Is Edison Schools a Rule Breaker?[Fool on the Hill] May 4, 2000

An Investment Opinion

Is Edison Schools a Rule Breaker?

By Bill Barker (TMF Max)
May 4, 2000

President Clinton is today wrapping up a four-day education tour with apparent praise for the exploding field of charter schools. The president pointed out that during the last seven years, the number of charter schools has expanded to about 1,700 from a mere one back in 1992. While some Republicans have countered that Clinton's taking credit for the expansion of charter school growth is akin to Al Gore's declaration that he invented the Internet, who gets to take the credit is not the issue -- the issue is the trend.

One company capitalizing on the nationwide dissatisfaction with the status quo in our public school system is my younger sister's employer, Edison Schools (Nasdaq: EDSN). Founded in 1992 by Christopher Whittle, Edison is the leading private manager of public schools. After putting three years of research into an innovative curriculum, it took over the management of four existing public schools on a contract basis in 1995, and has been roughly doubling its school base annually ever since. This year Edison is running 79 schools, with roughly 37,000 students enrolled. A look at Edison's annual revenues (in millions) gives some idea of the growth here:

  1995:    0.0
  1996:   11.8
  1997:   38.6
  1998:   69.4
  1999:  132.8
 2000E:  227.0
Looking ahead, continued revenue growth in keeping with that of the past seems pretty likely especially considering the size of the market here. Edison recently signed a contract with the Dallas Independent School District for the fall of 2000 to serve up to 6,500 students, with the potential for expansion in the future. Additionally new contracts have been signed to start schools in Pennsylvania, Delaware, New Jersey, Maryland, Wisconsin and New York, bringing the total number of states with Edison-managed schools up to 20.

Furthermore, at least as far as I can tell, Edison has managed to renew all of the contracts with its original schools. There's general customer satisfaction here, as Edison can point to some positive general test score improvements in the schools at which it has been in charge for a few years. (The American Federation of Teachers disputes Edison's results.)

Simple revenue growth isn't really the be all and end all of a worthy company to invest in. Edison hasn't exactly been translating that phenomenal top-line growth into earnings yet. Looking over the historical cash flow per share figures is likely to give pause to even the staunchest Edison supporter:
  1995   -$2.27
  1996   -$1.63
  1997   -$1.27
  1998   -$3.10
  1999   -$6.28
Of course Edison has been investing aggressively for future expansion, but the figures raise the question of at what point Edison will have built up enough of a critical mass to realize some economies of scale here. That just isn't particularly easy considering the business model. Edison receives no more money for taking over the management of a school than the public school system would otherwise have paid to run the school itself. Since Edison's plan calls for a longer school day and year than the normal public school schedule, it isn't all that easy to find a profit left over after providing all that it currently plans to.

Though there are some legendary inefficiencies in the administration of public schools, any efficiencies that Edison might provide are currently thwarted by operating a school system spread throughout 20 states. It will have to get much, much bigger to really enjoy some economies of scale here. (By the way, please don't flame me if you disagree about the "legendary inefficiencies" line. I'm relying in part of my schoolteacher/wife's analysis in this regard -- so send nasty e-mails to her if you have to.)

At any rate, profits aren't there yet and they don't appear to be coming in the near future. Current analyst estimates call for losses per share of nearly a dollar this year and almost as much next year. If Edison is an attractive stock at all -- and I'm not sure that it is -- the most likely way you're going to arrive at that conclusion is if you can shoehorn your analysis of the company into some variant of the Rule Breaker methodology for looking at promising young companies. Let's take a quick look at what that would produce regarding Edison.

According to the local formula, a Rule Breaking company needs to be,

1) The top dog and first-mover in an important, emerging industry...

I think that Edison qualifies as a top dog and first-mover in an important, emerging industry. Of course, whether Edison is in an "emerging" market depends on whether you define the industry as schools in general, or private management of public and charter schools. I could go either way on that, but I think the industry is an important one.

2) Sustainable advantage gained through business momentum, patents, visionary leadership, and/or inept competition...

Edison appears to have a sustainable advantage stemming from the substantial amounts invested in creating its own unique curriculum. Given the test scores produced by Edison students so far, there appears to be a real advantage to the program -- and buyers are lining up. CEO Whittle can legitimately claim to have vision, and the competition for Edison -- the national public school system generally -- while not inept, has significant shortcomings. If it didn't, Edison wouldn't have been successful starting schools in as many different states as it already has.

3) Excellent past share appreciation, measured by a relative strength of 90 or higher...

According to Moneycentral, Edison has a three-month relative strength of 100, and hasn't been public long enough for a six-month or twelve-month relative strength measurement. Part of that three-month strength, however, comes from the fact that Edison, which came public in November at $18 a share, fell below its IPO price and was available for about $12 a share three months ago. On the heels of several announcements of new school openings for next year, the shares now trade at $25.

4) Good management and smart backing...

Hard to say. Founder and President/CEO Chris Whittle has a checkered past regarding companies he's managed, with Channel One in particular being less than a success. Chairman Benno Schmidt was the President of Yale prior to joining Edison. Among the early investors in Edison are second-richest-guy-in-the-world Paul Allen.

5) The greater the consumer brand, the better...

Pretty tough to assert that Edison has a strong consumer brand, though in the sense that there are waiting lists at the Edison schools for parents to get their children into the schools, you could argue otherwise.

6) A significant constituent of the financial media is recently on record for calling it overvalued...

Prior to its IPO, Christopher Byron wrote a humorous and unbalanced piece about Edison entitled, "Whittle and Benno Schmidt Try Another I.P.O. Fast One." In between dozens of ad hominem insults hurled at Edison's management, the article essentially concluded Edison would be overvalued at virtually any price. Byron's work appears in many, many places, and the article was carried on as well as in The New York Observer.

One might conclude, were he or she predisposed to do so, that Edison could qualify as a Rule Breaking company. On the other hand, the economics of the industry don't appear particularly attractive to me, and simply on that basis I can't say that I'd be interested in investing in the company.

It's an interesting experiment, though, and I wish it well. For one thing, my sister might someday buy me a better Christmas present if the company ever strikes it rich. (Currently, I receive a pair of gloves every year which I dutifully lose by March as an annual ritual.) More importantly, the company provides stock options to any of its employees who want them -- including the hundreds of teachers in its employ. If the company ultimately succeeds, the ripple effect could dramatically alter the way that teachers across the country get paid.

Let's hope so.