With shares of most for-profit education companies in a free fall for more than a year, many stocks in the sector have been appearing on value investing screens (and even some value investor’s portfolios). Strayer appears on Gurufocus’ Low P/S Screener and is owned by Ron Baron, Joel Greenblatt, and Wallace Weitz.
By now the pitch is well known; the companies appear very cheap based on last year’s or trailing twelve month's earnings and the companies earn high returns on capital. The question is with all the new regulations, will revenue, margins, and returns on capital look the same in the future as they have in the past?
The first question a potential investor might ask about investing in for-profit education and Strayer in particular is a moral and ethical one. How much of all negative press surrounding for-profit schools is true and do for-profit education companies like Strayer even have a role in the higher education arena?
Well, many of the investigations and alleged misdeeds that happened at for-profit education don’t apply to Strayer. For starters the GAO investigation of for-profit schools did not target any Strayer campuses (the report was also later heavily revised, and even then some errors still remained). The furor over recruiter compensation is a non-issue at Strayer as well, as it has never paid incentive compensation. Strayer also isn’t saddling students with high debt and leaving them unprepared for the workforce. Strayer’s published four year tuition of approximately $60,000 is well below the average of public out-of-state four year tuition rates of $78,380 and private four year tuition rates of $109,172 (source: Strayer 10K, College Advocacy Board).
Astute readers might point out that many non-profits offer scholarships, so the published tuition rates might overstate the true financial burden. Strayer fares well when looking at student debt too. Strayer’s students average $22,500 of debt compared to a national average of $24,000, private non-profit average of $27,650, and for-profit average of $33,050 (source: Strayer 2009Q4 conference call, Project on Student Debt). Students may graduate with low debt but what if they got a degree from a for-profit education company that’s worthless? If the degree was worthless we would expect to see a high level of defaults on student loans and we do not. Strayer’s 2008 two year cohort default rate was 6.7% compared to non-profits which averaged 7.0%. The average of all for-profits was 11.6%.
Furthermore, Strayer does not have any contact with students regarding loan repayments once they graduate. So there is no need to worry about allegations that for-profits heavily “manage” the default rates when it comes to Strayer. Also, Strayer is regionally accredited by the Middle States Commission on Higher Education. This is one of six regional accrediting bodies that accredit a vast majority of traditional non-profit colleges.
So, Strayer looks like a good school so far but what effect will existing regulations and the new Gainful Employment rules have? Strayer’s management believes the new rules will have little to any effect on Strayer’s business model (and we concur).
Strayer does not have any problems with the 90/10 rule. This rule specifies that a for-profit company can receive no more than 90% of its revenue from the Federal government. Some other for-profit schools risked running afoul of this rule and were forced to raise their tuition or change how their programs were structured. Strayer only receives 78% of its income from Federal sources and thus has plenty of room to weather any changes to how the 90/10 rule is calculated and has no need to increase tuition prices further unless dictated by the market.
Strayer should also have no problem meeting the new Gainful Employment rules. The Gainful Employment rule states that school will be ineligible for Title IV funds if students do not meet one of several income or debt repayment measures. The basics of the rule are that programs need to show one of the following to maintain eligibility: at least 35% of graduates are repaying their loans, or graduates are spending no more than 30% of discretionary income on loan payments, or graduates are spending no more than 12% of income on loan payments. Schools have three years to correct any problems before sanctions are imposed (2015 is the first year any sanctions would happen). With Strayer’s low cohort default rate we should expect Strayer to easily meet the loan repayment threshold. Additionally, with low loan balances and 57% of students pursuing a bachelor’s degree and 28% pursuing a master’s degree, graduates should be able to find higher paying jobs and easily meet the debt to income ratio tests.
The final piece of the puzzle is what new student growth will look like. Because a school can withdraw Title IV funds before providing education services this acts as a form of operating leverage and free cash flow as long as the student population keeps growing. If the student population begins to shrink the leverage works in reverse and margins begin to shrink.
For-profit schools have seen enrollments fall of the past several quarters. Some of these enrollment declines were self induced as school cut programs, delayed introducing new programs, instituted stricter screening criteria for new students, or ceased enrolling certain types of students.
With Strayer the cause of enrollment declines certainly isn’t related to any overt measure on the school’s part as it has been business as usual at Strayer. We think enrollment growth will eventually return as education is crucial for a modern workforce. Indeed, a recent study by Georgetown University estimates that we will need to education an additional 20M students by 2025 to meet employer demands. The U.S. has fallen behind countries like Australia, Denmark, Japan, and Canada in college degree attainment by 25-34 year olds. State and local governments have been cutting education budgets (state funding is at its lowest level since the 1980s and many public schools have been forced to reduce capacity as a result. With more budget cuts on the way, that leaves private non-profit and for-profit education schools as the only ones left to pick up the slack.
Despite the new rules and declining enrollment trends it looks like for-profit education and Strayer are both here to stay.
Readers might be interested to know that Jim Chanos, a noted bear on for-profit education, disclosed that he was not short Strayer at VALUEx 2011 in Vail, CO.
Disclosure: Long STRA