While doing some work on K1 Venture, I realized that quite a number of the US listed for profit education stocks are trading at rock bottom valuations. We are talking about EV/EBITDA of <2x. Undoubtably, they are very cheap. But, are those valuations justified? Most of the time, cheap assets are cheap for a reason, and they stay that way. It is the job of a good value investor to do a thorough investigation to prove otherwise.
Education Sector
The for profit education in America has come under attack in the last two years, following a report released by the Senate Committee on Health, Education, Labour and Pensions. It addresses the concern that many for profit colleges are funded by tax-payers, since most of their students take on federal funded student loans. Yet in 2008-2009, more than half of the students who enrolled in these colleges left without a degree or diploma within a median period of 4 months. For profit colleges spent a disportionate amount of resources on recruitment, with an estimated 2.5 recruiter for every support service employee. The ratio of recruiters to career services staff is even worse, at 10:1. Many students complained that while there were no problems with finding someone to speak on enrollment, help was nowhere to be found when student wanted career or employment advice.
The report itself is rather damning - a tell it all on how pro-profit colleges lured students on board, leaving them with an un-recognised degree and a mountain load of debt. I will leave it to you to plough through if you are keen. Reading all these anecdotes, one might come to an immediate conclusion that there is no way these organisations should be allowed to keep up with such predatory behavior. Morally, I agree. Rationally, I believe they will still be allowed to operate, just in a less aggressive form. Many of these companies have spent a lot of money lobbying for more lenient regulations. What is most likely to happen is a period of restructuring and transitioning, to improve educational standards and student services. Some schools will be shut down but other will remain. The trick here is to identify who the survivors are, and how profitable the business model will be under the new regime.
Senate's recommendations
Following their investigation, the Senate recommended a number of changes. The ones which are most relevant to our investment thesis here are:
i) Establish a uniform and accurate methodology for calculating job placement rates,
ii) Tie access to Federal funding aid to meeting minimum student outcome thresholds,
iii) Improve cohort default rate tracking by expanding the default reporting rate period beyond 3 years,
iv) Require that for profit colleges receive at least 15% of revenues from sources other than Federal funds,
v) Create an online student complaint clearinghouse, managed by the Department of Education, for the collection and referral of student complaints to appropriate overseeing agencies, organization and division,
vi) Enforce minimum standards for student services that include tutoring, remediation, financial aid, career counseling and job placement.
What all these means is that, for profit colleges will need to spend more to enhance their offering. They need to be more selective on the kind of students they take in to ensure a minimum level of academia standard. More importantly, for-profit colleges need to ensure that their students are employable when they graduate. Note that the report does not recommend that for education colleges be shut down. Rather, it aims to further regulate these entities and improve their academic standards. In the words of the report:
Apollo Group
Apollo Group (APOL) is the largest listed for profit education company, and one of the pioneers of the modern for profit education model. Its main campus is the University of Phoenix, which is the nation's largest regionally accredited private university. University of Phoenix accounts for over 90% of APOL's revenue. APOL also owns campuses in other parts of the world, including BPP Holdings in the UK, Universidad de Artes - Ciencias y Comunicacion in Chile and Universidad Latinoamericana in Mexico. APOL runs a PE fund as a JV with The Carlyle group, investing in the international education services industry.
Revenue has plateaued in 2010 and have been slowly declining since. Margins have also been on a downtrend. Fortunately, this is a business model which generates a lot of free cashflow. The management has put this cash to work through share buybacks and acquisitions. Their balance is relatively clean with little debt. Thus, the threat to their business model is political rather than financial. With the amount of free cashflow they are generating, they are in no need of cash for restructuring. Whether APOL is cheap or not depends on (i) whether APOL can be allowed to continue operating and (ii) when enrollment numbers/revenue will stabilise and rebound.
