

side, despite long exposure being at least twice as large as short exposure. In other words, our

fund’s short book has performed unusually badly.

So is the problem that I’m simply uniquely bad at shorting (in which case, I should just stick to

the 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 in

their short books. One can see this reflected in the HFRX Equity Hedge Fund Index, which was

up 6.7% year to date through September – less than half the return of the S&P 500, due largely to

losses on the short side I have no doubt.

In the past year, I’ve seen more pain inflicted upon short sellers than at any point since the

internet bubble in 1999 and early 2000. One 20+ year veteran said it well when he told me:

I don’t have the antidote to your pain. We’ve been bludgeoned by this melt-up as well. It’s

unbelievably unpleasant.

I’ve never seen such widespread capitulation among seasoned short sellers. Many are out of

business.

This stretch is worse than the internet bubble for me. It’s constant pain across my entire short

book, whereas the internet was isolated to one industry – and then you got relief when the bubble

burst.

So while it’s been painful, this is the kind of environment, I believe, in which those with the

courage to maintain a short book will be well rewarded.

Adjustments to my short strategy

This isn’t to say that there isn’t room for improvement. There is. Specifically, I plan to make the

following adjustments:

1) Smaller positions. Over the last 15 months, I’ve been managing the fund’s short book

identically to its long book in terms of the number of positions – about a dozen exceptionally-

high-conviction positions – but roughly half the size. Thus, the average long position has been

around 5-6% whereas the average short was in the 2-3% range.

I’ve learned the hard way the perils of sizing too many short positions above 2%. Every five or

ten years, the market goes through periods like the current one in which overvalued stocks can

become even more overvalued, rising 50-100% or more, which causes a lot of pain and

sometimes 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 will

enable our fund to better weather the market’s periodic bouts of foolishness.

This means, of course, that the fund’s short book will be comprised of more positions, but I

believe I can manage this, especially in light of today’s incredibly target-rich environment.

2) Better match the fund’s long and short positions. A meaningful percentage of the fund’s long

exposure 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, more

volatile, heavily shorted, battleground stocks. These stocks tend to be the most overvalued and

have the potential to fall the furthest – often, I believe, 100% – but they can also rise the most

during periods of excess liquidity and complacency. (It hasn’t been a complete mismatch, as the

fund’s 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 fund’s 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,

I’ve had too many of the first two and not enough of the letter – what one friend called “reverse

compounders.” A good example in our short book today is St. Joe, a stock I’ve written

extensively about in past letters, where very little is happening and I see minimal value beyond

the timberland.

3) Be more patient. I’ve been reasonably successful over the years in being able to identify

hugely overvalued stocks, but have been less successful in getting the timing right. I find that I

can frequently correctly foresee what’s going to happen a year or two in the future – but am often

amazed at how the market – especially this market – ignores huge red flags at certain companies

and runs their stocks up further in the short term. I’ve certainly gained a greater appreciation for

the power of short-term stock price momentum and am going to make more of an effort to be

patient, stay out of the way of freight trains on the way up, and make money shorting these types

of stocks on the way down. Allow me to illustrate this with two examples.

First, I’ve recently cut our fund’s short position in World Acceptance, which I discussed at

length in my Q2 letter, from a bit over 2% to 0.5% – not because I’ve lost any degree of

conviction 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 the

vast majority of its customers is a heck of a good business, so I expect the company will continue

to grow – and its share price will continue to rise – so I’ll patiently wait with a toe-hold position

until there’s clear evidence that regulators are taking action and only then size up the position.

Sure, I’ll miss the peak and the stock might be down 10-20% before I act with conviction, but I

think the downside here is 70-100%.

Another example of the need for me to be more patient is Green Mountain Coffee Roasters,

where I’ve 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 of

2011, and then made it all back and then some as it collapsed in late 2011 and early 2012. But I

would have made more if I’d waited until after the company missed expectations and lowered

guidance to short it. Even though the stock had fallen 20% at that point, it was still a great short

because the momentum was broken yet the valuation remained extreme (it ultimately ended up

collapsing 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 expired

in September 2012. My research led me to believe that numerous competitors would then enter

the market and both take market share and force Green Mountain to reduce pricing, severely

impacting Green Mountain’s profitability, especially since it’s a high-cost producer.

Sure enough, the stock more than doubled off its lows and I reestablished the short position from

January through April of this year at prices ranging from $40 to $55 – and got run over as the

stock 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 emerge

soon after Green Mountain’s 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 it

would take time for competitors to ramp up K-cup production and win shelf space among the

nation’s retailers.

But today, the evidence is clear that a competitive tsunami is hitting Green Mountain. As you can

see in this chart, competitors already have approximately 20% of the market and are gaining

more than one percentage point per 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 Green

Mountain owned and licensed brands rose a mere 4.5% year-over-year in September while

average pricing fell 3.3%, resulting in tepid 1.1% dollar sales growth – all terrible numbers that

are far below the company’s guidance and analyst estimates, so it’s not surprising that the stock

fell 7% yesterday (and it’s down again today on news that Whole Foods is now selling private

label 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 dark – and Green

Mountain is, of course, trying to keep them there: at its analyst day last month, it presented a

slide 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 retailers

nationwide. 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.” Here

are some quotes:

“Green Mountain’s rate of growth is decelerating because there is so much more competition out

there, 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 beers – lots

of local brands. It is open season right now.”

