The Post-Secondary Education Market

by: Ron Sommer

Once again, the winds of change are blowing through the ivy covered halls of academia. The business models of both public and private universities are changing for the first time since the turbulent 1960s, and for-profit schools are suffering the worse for it.

For-profit post-secondary education companies are being hammered by increased regulatory oversight and shares trade at factions of previous levels. The bubble burst on this sector and the market collapsed. Is a rebound possible?

Historically, post-secondary education was the domain of the elite. During the nineteenth century, public universities opened throughout the U.S. primarily to democratize access to higher education and to provide skilled professionals as the country transitioned from a rural economy to an industrial state. This process of democratization accelerated following World War II and the introduction of the G.I Bill of Rights. The G.I. benefits made higher education affordable to millions of returning veterans, which in turn provided an ample skilled workforce of teachers, doctors, engineers and others. The availability of this skilled workforce fueled the economic expansion of the 1950s and 1960s.

The next major change came in the 1960s and 1970s to further democratize access to higher education. In this phase, public universities and colleges changed admissions policies to make it easier for underserved communities to gain access to higher education. To meet the demands of this influx of new students, state and local governments vastly expanded their networks of schools, facilities and staff. Of course, all this costs money. Whereas the publicly funded educational systems had previously made access affordable to the middle-class, governments could no longer bear the lion's share of the financial burden. As government cut back on financial support, tuition became a more significant revenue factor for the educational system. To make this burden easier to swallow, governments instituted a system of means-tested grants and student loan programs.

While all this was going on, the student profile was changing, as were the needs of the students. If previous generations sought liberal educations or specific professional careers, the changing economy was forcing other students to acquire new skills just to stay relevant to the workforce. The door now opens for the for-profit education market.

There is nothing new about the for-profit educational industry. Schools have long existed to provide skills training for those seeking entry to the job market. In a way, the for-profit schools became a substitute for apprenticeships.

As the costs to attend both public and private not-for-profit colleges skyrocketed, the for-profit sector offered a lower-cost alternative. The degree programs offered by the for-profit sector were very much job directed. The for-profit schools, unencumbered by union contracts and the demands of social policy, are better able to tailor programs that are attractive to working students. Online programs are particularly attractive.

However successful the for-profit schools were, they lacked broad acceptability among employers and especially in the academic community. Students found that credits earned at a for-profit institution were not transferable to traditional schools. To gain respectability, the for-profit schools went through the arduous process of obtaining accreditation from the recognized regional accreditation organizations. In some cases, for-profit schools, which had only offered online courses, purchased brick and mortar educational institutions. Overnight, these companies transformed from a virtual school to an established accredited institution offering online courses to nontraditional students.

Technology is changing the playing field again. Years ago, the traditional schools introduced online learning and even some online degree programs. However, these offerings were still tied to the old business model and remained expensive. The newest innovation is MOOC for massive, open, online classes. The three largest purveyors of MOOCs are Coursera, Udacity and edX.

Generally speaking, MOOCs provide free Web-based courses from the leading universities to improve the educational experience of millions of students, including midcareer professionals and those without access to post-secondary education.

Coursera is a one year old for-profit startup funded by Kleiner Perkins Caufield & Byers, New Enterprise Associates and university partners. It has more than 3.5 million registered users for 370 courses. It now has 69 partner institutions supplying content, including big name schools such as Duke University, the University of Pennsylvania, Case Western Reserve University, the Ecole Polytechnic (France), the Pennsylvania State University, Rutgers University, among others. The Wall Street Journal recently reported that ten large public university systems, including those of New York, Tennessee, Colorado and the University of Houston, have signed up to offer their own MOOCs through Coursera's platform.

edX is a non-profit consortium founded by Harvard and the Massachusetts Institute of Technology. Participating schools include brand names such as the University of California (Berkley), Boston University, Rice University and Georgetown University, among others.

Udacity is another for-profit company breaking new ground. The company was founded by Google executive Sebastian Thrun. According to Thrun, Udacity's market is people aged 25 to 35 who want mid-career training.

The MOOCs are so new, it is difficult to evaluate the impact they have on the market. The courses that are offered through MOOCs are not credit bearing at this time. Do program participants care when they can claim they took courses at Stanford or Harvard? Are employers concerned? I do not know the answer to these questions, but in time, the market will decide.

Faculties at colleges across the country are beginning to resist. In April, the faculty at Amherst College voted against joining edX. The philosophy department at San Jose State College publicly described MOOCs as "harbingers of the dismantling of departments and a diminished quality of education."

MOOCs offer the opportunity for people to communicate with others studying the same material in real time throughout the words 24/7; the ability to watch and review, if necessary, taped lectures 24/7; the ability to read supplementary material at anytime, anyplace; and the ability to communicate directly with the instructor regardless of where the student is located.

It is not, as some suggest, video education redux nor is it a poor excuse for education. It is another option that as with traditional education, some of the programs will succeed and others will not. It expands opportunities for those seeking education credentials by making courses more widely available. It is a game changer and for those who wish for things to remain as they have, its rapid incorporation will certainly be a disappointment.

