Caution Warranted Despite Apollo's Revenue Surprise
In a recent article ("Is Momentum Shifting For For-Profit Colleges"), Seeking Alpha contributor BubbleBustInvesting noted that for-profit college operators such as Apollo Group, Inc. (APOL), Corinthian Colleges, Inc. (COCO), Strayer Education, Inc. (STRA), and DeVry, Inc. (DV) rallied early Monday after Apollo reported revenues that beat estimates and forecast profits higher than analysts expected (shares of Strayer and DeVry closed in the red Monday, but shares of Corinthian and Apollo closed up 2.38% and 7.10%, respectively). BubbleBustInvesting pointed out a few reasons why he thought investors should stay away from the sector. Among them:
- The difficulty of students getting loans, as default rates rise.
- Increasing competition from traditional universities offering online courses.
There are additional reasons for investors to be cautious about this sector. We'll consider a few of them below, and then show two ways for investors who decide to stay long Apollo to limit their potential downside in the face of these headwinds.
Additional Headwinds For For-Profit Schools
- Rising default rates are a symptoms of a deeper problem: the inability of many graduates to get work in their field of study that pays enough to enable them to make their loan payments. Bloomberg reported on a memorable example a few years ago, of a woman who spent $70,000 at a for-profit school for a degree in video game design, only to be offered a $12 per hour job as a recruiter for video game companies. She decided to work as a stripper instead -- something she could have done, of course, without taking on $70,000 in debt. As anecdotes such as these proliferate, no doubt increasing numbers of prospective students will become wary of for-profit colleges.
- As difficult as the job market is for for-profit college graduates, at some for-profit colleges, only a minority of students ever graduate. For example, at Apollo Group's University of Phoenix subsidiary, according to the most recent available data from the National Center For Educational Statistics, only 1% of full time students pursuing a bachelors degree graduated within 4 years (another 6% graduated within 6 years, and an additional 6% graduated within 8 years). As more prospective students come across statistics like these online, it's likely more of them will think twice before enrolling at for-profit colleges.
- For-profit colleges aren't just facing competition from traditional colleges now, but from lower-cost educational start-ups as well. In a recent article in Wired, Marcus Wolhlson reported on one such start-up, App Academy, that operates under a radically different model than either traditional colleges or for-profit colleges: instead of offering four years of classes, it steers its students through a 9-week "boot camp". And instead of its students getting stuck with loans they can't pay when they graduate, App Academy collects a 15% commission on its alumni's first year salaries after graduation. Educational start-ups aren't limited to computer programming. Skillshare, for example (which is backed by Union Square Ventures, a venture capital firm that was one of the early investors in Twitter) offers courses in a wide variety of areas.
The combination of negative outcomes for students of for-profit colleges and the proliferation of less-expensive educational start-ups - on top of the increasing difficulty of potential students of for-profit colleges in getting loans and the competition between for-profit and traditional colleges in online education - presents formidable risks for shareholders of for-profit college operators such as Apollo Group. Below, we'll look at two ways Apollo longs can limit their downside risk, and we'll compare the costs of similar downside protection for the other for-profit college operators mentioned above.
Two Ways Of Hedging Apollo Group
Here are two ways for an Apollo shareholder to hedge 1000 shares against a greater-than-20% drop between now and August.
1) The first way uses optimal puts*; this way allows uncapped upside, but is more expensive. These were the optimal puts, as of Monday's close, for an investor looking to hedge 1000 shares of APOL against a greater-than-20% drop between now and August 16th:
As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was 5.92%. By way of comparison, the cost, as a percentage of position value, to hedge the SPDR S&P 500 Trust ETF (SPY), over a slightly longer time frame (until September 20th), was 0.65% of position value.
2) An APOL investor interested in hedging against the same, greater-than-20% decline between now and August 16th, but also willing to cap his potential upside 20% over that time frame, could have used the optimal collar** below to hedge instead.
As you can see at the bottom of the screen capture above, the net cost of this collar, as a percentage of position value, was negative, meaning the investor would be getting paid ($10, or 0.05% of his position value) to hedge in this case.
Note that, to be conservative, the cost of both hedges was calculated using the ask price for the optimal puts and the put leg of the optimal collar, and the bid price of the call leg of the optimal collar; in practice, an investor can often buy puts for some price less than the ask price (i.e., some price between the bid and ask) and sell calls for some price higher than the bid price (i.e., some price between the bid and the ask).
Possibly More Protection Than Promised
In some cases, hedges such as the ones above can provide more protection than promised. For a recent example of that, see this Instablog post about hedging shares of the drug company Affymax, Inc. (AFFY).
Hedging Costs For All Four For-Profit Schools
The table below shows the costs (where available) of hedging these for-profit college operators in the same manner as APOL: against a >20% drop using optimal puts, and against a >20% drop with an upside cap of 20% using an optimal collar. There were no optimal puts for Corinthian Colleges because it was too expensive to hedge against a >20% drop as of Monday's close. The same was true of Strayer, but, in addition, there was no optimal collar available to hedge Strayer at those parameters either. Apollo was the least expensive of these four stocks to hedge.
Optimal Put Hedging Cost
Optimal Collar Hedging Cost
No Optimal Puts
No Optimal Puts
No Optimal Collar
*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance Ph.D to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones.
**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University. The screen captures above come from the Portfolio Armor iOS app.