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Strayer Education (STRA): A Bright Spot in a Dark Industry

August 19, 2013 | About:
Last week I put 6% of the assets into Strayer Education (STRA). I think the stock is unduly cheap. The company has a market cap around $475 million, but has generated $71 million in free cash flow in the last 12 months (a 15% FCF yield). In the last six months alone, the company has generated $46.6 million of free cash flow. It's a good business with high returns on capital, low fixed costs, high free cash flow yield and even some growth potential that's not priced in. They also have a great management team that has been buying back a considerable amount of stock.

Strayer is a for-profit education company. Its main asset is Strayer University. Strayer has been around since 1892. It has a long history in the D.C. area. It went public in the 1990s, and began growing from a few campuses in the Washington D.C. area (it had eight campuses when it went public) to 100 currently.

Strayer’s chairman, Robert Silvermann, is the former CEO of Cal Energy, which was a Berkshire Hathaway holding. Silvermann was the CEO until this year, but he will continue as chairman going forward. STRA is a very well-managed company and I get the strong feeling from reading the annual report that they do care about their students and their shareholders (a key point to consider in the for-profit industry).

Here is my basic thesis for investing in STRA:

  • It’s cheap because of regulatory risk, but the company is one of the best and most respected in the industry, even among regulators.
  • It’s cheap at 8 times FCF (it’s already produced $47 million in FCF for first six months of 2013, which implies a multiple of about 5).
  • It has historically grown FCF at a 14% per year.
  • It has produced significant FCF in each of the last 10 years.
  • The stock is at 10-year lows.
  • The company is buying back stock. He has $100 million left on its buyback plan (over 20% of current market cap).
  • Company insiders own about 6%, but have been purchasing more shares lately.

For-Profit Education: A Hated Industry

The for-profit education stocks have been absolutely crushed over the past year and a half, and many are selling 70% to 80% below their recent highs. The industry is wrought with questionable motivations, poor recruiting practices, mediocre student results, high default rates and government regulatory scrutiny. Sounds like fun, right?

My initial foray into this industry began by researching a bunch of stocks that were clearly cheap on most statistical metrics (they all are cheap relative to their former valuations, and most have single-digit earnings and cash flow multiples). Any quick and dirty valuation screen pulled up many of the stocks such as COCO, CECO, APOL, CPLA, DV and a few others, STRA included.

I began noticing how hated the industry is, which is usually a reason to at least give it a look. One thing I’ve learned through observation is that markets tend to misprice stocks that are involved with known and identifiable risks. In other words, if you can list all the reasons why you should hate a stock, there might be a good chance that the market is undervaluing that stock.

It’s common sense when you think about it: If everyone hates it, and everyone knows why everyone should hate it, by definition, the majority of market participants are not going to want to own it regardless of the valuation.

Jamie Mae, of Cornwall Capital and Michael Lewis’ "Big Short" fame said something similar in an interview with Jack Schwager:

“Markets tend to overdiscount the uncertainty related to identified risks. Conversely, markets tend to underdiscount risks that have not yet been expressly identified. Whenever the market is pointing at something and saying this is a risk to be concerned about, in my experience, most of the time, the risk ends up being not as bad as the market anticipated.”

Low industry tides lowers all the boats in most cases, and despite being an above average business, and one of the most well-respected companies even among the regulators, STRA has been punished along with the rest of the group.



The stock is down 80% from its five-year high. I think this is mostly due to the overall sentiment in the for profit education industry, but the Strayer is certainly not completely immune to the problems in that group. Enrollments are down, regulatory requirements will make it more difficult to do business, and students may question the value of paying for education at many of the schools in this industry. However, I think the upside vastly outweighs the risk, and I think the worst case risks are more than priced into the current valuation.

