The for-profit education industry has been beaten down badly in the recent past. I am sure that many value investors have done some research in this section of the market in search for bargains. There are numerous articles on companies such as Apollo, ITT Education, Career Education, Corinthian Colleges, Capella University, etc. Most articles conclude that for-profit education stocks are cheap based on valuation metrics, but the regulatory risks are also very high. I will not repeat what has been widely known by the market participants. My thesis is built more on the qualitative analysis.
I started my research on the for-profit education a few months ago. My goal was to find a company that combines quality and value in the for-profit education industry. My initial list includes Strayer Education, ITT Education, Apollo, Career Education, Corinthian Colleges and Capella University. After reading some 10-Ks, earnings call transcripts and articles, I've narrowed it down to Strayer Education and Capella University.
I eliminated the others mainly based on qualitative issues. For example, while reading Apollo's annual report, I noticed that management claims that Apollo has "aligned our admissions practices to better support our students's success by eliminating enrollment measures as a factor in the evaluation and compensation of our admission advisory teams." This sounds like a good intention. However, new regulation specifically states that "a school participating in Title IV programs may not pay any commission, bonus, or other incentive payments to any person involved in student recruitment or admissions or awarding of Title IV program funds, if such payments are based in any part directly or indirectly on success in enrolling students or obtaining student financial aid." If a management team blatantly writes misrepresenting statements in the annual letter to shareholders, I don't think there is much integrity in the business.
Other examples include ITT Education's abysmal reviews from its students, Corinthian Colleges' officials' engagement in a no-holds-barred campaign to drive down their schools' rates by pushing former students to obtain temporary forbearance and deferments on their loans. The for-profit education industry is one in which greedy management can take advantage of the underprivileged students even though education in general is supposed to have noble intention. No wonder the regulators have been more stringent. Unsurprisingly, on a quantitative level, such as manifested by the cohort default rate, schools with questionable management also score very low. The three-year cohort default rate for the 2009 class is 26.4%, 28.8% and 34% for for Apollo, Corinthian College and ITT Education, respectively, whereas for Strayer and the Capella, the rates are only 13.9% and 9.70%, respectively.
The more research I've done, the more Strayer Education stands out from its peers, both from a qualitative perspective and quantitative perspective. So after months of research, I've decided to select Strayer Education within the for-profit education industry as my recommendation.
Strayer Education Inc. was founded in 1892. Strayer University is an institution of higher learning that offers undergraduate and graduate degree programs in business administration, accounting, information technology, health care, education, and public administration at over 60 physical campuses. The Company is a for-profit post-secondary education services corporation. Its mission is to make post-secondary education achievable and convenient for working adults in today's economy. It works to fulfill this mission by offering a variety of academic programs through its wholly owned subsidiary, Strayer University Inc., both in traditional classroom courses and through Strayer University Online.
Strayer University makes post-secondary education accessible to working adults who were previously unable to take advantage of higher education opportunities. Strayer University provides access to higher education to working adult students. Marketing activities include direct mail, Internet marketing, marketing to its existing students, print and broadcast advertising, student referrals, and corporate and government outreach activities. Strayer University maintains booths and information tables at appropriate conferences and expos, as well as at transfer days at community colleges. It has a total of 92 campuses in various stages of growth. As an institution of higher education accredited by Middle States and operating in multiple jurisdictions, Strayer University is subject to accreditation rules and varying state licensing and regulatory requirements.
Quality of Business:
Strayer Education's moat fundamentally comes from a top-notch management team. The current Chairman and CEO Robert Silberman (who will step down as the CEO but will remain chairman of the board), worked as the COO of Cal Energy, which was owned by Berkshire Hathaway, before he was recruited as the CEO of Strayer Education. He has done a remarkable job building up Strayer Education's moat in the for-profit education business. In his book "The Investment Checklist," Michael Shearn enumerated various instances where Robert Silberman showed integrity and great leadership. Here is an excerpt from the book:
"When Robert Silberman took over as CEO of Strayer Education in 2001, he said he was not going to focus on any of the metrics that generally drive public company valuations, such as revenue growth, operating income growth and margin expansion. The only thing that was going to drive real sustainable long-term value of owners was the intangible value of Strayer University and the to increase the intangible value, you increase the level of learning outcomes."