“They’re 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 competition’s $4.99 ad.”

0%

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

GMCR Owned GMCR Licensed Non-Licensed

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“Discounting is much more aggressive now due to competition; that’s what is driving the prices.

Green Mountain hasn’t been as aggressive and that’s why they’re in so much trouble right now.”

A small anecdote that supports my thesis – this is what I saw when I visited Costco yesterday:

Costco is selling four brands of K-cups: (from left to right) Starbucks, Green Mountain,

Newman’s Own, and Kirkland. Starbucks and Newman’s Own are both licensees of Green

Mountain, whereas Kirkland is the Costco store brand, so in terms of shelf space, the non-

licensed brand has 25% share. I don’t 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 box

has 100 K-cups whereas the others only have 80 – in other words, Green Mountain’s K-cups are

25% more expensive. In this hyper-competitive world, I don’t think that kind of price

discrepancy is sustainable.

I think it is highly likely that Green Mountain and its licensees continue to lose unit market share

at a rapid rate and will be forced to continue cutting pricing as well, which will severely impact

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Green Mountain’s earnings – and its richly valued stock, currently trading at 24x trailing

earnings.

As an added bonus, the numbers Green Mountain is reporting don’t make sense to me, which

makes 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 Mountain

Coffee: One Of My Favorite Shorts (see Appendix A).

In summary, while I was too early in getting back into the GMCR short, I’m convinced that the

stock is a fantastic short today and hence it’s among my largest at 2.2%.

K12

I gave a detailed presentation on why K12 was our fund’s largest short position at the Value

Investing Congress three weeks ago (I emailed you the slides the following day; the latest

version is posted here). At the time, the stock was at $35.15. In the following weeks, the stock

trickled down to around $28 – and 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 public

with my concerns.

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

• K12’s aggressive student recruitment has led to dismal academic results by students and sky-high

dropout rates, in some cases more than 50% annually • I wouldn’t be short K12 if it were carefully targeting students who were likely to benefit from its

schools – typically 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 I’m convinced

the 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 K12’s growth – and I believe this trend will

accelerate

• K12’s 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 free

cash flow

Like subprime lending and for-profit colleges, the business makes sense on a small scale but, fueled

by 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 I’m Not

Covering My K12 Short (Appendix C).

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Conclusion

Thank you for your confidence and support. If you have any comments or questions, please call

me anytime at (212) 277-5606.

Sincerely yours,

Whitney Tilson

The unaudited return for the Kase Fund versus major benchmarks (including reinvested

dividends) is:

September Q3 YTD Since Inception

Kase Fund – net 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 Fund

was launched on 1/1/99.

Kase Fund Performance (Net) Since Inception

Past performance is not indicative of future results.

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60

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160

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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

August 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

TOTAL31.0 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

-14-

Appendix A

Green Mountain Coffee: One Of My Favorite

Shorts

Whitney Tilson

2,017 Followers

September 13, 2013

http://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 questions

about Green Mountain Coffee (GMCR) and its accounting in his column that ran in the New

York Times earlier this week, Seeking Answers From Green Mountain Coffee, which begins:

Green Mountain Coffee Roasters’ first-ever investor day is Tuesday, and the company is flying

high.

The stock price of the company, which sells coffee machines under the Keurig brand and the little

K-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 Exchange

Commission. In 2011, the hedge fund manager David Einhorn, who is betting against Green

Mountain’s stock price, delivered a highly critical 110-slide speech at an investor conference,

raising questions about the company’s future prospects and, more seriously, its bookkeeping. He

followed up a year later with another one.

A class-action lawsuit, which was dismissed, quoted anonymous former employees about

suspicious 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 its

real money on the K-Cups. It used to disclose exactly how many K-Cups it sold but stopped

doing so in 2010. Instead, it tells investors the year-over-year percentage growth. Wall Street has

dutifully plugged numbers in to estimate the unit sales.

-15-

Last year, Green Mountain faced expirations of the patents that covered its brewing system. Wall

Street has been monitoring whether Green Mountain will lose market share to new private-label

knockoffs. And indeed, a recent Barron’s article suggested that it was losing share faster than

expected.

A recent disclosure from the company’s new chief executive, Brian Kelley, has revived the

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

warehouse workers.

Because Green Mountain’s investor day will give analysts and shareholders unusual access to

company 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 Street

understands?...

*How wide is the gap between how many K-Cups the company says it has sold and how many

have ended up in customer’s hands? And why?...

*What explains the unusual movements of Green Mountain inventory described by some former

company workers and associates?...

*What is happening with the SEC.’s investigation of Green Mountain, which the company has

said involves its accounting practices?...

Let’s take a closer look at K-Cups, where the math just doesn’t make sense - and the company

isn’t helping with an explanation. At the analyst day earlier this week (see webcast and 188-slide

presentation here), 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 million

brewers, 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 doesn’t even count maybe 15-20%

additional consumption away from home).

But GMCR isn’t selling anything close to this number of K-Cups, per both analysts and the

company (see Eisinger’s article), so what gives? My answer: usage is declining. It makes sense

that the people who bought brewers first are likely to be the heaviest users, so the company and

analysts should be modeling declining attachment rates - but of course they’re not.