For-profit colleges have an important role to play in higher education. The existing capacity of nonprofit and public higher education is insufficient to satisfy the growing demand for higher education, particularly in an era of drastic cutbacks in State funding for higher education. Meanwhile, there has been an enormous growth in non-traditional students -- those who either delayed college, attend part-time or work full-time while enrolled, are independent of their parents, or have dependents other than a spouse. This trend has created a "new American majority" of non-traditional students.

In theory, for-profit colleges should be well-equipped to meet the needs of non-traditional students. They offer the convenience of nearby campus and online locations, a structured approach to coursework and the flexibility to stop and start classes quickly and easily. These innovations have made attending college a viable option for many working adults, and have proven successful for hundreds of thousands of people who might not otherwise have obtained degrees.

But for-profit colleges also ask students with modest financial resources to take a big risk by enrolling in high-tuition schools. As a result of high tuition, students must take on significant student loan debt to attend school. When students withdraw, as hundreds of thousands do each year, they are left with high monthly payments but without a commensurate increase in earning power from new training and skills.

In the 1990s, two-thirds of for-profit colleges enrolled students in training programs lasting less than 1 year. The sector was primarily composed of small trade schools that awarded Certificates and diplomas in fields like air-conditioning repair, cosmetology, and truck driving. While Certificate and diploma offerings have continued to grow, growth in degree programs has been more significant. Between 2004 and 2010, the number of Associate degrees awarded by for-profit colleges increased 77 percent and the number of Bachelors degrees awarded increased 136 percent.

For profit colleges are rapidly increasing their reliance on taxpayer dollars. In 2009-10, the sector received $32 billion, 25 percent of the total Department of Education student aid program funds. Pell grants flowing to for-profit colleges increased at twice the rate of the program as a whole, increasing from $1.1 billion in the 2000-1 school year to $7.5 billion in the 2009-10 school years.

The U.S. Senate Committee on Health, Education, Labor and Pensions investigated the for-profit colleges in 2010. Among the companies examined by the committee, the share of revenues received from Department of Education Federal student aid programs increased more than 10 percent, from 68.7 in 2006 to 79.2 percent in 2010. Committee staff estimates that in 2009, when all sources of Federal taxpayer funds, including military and veterans' benefits are included, the 15 publicly traded for-profit education companies received 86 percent of revenues from taxpayers. For-profit colleges also receive the largest share of military educational benefit programs: 37 percent of post-9/11 GI bill benefits and 50 percent of Department of Defense Tuition Assistance benefits flowed to for-profit colleges in the most recent period. Because of the cost of the programs, however, they trained far fewer students than public colleges. Eight of the top 10 recipients of Department of Veterans Affairs post-9/11 GI bill funds are for-profit education companies.

Government investigations and widespread dissemination of industry practices considered predatory have increased regulatory oversight of for-profit colleges. As a result, publicly traded post-secondary schools have taken major hits in the market.

The following chart contains those factors that I think drive market prices. I include an income statement and a statement of cash flow based valuation metric, a quality of earnings metric and profitability metrics. Finally, to judge market sentiment, I use a company's current share price in relation to the range the shares have traded during the trailing 52 week period.

This is my interpretation of these statistics. Off the bat, we see that Career Education Corp (NASDAQ:CECO), Education Management Corp (NASDAQ:EDMC) and Lincoln Educational Services (NASDAQ:LINC) do not generate earnings before interest, taxes, depreciation and amortization. If a company cannot generate even this very basic level of earnings, no further interest is warranted.

A closer look at CECO reveals that the company is both free cash flow negative and has no operating income. EDMC does have operating but is negative free cash. The same is true for LINC and Universal Technical Institute (NYSE:UTI). I think companies that fail to generate positive free cash are not sustainable.

I have eliminated four of the original fourteen companies for failing to be profitable on either an earnings or cash basis. For those companies that are measurably profitable, I turn to a measure of quality. I like to see a very high ratio of free cash to operating income. This is a very subjective measure, and only two companies, Capella Education Company (NASDAQ:CPLA) and Corinthian Colleges (NASDAQ:COCO), exceed the minimum I require.

I am now turning to profitability as measured first by EBITDA less Capital Expenditures to Invested Capital and then by Free Cash to Invested Capital. In my opinion, the first profitability measure is more informative that either ROE or ROIC. The CFROI metric confirms that the company is profitable on a cash basis.

In my interpretation of the data, COCO is not as profitable as I require to initiate a new position. However, if I already owned COCO, I would hold it at this time.

The final candidate is CPLA. It meets all my criteria, as described above. It would seem that the market has faith in the company. The share price is up almost 42% over the past 52 weeks and at $43.56, shares are trading close to the 52 week high.

However, caveat emptor ("let the buyer beware"): the for-profit education market is a tough playground and should be approached with care.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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