Strayer's annual reports also stand out from those of its peers. Each year's annual report contains a reprint of the Strayer's Business Model from the 2001 letter to shareholders, which clearly outlines
- What Strayer does
- How Strayer's business model generates both reported net income and owner’s distributable cash flow, and
- Strayer's strategy to increase the intrinsic value of your investment in Strayer Education.
[/i][i]"After reviewing all the data, I believe that the most significant factor behind Strayer University’s extended decline in new student enrollments during 2011 must have been the sustained level of distress across the economy, and specifically the markedly higher level of unemployment in our target student population. Real unemployment in this country among 25–50 year olds without a college degree was a devastating 22% in 2011, up from 6% in 2008. It is even higher in some of our newer geographic markets in the industrial Midwest. We know from surveying our students that the large commitments of time and finances necessary to succeed in our undergraduate academic programs are often too daunting for those adults who have no steady means of income (particularly those with dependents). We also know from our surveys that most of our undergraduate students have contemplated returning to college for upwards of two years before making the final commitment. They have had to truly “screw their courage to the sticking point” before actually enrolling. Therefore, in many ways, there is a lag factor to the effect of serious economic disruptions on our new student enrollments. As I have written in this letter in the past, while some level of economic insecurity does indeed drive working adults back to college, sustained unemployment does not, at least not to Strayer University."
Silberman also summarizes the capital allocation results from the prior year and lays out the plan for next year. Capital allocation is extremely important for any business yet rarely does a CEO of a public company present the result of prior year's capital allocation in a shareholder-friendly way. This transparency by Silberman is another indicator of management quality.
At the end each year's annual report, Strayer's Heritage reprinted from the 1912 student catalog is always attached. This section speaks the character of the business. Below is the full catalog:
This catalog was written with a view of setting before the men and women of this community some of the advantages of a business education, and of acquainting them with the superior facilities of this school for giving high-grade business training.
[/i][i]The courses have been designed and presented to meet the needs of the business office of today. The teachers are men and women who are specialists in their respective subjects. The school rooms have been chosen and equipped with special reference to light, comfort and sanitation, so as to make it an ideal place for study.
[/i][i]We ask that the public, in determining which school it shall attend, to consider the facts in connection with this school, as are outlined in this catalog and supplementary literature. It is twenty years old. It has grown steadily since the beginning. It attributes its growth to correct ideals, careful management and successful, enthusiastic, and rapidly increasing alumni.
[/i][i]While it is essential to its success that a school should give thorough instruction in the subjects that comprise its courses, yet the school that does only this, falls short of its full mission. The development of those traits of character which make for reliability in business and good citizenship are the peculiar province of the school as well as the home. This school, then, has nothing in common, can have nothing in common, with those so-called business schools offering cheap and superficial courses. Such courses, while inexpensive, and possibly of short duration, cannot result in anything but disappointment in the end.
[/i][i]This school, then, stands for high ideals, it courts investigation, welcomes comparison, and stands by its promises. It is a school to which you may attend with the knowledge that you will be in pleasant surroundings, will be accorded fair treatment, and will be given thorough and painstaking instruction.
[/i][i]Finally, in presenting this catalog, we want to thank a discerning public for its support, and assure it that we shall endeavor to continue to merit the bountiful confidence it has heretofore placed in us. [/u]
I have read all Strayer's annual report for the past 10 years and I encourage potential investors in the for-profit education industry to read them as well. You can very often tell the quality of management and business by reading letters to shareholders (think about Berkshire Hathaway and JP Morgan). Compare Strayer's letters to shareholders to that of Apollo, you will get a sense of the difference in quality.
