The good old days of tremendous profitability and returns on invested capital far in excess of other sectors are likely gone for the for-profit education sector. The recent economic downturn, while initially bolstering enrollments, has coupled with stringent new government regulations that will squeeze margins of the sector and has eroded the economic moat for many stocks in the for-profit education space. Our two favorites in the industry from the perspective of durable competitive advantages and valuation are Apollo Group Inc. (NASDAQ:APOL) and Strayer Education Inc. (NASDAQ:STRA).
Apollo Group Inc.
Apollo Group is one of the largest providers of adult education in the U.S., serving 40 states through University of Phoenix and a network of institutions (BPP, Western International University, UNIACC, ULA, IPD and CFFP). University of Phoenix is the biggest source of revenue for Apollo, constituting over 90% of the revenues.
The company was incorporated in 1981 in Arizona and is currently headed by Gregory Cappelli and Charles Edelstein as co-CEOs. So far, the dual leadership and long-distance management style have worked well for Apollo. Its key competitors are Corinthian Colleges Inc. (COCO), DeVry Inc. (NYSE:DV), Education Management Corporation (EDMC), Strayer Education (NASDAQ:STRA), ITT Educational Services (ESI), Career Education (NASDAQ:CECO), National American University Holdings (NASDAQ:NAUH), Capella Education Company (NASDAQ:CPLA), Grand Canyon Education Inc. (NASDAQ:LOPE), and Bridgepoint Education (NYSE:BPI).
Growth and Performance
Over the last decade, Apollo’s revenues have registered a CAGR of 19.9%, weakening during the recession and entering into the negative zone in fiscal year 2011. Overall softness in the economy and tightening government control is reflecting in the lackluster performance of the industry as a whole. The company does not pay cash dividends. Its compounded annual stock return over the last 10 years was 4.2%. It is an outperformer in terms of returns as mentioned in the table below:
|5-yr Average ROA||20.7%||5.2%||6.7%|
|5-yr Average ROI||42.6%||7.7%||8.9%|
|5-yr Average ROE||54.1%||10.6%||21.5%|
EPS growth has been volatile in the long term on a year-to-year basis with an overall uptrend as indicated in the chart above. The company has estimated revenues in the range of $4.1-$4.3 billion for fiscal year 2012, while the consensus estimates are in the range of $4.2-$4.3 billion. The EPS estimate is in the range of $2.9-$3.8. The five-year growth forecast for Apollo is 8.8% as compared to 17.0% for the industry.
Long-term Strategy and Vision
Apollo group is reaping the benefits of its low-cost operations derived from a policy of focused investment, and exclusion of non-essential facilities/services, such as dormitories, cafeterias and sports facilities, due to its industry-leading online presence. An established brand name and strong geographical presence give rise not only to economies of scale, but also a network effect.
However, the economic downturn and stringent new regulations have put a damper on the entire industry. In the past, the students have been insensitive to the fee structure of for-profit institutions due to the availability of Title IV funding and Pell Grants. Any new restrictions to extent of funding could take a toll on new enrollments, whereas a breach of the new compliance requirements places Title IV at risk. In addition, the institutions are required to maintain some standards with respect to the level of funding and repayment of loans. Looking at the 90/10 rule, Apollo is in a risky position, hovering too close (85%-88%) to the upper limit of 90%. On the other hand, the cohort default rates have been steadily rising over the last couple of years. The two-year cohort default rate at the University of Phoenix was 18.8% in fiscal year 2009 as compared to 15.0% for the industry.
On the positive side, the company has a highly positive debt profile (Debt-Equity: 0.1) and strong cash profile to put it in a strong financial position. Cash and cash equivalents of more than $1.5 billion allow it to consider strategic investments for planned growth. For instance, in 2009, it acquired UK-based BPP Holdings for $607 million that helped it make inroads in UK and the rest of Europe.
To consolidate its position in a highly competitive industry, Apollo is taking new initiatives along the value chain. It has boosted its retention rate by introducing a new orientation program with a success rate of 80%. The program delivery stage has been enhanced by upgraded learning platforms, tailor-made course contents that meet employment standards, and innovative teaching methods. At the recruitment stage, Apollo has adopted a two-pronged strategy of employer partnerships and alumni engagement. These channels are designed to improve placement rate of the graduating students.
Strayer Education Inc.
Strayer Education is a provider of adult education in the form of graduate and undergraduate courses in the domains of business administration, accounting, information technology, education, health services administration, public administration, and criminal justice. Unlike Apollo, Strayer currently serves only 22 U.S. states through its single channel, Strayer University. Tuition fee constitutes 97% of the revenues.
The company was founded way back in 1892, but got listed in 1996. Since then, it has registered an impressive growth and profitability. It has increased its size from 8 to 92 campuses. A lot of later success of the organization is attributable to a number of strategic decision taken 2001 that included a new management team, significant ramping up of its online platform that helped it cross borders, and geographical expansion. Strayer is currently headed by Robert S. Silberman, who serves as the chairman and CEO. Its key competitors are Corinthian Colleges Inc. (COCO), DeVry Inc. (NYSE:DV), Education Management Corporation (EDMC), Apollo Group Inc. (NASDAQ:APOL), ITT Educational Services (ESI), Career Education (NASDAQ:CECO), National American University Holdings (NASDAQ:NAUH), Capella Education Company (NASDAQ:CPLA), Grand Canyon Education Inc. (NASDAQ:LOPE), and Bridgepoint Education (NYSE:BPI).