When Mark Astrachan, the Stifel Nicolaus’ analyst (and the only one with a “sell” rating on the

stock), asked about this at the analyst day, Green Mountain’s CEO Brian Kelley said: “We don’t

multiply it by 365. (inaudible) You’re applying straight math that we don’t do.” (Yes, he really

said that!) When Astrachan tried to follow up, Kelley said: “We’re not going to get into that

here. That’s not the intent and we’re not going to get into the model in that kind of detail here.”

(The “detail” he’s referring to is the attachment rate of the brewers - one of the most important

metrics there is!)

-16-

An even greater concern is that 700-900 million K-Cups can’t be accounted for. Eisinger writes:

That’s a far cry from 5.6 billion. There seems to be a gap in the United States of about 900

million K-Cups.

What’s going on?

Mr. Brandt said the company declined to give its overall sales volume, but said the IRI number

that I was furnished with was too low. He said a company analysis indicated that this portion of

Green Mountain’s sales should be about 2.7 billion, not 2.6 billion.

Still, even if we use the company’s figure of 2.7 billion, total sales in the United States would be

4.9 billion, or about 700 million K-Cups short of what the company has said. That’s a lot of extra

K-Cups sitting in the channel.

Maybe I’m just being paranoid, but I’ve seen this kind of thing before: in many of the China

frauds, companies were booking fake sales, resulting in fake profits. But that leads to a big

problem for the companies: it’s hard to fake all the cash that should be in the bank as a result of

the supposed profits. The solution? Make overpriced/fraudulent acquisitions and/or fake

excessive cap ex to reduce the cash (that was, of course, never there).

Now go back and read David Einhorn’s 110-slide presentation on GMCR at the Value Investing

Congress on Oct. 17, 2011 (posted here) and look at the high-priced acquisitions on pages 50-53

and pages 68-72 on cap ex. Einhorn estimated that $431 million (58%) of GMCR’s 2012 cap ex

was “unexplained” and 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 didn’t release the slides, but here are my notes:

GMCR’s 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 range

of 1.0% to 6.3%.

GMCR’s cumulative cap ex from 2007-2012 was $1.043 billion and K-Cup shipments in 2012

were 7.1 billion. Divide these two and you get 14.7 cents of cap ex over six years for each K-Cup

produced in 2012. Einhorn compared this to a competitor, which spent 3.8 cents for each K-Cup

produced (buying the same production equipment as GMCR). Again, massive unexplained cap

ex.

Einhorn then turned to the production capacity that GMCR’s competitors were bringing online

and estimated that they would have enough capacity to take 19% market share by the end of 2012

and 26% by the end of 2013.

-17-

Lastly, Einhorn showed that competitors were already selling K-Cups for 22-39% less than

GMCR was, and highlighted price cuts GMCR had taken that would wipe out nearly all of its

profit.

(Obviously these last two things haven’t occurred yet - but that doesn’t mean they won’t…)

Is GMCR committing massive accounting fraud? I don’t know - and I certainly can’t prove it -

but there are a number of warning flags, so I sure can’t rule it out. The company could easily put

a lot of these concerns to rest by providing some obvious disclosure - like number of K-Cups

sold - but refuses to (despite providing highly granular disclosure on most other matters), which

makes me all the more suspicious…

The nice thing about GMCR as a short is that I think it’s a good one even if its accounting is

clean because of its very high valuation (29x trailing EPS and 22x FYE 9/14 estimates (if you

believe them)) combined with its patent loss a year ago, which is resulting in a ton of low-cost

competition entering the market (see page 44-48 of Einhorn’s 2011 presentation and my notes

from his 2012 presentation above).

It’s almost never pretty when a company with a monopoly market share and monopolistic pricing

begins to face competition from low-cost generic producers (think what happens when a drug

goes off patent) - but it can take some time for the competition to emerge and impact the

monopolist’s financials, during which time the monopolist can give whatever guidance it wants

(and you can be sure that Wall St. “analysts” won’t question the pie-in-the-sky guidance).

Witness this week’s analyst day…

-18-

Appendix B

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

Whitney Tilson

2,017 Followers

September 22, 2013

http://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 (posted here)

about my largest short position, K12 (ticker: LRN). In it, I shared the many reasons why I think

the company (and the entire sector) have run amok and why, at 46x earnings, I think the stock is

a 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 its

revenue 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 the

next 12 months, fueled 10 new schools and enrollment cap expansion of 17,000 new seats. And

$0

$100

$200

$300

$400

$500

$600

$700

$800

$900

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

-19-

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

billion annually.

It’s also important to note that online schools sector – schools in which students are supposedly

learning by sitting at home all day in front of a computer, interacting with teachers almost

exclusively online – can be an excellent option for certain students – for example, children

whose pace is extremely accelerated, entertainers, solo athletes, teenage mothers who need to

stay home with their babies, victims of bullying, children with cancer, seizure disorders, peanut

allergies, etc.

K12 has a well-regarded curriculum, reports very high parental and student satisfaction, and has

strong political support, especially among Republicans, for giving parents school choice. Finally,

it’s operating in a space, online learning, that has enormous buzz (think MOOCs, etc.).

So what’s not to like? Let me count the ways…

(Note that my critique is specifically of K12, not all online charter schools, for-profit charter

schools or blended learning schools. While I think the online charter school sector has, overall,

run amok, there are a small number of good online schools – and a few students at even the worst

online schools are doing well.)

