Why Barron's Is Wrong About For-Profit Education Stocks

ITT Educational Services (ESI) is a for-profit education company, with over 79,000 students enrolled at its ITT Technical Institutes and Daniel Webster College, which was just acquired this past April. The company currently operates 112 ITT campuses, 9 learning centers, and 2 Daniel Webster locations, as well as online programs. Historically, ITT was focused on short, 2-year, technology-related degree programs. But more recently, ITT has expanded into both non-technology areas and higher level degrees. Currently, over 70% of locations offer bachelor's degree programs in a studies ranging from Criminal Justice to Business Administration. While most students are still in 2-year degree programs, slightly over a quarter of enrollment is in 4-year bachelor degree studies.

For-profit education is a great business that has been broadly sold off over the past month or so. The reasons for this are cloudy, to be sure. Industry leader Apollo Group (APOL) announced an informal SEC inquiry, and widely read trade publications like Barron's and Bloomberg have run negative articles on the industry. Three of the top publicly traded for-profits are all currently on the Magic Formula screen (ESI, APOL, and Corinthian Colleges - COCO).

It seems like an irrational sell-off. All of these companies are growing sales, profits, and enrollments by 20% or more, as high unemployment has driven many thousands of people back to school to improve their education. In ITT's case, sales grew 34% and net profit 50% year-over-year in the just completed third quarter. For 2010, the company is expecting another 25% increase in sales and profits. This puts ITT's forward earnings yield at 16%, which is extremely cheap for the quality we are buying here.

This is a company that squarely meets the 3 points of investment: growth potential, competitive positioning, and financial strength. Growth will not be a problem over the near to mid-term. Over the next couple of years, higher enrollments due to high unemployment will boost margins. ITT continues to expand by opening new centers (6-8 a year), adding new programs (over 250 in 2009), and increasing tuition along with public schools (3-5% a year). The company has also shown a desire to growth through acquisition, such as the Daniel Webster purchase. Analysts forecast 17% annual profit growth over the next 5 years - quite healthy. I think it could do better than that.

From a competitive standpoint, all for-profit education providers enjoy great business advantages. These companies operate lean cost structures, but set tuition based on higher-cost traditional schools, which have to pay for services like dorms, food, sports, and so forth. Since government financial aid limits are set for these traditional schools, for-profits enjoy juicy operating margins over 25%. ITT is one of the best run, bringing in operating margins well over 30%. Also, barriers to entry are high, as government accreditation is a long and difficult process. Finally, the business model is highly scalable. Once the capital outlay for a campus is invested, that campus earns low-cost revenue with every student added, and each campus can be expanded with more programs as time goes on.

Financially, ITT is solid. Cash holdings are $275 million, debt just $150 million, and free cash flow is close to $200 million annually. Free cash margin is consistently in the high teen percentages. Returns on capital are out of this world, averaging 78% (traditional) and 148% (MFI) over the past 5 years. The company does not pay a dividend, but has been aggressive in repurchasing shares, reducing the share count by 4% annually since 2004.

So what are the risks? For-profits have sold off due to a few factors. First is the concern that the SEC inquiry towards Apollo could be industry-related, but I see little evidence to back this up. Secondly, some investors are worried about increased regulation of for-profit schools due to lower graduation rates. This again seems unlikely to me, as comparing these schools (which have largely working adult populations) to traditional schools (which are non-working young adults) is grossly unfair. It only makes logical sense that older adults, with full-time jobs and families, are less likely to complete a degree program than young people with few responsibilities.

One risk specific to ITT is the firm's higher-than-average reliance on private loans to its students. In 2008, difficult credit markets reduced the percentage of these loans from 27% in 2007 to just 18% in 2008, and ITT took on a risk-sharing component to help fund them. As a result, the company has had to provision for bad debt expenses, which have risen to above 5%. While the rebound in credit has eased most fears here, I would prefer to see ITT get out of the loan business altogether.

Overall, ITT offers investors outstanding and reliable growth at a bargain price, with what amounts to mild risk, in my opinion. As such, this is a candidate for the MagicDiligence Top Buys list and a strong choice for a new MFI position.

Disclosure: Steve owns APOL

Comments

[No_Schlock]

Look, reasonable people can disagree on the point, but you can't defend the sector without discussing the central criticism: a lot of these "schools" (ITT's technical degrees may be an exception) are diploma mills whose degrees evidence no level of skill and confer no value on the student. Loan defaults in the sector are so sky high even the government won't lend their students money - and that's really saying something. The reason defaults are so much higher than at traditional schools is that students leaving these schools make the same as...wait for it...high school graduates.

2009 Nov 25 07:59 AM

[Paul Price]

ITT Education [ESI] is a great company trading at a bargain price.

Today's investors should do very well from the present quote going forward.

2009 Nov 25 08:06 AM

[bbowen7]

The best of the bunch if you buy the premise of out of work young adults looking to improve technical skills. Perhaps DeVry as an alternative.

2009 Nov 25 02:01 PM

[Were you even listening to ...]

I tend to disagree, these schools offer technical training in a specific field of concentration. The same "experts" made blanket statements wait for it....about online schools. The days of an over priced 4 year schools will always have its place. A place where the vast majority of their students enter with no idea what they want to accomplish. Spend tens of thousands of dollars that they may not have only to get a degree that has no value or specific training.

