K12 Backed by Milken Suffers Low Scores as States Resist

Tucker Family
Houston Tucker, left, who used to work for K12 Inc. as a marketing director, pulled his two sons out of an online public school run by the company. Source: McKenna Tucker via Bloomberg

K12 Inc. was heralded as the next revolution in schooling. Billionaire Michael Milken backed it, and former Florida governor Jeb Bush praised it. Now the online education pioneer is failing to live up to its promise.

Plagued by subpar test scores, the largest operator of online public schools in the U.S. has lost management contracts or been threatened with school shutdowns in five states this year. The National Collegiate Athletic Association ruled in April that students can no longer count credits from 24 K12 high schools toward athletic scholarships.

While the company says its investments in academic quality are starting to pay off, once-soaring enrollment at the more than 60 public schools it manages has dropped almost 5 percent. Targeted by short sellers, who benefit from a company’s decline, K12 shares have tumbled by two-thirds since reaching a near-record high in September 2013. Companies controlled by Milken have moved on, shifting their shares to investors.

K12 grew too fast and invested too little in instruction, said Houston Tucker. In 2012, he pulled his two sons out of a K12 virtual school in Tennessee and last year quit his job as a marketing director at the company.

“In the early years, K12’s mission was something to rally around,” Tucker said. “It was brand new in the world of education. The K12 I joined isn’t the one I left.”

Homeschool Families

K12, which started by offering an online curriculum to homeschooling families, now manages virtual charter schools -- online versions of the privately operated public schools favored by Presidents George W. Bush and Barack Obama. K12 lobbied successfully for laws permitting these online schools, which enroll students statewide.

Like for-profit colleges, which also rely on taxpayer funding, K12 has faced criticism from educational traditionalists of its academic results and marketing tactics. Some true believers in virtual education, like Tucker, have also grown disenchanted with K12.

Its enrollment has expanded to include a disproportionate number of low-income students and those who have fallen below grade level at other schools. K12’s travails indicate that online education, while appealing to a digitally savvy generation, may be appropriate for a narrower group of students than boosters originally hoped.

“Virtual education is here to stay,” K12 co-founder Ron Packard said. “For a large number of students, it works great. It may be their best alternative. It may not work for every child.”

Failing Grades

Of the full-time online schools assigned ratings by their states, only one-third were considered academically acceptable in 2012-2013, the National Education Policy Center at the University of Colorado reported this year. The percentage of K12 students achieving proficiency on state math and reading tests is generally below state averages, according to the company’s 2014 academic report.

Ohio Virtual Academy, which accounts for 10 percent of K12’s annual revenue, received failing grades on a state report card last year for student test-score progress and graduation rates. Only 37 percent of its ninth graders receive diplomas within four years.

K12 says its results reflect the students it now attracts. Sixty-two percent qualify for free or reduced-priced lunches, exceeding the national average of 49 percent. K12 can’t limit enrollment to children best suited for online education because its schools, as public institutions, must be open to all, Packard said.

‘Reputational Issue’

The company points to bright spots. In certain subjects, K12 surpasses school districts with comparable demographics in states such as Louisiana, Georgia, Ohio and Texas, it said. As an example, it cited K12’s virtual school in Texas, which has reading scores similar to the state average and higher than the Dallas district.

Scores at Ohio Virtual Academy have improved for the past three years, the company said. Its graduation rate is misleading because its “highly mobile” students often transfer to other schools, it said.

K12 has a “reputational issue” because of its test results, Chief Executive Officer Nathaniel Davis said in a phone interview. The company, based in Herndon, Virginia, is starting to improve scores by hiring staff and spending $75 million to $85 million a year on curriculum and technology, executives said.

“I’m very proud of what the organization is doing,” said Davis, former CEO of XM Satellite Radio. “I understand the questions people have about what happened in the past. All I can say is we’re fixing a lot of those problems and we’re now beginning to see the results.”

Learning Coaches

From the start, K12 attracted families for whom online education has particular appeal, including homeschoolers, athletes, and those recovering from illness or accidents. It was a way to give children, even in remote areas, access to a free charter-school education on the Web, with funding that usually flows to traditional public schools. Kindergarteners to high school seniors could attend from their bedrooms or basements. In early grades, parents acted as unpaid “learning coaches.”

