Profit on the Future of Education

07/19/2011 8:30 am EST

Focus: STOCKS

There’s no doubt the current educational system is in need of ways to educate better while spending less, and this company does just that, write Stephen Ellis and Michael Tian of Opportunistic Investor.

Somehow, it just feels better investing in a business that does good. Business can be controversial. But a few seem to offer some­thing of unquestionable value to society.

Among these, a minority are profitable enough to be consid­ered good businesses. Even fewer trade at attractive enough valuations to be good investments.

Renaissance Learning (RLRN) is such a company. The business is fairly simple: Renaissance’s software packages improve kids’ reading and math skills, something that most people would agree we sorely need.

Moreover, at $2.50 to $5 per student per year, its products provide tremendous value for school systems. And we believe the firm is dramati­cally changing its business model for the better.

More importantly, the stock is trading at a pretty attractive valuation. The free cash flow yield is about 10%, the balance sheet is clean, and the company has a solid dividend history.

The regular dividend yield is about 3%, but management (which owns most of the stock) has a long history of paying special divi­dends. When including these, we expect the average yield to be closer to 7%.

Given the long-term tailwinds in place, we think earnings and dividends will grow, giving shareholders a handsome return.

Renaissance’s flagship product is Accelerated Reader, which is the most popular computer-aided reading software of its kind.

AR is a pretty simple concept: After students read a book, they take a quiz to test their knowledge and grasp of plot points. AR doesn’t provide the books, but has a library of over 100,000 quizzes, the largest of its kind.

It also provides a ranking system for books, with longer and more diffi­cult books being worth more points. Students work toward goals, and the number of points achieved can even be incorporated into a student’s grade.

An ecosystem also developed around AR, which helps make customers “stickier.” For example, school library books are color-coded to reflect their AR points, parents like the product, and Renaissance provides seminars or coaching support for teachers on how to use AR effectively.

All this, when combined with the low price point of about $5 per student per year for the enterprise version, has made AR customers remarkably loyal. Renewal rates are well above 90%.

Accelerated Reader provides close to 50% of Renaissance’s revenue. Some of the other important products are Accelerated Math, STAR Reading, STAR Math, and STAR Early Literacy.

The STAR products are quick, computerized quizzes taken a few times per semester to assess a student’s progress against benchmarks or goals. They can be tailored to assess a student’s progress against state or federally mandated standards, which are becoming more important by the day.

Aside from a bit of investor ignorance about the quality of its business, the biggest overhang today is the economic climate. Given that a school’s cost structure is not very flexible, technology purchases are the first to be curtailed.

Even worse, most of the company’s more discretionary offerings—such as standalone quizzes, hardware products, coaching, and consulting—are actually declining. Continued conversion of schools onto the enterprise platform is a tailwind, but revenue growth will be in the low single digits this year, well below the trend.

But we don’t believe these headwinds diminish Renaissance’s long-term potential. At its core, Renaissance uses technology to make classroom instruction cheaper and more effective.

Technology has the potential to make a big difference in this fight. A school can buy all of Renaissance’s most important products for around $10 per student per year. This is roughly 0.1% of a student’s budget.

And yet, adopting these products can make a big difference in the classroom. Teachers could encourage students to read and do math problems and save a ton of time administering and grading tests.

Renaissance won’t ever be a Salesforce.com CRM and trade for 80 times earnings while growing 30% a year, but it will be stable and profitable, and benefit from robust free cash flow.

Over time, I suspect that will be a winning combination. RNRL is a buy.

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