Like in life you get out of what you put in. If you do not think that traditional sencondary education is a business, then you may possess one of those degrees that I just refrenced. Happy "TURKEY" day

2009 Nov 26 08:16 AM

[donzelion]

Conceptually, the for-profit education system is an intriguing innovation - coupled with distance learning, the ability to train persons for new fields wherever they may be would open doors for millions of people around the world. Like cheap, throwaway Japanese autos of the 60s-70s, it's easy to dismiss the system at this point, and old, established players have every incentive to do so.

The questions about quality are important - retention matters somewhat, but more important is value for the hour to the student: how many come back a year later, how many willingly continue to invest more time in the program after they use it to get one job or the other. There is potential here for significant social change: I'll put a few bucks down and see how it plays out.

2009 Nov 27 07:07 AM

[Tanjore]

The real problem is the growing loan default rates by students. If the trend continues to worsen then it is direct impact on revenue and earnings growth of these working adult trade schools.

There is no doubt that online schools can be as effective as traditional colleges and universities. But if 80% to 90% of the revenues come from student loans backed by US Government, then the default rates will hurt these schools as they do not have endowments to subsidize tuition.

2009 Nov 27 10:27 AM

[Chob]

Virtually all schools offer and in some cases students have no choice but to take an online course (for-profit and public), so attacking a school who makes money on providing an education is absurd. Defaults may be higher these days than in the past, but where is there proof this is due to for-profit educators? Maybe the public should hold those accountable who do not complete their program and then default on the loans. If the number of people going to college nation wide has increased and costs have soared, the number of defaults is sure to rise along with it. You also have a substantial number of people (educated too) who are out of work. My point is, it's really easy to blame those who profit and not sit back and really weigh out everything else.


On Nov 25 07:59 AM No_Schlock wrote:

> Look, reasonable people can disagree on the point, but you can't
> defend the sector without discussing the central criticism: a lot
> of these "schools" (ITT's technical degrees may be an exception)
> are diploma mills whose degrees evidence no level of skill and confer
> no value on the student. Loan defaults in the sector are so sky
> high even the government won't lend their students money - and that's
> really saying something. The reason defaults are so much higher
> than at traditional schools is that students leaving these schools
> make the same as...wait for it...high school graduates.

2009 Nov 30 10:44 AM

[Zizo]

The sector is under the suspicion that for-profit colleges are bilking the government through the grants and loans that their students receive and cannot pay back. According to a recent AP analysis 24% of all Pell grants, $4.7 billion, went to students enrolled in proprietary colleges, which enroll only 10% of college students. If the rules for eligibility of a school for government-guaranteed loans are tightened by the upcoming review by the Department of Education, I suspect these stocks have a lot of downside. Even if there isn't any regulatory pushback, the cyclical benefits of high unemployment will go away in the not-so-distant future. As a result, the stocks in this sector (APOL, ESI, CECO, COCO, CPLA, STRA etc.) are attractive shorts in my opinion.

2009 Dec 01 01:00 PM

[User 370365]

Lets take a good look at your comment Zizo. Your backwards statistic that u threw out there, "According to a recent AP analysis 24% of all Pell grants, $4.7 billion, went to students enrolled in proprietary colleges, which enroll only 10% of college students. " speaks loudly to the fact that perhaps your argument was not well though out or you are using a backward stat to sustain your house of cards argument. My guess is the reader is to infer that 76% of all pell grants went to students enrolled in for profits of which 90% are college students. NOT. Furthermore pell grants are just that grants that have no obligation from the grantee to repay the grantor. How that ties to the DOE "potentially" (?) tightening restrictions on "LOANS" according to your smoke and mirror logic makes no sense whatsoever. Additionally if you were even somewhat familiar with this sector you would also know that prior to this recession this sector was experiencing double digit sequential growth even in the "good times". You shorts crack me up. You tend to be "short" on fact, and long on innuendo, rumor and conjecture.

P.S. No-Schmuck's comment doesn't even dignify a response as warranted by the posts that follow it shooting major holes in it. An example of...wait for it.... premature ejacaPOSTulation long on runneyness but lacking thickey substance. LOL

2009 Dec 01 02:42 PM

[31October]

I worked at a private college and was the Bursar at a state school. A stunning percentage of students take out loans and have no intention of learning anything. Some schools have such high default rates on Title III funds that they have been put on a cash-basis: They cannot advance any Stafford or Pell until the federal funds are actually in the school account. A peer at ECPI left and came to us, in fear that they would go under, only to find that the state system was much worse. If unemployment stays high (it will), then more schools will cross the post-school default threshold, putting their flexibility with funds at risk. Those like ITT who can advance funds will get defaulted on (The school allows enrollment and books on credit, in expectation of Stafford/Pell coming). And those on cash-basis will not be able to attract cash-poor students. But COCO & ESI look like those risks are almost factored in. Maybe another 15% drop....


On Nov 27 10:27 AM Tanjore wrote:

> The real problem is the growing loan default rates by students. If
> the trend continues to worsen then it is direct impact on revenue
> and earnings growth of these working adult trade schools.
>
> There is no doubt that online schools can be as effective as traditional
> colleges and universities. But if 80% to 90% of the revenues come
> from student loans backed by US Government, then the default rates
> will hurt these schools as they do not have endowments to subsidize
> tuition.

2009 Dec 11 10:56 AM