The following is excerpted from the October 31 edition of Value Investor Insight:
When describing what he considers a compelling investment idea, Hawkshaw Capital's Kian Ghazi [VII, July 29, 2005] usually starts with a detailed description of the negative case for the company in question. In order to ensure you have a variant view on a potentially undervalued stock, he says, you first have to have a clear understanding of what the prevailing view is.
In the case of Universal Technical Institute (NYSE:UTI), which provides primarily auto-mechanic educational programs to 16,000 students at 10 U.S. campuses, the bears have plenty to work with. The company increased its student capacity by 35% in 2005 and 2006, completing the expansion just as an ongoing string of nine quarters of flat or declining student enrollment began. EBIT margins have fallen from a peak of 19.6% in fiscal 2004 to 2.4% in the past twelve months.
At a time when the economy and credit markets are in disarray, UTI’s programs are expensive, with tuition for its typical 16-month program averaging roughly $30,000. To top it all off, the company's stock hardly appears cheap. At a recent $15.80, the shares are down nearly 70% from their 2004 high but still trade at 32x consensus 2009 earnings estimates.
In taking a closer look under the hood of UTI's operations, however, Ghazi sees several reasons for optimism about the company's prospects. For all its recent setbacks, UTI is still the clear leader in its market, with twice the students of its closest competitors, WyoTech and Lincoln Technical Institute. More importantly, it has deep relationships with more than 20 original-equipment manufacturers – who provide such things as vehicles, diagnostic equipment and instructor training – while competitors have one or two such ties at best. The vote of confidence from OEMs reflects the quality of UTI’s programs, which sport industry-high graduation and job-placement rates.
Winning in a declining market would be a hollow victory, of course, but Ghazi believes there are both short- and long-term industry trends working in UTI's favor. Some 50% of the 1.3 million auto mechanics in the U.S. will reach retirement age over the next ten years. At the same time, the increasing technological sophistication of cars and trucks, and dealers’ continued emphasis on higher-margin parts and service, should put a premium on the kind of in-depth mechanic training that UTI graduates receive. The faltering U.S. economy should also benefit the company, says Ghazi.
UTI's enrollment troubles in recent years were partly a function of the strong market for relatively unskilled labor. With $30-per-hour construction jobs plentiful, why spend the money on advanced mechanic training? The company has historically seen a strong positive correlation between its enrollment starts and the unemployment rate for 20-24 year old males, a number which has been rising sharply. “The countercyclical headwind is now becoming a tailwind,” says Ghazi.
The affordability of the company's programs is another headwind starting to turn the other way. Over the past five years, rising tuition rates combined with flat federal funding for student loans and grants led to an 11% annual increase in the “funding gap” the typical UTI student had to make up from either savings or private loans. Congress recently increased its student grant and loan funding, however, and Ghazi estimates this gap – calculated by subtracting estimated per-student federal loan and grant money from tuition – will fall 25% over the next year. That would bring it back to less than $9,400, below the level of four years ago.
From an operational standpoint, the company has overhauled its advertising and marketing strategy, while retraining its sales force to more diligently handhold students from the point of signing a contract to actually showing up for class. The results of such efforts are just starting to bear fruit: In the most recent quarter, customer leads grew 41%, signed contracts grew 21% and the “show” rate – the percentage of students who sign contracts who eventually end up starting class – grew by 530 basis points, to around 50%. Given UTI’s relatively high fixed costs and surfeit of available capacity, rejuvenated top-line growth should translate into substantial earnings upside, says Ghazi. With 5% annual growth in new contracts and a 350-basis-point per year increase in show rates, the company’s student enrollment would grow at around 12% per year over the next two years, he says. As capacity utilization moves up to around 80%, the operating leverage in UTI’s business model should result in EBIT margins rising to 15% by 2011 – still below 2003-2005 levels – and earnings per share would increase to nearly $2. Even at a conservative multiple of 15x, he says, that would translate into a share price of $30 – almost twice today’s level. He adds that only modestly higher assumptions for contract growth and incremental margins would result in a normalized EPS estimate of closer to $3. The biggest risk, says Ghazi, would be if a crippled credit environment kept even the most credit-worthy students from securing private loans to help pay for UTI programs. That couldn’t help but curtail growth, he says.
“This is currently our largest position,” he says. “When something passes all our due-diligence tests and is counter-cyclical to boot, that's a pretty interesting opportunity in today’s environment.”