Hugh Hendry of Eclectica Asset Management (interview):
In some respects, I don't want to know...I don't want to do stock research...I want to have that trepidation that says I don't know the complete picture here.
Apollo Group (APOL) has been one of the most beaten down stocks in a beaten-down for-profit education sector this past year. Plenty of pessimistic animal-spirits surround the stock in terms of analyst downgrades, regulatory scrutiny, and even negative articles on Seeking Alpha. In the end, not so easy to see a value-play on what has turned out to be so profitable for anyone short since 2009.
But that is precisely the aim of this article. I will argue that all the negativity surrounding the stock has been baked into the price, and make a case for long-term growth.
Background: I know, it looks like toxic garbage
Apollo Group consists of The University of Phoenix, and two other education companies which are too small to be of material importance to the company's bottom line. The University of Phoenix makes up 91% of the company's total consolidated net revenue and is the largest for-profit in the country.
In reality, Apollo stopped being a growth company starting back in 2009:
Apollo currently sports an impressive earnings yield (EBIT/EV) of 48.4% and return on capital [EBIT/(Net Working Capital + Net Fixed Assets)] of 59.8%. It currently trades at a PE (TTM) of 5.677. Net of its huge cash position(~$9.92/share), it trades closer to a PE of 2.48. This is well below the PE considered for no-growth companies (Benjamin Graham gave it an 8.5 for no-growth) and is more appropriate for companies in distress. In other words, the market has priced Apollo for the zombie apocalypse. However, I believe the slide in EPS is close to bottoming out, and growth will eventually return along with stock buybacks and cost reductions.
Really the two most important numbers for Apollo and for the for-profit education industry as a whole are:
1.) Enrollment rates
2.) 3-year cohort default rates
Again, the numbers for both key metrics have not been great. Enrollment rates represent a major business risk, while the 3-year cohort default rates represent a major regulatory risk. But before we go on to discuss these metrics, there exists a third metric representing regulatory risk that investors should be aware of. That metric concerns what is known as the "90/10" Rule. A provision of the Higher Education Act, the "90/10" Rule basically says that if a for-profit institution derives more than 90% of its revenues from Title IV funding for two consecutive years, it runs the risk of losing that funding. Here is the breakdown for the University of Phoenix for the past three years:
90/10 Rule Percentages for Fiscal Year Ended Aug. 31
|University of Phoenix||84%||86%||88%|
|Western International University||68%||66%||62%|
*Apollo Group 10-K(most recent)
Aware of the significance of this regulation, Apollo has managed to steadily bring down the percentages for the University of Phoenix for the past three years.
As stated before, declining enrollment rates also pose a risk:
New Degreed Enrollment for University of Phoenix As % of Total
*Apollo Group 10-k(most recent)
Total new degreed enrollment declined from 98,100 in Q1 2010 to 52,800 in Q4 2012. It's debatable whether this represents an inflection point in enrollments, but what I find truly remarkable about these numbers is the downward trend in the percentage of students trying to obtain associate's degrees and the upward trend in students trying to obtain bachelor's degrees and master's degrees. In essence, students are trading up to something that will give them a better chance in this struggling economy. And it is precisely the type of trend we would find in an economy attempting to adjust to structural unemployment issues.
The idea that we are going through a massive shift in the labor market that trumps the cyclical demand-side adjustment from the 2008 Great Recession is an important one. For example, I have a very hard time believing that the current slump in employment is simply due to the business cycle when looking at the following time series:
For another example of structural issues in the labor market, the following graphic is from the economics blog Marginal Revolution by Professor Alex Tabarrok:
We are graduating less knowledge workers today than thirty years ago! And slowly, but surely students of all stripes and colors are beginning to find out that even a simple bachelor's degree, let alone an associate's degree simply doesn't bring home the bacon like it used to. As a result, I believe the increase in students ditching associate's degrees for bachelor's and master's degrees will become a source of long-term growth for Apollo Group along with higher margins.
Furthermore, one of the chief arguments against for-profit institutions in general goes along the lines of something like this: "These schools are completely useless because they take in students that would otherwise be rejected from traditional 4-yr universities and community colleges, give them 100% loans which they can't default on, and when they graduate aren't all that employable than when they had started."
