Fears Surrounding Education Create a Buying Opportunity
Economic and regulatory concerns have kept Apollo's shares cheap.
Even though the for-profit educational companies we cover have recently reported operational results that were much better than expected, the stock performances of these companies have been lackluster. Since the market bottomed in early March, most education stocks have underperformed the market. Enrollment growth has been impressive and profitability is improving because of scalability and a cheaper advertising environment. However, despite record-breaking results, these stocks are having a hard time keeping up with the market. We think this has created an opportunity.
In past articles like this one, we have discussed why we like the for-profit education industry. Given the high demand for educational services, the limited reinvestment costs, scalable business models, price inelastic customers, and government-aided tuition pricing, we believe many companies in this industry have established a wide moat. So when the market creates an opportunity in this profitable industry, we think investors should take a look.
Do Your Homework on the Industry
Education is often looked at as a defensive investment because of its countercyclical nature. During weak economic times, individuals see education as a way to improve their job skills and marketability. If investors start to think that the economy is improving, however, they might shift out of more defensive investments and into more cyclical names. Although most education companies have performed well during both good and bad economic times because of positive secular trends, the strong tail winds that have helped accelerate enrollment growth could subside if the economy rebounds and the job market improves. This doesn't mean that education companies will stop growing if the economy picks up, but the extra bump we have seen in the last few quarters could go away.
Oddly enough, the weak economy is also raising some concerns about this often-countercyclical industry. With unemployment approaching double digits, it is becoming difficult for graduates to locate jobs. If this trend lasts long enough, some potential students may decide not to take on the cost of education because of a lack of opportunities at graduation. Although we have seen some lower job-placement rates, so far this has not had a significant impact on demand. Additionally, many schools are focused on areas with strong long-term demand, such as health care. Even if placement rates drop a few percentage points and finding a job takes a bit longer, the long-term value proposition of a degree is still enticing.
Government-aided student loan default rates are also a concern because of the economy. With high unemployment, some former students are not able to pay back their loans in a timely manner. This is not a direct concern to most schools because they only provide minimal direct lending to students, and loan defaults are the concern of the loan holder and the government, which guarantees the loans. However, once cohort default rates reach a certain level, schools can be put on probation or have their students' access to government-aided loans revoked. Although cohort default rates are something to keep an eye on, most are nowhere near the Department of Education's cohort default limits, which are 25% for three consecutive years or 40% for any one year. Additionally, we should note that the Department of Education tends to be very slow to shut off a school's access to funding. Just like with accreditation issues, there is an appeals process. We expect the Department of Education would take into account the current economic situation when it looks at default rates.
Additionally, as with the health-care industry, concerns about regulatory changes have arisen under the new Obama administration. President Obama has made education a focus of his administration and has pointed to elevated post-graduation debt loads for students as a concern. However, post-graduation debt loads are high among all students, nonprofit and for-profit alike. With the tight budgets that state governments are experiencing, nonprofit schools are actually raising tuition and fees. So far, the federal government has focused on making education more affordable through increased financial aid and not on lowering the cost of education. Unless we see the government start to rein in tuition at traditional schools, something that their budgets won't be able to handle very well, we don't see a major threat to for-profit competitors, who typically price tuition in line with traditional schools.
The president has also proposed the American Graduation Initiative, aimed at funneling $12 billion during the next decade into community colleges, leading some to fear that for-profit schools will be facing increased competition. This increased funding, if approved by Congress, will help community colleges revamp and expand their offerings. However, we don't think this will have a major impact on competition because many community colleges are bursting at the seams and still wouldn't be able to meet the demand that is in front of them. Also, only $500 million is set aside to help community colleges set up online programs. In fact, increased community college funding could be a good thing for for-profit schools. Obama's call for 5 million more community college degrees and certificates by 2020 means 5 million more students could potentially transition into a for-profit bachelor's degree program. Just recently, Bridgepoint Education (BPI) partnered with Colorado's community college system, making it easier for associate degree graduates to transfer credits to one of Bridgepoint's bachelor's degree programs. Initiatives like this one in Colorado, increased financial-aid limits, and the President's focus on professional education and training make us think that regulatory concerns might be a bit overblown, and these three factors are actually a small net positive for the for-profit education industry.
Consider Applying Here
Despite all the concerns surrounding education, we think fear has presented a few buying opportunities during the last few quarters. As of today though, Apollo Group (APOL) is our only 5-star call in the industry. Apollo is the largest for-profit education company with more than 400,000 students. With an August fiscal year-end, Apollo is the first company to report results from the sector. Along with a few others ( Capella Education (CPLA) and ITT Educational Services (ESI)) that have already reported impressive results so far this quarter, Apollo reported 26% growth and roughly a 500-basis-point improvement in its operating margin to 32%. On top of its solid growth, Apollo is moving into new areas, as well. The pending acquisition of a British education company is one of the first major steps in its international expansion partnership with The Carlyle Group. The stock trades at a 27% discount to its 52-week high experienced in early 2009. The current market price is only 12.9 times forward earnings (fiscal 2010) and represents nearly a 6% trailing free cash-flow yield. Given the company's growth prospects, we think this is an attractive valuation for this bellwether education company, and we think investors would be wise to give it a look.
Todd Young does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.