Apollo Group: Promising Growth Opportunities Barring Changes in Policy, Economy

Apollo Group (APOL), by far the largest for-profit education company, recently released its FY3Q09 results, beating street estimates and sending its shares up almost 8% today as a result. The following is a concise overview of the earnings, the analyst conference call, and Apollo's outlook.

Latest Performance

Strong demand for education in a weak economy

Apollo results show that indeed people re-educate themselves in a weak economy, as they should. The company reported 22% YoY growth in total enrollment, which now totals 420,700 students. Revenue growth even outpaced strong enrollment growth, growing 26% and breaking US$1bn for a single quarter. Also, if we compare enrollment growth in the latest quarter to the nine-month trailing growth number of 20%, then we see that does not appear to be any signs of a slow-down in enrollment growth, and in fact perhaps there was a bit of a pick-up. Breaking enrollment data down by degree type, using University of Phoenix data (a proxy for the entire company), enrollment growth was highest for shorter Associate degree programs, up 39%, vs. 13% growth for Bachelors degrees and 17% for Doctorates.

APOL exhibits pricing power...

Revenue growth outpaced enrollment growth as the company was able to exert pricing power YoY, increasing Associate, Bachelor, and Doctorate program tuition by 10%, 4%, and 5% respectively. This was partially offset by a higher mix of Associate students since these degrees have lower absolute prices.

...and benefits handsomely from operating leverage

The company improved its margins due to lower instructional costs/services and selling / promotional expenses as a percentage of revenue, falling to 38.1% from 41.6%, and 23.2% from 24.4% respectively YoY. This was attributed to leveraging fixed costs such as classroom space plus improvements in counseling to keep people enrolled (less churn, less need for promotional expense) and employee retention. In their earnings call, the company said that they have improved retention rates YoY for each degree level. General & Admin expenses also fell as a percentage of revenue, to 6.8% from 7.3% due to leveraging some relatively fixed staff costs.

FY3Q09 EPS up 48% YoY

Reported net income for the quarter came in at $1.26, up 48% YoY, as the company reaped the benefits of rapidly growing revenue over operating leverage of fixed costs. For the nine months, reported EPS was $3.15, up about 51% YoY from adjusted FY9M08 EPS of $2.09. Most revenue growth and essentially all operating profits were generated by the company’s University of Phoenix segment, which is by far the largest business segment, accounting for 96% of FY3Q09 revenue.

Net cash balance sheet and strong free cash flow

Balance sheet remains strong, with net cash of about $600m excluding restricted cash deposits. Free cash flow (FCF, Op cash flow minus capex) for FY9M09 came in at $715m vs. $507 reported net income. This excess FCF over net income was similar to the result of FY9M08, when about $490m (or $420m if we strip out business acquisitions) in FCF was generated vs. reported net income of about $250m. Excess cash flow vs. net income is partly due to cash float generated by student deposits, depreciation, and some write-backs of previously expected losses. For FY3Q09, the company generated adjusted FCF of $312m, up 34% YoY, as per APOL’s earnings call.

Key Issues

Share buybacks

In the earnings call, management explained that share buybacks added about $0.02 to FY3Q09 EPS. The below is taken from their earnings release.

During the third quarter of fiscal 2009, the Company repurchased approximately 7.2 million shares of its common stock at a weighted average purchase price of $61.62 per share for a total expenditure of $444.4 million (of which $38.8 million is included in accrued liabilities for repurchased shares that settled subsequent to May 31, 2009). On June 25, 2009, the Board of Directors authorized an increase of the share repurchase program to an aggregate of $500 million.

Acquisition of BPP Holdings in the UK

This is an interesting development, but near or even mid-term earnings impact will be minimal, given its relatively small size, as confirmed by management during their earnings call. Most of APOL's international business is more of a long-term growth story, say 3+ years out given that they are relatively small vs. APOL's huge US University of Phoenix business and are also far less profitable at the operating income level.

On June 7, 2009, our 80.1% -owned subsidiary, Apollo Global entered into an Implementation Agreement to acquire BPP Holdings plc (“BPP”), a UK-based provider of education and training to professionals in the legal and finance industries. Pursuant to the acquisition arrangement, Apollo Global will acquire all of the outstanding shares of BPP for a cash purchase price of 620 pence per share, which represents an enterprise value of approximately $540 million based upon the exchange rate on June 5, 2009... (10-Q)

BPP is a leading provider of education and training to professionals in the legal and finance industries and is the first private sector institution to have been granted degreed awarding powers in the U.K. (earnings call)

Potential limits on near-term growth due to the 90/10 rule

Regulations require that private for-profit education companies such as Apollo receive no more than 90% of their revenue from Title IV programs (US government sponsored student aid), for any two consecutive fiscal years. Apollo said in their earnings conference call that expect to approach this limit for 2009, but are working to find ways to diversify revenue sources towards more student or employee funded courses. This regulatory limit, and the company's approach of it, could limit near term revenue growth potential.

Based on information currently available to us, we believe that the 90/10 Rule calculation for University of Phoenix will approach, but will not exceed 90% for fiscal year 2009. However, there are many relevant factors that are difficult to forecast. As a result, there is no assurance that the 90/10 Rule calculation for University of Phoenix will not exceed 90% for fiscal year 2009.

Small uptick in bad debt, but manageable

This shouldn't be too much of a worry in my view due to the fact that the majority of their students are using US government student financial aid.

Bad debt expense increased 100 basis points to 3.4% of revenue compared to 2.4% a year ago. The year-over-year increase was primarily due to the increased ageing of receivables and the related risk of collecting them, coupled with lower collection rates of older receivables. Consistent with past quarters, our total allowance for doubtful accounts continues to exceed all receivables greater than 90 days old. It is important to note that over time, we have the ability to exercise significant control over our receivables and bad debt levels. For example, we control the timing of when a student begins class relative to our loan certification process... We are comfortable with our current bad debt levels.

Risk from potential US policy shift towards education

The Obama administration and its penchant for public rather than private solutions.

The Obama administration's push for community colleges (major competitors for for-profit schools' students) and the tough line it has taken with the industry. Deputy Undersecretary of Education Bob Shireman has said that he will tackle potential changes to the way for-profit recruiters are compensated, and may push to redefine the gainful employment metrics that for-profits tout.

Conclusion

APOL is by far the largest player in its space, far larger than companies such as Career Education (CECO) or DeVry (DV), and carries the well-known University of Phoenix brand. It is net cash, highly cash generative, and likely has a strong long term future barring some sort of negative legal or US government policy surprise. It also has the opportunity to grow internationally via recent acquisitions, simply taking the Phoenix model and rolling it out elsewhere. Additionally, in the current environment it's also proving itself as a countercyclical business, showing EPS growth numbers we rarely see these days.

Still, bulls need to be a bit cautious here given that the stock has rallied substantially to $71 from $56.5 just back in late May. Trailing PE is about 17x, forward under 15x, and EV/EBITDA around 9.6X, which in the current market isn't obviously cheap on a relative basis, especially vis-a-vis future growth potentially held back by the 90/10 rule, potential negative changes in US education policy towards private schools, or simply lower education demand should the economy start to recover.

Nevertheless, APOL valuation is for another['s] study, here I'm simply bringing the latest performance into perspective.

Disclosure: No position