Regulatory compliance is the biggest perceived risk in this industry. Although this risk can be high for companies like Corinthian, Career Education and ITT Education, Strayer is probably one of the best-positioned companies in the for-profit industry and it is a good thing that regulators are spending more time and effort addressing the questionable practice by a lot for-profit educational companies. Strayer's risk of non-compliance is very low. The most recent three-year Cohort Default rate is 13.9%, well below the 25% threshold, and the revenue percentage from Title IV loans is only 76%.
Also, as noted in the 2012 annual report,
"Senator Tom Harkin (D-Iowa), Chairman of the U.S. Senate Committee on Health, Education, Labor and Pensions (HELP). Senator Harkin’s committee staff conducted a two year investigation into tax-paying, investor-funded post-secondary educational institutions and concluded that, “Strayer’s performance is one of the best of any institution examined, and it appears that students are faring well at this degree-based college.”
"For the last three years the Department of Education has reviewed the regulations that govern how for-profit universities qualify to receive the proceeds of Federal student loans as tuition revenue.The Department ultimately adopted a number of new [i]regulations, the most important of which (the “Gainful Employment Regulation”) measures the earnings of graduates of for-profit universities and compares those earnings to the debt levels the graduates incurred to finance their education. There is a rather complicated process for measurement, and the first full measurement year was not slated to be until 2012, but the Department released in 2012 “illustrative” data for all for-profit universities for the year 2011, so as to give these universities an early look at their compliance. I am pleased to report that using the illustrative 2011 data, all of Strayer University’s programs passed the Gainful Employment Regulation with flying colors. Although the regulation has since been declared invalid by a U.S.District Court, and the Department has not yet announced its plans going forward, we remain confident in our ability to run our university in compliance with ]what we believe to be the Department’s intent." [/i]
[/b]Based on my observation and understanding of the business, free cash flow is probably best metric to be used to value Strayer Education. FCF per share was $3.93 10 years ago, peaked at about $10.45 during 2011 and dropped precipitously to just above $5 per share during 2012. On a statistical basis, if we take the [b]lowest price of Strayer stock in each of the past 10 years, divided by FCF per share, the average P/FCF using the lowest price is about 14. If we take the highest price of Strayer's stock in each of the past 10 years, divided by FCF per share, the average P/FCF using the highest price is about 25. Where does the P/FCF stand now? It's about 10 times, or more than 20% lower than the historical average using the lowest price during each of the past 10 years. Looking out 5 years, if the industry stabilizes and unemployment drops, Strayer can earn $8 FCF per share and apply a 14 times multiple, we get $112 per share. 133% higher than current price and approximately 18.5% compounded annually.
We can also use the P/S multiple as revenue fluctuate less than FCF and earnings. Again, on a statistical basis, if we take the lowest price of Strayer stock in each of the past 10 years, divided by revenue per share, the average P/S using the lowest price is about 3.6. If we take the highest price of Strayer's stock in the past 10 years, divided by revenue per share, the average P/S using the highest price is about 6.64. Where does the P/S stand now? It's about 0.9, or more than 75% lower than the historical average using the lowest price during each of the past 10 years. Even if revenue per share stays the same at $50 per share and assume things revert back to the mean in five years, Strayer should be trading at $180 per share, 275% higher than the current price and approximately 30% compounded annually.
Strayer does look cheap from a statistical perspective. However, as Robert Silberman has candidly mentioned in the most recent annual report, things may very well not get better in the next several years. In this case, the return can be expected from shares repurchase (which is increased to $150 million). Assuming the shares are repurchased at $50 per share, resulting in a 3 million share (27% of total shares outstanding) shrinkage to 8 million shares outstanding, with $57 million FCF, the per share FCF will be approximately $7. Apply a 14 times multiple, we get $98 per share, or 15.5% compounded annually for five years.
In the end, I'd like to quote Robert Silberman, "As shareholders, we own a business which has a unique characteristic, to wit, the value of our enterprise is determined by the quality of our customer. To prosper long term, we must continue to be worthy of the types of students who decided to make Strayer University their academic home."[/b][b]At $48 per share, Strayer is a good combination of quality and value in the for-profit education industry.
Disclosure: Long STRA.
As always, seeking different opinions and constructive criticism.