Strayer Education Takes The Initiative To Combat Falling Enrollment

| About: Strayer Education, (STRA)

For profit educators continue to suffer from prolonged enrollment declines. At Strayer (NASDAQ:STRA), which recently released Q1 2013 results and hosted a full Investor Day on May 2, 2013, total enrollment declined 9% to 46,130 during Q1 2013, compared to 50,896 for Q1 2012, while revenue declined 8% to $13.75MM. Operating income declined 27% to $29.9MM, with compression of operating income margin to 21.8%. Net income declined 28% to $17.2MM, while diluted EPS declined 24% to $1.59, of which $0.09 was due to share repurchases. The company estimates Q2 2013 diluted EPS between $1.37 and $1.39.

During the Investor Day presentation, CEO Karl McDonnell said that the prolonged elevated unemployment rates since 2009 have weakened demand significantly, making affordability the major issue for Strayer's undergraduate programs, which account for 67% of total enrollment. Other factors, including continued regulatory uncertainty, increased competition, and concern over the value of education likely also contributed to falling enrollments.

To address affordability, Strayer will freeze tuition for all current students and for the year 2014. This will hurt revenue per student for the next few years, but should help increase enrollment. Moreover, starting summer academic term (Q3 2013), a new scholarship program called the Strayer University Graduation Fund (SUGF) will offer up to 25% off a bachelor's degree, by awarding 1 free class to redeem in the final year for every 3 classes passed. Using accrual accounting, the SUGF will reduce revenue in the quarter in which the awards were earned, defer the revenue to the quarter of redemption, and set up a reserve fund for the deferred revenue. Because the exact amount requires estimation of the likelihood of redemption, which is highly uncertain and requires reevaluation quarterly, Strayer will cease issuing earnings guidance starting in Q2 2013.

Mr. McDonnell said that the new scholarship program aims to increase student retention (currently about 50% of all students graduate) and therefore total enrollment, at the expense of temporarily decreasing revenue per student. A sign that this is working in the future is when the reserve amount increases, which occurs when the retention/redemption rate increases and enrollment increases.

Additionally, to cope with the current challenging environment, no new campuses will be planned for 2013. Instead, the company will focus on managing costs via creating synergies within markets, task automations, and prudent capital deployment, moderating regulatory risks by focusing on academic quality, and investing in growth from higher quality earnings from institutional alliances, such as the Jack Welch Management Institute, and experienced student segments.

In its recent 10K, Strayer provided full-year 2013 guidance as follows: assuming 2012 revenue, operating expense would increase 1-2%, operating margin would be 19-20%, and EPS would range $5.40-5.60; each 1% change in revenue will have 50 basis point change in operating margin, and $0.20 impact on EPS, assuming a tax rate of 39.5% and 11.5MM diluted shares. Based on Q1 2013 results and the new measures introduced, the company lowered its full-year outlook, as revenue is likely to decline, operating costs should decline a little, tax rate is expected to be around 39.8%, and share repurchases might prop EPS up a little. It is uncertain how revenue will respond to the new policies and external factors.

I will attempt to estimate 2013 EPS here by first using $1.59 for Q1 and projected $1.38 for Q2, so $2.97 for the first half. For Q3 and Q4, let's assume enrollment will decline 10% due to continued weak market conditions, while revenue per student will decline 9% (60% undergraduate * 25% scholarship discount * 60% retention), then revenue will decrease 1 - (0.9*0.91) = 18% to $218MM. Let's assume operating expenses decline 5% to $228MM due to effective cost control, so operating income becomes ($10MM). Assuming each quarter has the same interest expense as Q1 ($1296k), net income would be (1.7MM). Assuming the remaining $70MM share repurchase authorized at made at $45/share, diluted shares would decline to 9.3MM, yielding EPS of ($0.18) for Q3-4. The full year EPS for 2013 would therefore be around $2.79. At $45/share, PE would be around 16, which is still reasonable.

If the new measures are successful, enrollment should go up for 2014, but revenue per student would be hurt by the tuition freeze, so I would not expect much change in revenue and EPS for 2014.

The expectation is that demand should pick up eventually as the economic recovery gains steam and unemployment goes down. Then Strayer will continue to grow, increase tuition in 2015, and open new campuses. And revenue, operating margins and EPS will strongly recover.

Overall, I believe the downside risks are real but somewhat limited compared to the potential upside for the patient investor. The biggest risks right now are the high leverage, low tangible book value around $3/share, and increased competition not only from other for-profit educators like Apollo (NASDAQ:APOL), Devry (NYSE:DV), Grand Canyon Education (NASDAQ:LOPE) and ITT Educational Services (NYSE:ESI), but also traditional universities offering massively open online courses (MOOC) that may gain wider acceptance and appeal. For safety, DeVry might be a better play in this sector due to its stronger balance sheet and better student mix including higher quality earnings from medical students. ESI is cheaper with a current PE and PE10 both around 4. Apollo offers a balanced risk to reward ratio, with a relatively low PE around 6, lower PB around 2 (compared to 12 for STRA), and relatively strong balance sheet.

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Disclosure: I am long STRA, DV, APOL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.