Risks
i) Risk of revoke of accreditation status. APOL received a notice of Probation of their accreditation status from the HLC in February earlier this year. HLC found compliance issues with its administrative structure and governance. Basically, HLC didn't think University of Phoenix has sufficient autonomy relative to the parent corporation APOL. It should be pointed out that the review team found the Phoenix was in compliance with substantially all of the other Criteria of Accreditation, including the criteria associated with academic matters and student services. The HLC team notes that the University is well-resourced and innovative, and has many strengths, including a high level of relevant student services and technology and systems that benefit students and provide a consistent approach to facilitate learning across its programs and facilities. Whether APOL will ultimately be put on probation, the decision will only be made June 2013. And if APOL is put on probation, it has until the fall of 2014 to address the non-compliant issues.
ii) The 90/10 rule of the Higher Education Act - Any proprietary institutions will be ineligible to participate in Title IV Program (Federal student aid program) if for any two consecutive fiscal years it derives more than 90% of its cash basis revenue from Title IV Program.
iii) Student Loan Cohort Default Rates - An educational institution will lose its eligibility to participate in some or all Title IV programs if its student loan two-year cohort default rates equals or exceeds 25% for three consecutive cohorts or 40% of any given cohort. Starting with the 2011, institutions' student loan three-year cohort default rates must also not equal or exceed 30% for three consecutive cohorts or 40% of any given cohort.
iv) A worsening of the US economy leading to continued poor demand for education.
In my opinion, (i) above is the biggest risk to the company. However, I think it is a problem which can be resolved. This involves changing the board of directors of the University. Many analysts believe the risk of loss of accreditation is low as well. APOL has an estimated 25% market share of the for-profit education sector. This could easily be a witch hunt where the regulators have to be seen doing something. But to go that far as to close down the market leader in the sector? That would be tantamount to saying that the whole for-profit sector has to go.
The rest of the risks pointed out above are not major issues. Based on data released by the company shown below, both (ii) and (iii) appears to be stabilizing. (iv) is only a problem if Europe goes further into recession or China slows down further. Otherwise, I expect the US economy to continue its recovery trajectory.
Investment Thesis
i) Strong balance sheet, little debt, net cash of $6.60 per share.
ii) Strong cashflow generative business model.
iii) Aggressively buying back shares for the past two years, reapprove another US$250m shareback program.
iv) Industry leader with the most number of student.
v) Management making an effort to address the concerns of the senate.
vi) Restructuring by shutting down 115 of its locations representing 40% of its total square footage. This is expected to reduce operating expenses by at least $350m by FY2014.
Scenario Modeling
Let's plug in some revenue and EBIT/net profit margin assumptions for a quick and dirty scenario modeling. How much will revenue have to contract before it is no longer cheap at the current price. Notice that I do not expect EBIT and net profit margins to drop significantly. Historically, between 1996 and 2011, EBIT margins has ranged between 16% - 31% while net profit margin has ranged between 10% - 19%. Margins were much lower before 1996 (<10%) but that was before APOL had nay scale in its operations. Revenue in 1995 was only US$163m, a far cry from the US$4bn now.
The projections are contingent on APOL passing the accreditation probation in 2014. I expect an enrollment and revenue recovery in FY2015 after the hangover from accreditation has passed. Under the three scenarios I have highlighted above, APOL still appears very cheap. Historically, free cashflow generation has been equal to or even higher than net profit. We shall use EPS as a quick approximation to FCF per share here. Even under the bear case scenario, APOL trades at a PE of 10x, which is a 10% FCF yield in FY2015. This is definitely undervalued territory. Again, I have to emphasize this is only if APOL passes the accreditation process. Personally, I will be watching this very closely and may swap one of the positions in my portfolio for this.
Education Sector
The for profit education in America has come under attack in the last two years, following a report released by the Senate Committee on Health, Education, Labour and Pensions. It addresses the concern that many for profit colleges are funded by tax-payers, since most of their students take on federal funded student loans. Yet in 2008-2009, more than half of the students who enrolled in these colleges left without a degree or diploma within a median period of 4 months. For profit colleges spent a disportionate amount of resources on recruitment, with an estimated 2.5 recruiter for every support service employee. The ratio of recruiters to career services staff is even worse, at 10:1. Many students complained that while there were no problems with finding someone to speak on enrollment, help was nowhere to be found when student wanted career or employment advice.