Trenton Baldrey, who attended a K12-run online school in Colorado from kindergarten until his 12th-grade graduation in 2013, said that its flexibility enabled him to volunteer with a theater production company and still take a rigorous load of Advanced Placement courses.

“I had an absolutely wonderful experience,” said Baldrey, 19, now a sophomore majoring in business and computer science at Rensselaer Polytechnic Institute in Troy, New York. “The transition from Colorado Virtual Academy to college was the easiest thing on the planet.”

Rapid Growth

K12 expanded rapidly, and now operates in 33 states and the District of Columbia. Volunteer boards, largely made up of parents, hire for-profit K12 to manage the nonprofit charter schools.

From 2008 until last year, enrollment at schools K12 manages almost quadrupled to more than 120,000, rivaling some of the largest U.S. school districts. That figure represents about one-third of enrollment at fully online schools, though less than 1 percent of all U.S. schoolchildren. Revenue -- from school management contracts, sales of curriculum materials, and other sources -- rose to $920 million in the year ended in June from $226 million in 2008.

The company advertises online and on television. A job posting for a K12 “enrollment sales consultant” said applicants should “be able to close the sale with a customer” and “meet or exceed team and individual sales goals,” according to a 2011 article in Bloomberg Businessweek.

“Compensation for enrollment counselors, both then and now, is predominantly salary based,” K12 said in an e-mail.

‘Enroll, Enroll’

Working in call centers, recruiters received bonuses tied to enrollment and were pressured to meet “unrealistic quotas,” with top performers offered lunches, cash and gifts, according to a 2012 shareholder lawsuit by the Arkansas Teacher Retirement System. The company’s philosophy was “enroll, enroll, enroll,” an anonymous former employee said in the class-action complaint in U.S. District Court in Alexandria, Virginia.

K12 denied any wrongdoing and settled the suit in 2013 for $6.75 million, according to a securities filing. Davis said the company settled to save the expense of litigation. The plaintiff dropped the allegations of aggressive enrollment practices “for lack of factual support,” K12 said.

Investor Bet

At a September 2013 investment conference, hedge-fund manager Whitney Tilson cited K12’s recruitment methods as one reason why he was shorting its stock, along with weak test results and high student turnover. In a short sale, investors sell borrowed shares, and profit when a stock falls by buying cheaper shares that are returned to the lender.

Three weeks later, shares fell 38 percent in one day because of an announcement about weaker enrollment. Tilson, the managing partner of New York hedge fund Case Capital Management, said one of his funds made $500,000 from the decline in K12 shares.

As a former board member of the National Alliance for Public Charter Schools, Tilson is an unlikely opponent of K12, he said.

“I’m not against charter schools, I’m not against for-profits, I’m not against online,” he said in an interview. “I’m just against all of those things run amok.”

In a statement, the company said most of Tilson’s analysis was “incorrect or tainted” because he “economically benefited from a negative report.”

Dropping Out

The company said student turnover is expected because 20 percent of children enroll to address a short-term need, such as illness, and return to regular schools once the problem is solved. Other students drop out in the first few months because they find courses more difficult than they expected, it said.

Early investors who bet on K12, including co-founder Packard, have also benefited. A former Goldman Sachs Group Inc. banker, Packard stepped down as K12 CEO last December. He’s now CEO of Pansophic Learning LLC, a McLean, Virginia, company developing online education programs outside the U.S.

Packard netted $21 million from share sales and exercising options since K12’s 2007 initial public offering, according to InsiderScore in Princeton, New Jersey, which analyzes such transactions. In the three months before the share drop in October 2013, Packard made about $3 million in profit from option-related sales, InsiderScore said.

Price Targets

Packard said he set up a plan in June 2013 to exercise stock options within two years of expiration and sell them weekly based on preset price targets. As K12’s share price climbed, reaching those targets, his sales automatically accelerated, he said.

He was no longer involved in day-to-day management after Davis became executive chairman in January 2013, and as a result didn’t know about the enrollment woes that sent shares tumbling, he said in a phone interview.

Like Packard, Michael Milken was a key figure in K12’s founding. A health-care philanthropist and former 1980s junk-bond financier, he served 22 months in prison after pleading guilty to securities fraud in 1990.

Milken has long supported for-profit education. His company, Knowledge Universe, operates more than 2,000 preschools as well as Asian International College in Singapore.

