For profit education rally is just beginning

I have a current working theory that the rally in for profit education stocks is just beginning.

The Obama administration was critical of the for profit education industry. The Department of Education proposed various regulations on the industry, like the 90/10 rule, which states that a proprietary education company cannot receive more than 90% of its revenue from Title IV loan programs, and the gainful employment regulation, which mandates loan repayment be less than 20% of discretionary income after graduation or 8% of total earnings.

Trump appears intent on rolling back many regulations placed under the previous administration. Newly appointed head of the Department of Education Betsy DeVos appears very unlikely to pursue further regulation of for-profit colleges, and I think there’s a good chance that the gainful employment regulation and the 90/10 rule are both rolled back.

In the meantime, the industry has been working hard to fix its problems. The industry has invested to lower dropout rates and increase employment post-graduation. Moreover, in a strong economy, more of these students can count on finding jobs when they graduate. Tuition has actually come down across the industry while tuitions at non-profits continue to rise. The schools seem to offer a better value proposition now.

And there may be more demand than ever for the types of technical degrees and certification programs that for-profit colleges excel in offering. I have read a number of reports that there is a “skills gap” that is partially to blame for the slow hiring in manufacturing, for example, this report from the manufacturing institute. Manufacturing companies are automating their processes, and new workers will have to certified in the technical skills necessary to operate in these highly automated factories. This is a secular trend in favor of companies that offer technical certifications.

Despite an impressive rally since the election, the companies still appear to trade at reasonable multiples, especially if you expect growth to pick up under the new administration.

I bought in a little cheaper than current prices in early March. Here are the multiples as they stand today:

Company P/Sales EV/Sales P/E EV/EBITDA EV/EBIT EV/FCF 5-yr Revenue Growth
DV 1.16 1.08 26.34 12.38 27.01 14.14 -3.1%
STRA 1.98 1.69 25.08 9.81 12.94 23.72 -5.7%
LOPE 3.75 3.74 22.05 11.53 13.76 N/A 14.3%

 

DeVry Education (DV)

DeVry Education looks interesting. It may be a good turnaround situation. It appears to have a similar P/E to the rest of the group, but it has one-time charges of a large asset write-down in the year ended June 2016, and a fine imposed on it by the Obama-era FTC in the current fiscal year. Adjusted for the fine and the asset write down, the company earned $176 million in operating income in the TTM period, as compared to the unadjusted figure of $74 million. The EV/EBIT goes from 26.05 to 10.94.

DeVry also has large restructuring charges. I am not sure whether the entire amount of restructuring charges can be added back as a one-time expense, but the restructuring charges do appear to be declining year over year, so I think its reasonable to expect that these expenses might continue to shrink.

Meanwhile, DeVry has been cutting down on administrative and overhead costs as well. SG&A is down from 37.8% of revenue to 34.4% in the TTM period.

That means, even with a slightly negative top line, DeVry can experience significant bottom line growth as restructuring charges shrink. Adjusted for a 50% reduction in restructuring expenses, the operating income at DeVry would be $200 million, putting the EV/EBIT at 9.64.

The risk with DeVry is that the reputation of the company has been tarnished after the FTC’s investigation. In the meantime, numerous competitors have sprung up without the baggage of a federal investigation, fines, and litigation. Management hasn’t had the attention or resources to defend against this competition, and has been cutting costs to get by, so it may be falling behind in its offerings.

I read gradreports.com, and I was surprised to see the amount of positive feedback on DeVry. It seems that students aren’t particularly deterred by federal investigations or general stigma against the industry. It was among the highest rated undegraduate experiences.

DeVry has a focus on healthcare education that puts it in enviable position. Healthcare has been one of the strongest areas of the economy in recent years

Strayer (STRA)

Strayer has finally managed to turn around a multi-year streak of negative revenue growth, eking out a 3% gain last year. However the operating margin has deteriorated, dropping from 18.3% in 2014 to 13.0% in 2016. I don’t think the drop in margins has been all bad news – 3% of the drop can be explained by increased marketing expenses. This was probably a big factor in turning around those revenues, and the investments in marketing may pay dividends for years down the road.

The rest is mostly made up of “Instruction and educational support costs”, but again, these costs may pay off longer term. Strayer appeared to have the worst reviews overall of the for-profit group, with many complaints that they are overly promotional and place pressure to sign up for classes, but abandon students once they have signed up. The increase in instruction and educational support costs as a percent of revenues seems to indicate that management is trying to address the problem.

The risk here is that the investments in educational resources and marketing don’t pay off. However, mitigating this risk is the low capital requirement of the company. It has a much lower invested capital, and thus, a higher ROIC, than the other for-profit colleges. Capital expenditures are also rising at Strayer, up from $6.9 million in 2014 to $13.1 million in 2016. If this capital has a return similar to the past, one might expect rising earnings in coming years.

Grand Canyon Education (LOPE)

Grand Canyon Education is probably the for-profit college that most resembles a traditional non-profit college. It ran as a private, non-profit, Christian university for 55 years, but transitioned to a for-profit college in 2004 to get additional investor funding. In the same year, it began to offer online courses. In 2008, it went public to get more funds.

The company is an exception to the rule in the for-profit industry. It has continued to grow enrollment and revenues and it reinvests a huge amount of capital back into the university. It has Division I NCAA sports teams for its campus. And, rather than refocusing on associates degrees and certification programs, it has doubled down on its full undergraduate offerings and graduate degrees.

In 2014, it was actually mulling over the decision to go back to a non-profit status, to avoid the stigma and regulations associated with the for-profit label. The stock price languished for 2 years despite consistently growing revenue and earnings. However, the election finally unleashed the stock and it rocketed up 50% over a short period of time.

It formed a base around $60 and has recently broken out again. I don’t think there is any telling how far this goes.

The company has no free cash flow, as it is continually reinvesting in its campus and its offerings. This currently doesn’t appear to be a problem as it is getting a pretty good return on its investments and growth shows no signs of slowing. If you own a stock that reinvests at a high rate, your investment can compound for several years until the company hits saturation or runs into competition issues.

I had figured that Grand Canyon would get good reviews because of its large investments, and overall, it seems to rank about the same as most average non-profit colleges.

I put the largest stakes of my investment in DeVry and Grand Canyon, and a small stake in Strayer. The group is up broadly since I invested about a week and a half ago. I plan to hold until I see reversal of the trend. I expect that we ought to hear some news announcements about DeVos rolling back regulations that will be positive near-term catalysts for this group.

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