The report itself is rather damning - a tell it all on how pro-profit colleges lured students on board, leaving them with an un-recognised degree and a mountain load of debt. I will leave it to you to plough through if you are keen. Reading all these anecdotes, one might come to an immediate conclusion that there is no way these organisations should be allowed to keep up with such predatory behavior. Morally, I agree. Rationally, I believe they will still be allowed to operate, just in a less aggressive form. Many of these companies have spent a lot of money lobbying for more lenient regulations. What is most likely to happen is a period of restructuring and transitioning, to improve educational standards and student services. Some schools will be shut down but other will remain. The trick here is to identify who the survivors are, and how profitable the business model will be under the new regime.
Senate's recommendations
Following their investigation, the Senate recommended a number of changes. The ones which are most relevant to our investment thesis here are:
i) Establish a uniform and accurate methodology for calculating job placement rates,
ii) Tie access to Federal funding aid to meeting minimum student outcome thresholds,
iii) Improve cohort default rate tracking by expanding the default reporting rate period beyond 3 years,
iv) Require that for profit colleges receive at least 15% of revenues from sources other than Federal funds,
v) Create an online student complaint clearinghouse, managed by the Department of Education, for the collection and referral of student complaints to appropriate overseeing agencies, organization and division,
vi) Enforce minimum standards for student services that include tutoring, remediation, financial aid, career counseling and job placement.
What all these means is that, for profit colleges will need to spend more to enhance their offering. They need to be more selective on the kind of students they take in to ensure a minimum level of academia standard. More importantly, for-profit colleges need to ensure that their students are employable when they graduate. Note that the report does not recommend that for education colleges be shut down. Rather, it aims to further regulate these entities and improve their academic standards. In the words of the report:
"American taxpayers are the single biggest investor in for-profit colleges, yet the government that holds their trust has little ability to ensure that they get the return on investment they deserve: educational and career success for the students who enroll. If for-profit colleges are going to deliver on the promise of a path to the middle class and to job security for students who might not have otherwise succeeded in higher education, Congress must put in place a much more rigorous regulatory structure that incentivizes the sector to make the financial investments necessary to result in higher student success.As for the listed for profit-colleges themselves, margins and ROEs are expected to come down as they invest to build their education offerings. Revenues are shrinking now, but when they rebound, they will grow at a much slower rate then the boom years of 2000-2010. This is due to a reduction in their recruitment force and less aggressive recruitment methods.
Apollo Group
Apollo Group (APOL) is the largest listed for profit education company, and one of the pioneers of the modern for profit education model. Its main campus is the University of Phoenix, which is the nation's largest regionally accredited private university. University of Phoenix accounts for over 90% of APOL's revenue. APOL also owns campuses in other parts of the world, including BPP Holdings in the UK, Universidad de Artes - Ciencias y Comunicacion in Chile and Universidad Latinoamericana in Mexico. APOL runs a PE fund as a JV with The Carlyle group, investing in the international education services industry.