Growth and Performance
Despite being a smaller market player, Strayer has been among the top performers who weather the recession with comparative ease. Strayer’s revenues have registered a CAGR of 21.2%. Unlike Apollo, it maintained its growth momentum even during the recession, though it is also affected by current industry headwinds. The company pays a quarterly dividend of $1 per share, as increased from $0.75 in October 2010. The payout ratio in 9M 2011 was 45.6%. Strayer’s near-perfect returns on capital currently make it a powerful contender in the industry, while its five-year returns bring it at par with the key competitors as indicated by the table below:
|5-yr Average ROA||26.4%||5.2%||6.7%|
|5-yr Average ROI||46.1%||7.7%||8.9%|
|5-yr Average ROE||48.8%||10.6%||21.5%|
As compared to the weakness in Apollo’s EPS performance during the recession, Strayer’s EPS trend indicates a consistent increase over the last 10 years, more significant since the recession. According to the consensus estimates, EPS in fiscal year 2012 is likely to be in the range of $8.6-$8.9, while revenues are expected to be $536.0-$651.0 million. Like Apollo, the future growth potential for Strayer is less than the market. The five-year consensus growth estimate is 10.4% against 17.0% for the industry.
Long-term Strategy and Vision
Strong financial performance, excellent admission practices, affordable fee structure, low cohort default rate, statutory compliance, and excellent management team are the core areas of strength for Strayer Education. However, it still needs to expand its geographical reach, which is limited compared to the competitors. Apart from the increasing number of physical campuses and articulation agreements for domestic growth, the online platform is opening new doors of global expansion for the company. The increasing income gaps between high school pass outs and graduates/post graduates indicates strong future potential for the industry. However, the current market dynamics remain challenging as mentioned above and Strayer’s performance is expected to remain affected in the near term.
Though the company is not pursing an active inorganic growth policy currently, it is continuously increasing its base through strategic SLAs (service level agreements). Institutions and corporate alliances are key focus points for this leg of its long-term strategy. With a number of big names in its ambit, Strayer is poised to gain in this direction.
The organization is also comfortably placed in terms of regulatory compliance. For instance, its three-year cohort default rates for fiscal year 2008 were 14.0% as compared to the national average of proprietary institutions of 25%. Strayer also satisfies the 90/10 rule as Title IV funding constitutes around 75% of its revenues. By targeting that section of adult students who plan for a degree course, the company has ensured better final job placements and lower dropout rates. Its gross margin is in line with the industry; the net margin is significantly higher as indicated below:
|5-yr Average Gross Margin||66.9%||54.7%||34.9%|
|5-yr Average Operating Margin||32.5%||14.1%||15.9%|
|5-yr Average Net Margin||20.4%||8.9%||11.5%|
As the profits translate into cash flows, Strayer can be expected to augment its liquid resources (cash and cash equivalents at the end of third quarter fiscal year 2011: $57.1 million) to embark upon an active policy of inorganic growth and strategic investments. This is particularly true in the light of its higher-than-average debt.
Which company is the better investment for value investors?
The year ending for Apollo is August 31, while that for Strayer is December 31. Both the companies appear to be attractively valued at their current prices. Apollo is trading at an approximately 22.1% discount to its intrinsic value, while Strayer is trading at an approximately 36.6% discount. EV/EBITDA multiple for both the companies is lower than the industry average, Strayer being higher. The earnings multiple for both is in line, while the PB ratio for Strayer is significantly high. The other metrics are in close range for both.
However, Strayer is definitely superior in terms of return on capital and indicates a rising trend, while Apollo indicates a flat trend that began setting from fiscal year 2009. The entire industry is expected to slow in the near term and the profits of the boom period may not be realizable for quite some time to come. Nevertheless, some companies are expected to perform better due to their structural strength and strong fundamentals.
In terms of the durable competitive advantage brought about by economies of scale and network effect, Apollo has a wider moa" than Strayer. In terms the rate of returns, dividends, expected growth rate, and current valuation, however, Strayer Education appears stronger. All in all, Strayer is a more compelling investment for us. Over the past 18 months, we have scaled into Apollo at $45, and then “backed the truck up” at $35. We have recently sold out at $49-$50.10 and intend to scale into STRA below $90.
|EV / EBITDA||3.92|
|Price / Free Cash Flows||9.20|
|Forward PE Ratio||13.12|
|Free Cash Flows Yield||10.87%|
|5 -Years EBITA Growth||17.53%|
|EV / EBITDA||5.49|
|Price / Free Cash Flows||12.30|
|Forward PE Ratio||13.70|
|Free Cash Flows Yield||8.13%|
|5 -Years EBITA Growth||19.30%|
About the author:
We apply Buffett's and Charlie Munger's four filters in selecting stocks as part of a concentrated portfolio (10-15 equities). Criteria for selecting companies are:
1.They are strong businesses; as defined by high long-term cash generation, above-average return on invested capital, possession of favorable underlying economics and a durable ...More competitive advantage, good financial health, and above-average profit margins
2. We understand the business
3. They are run by competent management
4. They are available at bargain prices.
We require a 25-50% margin of safety, depending on the stability and economic moat for the company.
In addition to equity research services, we are a member of the Gerson Lehman Group Expert Counsel of Advisors and provide research/consulting services to investment banks.