Larry Ellison

He and his brother Lowell, along with Oracle Corp. founder Larry Ellison, invested $10 million in K12 when it was founded in 2000. Lowell Milken is chairman of the family’s philanthropic foundation.

A company controlled by Ellison, which once owned 9.3 percent of K12, listed no shares at the end of 2009, securities filings show. Through an Oracle spokeswoman, Ellison declined to comment.

Knowledge Universe and other companies controlled by the Milken brothers once owned a 19 percent stake in K12. In September 2013, a month before K12’s disappointing results were announced, the companies distributed about $270 million in shares to unnamed limited partners and shareholders including the Milkens, a securities filing shows.

After the brothers gave shares worth $30 million to charity, they ended up with a 4 percent K12 stake, valued at $63 million on the day of the September transaction. Filings don’t indicate whether investors in the Milken-related companies, or the brothers, sold shares. Knowledge Universe still lists K12 on its website as one of “our institutions.”

Milken Transaction

Michael Milken “was never on the K12 board and was not involved in management,” his senior adviser, Geoffrey Moore, said in an e-mail. Moore declined to say whether Milken sold shares. Milken also “had no idea what partners did with their shares,” Moore said.

The partnership distribution of K12 shares “had been planned for a long time,” Moore said. Milken “certainly did not know the company’s financial results in advance. He learned those results at the same time as other shareholders and the public.”

A spokeswoman for Lowell Milken’s foundation said he was unavailable for comment.

Former Florida Governor Jeb Bush was also a prominent supporter. Bush, who promoted charter and online schools as governor, had praised K12’s Nevada Virtual Academy for helping two seriously ill Las Vegas teenagers earn high school diplomas and go to college.

Jeb Bush

“Students in these programs can learn anywhere, at any time,” Bush wrote in January 2013 on CNN’s website.

The Foundation for Excellence in Education, which Bush founded and chairs, supports “expanding quality education options for parents, including charter schools,” spokeswoman Jaryn Emhof said in an e-mail response to questions about K12’s recent problems.

Still, “charter schools -- whether traditional, virtual, or blended -- should be closed if students aren’t learning,” Emhof wrote.

Pennsylvania, the first state where K12 won approval to run a virtual school, illustrates the reversal in its fortunes. There, a volunteer board of parents selected the company to manage Agora Cyber Charter School. K12 received an average of $11,039 per Agora student last year in government money, including both regular and special education.

In January, Agora told parents on its website that the federal government had designated it as a “focus school,” meaning it ranked in the bottom 10 percent of schools serving disadvantaged students because of low test scores and a graduation rate below 50 percent.

‘Massive’ Turnover

Michael McNulty teaches online high school math to 150 Agora students, and sometimes more because of “massive staff turnover,” he said. “We were scrambling to hire enough teachers.”

As enrollment surged, Agora drew more students who had been truants at regular schools, and they didn’t show up online either, neglecting to log on or hand in homework, he said.

Student-teacher ratios in online schools are “generally higher than traditional classrooms where space constraints and classroom management are issues,” K12 said. Agora students’ improvement on test scores is “competitive with other Pennsylvania cyber charter schools,” K12 said.

Agora monitors truancy, contacting families and school districts to get students back in class, the company said. It removes students from its rolls after 10 consecutive unexcused absences, it said.

Lost Contract

Agora’s board decided in August that it will hire its own staff after K12’s management contract expires next year. While Agora will keep using K12 curriculum for three years, losing the contract is expected to cost K12 about 10 percent of its total revenue, said Trace Urdan, an analyst with Wells Fargo Securities in San Francisco.

“I’m thrilled” with K12’s departure, McNulty said. “I know a lot of people who are ready for a change.”

Agora’s board declined to comment. Boards seek to manage cyber schools themselves because they believe -- wrongly -- that they can save money, K12’s Davis said.

Another of its early online schools, Colorado Virtual Academy, didn’t renew its contract with K12, which ended in June, according to Brian Bissell, the board chairman. Like Agora, Colorado Virtual will still use K12’s curriculum.

With test results lagging, the board decided it wasn’t getting its money’s worth from K12, said Bissell, who has three kids at the school.

Colorado Discontent

Over the past five years, the school received $125 million in taxpayer money, with $100 million flowing to K12 for management, technology, curriculum and fees, he said. Parental discontent was growing, he said.

