My latest investment idea, Capella Education, comes from the battered for-profit education sector. It is the parent company of Capella University, an online-only institution who’s clientele is comprised at 80% of professionals seeking graduate degrees and with an average age of 39. As per the usual cliché, the market tends to throw the baby out with the bathwater and I think this was the case here. Not to trivialize the concerns attributed to this sector for they were very real for the most part. To briefly recap, stocks in for-profit companies had increased substantially over the past few years as they became a popular alternative to traditional schools. They continued to rise during 2008 while the broad market tanked as the difficult economy gave a double incentive for people to go back to school in the form of more free time and the necessity to compete for fewer jobs. But in 2009-10, the situation reversed dramatically: as the markets roared back, education stocks as a whole were falling badly. Part of it was a much needed cooling off period after an extended growth run, as education stocks had traded at hefty valuations previously. But for the most part, it was because the industry as a whole was in turmoil.
As it turns out, the value that the sector brings was being called into question. The US Government Accountability Office released a report detailing its investigation into questionable recruitment tactics, going from misrepresenting employment prospects and financial aid eligibility to encouraging outright fraud. Also in the spotlight have been attempts by for-profits to recruit within homeless shelters. A far larger proportion of students go into default than in traditional institutions. At the same time, many former students complain that they haven’t been able to find meaningful employment in their field following graduation, if they graduate at all for in that respect also the numbers are significantly worse than in traditional colleges. This is largely reminiscent of a similar rough patch for the industry in the late 80s, when various allegations of fraud and other dubious practices led to restrictions on access to federal funding for students of these institutions. These reforms had been partly undone by the Bush administration, therefore enrollment soared and stock prices along with them in the past decade.
Now, there is scrutiny on the for-profit sector and the Department of Education had been working on changing the rules that govern whether a student that goes to these institutions can receive federal aid. Ostensibly, if a prospective student cannot get funding from attending a certain institution, then they would not be interested in that institution. This would effectively kill the business. On June 2nd, 2011, the Department of Education added a rule on "gainful employment" to the existing rules that determined eligibility to federal funds. All interested observers had been awaiting the official announcement on the gainful employment rule for a long time now, hence the uncertainty around the sector for the last while. All in all, and in spite of most of the industry’s protests to the contrary, the new criteria proved to be much weaker than previously anticipated and so for profit stocks had a nice bounce in the aftermath. But as much as the entire sector had been oversold previously, plenty of otherwise weak companies have recovered to the same extent as their stronger peers. Buying in a distressed sector is an almost universally sound way of turning up very profitable investment. However the important idea is to choose wisely within that sector, not buy blindly whatever pops up. A casual reading of news concerning the for-profit industry will turn up more or less the same names mentioned negatively and another set of names positively.
Here are the 3 main rules affecting eligibility to federal funds:
1) Gainful Employment. There are 3 subtests to this general criteria: A) At least 35% of former students are repaying their loans, or B) Estimated annual loan payment of a typical graduate must not be bigger than 30% of his or her discretionary income, or C) Estimated annual loan payment of a typical graduate must not be bigger than 12% of his or her total income. This rule won’t take effect until 2015.
2) 3-year cohort default. Modified from its prior version in 2009, this is the proportion of students in a cohort taking debt who default 3 years after leaving school. An institution can have its eligibility in jeopardy if its 3-year default rate is 25% or more for 3 consecutive years.
3) The “90/10” rule. An institution cannot derive more than 90% of its cash sales from Title IV federal funds for 2 consecutive years.
The Department of Education estimates that only 5% of all programs offered by for-profit organizations will be affected, the precise amount probably varying from one company to the next. Nevertheless, having only until 2015 to comply, the date is far enough that at least some organizations can adjust so this is not a concern for the most part. The latest numbers on 3-year cohort default rate, though available for the most part in annual reports, can also be conveniently found at the level of the industry here. Compliance with the 90/10 rule should be available in the financial statements.
In short, some companies indeed standout very much from the rest, both in the news (some mostly for not being mentioned in the news in the first place) and in the metrics. There are 3 that I was particularly looking into: Strayer, Devry and Capella. Devry’s showing in regards to the 90/10 rule was exemplary, at least for a for-profit organization (74% of revenue from federal funds according to its 2010 annual report) but I do not like that the 3-year cohort default for 2008 was 20%, not bad but far from stellar either. Strayer clocks in at 14% and Capella only 8%. Both Strayer (latest figures are of 2009) and Capella have 78% of their revenues provided by federal funds so they are far enough from the 90% threshold for it to be a concern. Overall they all have similar business risk profiles (i.e. relatively little) with Devry probably slightly less good. As a measure of financial analysis, their respective Piotroski F-scores are all excellent. However, I give preference to Capella due to its much stronger balance sheet compared the others. Its current ratio is above 5 and, at its current price, cash and equivalents represents well over a quarter of the market cap of the company. It also happens to trade at barely 10X its (adjusted) free cash flow so from a valuation perspective it is definitely very attractive. By comparison, Devry is both expensive and has quite a bit less protection on its balance sheet. Strayer is about as cheap as Capella but its leverage has been going steadily up for a number of years and it also doesn’t have much protection left in the form of a solid current ratio. Capella, at current prices of around $43-44, offers the most protection both on the balance sheet and from a valuation perspective.
Disclosure: Konrad does not own any of the securities mentioned in this article.