Weakening Financials and Aggressive Accounting

In my presentation, I show that K12’s profit margins and free cash flows are low and erratic,

days sales outstanding has doubled in the past five years, the company uses aggressive

accounting techniques to inflate reported profits, and K12’s founder, Knowledge Universe,

distributed its entire stake to its investors only a few weeks ago. But I want to draw particular

attention to this chart, which shows that year-over-year revenue growth – critical for a stock

trading at 46x earnings – has been falling sharply over the past two years, and is projected to fall

further in the next year (to 16%):

Year-Over-Year Revenue Growth

0%

10%

20%

30%

40%

50%

Q1 '11 Q2 '11 Q3 '11 Q4 '11 Q1 '12 Q2 '12 Q3 '12 Q4 '12 Q1 '13 Q2 '13 Q3 '13 Q4 '13

-20-

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 number –

typically those who have a high degree of self-motivation and strong parental commitment. It’s

sort of obvious if you think about it. Do you think you would have learned more during your K-

12 educational experience if you’d sat at home in front of a computer, or gone to school and had

daily face-to-face interaction with teachers? How many of today’s youth – in a world filled with

500 TV channels, texting, video games, etc. – do you think are better off at home rather than

being at school? Lastly, what do you think the answer is for the most at-risk kids, who typically

come from poor, single-parent households, in which the parent has little time or ability to be the

“parent coach” that’s so critical to online education?

Tom Loveless, an education researcher at the Brookings Institution who did paid consulting for

K12 in its early years, said: “The enthusiasts for cyber learning have overstated the potential.

What they keep forgetting is we’re not talking about college students here. We’re talking about

high schoolers and young kids. The idea that parents go to work and leave their kids in front of a

computer—it’s 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, warning

parents 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 former

employees have told me that K12 has adopted a growth-at-any cost mentality in order to support

its richly priced stock. Jeff Shaw, the former Head of School of Ohio Virtual Academy (which

today accounts for 11% of K12’s revenue), told me:

After the IPO, I got discouraged because the company’s priority seemed to shift from academics

to growth – it wasn’t so much about academic achievement but on delivering the promised

enrollment numbers to shareholders.

[K12’s] call centers that were encouraging enrollment and enrolling students who were obviously

ill-suited for learning in a virtual environment. It was apparent to those of us operating schools

that parents weren’t being given the whole story. K12 oversold students’ potential to be

successful and obligated teachers to do things they wouldn’t likely to be able to do.

Eventually, it seemed as though K12’s enrollment strategy was to cast a wide net into the sea of

school choice and keep whatever they caught regardless if the catch was appropriate for virtual

learning or not.

…I am shocked that the stock continues to rise. I think it’s a house of cards that is going to

collapse. It boggles my mind when I read about and hear stories about what’s going on in schools

managed by K12.

Numerous other insiders confirm that what Shaw observed at his school was equally true across

the company (notes from these interviews as well as the entire interview with Shaw are included

in my presentation).

-21-

Deliberately Targeting At-Risk Students

Worst of all, K12 in recent years has been deliberately targeting at-risk students, who are least

likely to succeed at an online school. K12 CEO Ron Packard claims that it’s for noble reasons:

It’s just K12’s culture. We want to help kids. It’s just so ingrained all the way through the

organization about helping as many kids, doing the right thing for kids.

At another time, he said:

We don’t want to be recruiting kids who it’s 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 Teachers

College, Columbia University, who has studied K12 carefully and published reports on virtual

schools, told me:

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

they didn’t sign up, many would be dropouts or go back to juvenile court.

K12’s phone banks have figured out a way to target dropouts and special ed kids. They will sign

up anyone – as long as that warm body signs in periodically, K12 can draw enrollment money

from the district.

It isn’t for some noble reason – it’s because these kids demand the least amount of education.

These aren’t kids and parents who will be knocking on K12’s doors saying, “Hey, you need to do

more for my kid.”

K12 and Packard use this as an advertisement, saying they’re doing noble things and wondering

why they’re being criticized. It’s almost comical. It’s so misleading and conniving.

Again, numerous people confirm Huerta’s account. One person told me that online charters

know that “internet advertising leads to lots of students enrolling, but none succeed. Yet online

charters are spending big money on this.”

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

They push these quotes and “true stories” about 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 success

stories come from homes where there is a large parental support and willingness for the student to

learn. 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 is

actually very well developed) simply will not work for a low educated family who is having a

hard time getting their child to go to a brick and mortar school, let [alone] apply themselves in a

home based environment. They push enrollments on families where the adult in the home cannot

even read, speak, or write in English, knowing that these students are destined to fail.

-22-

While K12 celebrates how many at-risk students it’s serving, I view it as an educational

catastrophe in light of the these students’ need for intensive, personalized instruction and hence

how inappropriate online education is for most of them.

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

K12’s online schools spend far less on teacher and administrator salaries than regular schools, as

this 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 Performance

in Schools Operated by K12 Inc., National Education Policy Center, 7/12.

In light of such low spending, it’s not surprising that many teachers report excessive class sizes

and feeling harried, overworked and unsupported. One teacher I spoke with, who taught English

from 2010-12 at Agora Cyber Charter School, K12’s largest, accounting for 14% of the

company’s 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 if

there were students who didn’t show up, they’d take them out and replace them with another. But

they 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 to

read each of the essays students turned in a try to grade it and spend the appropriate time, but I

was really struggling with that. I couldn’t keep up. I was told to skim over the papers and grade

with a rubric.

For each class, I’d have maybe seven out of 30 students in that particular section attend – and

even among those seven, just because their name was there showing them present doesn’t mean

they were at their computers.

