[ Enlarge Image ]
Business Description: Capella University is a regionally accredited online postsecondary education services company offering BA, MA, and Ph.D. degrees and certificates in public service leadership, behavioral health & human services, business management & technology, and education. The company offers over 1450 online courses and 43 academic programs with 140 specializations to over 37,000 students. As of fiscal year 2012, 76% of students were pursuing graduate or professional certificate programs. On July 15, 2011, the company acquired 100% interests in Resource Development International Limited (RDI), which expanded its offering on a more global scale.
Investment Thesis: Momentum in CPLA’s business appears to have shifted positive and this change does not appear to have yet been reflected in the company’s valuation. The company: (i) is seeing a recovering / growing new-enrollment rate; (ii) continues to improve student retention rates; (iii) has designed a well-differentiated and higher-quality product offering that has generated tangible results; (iv) has sustained a conservative balance sheet; (v) has positive FCF characteristics derived from its high operating leverage; (vi) has protected its untarnished regulatory reputation; and, (vii) is anticipated to achieve double-digit earnings growth by end of year 2013e.
CPLA also appears to have established a quasi-competitive advantage through its proprietary technology, as it has invested heavily in its superior online learning platform as well as its learner data-monitoring and interpretation capabilities, which has positioned it to sustain longer-term relationships with students resulting in heightened “lifetime learner” revenue levels generated through its average student. Thus, CPLA shares currently represent an attractive investment opportunity, particularly at any price below $33.50 per share (based on perceived margin-of-safety requirements).
The market appears to be taking an overly near-sighted view in valuing CPLA. The for-profit education industry has been hit hard as a whole by challenging macroeconomic conditions as prospective students are less willing to take on additional debt and many companies have cut back on their budgets to invest in employees. There is a significant lag effect in this market segment as variables that have an unfavorable impact on prospective students’ willingness to enroll in secondary educational programs do not immediately impact revenues. Students that have continued with their programs beyond their first term typically tend to stick with the programs. While new enrollment rates fell dramatically in the mid-to-late stages of the financial crisis, total enrollment levels (and associated growth rates) did not begin to fall significantly until 2010. Until recently, the leading new-enrollment indicator was continuing to decline, suggesting that a reversal in total enrollment was not on the radar. However, in the second half 2012, new enrollments at CPLA increased a healthy 5% and are expected to continue to increase an additional 5% in the first quarter of 2013, suggesting a recovery is underway. However, revenue is expected to continue to decline through the first half of 2013 due to the declines in new enrollment seen through the beginning of last year.
Moreover, the market is applying additional skepticism to the stock as there is a greater degree of caution held among prospective students for the higher-margin master’s and Ph.D. programs (CPLA’s target market); as a result, the recent growth in new enrollment has been driven primarily by new students in the lower-margin bachelor’s (and certificate) programs. In addition to being less profitable, this shift has also contributed to a growing level of bad debt exp., which has been one of the focal points of the company and the industry as a whole. As a result, market sentiment towards CPLA’s near-term horizon rightfully remains negative. However, I believe that the market is misinterpreting the recent shift in new enrollment to bachelor's programs as mutually exclusive with a potential recovery in higher-margin post-bachelor's programs. I would argue that the fact that increases in bachelor's program new enrollment is an indication that CPLA’s marketing strategy is achieving success, and that when the later-stage MA and Ph.D. programs eventually do recover, this improvement will complement (rather than replace) the growth in bachelor's program students. Moreover, I expect that bad debt expenses will subside as higher-income master’s and doctoral students enroll compounded by any additional benefit realized if broader economic recovery continues.
Distribution of potential returns skewed towards upside: The most feasible scenario in which CPLA could incur losses beyond my down case would be if the company lost its standing with the federal government allowing it to continue to accept federal grants, which seems particularly unlikely given the company’s track record relative to most of its for-profit educational services peers, the fact that it does not have a comprehensive review by the HLC scheduled until 2015, its participation in the AQIP Quality Program, as well as the company having its own employees serving on HLC review teams, which facilitates keen awareness regarding new standards. That scenario aside, I estimate that the company’s risk/return profile is skewed towards the upside (4.8x ratio). One element of this relates to cyclical factors highlighted by CPLA’s normalized EPS exceeding 2012a EPS by nearly 20%. Upside potential is even further expanded due to new initiatives CPLA is pursuing to efficiently pursue cost-efficient growth.
Strong management with cost-efficient strategy combined with attractive operating leverage: CPLA mgmt. has demonstrated a commitment to maintaining a focus on investing in continued revenue growth in a responsible manner while also remaining as nimble as possible in addressing its recent rev. declines by reducing its exp. structure. The for-profit education space is a highly fragmented market fraught with acquisition opportunities, particularly for global geographic expansion efforts, as this industry is even less developed abroad than domestically. Just like any industry, this offers as much potential risk as opportunity. However, CPLA recently acquired (for $1.2 million) the outstanding interest in a JV it had formed itself and made a full acquisition of RDI in the UK (upfront purchase price of less than $20 million with a significant contingent consideration component). These investments seem to be guided towards appropriate geographic expansion without putting too much capital at risk and responsibly structuring the transactions.
Moreover, due to rapidly increasing competition, many CPLA competitors have invested heavily in marketing initiatives. While marketing efforts are central to CPLA’s strategy as well, management has directed its marketing-related efforts to cost-efficient programs that focus more on enrolling interested students rather than inefficiently mass-marketing to the broad public. This was highlighted by evidence seen in a survey of 72 people I conducted as Capella was on the lower end in terms of overall awareness. However, by investing in proprietary technology, directing a substantial share of its budgeted marketing resources to partnering with corporations, and investing in retaining registered students almost as much as attracting new prospects, the company has been able to control expenses while outperforming its peers on a relative basis in terms of minimizing the revenue contraction it has incurred in the recent environment. Similarly, management’s focus on experienced management was also highlighted by its successful expense reductions in 2011, as it proactively reduced its teaching staff headcount in response to the reduced number of new students enrolling. These factors position CPLA well for margin expansion with revenue growth.
Compelling Market Niche: After conducting a study with 72 respondents, I found evidence that, relative to its peers, CPLA’s positioning as a purely online secondary education services provider, the superior services that the company offers (which appear to be important to customers based on the survey, and superior to competing services offered with regards to areas such as career counseling based on discussions with two recruiters), as well as its targeting of master’s and doctoral-level students, all seem to be more aligned with customer needs than competitors (despite having less recognition due to lower marketing expenses).
Valuation: I used the EPV methodology for my valuation, blending valuations from multiple time horizons. My floor was further reiterated by an asset-based valuation of $27 per share. My base target price of $50 per share represents upside of 67% to where the stock is currently trading, and represents 14.5x & 12.5x P/E ratios to LTM reported EPS and normalized EPS, respectively (when excluding excess cash). My model also assumes that CPLA continues its track record of returning a percentage of excess cash to shareholders through share repurchases. Considering the strong FCF capacity and the varying degrees of cash expected to be returned to shareholders, IRR estimates are -1%, +30% and +50% for down, base and up, respectively.
 Recent survey of alumni indicated that students saw an average compensation increase of approximately 10% upon completing programs
 See Appendix for relevant sensitivity table pertaining to margin-of-safety
 See Enrollment Growth Trends and Forecasts chart in Appendix
 Calculated as: (five-year average ROE)* (current BVPS)