Last week I put 6% of the assets into Strayer Education (NASDAQ:STRA). I think the stock is unduly cheap. The company has a market cap around $475 million, but has generated $71 million in free cash flow in the last 12 months (a 15% FCF yield). In the last six months alone, the company has generated $46.6 million of free cash flow. It's a good business with high returns on capital, low fixed costs, high free cash flow yield, and even some growth potential that's not priced in. They also have a great management team that has been buying back a considerable amount of stock.
Strayer is a for profit education company. Their main asset is Strayer University. Strayer has been around since 1892. It has a long history in the DC area. It went public in the 1990s, and began growing from a few campuses in the Washington DC area (it had 8 campuses when it went public) to 100 currently.
Strayer's chairman, Robert Silvermann is the former CEO of Cal Energy, which was a Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) holding. Silvermann was the CEO until this year, but he will continue as chairman going forward. STRA is a very well-managed company, and I get the strong feeling from reading the annual report that they do care about their students and their shareholders (a key point to consider in the for profit industry).
Here is my basic thesis for investing in STRA:
- It's cheap because of regulatory risk, but the company is one of the best and most respected in the industry, even among regulators
- It's cheap; 8 times FCF (it's already produced $47 million in FCF for first 6 months of 2013, which implies a multiple of about 5)
- It has historically grown FCF at a 14% per year
- It has produced significant FCF in each of the last 10 years
- The stock is at 10 year lows
- Buying back stock. Has $100mm left on its buyback plan (over 20% of current market cap)
- Company insiders own about 6%, but have been purchasing more shares lately
For Profit Education: A Hated Industry
The for profit education stocks have been absolutely crushed over the past year and a half, and many are selling 70-80% below their recent highs. The industry is wrought with questionable motivations, poor recruiting practices, mediocre student results, high default rates, and government regulatory scrutiny. Sounds like fun, right?
My initial foray into this industry began by researching a bunch of stocks that were clearly cheap on most statistical metrics (they all are cheap relative to their former valuations, and most have single digit earnings and cash flow multiples). Any quick and dirty valuation screen pulled up many of the stocks such as Corinthian (NASDAQ:COCO), Career Education (NASDAQ:CECO), Apollo (NASDAQ:APOL), Capella Education (NASDAQ:CPLA), DeVry (NYSE:DV), and a few others… STRA included.
I began noticing how hated the industry is, which is usually a reason to at least give it a look. One thing I've learned through observation is that markets tend to misprice stocks that are involved with known and identifiable risks. In other words, if you can list all the reasons why you should hate a stock, there might be a good chance that the market is undervaluing that stock.
It's common sense when you think about it… if everyone hates it, and everyone knows why everyone should hate it, by definition, the majority of market participants are not going to want to own it regardless of the valuation.
Jamie Mae, of Cornwall Capital and Michael Lewis' Big Short fame said something similar in an interview with Jack Schwager:
Markets tend to overdiscount the uncertainty related to identified risks. Conversely, markets tend to underdiscount risks that have not yet been expressly identified. Whenever the market is pointing at something and saying this is a risk to be concerned about, in my experience, most of the time, the risk ends up being not as bad as the market anticipated.
Low industry tides lower all the boats in most cases, and despite being an above average business, and one of the most well-respected companies, even among the regulators, STRA has been punished along with the rest of the group.
Click to enlargeThe stock is down 80% from its 5 year high. I think this is mostly due to the overall sentiment in the for profit education industry, but the Strayer is certainly not completely immune to the problems in that group. Enrollments are down, regulatory requirements will make it more difficult to do business, and students may question the value of paying for education at many of the schools in this industry. However, I think the upside vastly outweighs the risk, and I think the worst case risks are more than priced into the current valuation.
Here are some things to like about STRA:
- Low fixed costs
- High returns on capital
- 10 years of FCF
- Growing historically, and has only 100 campuses in 24 states.
- Scalable business model that can grow much larger over time
- Even without opening campuses, the company has only 520 students per campus and their goal is to have about 1,000 per campus, so even without adding campuses, it can grow significantly
- Company is cheap; 8 PE and 9 EV/FCF, 5 EV/EBITDA
- Buying back a lot of stock
- 10 year accreditation from Middle States. They applied early and received their accreditation without any adverse findings.
- Really good reputation in the industry for a well managed university. No signs of the ill-practices at other for profit education schools.
- Sen. Tom Harkin says it's "one of the best" and he wrote a scathing report on the whole industry
Strayer is a good business at a cheap price, and I think the lower enrollment trends and the regulatory headwinds are already priced into the current valuation. The business uses very little in the way of fixed assets, so it produces high returns on the assets and the capital that it invests in the business. Most of the cash flow passes to the owners (owner earnings, or operating earnings less maintenance capex), as there is very little maintenance capex requirements. Here is a quick look at a few of the numbers from the last 10 years:
So the business produces above average returns, high free cash flow, and is available at a cheap price.... but what about the business and regulatory risks?
As I mentioned earlier, I began investigating the industry based on the cheapness of most of the stocks. My initial plan was to buy a basket of these cheap stocks. I still may end up owning a couple others, but most of the businesses are indeed at risk of regulatory penalties, and I'm not interested in taking that risk. Strayer is subject to the same regulations, but has done a much better job complying with the new, and proposed rules, and from what I can tell, has no real risk of major regulatory problems.
However, the for profit education industry has been riddled with controversy and scrutiny over the past few years. Less than admirable recruiting practices and methods of doing business has given the industry a black eye. Congress has stepped in and has taken out the microscope to try and put the reins on the companies in the industry that are at the root of the problem.
