"Back to School"
The IPO market sprang to life last week with 7 deals completed, and the momentum is set to continue this week with another 4 deals slated to price. Similar to last week, the current IPO line-up is well-diversified in terms of size, sector and growth profile, and includes two PE-backed deals, a venture-backed growth enterprise and another newly-formed specialty finance company looking to take advantage of opportunities in the distressed debt marketplace. Akin to the two deals that we featured in our write-up last week (Select Medical and Shanda Games), our current featured IPO is anything but a newcomer to the public arena.
For-profit post-secondary education provider Education Management (NASDAQ:EDMC) went public for the first time in 1996, and made a lot of investors very happy before it was ultimately taken private in 2006 by Providence Equity Partners and Goldman Sachs for more than $3 billion. Over its near decade as a public company, Education Management’s stock soared 11-fold on a split-adjusted basis (a 28% compounded annual return). While the business and management team have evolved since its first go-around, the investment story is still exciting with its strong education heritage, proven track record and large market opportunity.
A little bit of history
Education Management, mostly known for offering specialized degrees through The Art Institutes and Argosy brands, was a highly profitable $1 billion enterprise when it was LBO’d in 2006. But its owners had higher aspirations for the business. After recruiting top executives from industry bellwether Apollo Group (NASDAQ:APOL), the company embarked on an aggressive program to improve operations, accelerate enrollment growth and bolster its branding. Over a three-year stretch, the company added 20 new campuses, launched 36 new programs, significantly upgraded its admissions and marketing infrastructure and unveiled an online platform.
Today, the company operates more than 92 campuses and a rapidly growing online division that together support more than 112,000 students as of July 2009. The Art Institutes (about 60% of students) still accounts for the bulk of its enrollment, but the company serves a much broader student population through its Argosy University (health sciences, education, business), Brown Mackie (vocational) and South University (health sciences, business) brands. Its schools offer traditional undergraduate and graduate degrees (64%) as well as specialty diplomas (36%) in the areas of graphic design, culinary and media arts and fashion.
Importantly, and in contrast to several of its public-traded peers, Education Management gets high marks with respect to student outcomes. It sports a significantly higher-than-industry-average persistence rate among its student population, and a high 87% of undergraduates who obtained degrees in 2008 found jobs within their field of study within six months of graduation.
Favorable outlook for growth and profits
Like most of its for-profit peers, Education Management is quite profitable and growing briskly, having posted nearly 20% annual enrollment growth over the past three years driven by double growth in its traditional campuses and ramping online enrollment. The company sees significant headroom for growth with the for-profit industry accounting for just a 7% slice of the overall postsecondary market. With its differentiated degree programs and brands, its plans to open 8-10 new campuses per year, and the continued expansion of its online platform, we think the business can grow in the 15-20% range for the foreseeable future.
Over the last couple of years, operating cash flow margins have hovered in the 20-22% range, but margins have room to scale as the company gains leverage on past investments and further increases its online mix. Although management’s focus on education quality and student persistence may keep its margins below those of some of its public peers, there is no reason that EBITDA margins cannot trend to the 25% level, if not higher. Trailing free cash flow was $120 million, but we expect that to rise materially over the next few years as margins scale and capital expenditures level off.
Regulatory and credit obstacles
The main risks to the EDMC story relate to the ongoing oversight of the for-profit industry, as the government seeks to crack down on aggressive enrollment practices and lending standards. Education Management has a clean background from a compliance perspective, but any industry sweeping changes could certainly impact growth and profitability.
Further, the recent credit crises and poor economy have disrupted students’ access to funds, resulting in rising overall bad debt expense (4% in its FY09, up from 2.7% in FY08) and forcing Education Management to launch its own internal student loan program. These developments have negative implications for cash flow and introduce additional collections risk.
Finally, the company remains leveraged thanks to the large amount of debt taken out to finance its 2006 LBO; while the IPO proceeds are earmarked to pay down a chunk of this debt, Education Management will still carry over $1.3 billion in net debt following the IPO or 3.9x trailing operating cash flow.
Two recent IPOs from this sector, Grand Canyon Education (NASDAQ:LOPE) and Bridgepoint Education (NYSE:BPI), are among the top IPO performers over the last 12 months, up 45% and 52%, respectively. While both companies are faster growing owing to their online delivery focus, their performance does send a positive signal with respect to investor interest in the sector.
Bridgepoint’s stock traded off 15% earlier this month following news of a regulatory audit that was likely to turn up findings of noncompliance, which highlights the volatility and regulatory risk that has plagued the group.
However, Grand Canyon completed a successful $100 million follow-on offering less than two weeks ago (and has since traded up 5%), signaling continued demand from investors for exposure to the large, fast-growing postsecondary education market.
This IPO gets high marks . . .
Education Management is an established and well-run organization in a profitable, growing market. While investor sentiment behind the broader group of for-profit postsecondary education stocks has been mixed owing to fears of increased regulatory oversight and concerns over rising bad debts, Education Management’s strong and differentiated program offerings, track record of regulatory compliance and seasoned management team should make this a sought after IPO.
As long as underwriters price with a curve . . .
As evidenced by last week’s disappointing trading debuts from Select Medical (NYSE:SEM) and Shanda Games (NASDAQ:GAME), underwriters must leave upside on the table to keep the IPO market wheels rolling.
Both of these deals were managed by Goldman Sachs (NYSE:GS), who also sits atop of the underwriter IPO tombstone for Education Management. Interestingly, Goldman is also one of Education Management’s key shareholders (it will maintain a 29% post-IPO stake), which may give it an extra incentive to ensure that the deal is a success.