A huge portion of my students never showed up or did anything. I have no clue what happened to

them, though I have no doubt Agora was charging the state for them.

-23-

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 they

were supposed to, it could work – but the majority of students weren’t coming from a family

where 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 Outcomes

In light of K12’s growth-at-any-cost approach, targeting of at-risk students, and low spending on

teachers, one would expect terrible educational outcomes – but they’re even worse than anyone

could imagine.

K12, of course, tries to hide this by producing a slick, colorful 132-page Academic Report

(which you can download here), which claims that for K12’s students in reading, “overall

achievement was 196% of the norm group gain” and in math, “overall achievement was 97% of

the norm group gain.”

These results are virtually meaningless for a number of reasons:

1) K12 measures its students’ academic 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 collection

efforts and more importantly evaluate its analysis of student achievement data, across all

K12 schools;

3) The Scantron test is given in the home, unsupervised and untimed, making it easy for

students to get help from a parent or the internet;

4) Only approximately 70% of eligible students take the test (likely to be the better

performing ones of course); and

5) K12’s purportedly strong Scantron results stand in stark contrast to K12 students’ dismal

results on state tests.

K12 now admits that the Scantron results can’t be relied on (but that hasn’t prevented the

company from peddling them to shareholders, politicians, regulators, etc.). K12 Executive

Chairman 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 group

of K12 students to the national norm, which isn’t appropriate.” The company, he said, needs to

find “a more honest assessment” of student progress.

Let’s look at other, independent measures of K12’s educational outcomes. There are various

ways to measure them, so let’s start with percentage of schools making AYP (Adequate Yearly

-24-

Progress) under the No Child Left Behind Act. As this chart shows, barely a quarter of K12’s

schools 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 Performance in 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 school

performance ratings by state education authorities failed to earn a rating that indicated

satisfactory progress status in 2010-11. Finally, it showed that K12 students trailed state averages

for the states in which K12 operates in both reading and math at every grade level (see charts in

my 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, it’s from a low

base so it’s not clear whether K12 is, in fact, serving a higher proportion of such students

relative to state averages; and

2) Even growth measures show dismal performance.

K12 argues (correctly) that “a more accurate method for measuring student performance is the

progress a student makes over the course of a school year, also known as a “growth measure”, so

let’s 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 all

1,300 elementary and middle schools in the state, including K12’s Tennessee Virtual Academy.

As you can see from this scatter plot of math results, TVA students at the beginning of the school

year are slightly below the state average (x axis), but their academic growth (y axis) is by far the

worst of any school in the state (the results for reading and science are nearly identical, as you

can see in my presentation):

-25-

Math

I think it’s safe to say that there’s almost no learning at all going on at TVA – and I’m not aware

that TVA is much different from K12’s other schools.

In Ohio, home to K12’s second largest school, Ohio Virtual Academy, which accounts for 11%

of K12’s revenues, the state recently reported that the six biggest cyber schools in the state all

got Fs on their state progress reports, with OHVA doing worst of all. The state counts a progress

score of -2 as a complete failure for a school – and OHVA’s score was -27!

Studies of growth metrics in Pennsylvania and Colorado show similar results, which I document

in my presentation.

Lastly, let’s look at graduation rates. As this chart shows, the on-time graduation rate for the K12

schools is 49.1%, compared with a rate of 79.4% for the states in which K12 operates schools:

-26-

Graduation Rate

K12’s Sky-High Student Dropout Rate

Another aspect of K12’s horrific educational outcomes is the sky-high student dropout rate,

which exceeds 50% annually at some schools. K12 has never released this data – it is nowhere to

be found in its 132-page Academic Report, and in a conference call on November 16, 2011, CEO

Ron Packard, while admitting that “[w]e track churn immensely,” said that “we haven’t chosen

to” disclose churn rates to investors. Instead, the company only acknowledges that “online

schools experience relatively high departure rates,” but says that it has “maintained consistent

retention rates over the past five years.” However, on that same conference call, Packer did

reveal that “about 60% of the kids who start with us in September are with us a year later” –

meaning a 40% churn rate!

This is consistent with other data that various researchers and journalists have been able to piece

together on a school-by-school basis. For example, Journalist Roddy Boyd of The Financial

Investigator, in an article entitled, K12: A Corporate Destiny Manifested, collected data for the

2010 school year for four of K12’s largest schools in Pennsylvania, Ohio, California and

Colorado and calculated that student churn ranged from 24-51%. Another study of online schools

in Colorado, of which K12’s is the largest, found that “half the online students wind up leaving

within 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 K12

doesn’t do this. Instead, it manipulates student counts and underreports student truancy and

withdrawals to increase its profits.

A study of 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, an article in the

NY Times reports:

Several current and former staff members said that a lax policy had allowed students to remain on

the rolls even when they failed to log in for days. Officials of the Elizabeth Forward School

District in western Pennsylvania complained that Agora had billed the district for students who

were not attending.

-27-

One of them was a girl who had missed 55 days but was still on the school’s roster, according to

Margaret 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 nonprofit

501(c)(3) entities, for which the IRS code states: “none of its earnings may inure to any private

shareholder and individual.” This presents a vexing problem for K12, but it gets around this by

signing long-term contracts with local nonprofit entities to provide management and other

services. While this type of arrangement doesn’t technically violate IRS regulations – nonprofits

contact with for-profit businesses all the time – it’s critical that the nonprofit be a truly

independent entity with an independent board of directors looking out solely for the nonprofit

mission of the organization.

