Archipelago Learning In Detention, But Still On Course To Graduate

By Stephen D. Simpson, CFA | February 29, 2012 AAA

Offering money-saving solutions for K-12 education is usually a pretty good business plan, but perhaps not so much in those times where state budgets and standards are in flux. While Archipelago Learning (Nasdaq:ARCL) offers attractive cloud-based supplemental education products, the company is seeing business slow a bit, due to those macro factors. While this company certainly carries above-average risk, it also offers above-average potential for risk-tolerant growth investors.

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Still Growing, But...
The recent issue with Archipelago isn't that it's no longer growing, but that its growth rate has declined recently. While the company was posting 30%+ year-on-year growth rates early in 2011, that growth has declined to the point where sell-side analysts expect only single-digit growth for the fourth quarter (to be reported in March).

There is relatively little evidence that this is a byproduct of more intense or effective competition from the likes of Pearson (NYSE:PSO), Houghton Mifflin or Reed Elsevier (NYSE:RUK). Instead, there is ample evidence that severe state education budget issues around the country are having a role. When classroom spending is being rolled back and teachers are being laid off, even a money-saving tool like Archipelago's Study Island may not get much consideration. (For related reading, see How Education And Training Affect The Economy.)

Penetration Improving, Now for the Follow-Ons
Although Archipelago is seeing challenges from budget pressures and changes in the standards in Texas, other large markets like California and Florida have been relatively healthy. Overall, the company has pushed its penetration to nearly one-third of the domestic K-12 market, and the company continues to develop and launch new follow-on products for areas like test prep, ESL and remediation.

It seems as though budget pressures have closed some minds in school systems with respect to new initiatives, but Archipelago still has a lot to offer from a long-term perspective. With incremental per-student, per-subject costs of less than $10, there's definitely an argument to be made that Archipelago is a money-saving tool for school systems that are under pressure to do more with less money. Although Archipelago isn't supposed to serve as a substitute or replacement for direct classroom education, the reality is that this may start happening to some extent, as there simply isn't the manpower or resources to go around.

Undervalued
There are risks and issues with the Archipelago business model. The problem with cloud-based subscription models like Archipelago's is that they're easy to get into and relatively easy to get out of. That's arguably more of a risk for smaller companies like Archipelago, Cambium (Nasdaq:ABCD) and Learning Tree (Nasdaq:LTRE), as opposed to the major multimedia publishers that can arguably fall back on bundling and integrated products (integrating text books with online services).

There are also issues with Archipelago's accounting. This is no way an accusation that ARCL is doing anything wrong; simply an acknowledgment that subscription models demand a different accounting treatment and that can create confusion and false controversy with some investors.

Certainly something seems to be weighing on these shares. Relative to deals involving Renaissance Learning, Pearson and Blackboard (which was bought by the same entity, Providence Equity, which owns a large stake in Archipelago), Archipelago is undervalued.

The stock also looks too cheap on a cash flow basis. While a decade of free cash flow compound growth of 9% may not sound especially conservative, I would argue that it is with Archipelago, considering the opportunity to add more school systems to the client list, the prospect of selling more services to existing customers, and continuing expansion in English-speaking markets like Canada and the U.K. (For related reading, see Free Cash Flow: Free, But Not Always Easy.)

With prospective fair value in the low-to-mid teens, Archipelago is a name worth considering, while state budget issues have cast clouds over the true long-term growth potential of the company.

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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