| Income Statement (US$m) | 2007 | 2008 | 2009 | 2010 | 2011 | YTD 3Q2012 |
| Revenue | 2,724 | 3,141 | 3,953 | 4,926 | 4,733 | 3,279 |
| Instructional and student advisory | (1,237) | (1,350) | (1,568) | (1,733) | (1,774) | (1,356) |
| Marketing | (659) | (801) | (953) | (624) | (655) | (484) |
| Admission Advisory | (466) | (415) | (298) | |||
| General and Admin | (202) | (215) | (286) | (301) | (356) | (252) |
| Provision for uncollectible accounts receivables | 0 | 0 | 0 | (283) | (181) | (133) |
| Depreciation and amortization | 0 | 0 | 0 | (146) | (159) | (108) |
| Goodwill and other intangibles impairment | 0 | 0 | 0 | (185) | (220) | (17) |
| Restructuring and other charges | 0 | 0 | 0 | 0 | (23) | (29) |
| Litigation and (credit) charges, net | 0 | 0 | (81) | (178) | 12 | (5) |
| EBIT | 626 | 775 | 1,066 | 1,011 | 961 | 597 |
| Other income, gains and losses | 1 | 7 | (7) | (1) | (2) | 0 |
| Financial income | 31 | 30 | 13 | 3 | 3 | 1 |
| Financial expenses | (0) | (3) | (4) | (12) | (9) | (7) |
| Profit before Tax | 657 | 808 | 1,067 | 1,001 | 954 | 591 |
| Tax | (248) | (314) | (457) | (464) | (421) | (248) |
| Net Profit | 409 | 494 | 610 | 537 | 533 | 343 |
| Net profit attributable to shareholders | 409 | 477 | 598 | 553 | 572 | 347 |
| EBITDA | 626 | 775 | 1,066 | 1,341 | 1,340 | 721 |
| FCF | 469 | 527 | 261 | 860 | 735 | 256 |
| No. of shares (millions diluted) | 174 | 166 | 160 | 153 | 142 | 125 |
| EPS | 2.36 | 2.87 | 3.75 | 3.62 | 4.04 | 3.69 |
| PE | 7.51 | 6.15 | 4.71 | 4.89 | 4.38 | 4.79 |
| PCF | 6.54 | 5.56 | 10.80 | 3.14 | 3.41 | 6.48 |
| EV/EBITDA | 2.69 | 2.00 | 1.52 | 0.97 | 0.77 | 2.11 |
| EBIT Margin | 23.0% | 24.7% | 27.0% | 20.5% | 20.3% | 18.2% |
| Net Margin | 15.0% | 15.7% | 15.4% | 10.9% | 11.3% | 10.5% |
Revenue has plateaued in 2010 and have been slowly declining since. Margins have also been on a downtrend. Fortunately, this is a business model which generates a lot of free cashflow. The management has put this cash to work through share buybacks and acquisitions. Their balance is relatively clean with little debt. Thus, the threat to their business model is political rather than financial. With the amount of free cashflow they are generating, they are in no need of cash for restructuring. Whether APOL is cheap or not depends on (i) whether APOL can be allowed to continue operating and (ii) when enrollment numbers/revenue will stabilise and rebound.
Risks
i) Risk of revoke of accreditation status. APOL received a notice of Probation of their accreditation status from the HLC in February earlier this year. HLC found compliance issues with its administrative structure and governance. Basically, HLC didn't think University of Phoenix has sufficient autonomy relative to the parent corporation APOL. It should be pointed out that the review team found the Phoenix was in compliance with substantially all of the other Criteria of Accreditation, including the criteria associated with academic matters and student services. The HLC team notes that the University is well-resourced and innovative, and has many strengths, including a high level of relevant student services and technology and systems that benefit students and provide a consistent approach to facilitate learning across its programs and facilities. Whether APOL will ultimately be put on probation, the decision will only be made June 2013. And if APOL is put on probation, it has until the fall of 2014 to address the non-compliant issues.
ii) The 90/10 rule of the Higher Education Act - Any proprietary institutions will be ineligible to participate in Title IV Program (Federal student aid program) if for any two consecutive fiscal years it derives more than 90% of its cash basis revenue from Title IV Program.
iii) Student Loan Cohort Default Rates - An educational institution will lose its eligibility to participate in some or all Title IV programs if its student loan two-year cohort default rates equals or exceeds 25% for three consecutive cohorts or 40% of any given cohort. Starting with the 2011, institutions' student loan three-year cohort default rates must also not equal or exceed 30% for three consecutive cohorts or 40% of any given cohort.
iv) A worsening of the US economy leading to continued poor demand for education.
In my opinion, (i) above is the biggest risk to the company. However, I think it is a problem which can be resolved. This involves changing the board of directors of the University. Many analysts believe the risk of loss of accreditation is low as well. APOL has an estimated 25% market share of the for-profit education sector. This could easily be a witch hunt where the regulators have to be seen doing something. But to go that far as to close down the market leader in the sector? That would be tantamount to saying that the whole for-profit sector has to go.
