Probably something like what we look for in the Micro-Cap Magic Formula Newsletter. To start, it’d have to have huge competitive advantages and an easily scalable business model. Then it’d have to have a history of strong growth and great returns on capital.
If you could find all that in a neglected stock in a hated industry trading at rock bottom multiples… Well, then you have the beginnings of an incredible magic formula stock. If it was too small for professional investors or Wall Street analysts to pick up, you’d definitely have a company we’d consider for the Micro-Cap Magic Formula Newsletter.
ITT Educational Services (ESI) fits pretty much every one of those descriptions. You’re probably familiar with them from their ITT Tech ads, but value investors are familiar with ESI because it pops up on almost every deep value screen you can imagine. Low price to earnings? Check. EV to EBITDA? Check. On almost any valuation screen you can imagine, ESI shows up. As such, any investor following a magic formula investing strategy (or any value investing strategy!) should take a deep look at the company.
Let’s start our review by taking a look at ESI’s historical numbers.
Wow. Those are some pretty incredible numbers. Operating income has grown 15x since the start of the decade. Most companies that grow quickly need to invest everything they earn and then some to fund that much growth. They’ll normally increase share count by at least 50%, normally two or three times , or pile on huge amounts of leverage to grow that much. But ESI hasn’t had to. In fact, they’ve managed to reduce their shares outstanding by 1/3 over this time period while building up over $100 million in cash.
How the heck can a company fund that much growth yet still return that much cash to shareholders?
The company is generating absolutely mouthwatering returns on capital. They started the decade generating returns on capital at over 60%. That number alone is better than 85% or so of S&P 500 companies… And ESI has consistently managed to improve upon it in the past 10 years, ending the decade at an out-of-this-world 223% ROIC.
So how do they earn such great returns?
Think about the economics of the online college business. Almost all of the costs are fixed: building the school, setting up online portals, getting accreditation, marketing, etc. Once you’ve paid all of those, the cost of adding a new student is basically nothing. So there’s some serious operating leverage to the business. Combine the operating leverage with the small moat from entrants needing accreditation and the difficulty of overcoming the marketing of the incumbents, and you’ve got a business that can generate amazing returns.
And it’s not just ESI that generates amazing returns. Every one of the major players in the industry earns out-of-this-world returns on capital… and trades at rock-bottom valuations.
All of the companies look incredibly cheap. But ESI has, by far, the best returns on capital, the best returns on assets, and the best returns on equity. As a matter of fact, they almost double their closest competitors in every category. And despite that, they trade for the lowest valuation of any of their competitors.
Now, you’re probably wondering: Why do all of these companies trade so cheaply?
Bears have been making the case that the for-profit college industry is basically a fraud. The government guarantees almost all of the student loans taken out to go to college, so the for-profit industry basically just needs to get people to enroll to make money. This created some pretty perverse incentives, and the industry got way too aggressive recruiting students. Investors are worried that the government is going to end this money train, and likely come back and sue the hell out of the operators who took advantage of the system.
The funny thing is, ESI seems to be one of the least exposed to potential repercussions. About three fourths of their students are enrolled in two year vocational programs, which are much less prone to potential fraud than the four year colleges. Plus, despite serving a generally poorer population (and thus, more likely to default) than competitors, ESI’s repayment rate is around the industry average. While there may be some bad apples in the industry, it really doesn’t seem like ESI is one of them.
So is there some risk? Yes, it’s always scary to be exposed to government regulation. And ESI is definitely massively exposed to government valuation. But, at these prices, ESI’s upside vastly outweighs its downside. Much like Almost Family (AFAM) and home healthcare companies, everything in this industry has been thrown out… And it looks like ESI is the proverbial baby thrown out with the bath water.