Looking at the graphic above, one can make the argument that traditional universities (non-ivy league) are also failing to graduate potentially productive people. How many finance and economics types on Seeking Alpha attempt to use regression analysis, yet have no idea how to perform matrix algebra, substituting excel functions for the mathematical foundations of the concept? (I admit I forgot how to do matrix algebra myself) For regular readers of Seeking Alpha, how useful is a contributor armed with an MBA throwing out concepts like regression analysis, beta, and weighted average cost of capital in their analysis of companies without having read a single word from their 10-Ks? How many times have we read articles discussing how cheap a company's valuation is without going into the reasons behind it, and instead cite numbers spit out by some DCF calculator they found on the internet?
The clue for another source of long-term growth can be gleaned by looking at the racial profile of students attending The University of Phoenix:
University of Phoenix Student Demographics
*Apollo Group 10-K(most recent)
We see that the only growth, in terms of race, came from the Hispanic population. While the growth may not be dramatic, I believe this is only the beginning of a longer-term trend of increasing enrollments by a growing Hispanic population. This source of growth is not to be underestimated. As a Bloomberg article states, around 80% of U.S. workers by the year 2050 will be Hispanic. The future of U.S. human capital, along with the economy in general will depend on an educated Hispanic population. However, as this census shows, Hispanics also have the lowest college enrollment rates out of all the races in the U.S. I believe this sets up a ripe condition for what economists call catch-up growth when they refer to the phenomenal growth of countries like India and China. While not a certainty, I believe there is a good chance for this type of catch-up growth for Hispanics in this country.
Moving on, as mentioned earlier, the most important source of risk for Apollo Group is the 3-year cohort default rate:
3-Year Cohort Default Rates for Cohort Years Ended Sept. 30
|University of Phoenix||26.4%||21.1%||15.9%|
|Western International University||13.7%||16.3%||26.5%|
|All for-profit post-secondary institutions||22.7%||22.4%||21.2%|
*Apollo Group 10-K (most recent)
The numbers don't lie. The default rates for the University of Phoenix look abysmal. With default rates we have to remember two points:
1.) Annual Test: If the 3-year cohort default rate for any given year exceeds 40%, the institution will cease to be eligible for Title IV funding.
2.) Three Consecutive Years Test: If the 3-year cohort default rate exceeds 30% for three consecutive years beginning with the 2009 cohort, the institution will cease to be eligible for Title IV funding.
The important concept to apply to a risk such as the one above is the fact that it is a known risk that can be managed. It is a lesson that we have all learned from thinkers like Nassim Taleb: unknown risks matter much more than known risks because it's the unknown risks that will have asymmetric impacts (black swans).
- Optically, Apollo Group looks toxic.
- Valuation is too cheap to be ignored.
- Long-term source of growth students trading up to Bachelor's degrees and Master's degrees, and increasing Hispanic enrollments.
- Chief risk lies in 3-year cohort default rate, but can be managed.
I began research on Apollo Group with the intention of figuring out whether there was still some life in the company, but ended up reflecting on the broader concern of what exactly value investing entails. Just as everything can look like a nail to someone with only a hammer, so can every beaten-down stock in the market look like a bargain to an amateur value investor. But not all dead-beat stocks can be value stocks, or else all investors would have to do to capture superior performance relative to the market would be to simply buy up all such stocks and wait for them to appreciate.
But we all know such strategies can be hazardous to one's wealth. So how do we boil value investing down to its simplest and purest essence? The answer came to me while watching the movie Life of Pi (One of the most visually stunning movies ever made). Value investing is essentially like being stranded on a boat with a Bengal tiger ready to eat you at any given moment. In terms of value investing, the tiger represents the investor's own volatile emotions driven by short-term myopic movements. Each value stock represents a different iteration of this tense and threatening scenario. And each value stock has the potential to tear into your financial life. The difference is that in the movie, the principal character relied on faith and trust while value investors rely on many hours of research and thinking. We know that, on average, good companies that carry the cheapest of valuations usually end up experiencing PE expansion. It's not about efficient markets, but more about how life just tends to work like 2 + 2 = 4. As a result, while being trapped on a boat with a hungry tiger seems incredibly dangerous, long-term, we are probabilistically shielded by a margin of safety. And that is precisely what I see in Apollo Group.
In line with the Hugh Hendry's quote at the beginning, I wrote this write-up not to give investors false confidence in Apollo Group, but to encourage them to actually sit down and think about the company without relying on the opinion of short-termist Wall Street analysts who couldn't care less about someone else's money. I am long Apollo Group knowing, in many respects, it is a medium-risk, high-payoff bet. Please do your own research before committing your own capital.