The rest of the risks pointed out above are not major issues. Based on data released by the company shown below, both (ii) and (iii) appears to be stabilizing. (iv) is only a problem if Europe goes further into recession or China slows down further. Otherwise, I expect the US economy to continue its recovery trajectory.
| Two Year cohort default rates | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | 2011 |
| Universty of Phoenix | 7.5% | 7.3% | 7.2% | 9.3% | 12.9% | 18.8% | 17.9% | 14.3% |
| Three Year cohort default rates | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 |
| Universty of Phoenix | N.A. | N.A. | 11.4% | 10.3% | 15.9% | 21.1% | 26.4% | 26.1% |
| 90/10 Rule Percentage | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 | ||
| Universty of Phoenix | 69.0% | 82.0% | 86.0% | 88.0% | 86.0% | 84.0% |
Investment Thesis
i) Strong balance sheet, little debt, net cash of $6.60 per share.
ii) Strong cashflow generative business model.
iii) Aggressively buying back shares for the past two years, reapprove another US$250m shareback program.
iv) Industry leader with the most number of student.
v) Management making an effort to address the concerns of the senate.
vi) Restructuring by shutting down 115 of its locations representing 40% of its total square footage. This is expected to reduce operating expenses by at least $350m by FY2014.
Scenario Modeling
Let's plug in some revenue and EBIT/net profit margin assumptions for a quick and dirty scenario modeling. How much will revenue have to contract before it is no longer cheap at the current price. Notice that I do not expect EBIT and net profit margins to drop significantly. Historically, between 1996 and 2011, EBIT margins has ranged between 16% - 31% while net profit margin has ranged between 10% - 19%. Margins were much lower before 1996 (<10%) but that was before APOL had nay scale in its operations. Revenue in 1995 was only US$163m, a far cry from the US$4bn now.
| Base Case | E2012 | E2013 | E2014 | E2015 |
| Revenue | 4,372 | 3,500 | 3,000 | 3,250 |
| EBIT | 787 | 630 | 510 | 553 |
| Net Profit | 437 | 350 | 270 | 293 |
| EPS | 3.50 | 2.80 | 2.16 | 2.34 |
| PE | 5.05 | 6.31 | 8.19 | 7.56 |
| EBIT Margin | 18.0% | 18.0% | 17.0% | 17.0% |
| Net Margin | 10.0% | 10.0% | 9.0% | 9.0% |
| Bull Case | E2012 | E2013 | E2014 | E2015 |
| Revenue | 4,372 | 3,700 | 3,500 | 3,700 |
| EBIT | 787 | 666 | 630 | 666 |
| Net Profit | 437 | 370 | 350 | 370 |
| EPS | 3.50 | 2.96 | 2.80 | 2.96 |
| PE | 5.05 | 5.97 | 6.31 | 5.97 |
| EBIT Margin | 18.0% | 18.0% | 18.0% | 18.0% |
| Net Margin | 10.0% | 10.0% | 10.0% | 10.0% |
| Bear Case | E2012 | E2013 | E2014 | E2015 |
| Revenue | 4,372 | 3,500 | 2,500 | 2,750 |
| EBIT | 787 | 595 | 400 | 413 |
| Net Profit | 437 | 315 | 200 | 220 |
| EPS | 3.50 | 2.52 | 1.60 | 1.76 |
| PE | 5.05 | 7.02 | 11.05 | 10.05 |
| EBIT Margin | 18.0% | 17.0% | 16.0% | 15.0% |
| Net Margin | 10.0% | 9.0% | 8.0% | 8.0% |
The projections are contingent on APOL passing the accreditation probation in 2014. I expect an enrollment and revenue recovery in FY2015 after the hangover from accreditation has passed. Under the three scenarios I have highlighted above, APOL still appears very cheap. Historically, free cashflow generation has been equal to or even higher than net profit. We shall use EPS as a quick approximation to FCF per share here. Even under the bear case scenario, APOL trades at a PE of 10x, which is a 10% FCF yield in FY2015. This is definitely undervalued territory. Again, I have to emphasize this is only if APOL passes the accreditation process. Personally, I will be watching this very closely and may swap one of the positions in my portfolio for this.
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