Here are some things to like about STRA:

  • Low fixed costs.
  • High returns on capital.
  • 10 years of FCF.
  • Growing historically, and has only 100 campuses in 24 states.
  • Scalable business model that can grow much larger over time.
  • Even without opening campuses, the company has only 520 students per campus and their goal is to have about 1,000 per campus, so even without adding campuses, it can grow significantly.
  • Company is cheap; 8 PE and 9 EV/FCF, 5 EV/EBITDA.
  • Buying back a lot of stock.
  • 10-year accreditation from Middle States. They applied early and received their accreditation without any adverse findings.
  • Really good reputation in the industry for a well-managed university. No signs of the ill-practices at other for- profit education schools.
  • Sen. Tom Harkin says it’s “one of the best” and he wrote a scathing report on the whole industry.
Strayer is a good business at a cheap price and I think the lower enrollment trends and the regulatory headwinds are already priced into the current valuation. The business uses very little in the way of fixed assets, so it produces high returns on the assets and the capital that it invests in the business. Most of the cash flow passes to the owners (owner earnings, or operating earnings less maintenance capex), as there is very little maintenance capex requirements. Here is a quick look at a few of the numbers from the last 10 years:





So the business produces above-average returns and high free cash flow, and is available at a cheap price. But what about the business and regulatory risks?

Industry Risks

As I mentioned earlier, I began investigating the industry based on the cheapness of most of the stocks. My initial plan was to buy a basket of these cheap stocks. I still may end up owning a couple others, but most of the businesses are indeed at risk of regulatory penalties, and I'm not interested in taking that risk. Strayer is subject to the same regulations, but has done a much better job complying with the new, and proposed rules, and from what I can tell has no real risk of major regulatory problems.

However, the for-profit education industry has been riddled with controversy and scrutiny over the past few years. Less than admirable recruiting practices and methods of doing business has given the industry a black eye. Congress has stepped in and has taken out the microscope to try and put the reins on the companies in the industry that are at the root of the problem.

Congress has a lot of power because the industry relies on funding from Title IV for the majority of their revenues. There are a few key laws to be aware of in this industry. Two of the most important when looking at companies are:

  • 90/10 Rule: This rule states that a for-profit education company can’t get more than 90% of its revenues from Title IV government financial aid. Many companies are in the '80s, and a few are even at or slightly above 90. Going over puts the company on probation and risks it losing the ability to use these funds, which would put them out of business.
  • Two or Three-Year Cohort Default Rate (CDR): The CDR tells you how many students are defaulting on their student loan obligations after two or three years. Both measures have been used. Basically, a company cannot have a CDR in any one year over 40%, and can’t have a two-year CDR over 25%. Many companies are around 15% to 20%, but the average in the industry is about 12%. Going over 25% puts the company in danger of losing its accreditation, which would seriously damage the business.
In both of the above categories, STRA is significantly better than average. They rely on Title IV funds for just 76% of their revenues, which is well below average. Their CDR rates using either two or three years, are also well below the industry average, and is in no danger of coming close to the 25% threshold.

There have been numerous reports on the industry written by regulators and lawmakers. Tom Harkins, chairman of the Senate HELP committee, wrote the most comprehensive one, and blasted many of the companies in the industry for unethical recruiting practices and poor student results. But, he had this to say about Strayer (emphasis mine):

"Like many for-profit education companies, Strayer Education, Inc. has experienced steady growth in student enrollment, Federal funds collected, and profit realized in recent years. However, the company's performance, measured by student withdrawal and default rates, is one of the best of any company examined, and it appears that students are faring well at this degree based for-profit college."

And again, this is coming from the man who is basically leading the regulatory charge against the entire industry. He is basically "for-profit education enemy No. 1." He also had this to say about Strayer to sum up his report:

"Students attending Strayer have significantly better rates of retention than other companies of comparable size... Strayer appears to have better controls on recruiting practices and a more robust set of student services than many other companies, particularly publicly traded companies... The company also has earned the confidence of a number of employers that provide tuition assistance for their employees to attend the school. This in turn helps the company to be better positioned with regard to regulatory compliance than many other publicly traded companies. As a result, students attending Strayer-owned colleges appear to be faring much better than at many companies examined and the company had the lowest withdrawal rate for Bachelor's students of any company examined..."

Pretty positive words from a mostly extremely critical report on the industry. The report did mention that Strayer exhibited a "lack of cooperation with the committee" that was "surprising," but as you read the latest SEC filings, you'll notice that Silvermann and the rest of the Strayer management team has gone above and beyond in terms of transforming their business to meet the new guidelines and requirements.

Other Risks:

I see very little valuation risk and very little leverage risk. The company uses very little equity (currently has about $45 million in shareholder equity because of very few fixed assets). The company has $125 million of debt, but has plenty of free cash flow to cover the debt, and has a strong liquidity position (current ratio about 3, and it has $67 million in cash).