Congress has a lot of power, because the industry relies on funding from Title IV for the majority of their revenues. There are a few key laws to be aware of in this industry. Two of the most important when looking at companies are:
- 90/10 Rule: This rule states that a for profit education company can't get more than 90% of its revenues from Title IV government financial aid. Many companies are in the 80s, and a few are even at or slightly above 90. Going over puts the company on probation and risks it losing the ability to use these funds, which would put them out of business.
- 2 or 3 Year Cohort Default Rate [CDR]: The CDR tells you how many students are defaulting on their student loan obligations after 2 or 3 years. Both measures have been used. Basically, a company cannot have a CDR in any one year over 40%, and can't have a 2 year CDR over 25%. Many companies are around 15-20%, but the average in the industry is about 12%. Going over 25% puts the company in danger of losing its accreditation, which would seriously damage the business.
In both of the above categories, STRA is significantly better than average. They rely on Title IV funds for just 76% of their revenues, which is well below average. Their CDR rates using either 2 or 3 years, are also well below the industry average, and is in no danger of coming close to the 25% threshold.
There have been numerous reports on the industry written by regulators and lawmakers. Tom Harkins, chairman of the Senate HELP committee, wrote the most comprehensive one, and blasted many of the companies in the industry for unethical recruiting practices and poor student results. But, he had this to say about Strayer (emphasis mine):
Like many for-profit education companies, Strayer Education, Inc. has experienced steady growth in student enrollment, Federal funds collected, and profit realized in recent years. However, the company's performance, measured by student withdrawal and default rates, is one of the best of any company examined, and it appears that students are faring well at this degree based for-profit college.
And again, this is coming from the man who is basically leading the regulatory charge against the entire industry. He is basically "for profit education enemy #1". He also had this to say about Strayer to sum up his report:
Students attending Strayer have significantly better rates of retention than other companies of comparable size... Strayer appears to have better controls on recruiting practices and a more robust set of student services than many other companies, particularly publicly traded companies... The company also has earned the confidence of a number of employers that provide tuition assistance for their employees to attend the school. This in turn helps the company to be better positioned with regard to regulatory compliance than many other publicly traded companies. As a result, students attending Strayer-owned colleges appear to be faring much better than at many companies examined and the company had the lowest withdrawal rate for Bachelor's students of any company examined...
Pretty positive words from a mostly extremely critical report on the industry. The report did mention that Strayer exhibited a "lack of cooperation with the committee" that was "surprising", but as you read the latest SEC filings, you'll notice that Silvermann and the rest of the Strayer management team has gone above and beyond in terms of transforming their business to meet the new guidelines and requirements.
I see very little valuation risk and very little leverage risk. The company uses very little equity (currently has about $45 million in shareholder equity because of very few fixed assets). The company has $125 million of debt, but has plenty of free cash flow to cover the debt, and has a strong liquidity position (current ratio about 3, and it has $67 million in cash).
The biggest risk is business risk… and actually not in the traditional sense. The business itself is an outstanding business with low fixed costs, high free cash flow, high returns on capital, and a strong record of growth. The main risk is regulatory. If the Congress begins to come down even harder on the industry, it could make business more difficult.
I do think STRA is the best prepared in the industry to handle further regulatory hurdles, and given the fact that even Tom Harkin complimented STRA, I think even the risk of regulatory problems is remote, and likely priced into the current valuation.
I never get very complicated when trying to determine specific value of a stock. I like Joel Greeblatt's idea that value investing is just "figuring out what a business is worth and pay a lot less". He also has mentioned that he is never sure what a business is worth precisely, but he has a general idea that the purchase price is a lot less than the value. i.e.... if a stock is worth $10 and he can buy it for $5 or $6, he gets interested. He might be wrong and the value might be $8, or $12, but he has a good chance that it's higher than what he's paying. I have taken a similar "approximately right is better than precisely wrong" stance to my valuation work.
In a business like STRA, most people would approximate the value using a DCF. I don't use DCFs, as I don't like the false sense of precision (not to mention the wide variations of outcomes you get from small changes in assumptions). I value businesses like I used to value apartment buildings that I was interested in... what do the assets look like?... What is the cash flow?... and how much is that worth to me over time? I simply look at the cash the business has produced and try to decide if the future stream of cash will continue and if so, what is that worth to me. In this case, if the business continues to pile up free cash flow and buy back shares, I think that alone will act as a catalyst to increase the value of the stock. The company doesn't need much cash to operate, and so even with no growth, the FCF yield will grow over time as the company buys back more and more stock.
One of the questions I ask myself at the end of the research is if I think the stock has 100% upside (i.e. a 50 cent dollar), and using just simple free cash flow buildup gives me a general sense that the stock could see $80-$90 in the next few years, especially if the regulatory uncertainty becomes clearer. If the business does better than people expect, the stock might have significant upside. It's not precise, but I have a strong sense that the possible upside vastly outweighs the downside.
To Sum it Up:
STRA is a great business selling at a very cheap price. The company has produced positive free cash flow in each of the last 10 years, achieves high returns on capital, has historically grown earnings and cash flow, and has an experienced management team. The company has a good runway for growth, but you get any growth for free because the stock trades at a multiple that suggests no growth. The stock trades at single digit multiples of earnings and free cash flow (EV/FCF is about 8), and has historically grown that free cash flow stream. And maybe most importantly, the company is buying back stock, and has committed to another $100 million of buybacks (about 20% of the current market cap).
Good capital allocation along with good fundamentals and a great valuation makes this an interesting idea.
Discl: aimerJohn Huber owns STRA for his clients and himself. This is not a recommendation or an endorsement. Please do your own research, as this investment may not be suitable for you.
Disclosure: I am long STRA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.