This doesn’t appear to be happening with many of the nonprofit charter schools K12 contracts

with. Rather, the relationship is often so rife with conflicts and self-dealing that K12 effectively

controls and operates the schools – and siphons off all of the profits for itself. Consider that:

K12 employees sometimes serve on the board of the nonprofits and, worse yet, are

sometimes involved with their very creation. (One person told me that “Many of these

nonprofit 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 Treasurer – a

particularly blatant conflict of interest.

K12 often reviews its own billings and then fails to provide the boards with detailed

accounting for its expenditures.

The contract with K12 typically results in the nonprofit entity reporting minimal “profits”

or, often, a loss, which K12 then “forgives” (in its latest 10K, K12 notes that: “We take

responsibility for any operating deficits incurred at most of the Managed Public Schools

we serve.”).

Jeff Shaw of the Ohio Virtual Academy told me:

It was rather obvious to me as Head of School that K12 wasn’t always interested in reducing the

non-profits’ expenses 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 was

soaked 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 OHVA

would show a small surplus for the fiscal year.

The volunteer governing boards assume a limited role in the school’s overall governance. The

boards tend to put their faith in K12 and count on it to do what is in the school’s best interest. A

Head of School walks a fine line in order to balance the best interests of both parties. In many

cases, the boards know only what K12 wants them to know. It’s like the fox guarding the

henhouse.

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For an in-depth expose of how this works at a K12-affiliated school in Newark, see this article in

the Newark Star-Ledger last week: Newark charter school contract with K12 Inc. shows

influence 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 most

states’ laws and IRS regulations.

The IRS appears to be looking into this (click here). If it acts, the consequences could be dire for

K12.

K12’s Political and Lobbying Prowess In light of so many red flags around K12, one might ask why states haven’t acted more quickly

and forcefully to rein in the company. There are many answers, but the most important is money

and politics. One person I spoke with told me that in many states, “the Republican legislatures

are bought and paid for” by K12. And the New York Times reported that: “An analysis by the

National Institute on Money in State Politics concluded that K12 and its employees contributed

nearly $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 K12’s

Agora Cyber Charter School and the nation’s largest online charter school sector, with 16

schools and 35,000 students. The Auditor General has released two scathing reports (click here

and here), calling for a 35% funding cut, because “PA spends about…$3,500 more per student to

educate a child in a cyber charter school compared to the national average, which adds up to

$315 million in annual savings.”

Yet the legislature hasn’t acted. Why? Perhaps it’s because, as the New York Times reported, in

Pennsylvania K12:

Has spent $681,000 on lobbying since 2007. The company also has friends in high places.

Charles Zogby, the state’s budget secretary, had been senior vice president of education and

policy for K12. In a statement, Mr. Zogby said he still owned a small number of K12 shares, but

did not make decisions specifically affecting online schools.

However, increased scrutiny of PA online schools could result from a federal indictment of the

founder and former CEO of Pennsylvania’s largest online charter school, who is alleged to have

stolen nearly $1 million in public money and improperly diverted a total of $8 million to avoid

federal income taxes.

In my presentation, I document similar tales of K12’s political influence in Tennessee, Ohio,

Massachusetts, Idaho and Maine.

K12 Is Encountering Regulatory Problems Across the Country

Despite its political influence, however, K12 is increasingly unable to hide its bad acts and

terrible results, so it’s beginning to encounter more and more regulatory problems across the

country. In Tennessee, for example, after the off-the-charts-bad results noted above, state

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Education Commissioner Kevin Huffman declared the Tennessee Virtual Academy’s results

“unacceptable” and demanded “an immediate turnaround”, and the state turned down K12’s

application to open a second school in the state. And parents are figuring it out as well, as

enrollment has plunged by two thirds.

K12 is also facing scrutiny in Florida and Georgia, where investigations (click here and here)

revealed K12 employees covering up the illegal use of uncertified teachers, and class sizes of up

to 275 students. And in Colorado, K12 is scrambling to launch a new school after getting hit with

a double whammy: the board of the Colorado Virtual Academy has fired K12, and the district

that hosted the school has said it won’t renew COVA’s authorization. Local media (click here

and here) reported that “the school’s 22 percent graduation rate, high student turnover and

questions about COVA’s management company, K12 Inc., originally led district staff to

recommend denying the virtual school’s multiyear charter application.”

Lastly, K12 was denied online schools recently in New Jersey, North Carolina and Maine, which

means that K12 is not opening schools in any new states in the next year.

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

Public Policy Recommendations

States are responding to the online charter school sector having run amok by adopting one or

more of the following changes, none of which are aimed specifically at K12, but all of which

have 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 provisions” for all charter schools so, for example, if a school is in the

bottom 25% of all charters in the state, it automatically won’t get its charter renewed. Or,

if a school gets an F for two or three consecutive years, it’s automatically closed (though

there’s usually an appeals process). This applies to all charter schools, but would

disproportionately affect the low-performing online schools.

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

authorizers.

6) Prevent charters from district/authorizer shopping.

I actually think the most elegant solution would be to let online charters pick and choose their

students, and then tie a meaningful portion of what they are paid to each student’s successful

completion of a course and demonstrating proficiency/growth. This would incent schools to help

students succeed and penalize them for enrolling those unlikely to succeed. (Note that states

would have to change their rules to allow this, as most have laws that prevent any charter from

being selective.)