“We weren’t serving students well,” Bissell said.

Bissell’s criticisms are “distorted,” the company said. Parent satisfaction was “relatively high,” with almost three-fourths saying they were likely to re-enroll their children, and test scores were in the middle of Colorado online charter schools, it said.

For the fees it charged, K12 trained teachers and provided thousands of students a year with “a full array” of services, according to the company.

Colorado Virtual Academy works best for students whose parents are involved in their education, said Jenifer Baldrey, who enrolled three of her children at the school -- including Trenton, the Rensselaer student.

The school “started absorbing too many individuals the rest of the system had dropped,” Baldrey said. “The families who expected the public schools to take care of them also expected K12 to take care of them.”

Tennessee Critics

In Tennessee, education commissioner Kevin Huffman is moving to close a K12-managed school unless it can improve results by the end of this school year. Tennessee Virtual Academy has test results “in the bottom of the bottom tier” and is an “abject failure” in improving student outcomes, Huffman said in a telephone interview.

Tucker, the former K12 marketing director, said that one of his sons had scant feedback from his teacher at Tennessee Virtual. The school put profit ahead of education, said Tucker. He now works as a consultant, helping regular public schools with online programs.

Students who leave after a year do “significantly better” at traditional schools, said Huffman. A member of Chiefs for Change, a group endorsed by Jeb Bush’s foundation, Huffman said he is a “huge supporter” of charter schools.

Like many employees who leave a company, Tucker has a “limited view of the business,” K12 said. Tennessee Virtual students show improvement in their second and third years at the school, Davis said. The school’s reading and math scores have gone up in the past two years, K12 said.

Michigan, Massachusetts

Authorities in Michigan and Massachusetts have also said K12-related schools will close if results don’t improve. K12 manages the Michigan school and supplies the academic program for the one in Massachusetts. Both schools have strong plans to boost results, K12 said.

At the same time, K12 has run afoul of the NCAA, whose decision not to recognize academic credits from two dozen K12 schools deals a blow to their students’ chances for athletic scholarships or college sports participation. At other K12 schools, students must get the regulator’s approval on a credit-by-credit basis.

The NCAA began examining non-traditional programs such as online schools because more student-athletes were taking “an inordinate number of courses that were completed in a matter of days” or lacked “meaningful student-teacher interaction,” NCAA spokeswoman Michelle Brutlag Hosick said in an e-mail. While Hosick declined to discuss K12, Davis said that the NCAA criticized its level of student-teacher interaction.

‘Highest Standards’

The NCAA accepts credits from many other online programs, including Pearson Plc’s Connections Academy.

The 24 K12 schools meet the “highest standards and the NCAA’s requirements,” the company said. The NCAA hasn’t set a “clear rubric” for student-teacher interaction, it said.

K12 points to students such as Scott Snow on its website. He attended K12’s Idaho Virtual Academy and was a member of the U.S. Ski Team from 2010 to 2012.

Shep Snow, Scott’s father, called the K12 curriculum “top notch.” The family argued for a year with the NCAA to get Scott’s K12 credits approved so he could ski for the University of New Mexico, Shep said.

Now a 21-year-old sophomore at New Mexico, Scott said that the K12 program prepared him well for college while enabling him to fit in ski races during the winter. He scored more than 2000 out of 2400 on his SAT, Scott said.

“K12 was great for me,” Scott said. “If I needed a teacher, they would get back to me right away.”

SEC Questions

The U.S. Securities & Exchange Commission has also taken an interest in K12. In letters, the agency this year asked the company for more public disclosure of student attrition rates and test scores.

Davis said the company doesn’t make attrition rates public because they are competitive information and are measured differently from one state to another. For the past two years, the company has provided detailed information on state test results, holding “ourselves accountable for the same test scores that every other public school does,” he said.

After three years of “relatively flat and even sometimes declining” scores, the percentage of K12 students achieving proficiency on state tests rose in many schools this year, especially in math, according to the company.

The NCAA scrutiny and the lost management contracts are temporary setbacks, Davis said.

“New markets will continue to open up,” he said. “We will be able to grow the business, and most importantly, our product is strong enough and good enough that customers are going to want to stay with us.”

Before it's here, it's on the Bloomberg Terminal. LEARN MORE