The biggest risk is business risk, and actually not in the traditional sense. The business itself is an outstanding business with low fixed costs, high free cash flow, high returns on capital and a strong record of growth. The main risk is regulatory. If the Congress begins to come down even harder on the industry, it could make business more difficult.

I do think STRA is the best prepared in the industry to handle further regulatory hurdles, and given the fact that even Tom Harkin complimented STRA, I think even the risk of regulatory problems is remote, and likely priced into the current valuation.

Valuation:

I never get very complicated when trying to determine specific value of a stock. I like Joel Greeblatt's idea that value investing is just "figuring out what a business is worth and pay a lot less." He also has mentioned that he is never sure what a business is worth precisely, but he has a general idea that the purchase price is a lot less than the value, i.e. if a stock is worth $10 and he can buy it for $5 or $6, he gets interested. He might be wrong and the value might be $8, or $12, but he has a good chance that it's higher than what he's paying. I have taken a similar "approximately right is better than precisely wrong" stance to my valuation work.

In a business like STRA, most people would approximate the value using a DCF. I don't use DCFs, as I don't like the false sense of precision (not to mention the wide variations of outcomes you get from small changes in assumptions). I value businesses like I used to value apartment buildings that I was interested in: What do the assets look like? What is the cash flow? And how much is that worth to me over time?

I simply look at the cash the business has produced and try to decide if the future stream of cash will continue and if so, what is that worth to me. In this case, if the business continues to pile up free cash flow and buy back shares, I think that alone will act as a catalyst to increase the value of the stock. The company doesn't need much cash to operate, and so even with no growth, the FCF yield will grow over time as the company buys back more and more stock.

One of the questions I ask myself at the end of the research is if I think the stock has 100% upside (i.e. a 50-cent dollar), and using just simple free cash flow buildup gives me a general sense that the stock could see $80 to $90 in the next few years, especially if the regulatory uncertainty becomes clearer. If the business does better than people expect, the stock might have significant upside. It's not precise, but I have a strong sense that the possible upside vastly outweighs the downside.

To Sum It Up:

STRA is a great business selling at a very cheap price. The company has produced positive free cash flow in each of the last 10 years, achieves high returns on capital, has historically grown earnings and cash flow, and has an experienced management team. The company has a good runway for growth, but you get any growth for free because the stock trades at a multiple that suggests no growth. The stock trades at single-digit multiples of earnings and free cash flow (EV/FCF is about 8), and has historically grown that free cash flow stream. And maybe most importantly, the company is buying back stock, and has committed to another $100 million of buybacks (about 20% of the current market cap).

Good capital allocation along with good fundamentals and a great valuation makes this an interesting idea.

Disclosure: John Huber owns STRA for his clients and himself. This is not a recommendation or an endorsement. Please do your own research, as this investment may not be suitable for you.

About the author:

John Huber
I am the Portfolio Manager at Saber Capital Management, LLC. Saber manages an investment partnership as well as separately managed accounts for clients interested in a focused value investing strategy. My investment style has been most influenced by Ben Graham, Walter Schloss, Warren Buffett, and Joel Greenblatt. I am also the author of www.BaseHitInvesting.com, a value investing blog.

Visit John Huber's Website


Rating: 4.0/5 (20 votes)

Comments

frankk
Frankk premium member - 7 months ago
Thank you for your informative and valuable article about Strayer.

I agree it is a good company, with a very good management. My first notice about the

company came through the book "The Investment Checklist" from Michael Shearn, where the

quality of Strayer management/Robert Silverman was several times mentioned..

John Huber
John Huber premium member - 7 months ago
Thanks for the comment Frank. I haven't read that book, but I've heard good things about it. And from what I've read elsewhere, Silverman has a great reputation.
bajjiblow
Bajjiblow - 7 months ago
Good analysis..but what happened in 2011 ? Receivables went from 200 to 25 millions and book value got slashed from $10.22 to $3.52 . Deferred revenue went down from $181 to $15 and added new debt of $118 millions. Did they write off the receivables and incurred more debt to support their operations ?

vgm
Vgm - 7 months ago
Outstanding analysis and commentary, John. And very clearly presented too. Thanks for sharing it.