The result would be online charters only serving a small fraction of the students they do now –

which would be a very good thing.

-30-

K12 Needs to Shrink

I don’t believe that K12 should go out of business. As I noted at the beginning of this article, the

company has a strong curriculum and online schools can be appropriate for certain students. But

K12 clearly needs to shrink substantially in order to properly serve students and states/taxpayers

– which 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 can’t see how K12 can get significant increases in student academic growth under their current

model. They need to say, “Let’s not focus on growth – let’s first get the academics right and then

look into growing in a controlled fashion so as not to sacrifice student achievement for growth. If

student really achieve, the company will grow for the right reasons.

Why would anyone in their right mind sacrifice student achievement for company growth? Those

of us at the school level sometimes felt as though Ron Packard was charging ahead full speed to

grow, 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 the

virtual school setting, you’re doing that student a terrible disservice. You have sacrificed a real

person for your own economic gain. And I think that’s immoral and unethical.

K12’s managed schools are public schools. Every student has a right to attend, but as education

professionals we have a responsibility to see that students are enrolled in a school most

appropriate for their needs. In the end, it’s the parents and students who make the ultimate

decision regarding what school they attend. Our obligation as professionals is to present them

with the realities of virtual schooling and how this school choice option may or may not be the

best choice. The profit motive should not guide this process – but at K12 it appeared to.

There’s a good case in Colorado of how shrinking a school can lead to better outcomes for

students, as this article documents:

One of Colorado’s 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 Colorado’s southeastern border with New Mexico ran the

state’s third-largest online school, enrolling more than 1,000 students. By 2010, the school had

dropped back to sixth in size, enrolling 427 students.

Branson assistant superintendent Judith Stokes, who oversees the online school, said the growth

and lagging scores – combined with a critical 2006 state audit of online programs – prompted the

ranching community’s school board to slow down.

“We had grown very, very rapidly at one time, before the audit, and at that point, we pulled

back,” she said.

Stokes said growth slowed when the school focused on ensuring families understood the online

program before enrolling because, “If you’re looking for easy, it’s not us.”

-31-

In spring 2011, Branson online students beat the statewide average in proficiency in reading and

were six percentage points short in math.

Conclusions and Catalysts

K12 is pursuing a growth-at-any-cost strategy that is harming countless students, likely violating

numerous state and federal laws and regulations, and wasting hundreds of millions of dollars of

taxpayer money every year.

What the company is doing is becoming increasingly well-known so states – and possibly the

IRS – are waking up and thus the company faces increased regulatory risks. The likely result is

that K12 will not only miss its growth projections (analysts project that K12’s revenues and

profits will grow 16% and 32%, respectively, in the next year), but will actually have to shrink

substantially in order to properly serve students (and states/taxpayers).

A possible short-term catalyst is that the company could disappoint when it issues FY 2014

guidance in mid-October and/or when it reports Q1 ‘14 earnings in early November because

growth has been slowing, preliminary enrollment data I’ve seen for a few schools are weak, and

analysts seem to be factoring in rising margins and continued growth in revenue per student, both

of which I think are unlikely.

Trading at 46x trailing earnings and 35x next year’s estimates, K12’s stock is priced for

perfection, yet its future is likely to be far from perfect.

Addendum

Since I made my presentation public last week, I am even more certain that my analysis of K12

is 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 into

the results, the business model, the organization, and discovered much of what you lay out in

detail in your presentation. As I said, they are terrible and epitomize everything that we should be

working against in the ed-reform movement.”

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

terrible reputation.”

“You’re totally right about K12 and, on top of it, they lie all the time. It’s naïve to trust anything

they say. So I’m not sure if their schools can be fixed, at least under the company’s current

leadership. There’s no such thing as a successful online school in the entire country. To be sure, it

works well for some students, but I’d guess only 15% of the ones cyber charters are currently

serving.”

Finally, lest you think I’m just talking my book for a quick trade, it won’t take you long to verify

that’s not how I operate. Agree or disagree with me, my views are based on the company’s

fundamentals and are genuinely held, irrespective of my funds’ position in the stock. Also note

that I am not short K12’s stock because I oppose charter schools, online education, or for-profit

schools. To the contrary, as you can see from my bio, I’m a champion of new models of

education, whether for profit or nonprofit, as long as they work for kids.

-32-

Appendix C

Why I’m Not Covering My K12 Short

Whitney Tilson

2,017 Followers

October 10, 2013

http://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 you’re

gonna get.’” – Forrest Gump

That line came to mind as I was thinking about the wild turn of events the last few days vis-à-vis

K12. The stock fell 38% yesterday and has been cut in half since I went public with my concerns

about the company (and my funds’ short position) three weeks ago at the Value Investing

Congress (I also wrote about it here on Seeking Alpha; the latest version of my K12 presentation

is posted here).

But let me start the story three days ago: on Monday night, I went to a dinner hosted Mayor

Bloomberg at Gracie Mansion for folks attending the Education Nation conference that was

going 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 I’ve said

and written very publicly about him and his company in the last three weeks, I feared an ugly

confrontation so I demurred.

But not long afterward, while I was talking to some other friends, she came over with Ron and

introduced us. We shook hands and he said he’d read my presentation and thought I got some

things wrong. I said I’d love to hear what and we started talking. And talking and talking...

