Focus on ITT Educational Services (ESI). ITT is one of the largest providers of postsecondary degree programs in the US, including master, bachelor and associate degree programs to approximately 65,000 students. The Company has 150 college locations across 39 states and its online programs are offered across 48 states. Our key rationale for our positive view on ITT include: its recession-resistant profile, robust returns on capital, and attractive valuation.
The education industry is counter-cyclical. Fitting with our thesis that the US economy will embark on a mid-cycle slowdown in 2013, the education industry's counter-cyclical attributes are attractive. Demand for new enrollment typically increases if employment prospects decrease due to a slowing economy. To illustrate this point, amidst the financial crisis in 2008, ITT's equity price actually increased 11.4% compared to the S&P 500 that declined 38.5%.
Changes in the industry impact enrollment trends. The education industry is highly-regulated, which creates barriers to entry. However, the high degree of regulation can also hurt existing participants when the degree of regulation is increasing. In particular, for-profit higher education companies came under fire in 2010 for allegedly saddling graduates with too much debt and insufficient employment opportunities to repay that debt. While this may also sound like many non-profit universities and community colleges during an economic depression, non-profit educational institutions were largely excluded from the scrutiny. After two years of study, the US Education Department on May 31, 2012 issued new rules aimed at ensuring that graduates are earning enough to pay down the loans taken out to earn the education. However, these rules were struck down by a federal judge in Washington in July 2012 as the new regulation was ruled as arbitrary. Nevertheless, in anticipation of changes and also a stronger employment market over the last two years, enrollment at many of the for-profit schools has been declining 10-20% annually as schools adjust programs and admission requirements. In the instance of ITT Educational Services, it began seeing enrollment declines in Q1/2011. In the most recent Q3/2012, total student enrollment was down 17.1%, which we believe will be the inflection point as we are seeing absolute student enrollment stabilizing around the 65,000 mark in the last two quarters. Furthermore, on its Q3/2012 conference call, management commented that enrollment was down approximately 9% Y/Y in October, which again would confirm that enrollment is stabilizing around 65,000-66,000 based on Q4/2011 enrollment of 73,255.
Return on capital is strong. The for-profit education sector is a low capital-intensive industry. ITT spends an average of $30-35 MM annually to maintain and expand its buildings and facilities, which is in line with its annual depreciation and amortization expense. The low capital intensity combined with lucrative margins, generate return on invested capital well in excess of 40% throughout the past decade. In 2013, which we expect will be the trough year for ITT, return on invested capital is forecast to be approximately 43%. Any business that can still generate four times its cost of capital (we estimate 10%) at trough of cycle is extremely rare.
Valuation is attractive. Given the changing regulations and declining enrollment, the education sector's valuations have plummeted to below long-term intrinsic value. The sector currently trades at 8.9x free-cash-flow and 10x 2013 EPS, compared to ITT at just 3.8x 2013 EPS. Our 3-6 month target for ITT is $30-35 (a 70-80% return), which is based on 6-7x 2013 EPS using the multiple of its closest comparable Apollo Group (APOL). On a 6-12 month basis, our target is $50-55 (triple the current value) that is based on the group median of roughly 10-11x 2013 EPS. It is always difficult to identify the bottom on value stocks in particular, since they often are heavily mispriced on emotion rather than fundamentals. However, the risk/reward appears attractive on ITT and the economic slowdown that is expected in 2013 could create a rebound in enrollment and ITT's stock price.
Disclosure: I am long ESI.