Doing a Munger "invert" on your thesis and conclusion, I'd ask the following questions: why do you think prominent value investors are not all over STRA? What might they see which is preventing them from investing in what otherwise seems like a compelling case? Credible value investors are often able to see past temporary problems to the light ahead (as you seem to be doing here).

Thanks again.

Victor
spark411
Spark411 - 7 months ago
What do you like about Strayer vs it's competitors like ESI and APOL? Also, if this is a good business and presumably sector, why hasn't there been consolidation in this sector?

thanks

John Huber
John Huber premium member - 7 months ago
Thanks for the comments...

Victor, I think one reason a lot of the big, well-known value guys are not interested in STRA is because it's a small cap stock. It's only a $450 million market cap, and so for many of the larger funds ($500MM and up), it really would be too small of a position to make a meaningful result, unless a fund wanted to take a major 10% stake or so in STRA. And even for relatively smaller funds, the stock is hard to accumulate because the volume traded is fairly low.

My guess is that there will be smaller value funds interested (funds that don't file 13-f's because they don't have to yet because of their size). But I don't know this for sure and it wasn't part of my thesis.

The only value guy I've heard mention this company is the well-known short seller Jim Chanos. I believe he was quite short the entire for profit industry at one point, (maybe still is), but he made a point not to short STRA (at least from what I read... since 13-f's don't publicize short positions).

I just like how cheap it is. Cheapness often acts as a significant catalyst, and the cash flow over time will build up. But this is a long term position and could certainly go lower.

Best Buy is a great case study... I bought it at $18 before it went to $11. Cheap often gets cheaper. But usually things don't stay at a 20% FCF yield very long. My hope is STRA turns around in a similar fashion, but we'll see. A group of these positions typically works out, and it doesn't have to be large group.

Spark, as for consolidation... it's difficult for these companies to buy one another. I am not an expert and wouldn't be right to explain it, but consolidation could happen, but not without dealing with regulation red tape among other things.

APOL and ESI are cheap, much cheaper than STRA on most value metrics, but STRA is a much better business, and in my opinion far less risk, which translates into much better risk adjusted potential returns. But a basket of these things could work. I know other value investors who bought a basket earlier this year including CPLA and ESI which have both doubled. The problem with ESI and APOL is that their cohort default rates are higher and there are some other risks (accreditation among other things) that I wasn't quite comfortable with. At some valuation, they might make more sense, but I really didn't see a big risk with STRA so I took a position.

I try to focus on downside first, and even though there is probably much more upside with some (for instance, some of these might have 3-5x potential if they survive, but I can't figure out the odds of that yet. With STRA, I'm very confident. (That doesn't mean the investment will work... some do, some don't, but on average, big cash flow yields combined with the compounding effects of buybacks like this work well over time on balance).
vgm
Vgm - 7 months ago
Thanks John. Your point re small cap status is well taken. The exclusion of some of the better known value investors based on that could be seen as yet another reason for (a) why it's cheap; and (b) why it could present good value to those who can invest in small cap.

Jim Chanos did indeed go short the for-profit space and presented his thesis at Ira Sohn in 2009. Ironically, at the same conference, Steve Mandel presented a very bullish rationale for Strayer as his long pick. This was when the stock was around $200. He got out not much later and I believe he doubled his money in STRA. Both theses are summarized here:

http://seekingalpha.com/article/153849-for-profit-education-steve-mandel-vs-jim-chanos

Looking at today's valuations, Chanos has been proved right over the intervening years however.

Thanks again for sharing - and good luck.
zollaron
Zollaron premium member - 3 months ago
i am trying to sort out the significant accounting manuever made in 2011.  apparently stra decided to reclassify accounts receiveable starting in the first quarter ending march 2011.prior to that accounts receiveable occurred upon student registration prior to beginning of the semester.as of 1qtr2011 accounts receivable occured after earned --- at the end of each semester.  payments made prior to completion of semester are classified as unearned income.apparently stra claims that past financial results--eps and other metrics were not effected.sounds suspicious to me in that this change is nicely hidden in a foot note on page 10 of the 10-Q.i could use some help the financial significance of this account change? on the investment attractivness of this firm. John any houghts? others?  
zollaron
Zollaron premium member - 3 months ago
apparently as part of the accounting maneuver we see a major adjustment to act rev in 2011 (150m),and major adj down to shareholder equity--retained earnings (150m).   can someone with an acting background make sense of this?

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