Somebody gave a speech – and we kept talking. Then some performers sang – and we moved to

the side of the tent and kept talking. The party ended, everyone left, the crew folded up all the

tables, and the clock struck midnight (3 ½ hours later) – and we kept talking. We figured they

were going to kick us out, so we left and walked a few blocks up to the corner of 88th

and Lex –

and kept talking. Finally, at about 12:45am, my worried wife called me and said, “Where are

you?!” I said, “You’re never going to believe who I’m standing here talking to…” So after 4 ½

hours, we both hopped into cabs and went our respective ways.

I have been shorting stocks for over a decade and have gone public with my short thesis on a

handful of occasions and, as a result, have been sued, deposed, subpoenaed and investigated

(there are good reasons why very few short sellers ever speak publicly) – but I can’t recall the

CEO of a company I’m short being willing to engage in a lengthy, frank conversation like Ron

-33-

and I had on Monday. (My only similar experience was when Reed Hastings published a

response in Seeking Alpha to my article in December 2010 in which I detailed why I was short

Netflix at that time; after the stock collapsed, I went long it and still hold it – it’s been one of my

best investments ever.)

I want to respect the privacy of our conversation, so I’m not going to detail what Ron said, but

do want share some of my thoughts.

First, I liked Ron. I found him very personable, I think he honestly believed everything he said to

me, he didn’t get angry or defensive when I pushed him on some pretty tough stuff I’ve heard

and written about K12, and we have a lot in common: early in our careers, he was at McKinsey

and I was at BCG; we’re both interested in stock picking (long and short); and of course we’re

both passionate about improving and reforming education and the role technology can play. I

think Ron is an incredible visionary and entrepreneur, and he’s built an important and innovative

company. I now see that there’s a lot of good in K12.

Before I met Ron, I thought he and the other leaders of K12 were deliberately targeting and

enrolling kids they knew were certain to fail in order to maximize their revenue, run their stock

price up, and make a few more millions for themselves. I no longer believe this about Ron. I

think he wants to do right by kids and that, if given the option of taking a student he knew

wouldn’t be successful at a K12 school, but would be highly profitable for the company, he

wouldn’t want that student. He believes – and I think he’s right – that there’s lots of room for the

company to grow for a long time serving only students who will benefit from a K12 school.

So I don’t think there was ever a meeting at K12 in which the company decided to pursue

maximum growth at any cost, even if it resulted in a lot of kids enrolling who were highly likely

to fail and suffer a major educational setback. Yet even if it wasn’t intended, that’s exactly what

I’m convinced is happening right now for a meaningful percentage of K12’s students (I’ve heard

estimates as high as 85%, based on the very low number of K12 students who are demonstrating

proficiency).

I think that a number years ago (coinciding, not coincidentally, with the company going public in

late 2007), K12, in balancing its desire for growth vs. doing right by kids, let that balance get

way out of whack.

I’ve seen it happen at countless companies – the board and management team get on a treadmill

of scrambling to meet analyst expectations every quarter, they start to think (albeit perhaps

subconsciously) that it’s their job to keep the stock price up, and they start doing all sorts of

unnatural, short-term-oriented, unethical and, in the worst case, illegal things to keep the game

going.

Fueling this is the genuine passion Ron and others at K12 have for online education. They have a

missionary’s zeal to make it available to the world, which is great, but I also think that blinds

them to the reality (as I see it) that a full-time online school is a terrible educational option for

the majority of students, especially at-risk ones. Thus, I think it’s incumbent upon K12 to do its

absolute level best to enroll only those students for whom one of its schools is the best option.

-34-

Ron said that K12 is already taking steps to ensure this (and perhaps the tepid FY 2014 guidance

the company issued last night in part reflects this), but I’m 100% certain that there’s a lot more

that K12 can and should be doing.

So with the stock down so much, am I covering my short? In a word: No. In light of the new

guidance (which, while below expectations, still showed enrollment growth of 5.7% year over

year), I don’t think K12 has come to grips with the reality that it doesn’t just need to slow its

growth, but must actually shrink its enrollment – and not by a little, but by a lot – to weed out the

students who are not appropriate for a full-time online school and thus are not engaging or

succeeding. Instead, my read of K12’s recent press release is that it’s doing what most

companies in this situation do – deny reality, rip the Band Aid off slowly, and prolong the pain.

What K12 really needs to do is come clean with all of its stakeholders (students, parents,

investors, employees, regulators, legislators, etc.) and say something like:

While we didn’t intend to do so, we grew too fast in recent years, resulting in many students

enrolling in K12 schools who shouldn’t have. That’s not only obviously bad for those kids, but is

also bad for us in the long run. Consequently, going forward, we are going to focus 100% on

improving its academic outcomes, both by doing everything we can to ensure that only kids who

are well positioned to succeed in a full-time online school enroll, and also by investing heavily to

better serve our increasing number of at-risk students.

If K12 did this, for sure its revenues and profits would fall in the next year or two and the stock

would get hit (again), but I’m convinced that the company would be far more valuable in the

long run. Look at what’s happened to Netflix’s stock since it stopped trying to be profitable, and

look at Amazon since its inception – it’s basically never been profitable! Investors don’t care

about near-term profits as long as they’re convinced that the company is a growing market leader

that, once it matures, will be highly profitable down the road (sometimes even very far down the

road).

Once K12 takes these steps, I will cover my short – and might even go long the stock!

-35-

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