Comprised of 14 mostly small and micro-cap companies, the publicly traded U.S. post-secondary education industry is collectively up 21.3% year-to-date as of the market close on October 18, 2013. This contrasts to 31.2% YTD for the Russell 2000® Index. The education services industry continues a relatively beaten down sector in an otherwise bull market. But as demonstrated by a market cap weighted average, it remains reasonably priced when compared to the U.S. small cap universe.
Looking at fundamentals, the U.S. education industry begins to show its hammering following three years of scrutiny from state and federal governments, mainstream media, brokerage analysts, and short sellers. Yet despite lethargic earnings and revenue growth, high betas, and low dividends, the industry is collectively strong in cash flow, debt, and returns on equity and capital.
When a company or industry is fundamentally strong and reasonably priced, savvy investors will measure margin of safety in determining its ultimate investment worthiness.
Decoding Margin of Safety
Benjamin Graham concluded in his groundbreaking book on value investing, "The Intelligent Investor" (Harper Collins) that margin of safety in a security is the favorable difference between the current price and an investor's appraised value. He and co-author David Dodd first broached this concept in 1934's "Security Analysis" (McGraw Hill) where it was referred as discrepancies between price and value.
Graham considered margin of safety calculations to be mostly an exercise in arithmetic, more tangible than not. This approach to securities analysis has transcended in the years since, most evident in brokerage analysts' sophisticated software driven financial models attempting to predict future price targets. The difference in the current price and a higher future price estimate is the analyst's quantitative measurement of margin of safety.
Inherently, if price targets were more often correct, observant investors would build and maintain wealth by simply following their broker's research division. Of course, the market would eventually catch up to this phenomenon if it indeed existed.
Somewhat to the contrary, Graham's most famous student, Warren Buffett, often refers to margin of safety as an intrinsic or perceived value of the stock. I have come to appreciate Buffett's view as more intangible, preferably focusing on threats and challenges facing a company whose stock is already determined to be relatively cheap. One example of Buffett's margin of safety as an intangible measurement is his infamous wide moat theory, or an investor's perception of a company's sustainable competitive advantage.
Convincingly, past analysis and future predictions of growth and profitability should figure in any investor's equation when estimating the value of a company's stock. But a more elusive notion of safety is founded in determining risk from a defensive posture as opposed to chasing price targets, or technical indicators for that matter. This is where an enduring competitive advantage or wide moat of a company comes into play. It often begs the question: Value play or value trap?
For the U.S. education services industry, competitive advantages presented by believable value propositions and risk vs. return trade-offs such as measured by regulatory records appear to be reasonable assessments in estimating a company's margin of safety or intrinsic value.
That being said, as Buffett famously reminds investors: If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. Whether Buffett meant wisdom or sarcasm in his anecdote, the advice taken verbatim may be a tough sell in the highly regulated for-profit education space.
In respect to margin of safety, let's take a look at value propositions and rate regulatory records of the U.S. companies deriving their primary revenues from post-secondary education.
Methodology: Value proposition statements are illustrative and based on interpretation of public information released by companies. Ratings awarded for regulatory record are based on interpretation of publicly available actions or inquiries from state, federal, and/or accreditation agencies, plus any reported active student/employer lawsuits and/or securities litigation per most recent company 10-K/Qs. Company loses one √ for any publicly disclosed regulatory action(s) or inquiry(s) within one of the five referenced regulatory bodies. Ratings as of September 30, 2013.
According to publicly available sources, six companies, Grand Canyon Education, Inc. (LOPE), Capella Education Company (CPLA), American Public Education, Inc. (APEI), Strayer Education, Inc. (STRA), Lincoln Educational Services Corporation (LINC), and National American University Holdings, Inc. (NAUH), have no significant regulatory exposure.
Somewhat to the contrary, DeVry, Inc. (DV) has disclosed inquiries in two areas of regulatory oversight: securities litigation; and a subpoena from the attorney general of Illinois regarding alleged compensation practices at the company. Universal Technical Institute, Inc. (UTI) has filed inquiries from both federal and state sources, specifically a false claims investigation from the U.S. Department of Justice regarding incentive compensation, and a civil investigative demand [CID] from the attorney general of Massachusetts relative to student financial aid at its Norwood, MA campus.
The remaining six companies score lower when evaluating current regulatory exposure.
Apollo Group, Inc. (APOL) in its most recent SEC filings lists securities class actions; state attorney general notices from Florida, Massachusetts, and Delaware; accreditation actions against its university operation in Chile; accreditation notices against its Phoenix and Western International university units; and a qui tam false claims lawsuit regarding incentive compensation.
Education Management Corporation (EDMC) has disclosed accreditation actions; qui tam civil lawsuits; shareholder derivative lawsuits; a subpoena from the Office of Inspector General [OIG] of the U.S. Department of Education; a subpoena from the SEC related to the company's valuation of goodwill and treatment of bad debt allowances; and state attorney general investigations from Massachusetts, Colorado, New York, Kentucky, and Florida.
In public disclosures Bridgepoint Education, Inc. (BPI) reveals investigations from the attorney generals of Iowa, New York, and North Carolina; a consolidated and settled employee class action lawsuit regarding its Ashford University unit; other employee class actions; a securities class action; a lawsuit regarding the recruitment and retention of students at both its university units; and as I previously reported here, an accreditation probation that was eliminated by successfully seeking initial approval from another regional accreditor.
ITT Educational Services, Inc. (ESI) in its most recent 10-Q, discloses a qui tam action civil lawsuit; two securities class action lawsuits; a shareholder derivative lawsuit; civil investigative demands from both the U.S. Consumer Financial Protection Bureau [CFPB] and the attorney general of Massachusetts; and a subpoena from the Securities and Exchange Commission [SEC] regarding its private loan program.
In SEC filings, Career Education Corporation (CECO) discloses securities litigation and shareholder derivative actions; student litigation and class action lawsuits; employment litigation; federal false claim acts, state investigations from the attorney generals of Florida, Illinois, and Massachusetts; and inquiries from the SEC and U.S. Department of Education regarding graduate job placement.
Corinthian Colleges, Inc. (COCO) says it has been contacted by the attorney generals in the states of Florida, Massachusetts, New York, Wisconsin, Minnesota, California, and Illinois for documentation regarding their business operations in those states. The company was also subpoenaed by the OIG of the U.S Department of Education relative to employment and placement rates reported to the accrediting agency of its Jonesboro, GA campus. Corinthian is also the subject to two qui tam matters, including an inquiry from the U.S. Department of Justice; a CID from the CFPB regarding a general investigation of the for-profit education industry; and a subpoena from the SEC relating to student information at the company's campuses.
According to the companies, some attorney general inquiries are broad to the industry as opposed to specific to the company. All cases/inquiries are pending, unless otherwise noted.
It's the Regulations … Idiot
In Warren Buffet's seminal essay on value investing, The Superinvestors of Graham-and-Doddsville (Hermes/Columbia Business School), he paid tribute to mentors and peers who practiced successful investing methodologies toward buying wonderful companies at reasonable prices. One of my favorite words of wisdom from the Oracle of Omaha:
Buy stock in businesses that are so wonderful an idiot can run them. Because sooner or later, one will.
I believe insiders responsible for destroying the reputation of the long standing, value added, for-profit U.S. education industry are either already gone from the sector or will be in time as a long overdue shakeup continues. Underestimating the firmly held stake of governments and accreditors in their companies' operations, ultimately led to the industry-wide fall from grace.
Focusing on the proverbial Wall Street quarter, over aggressive lobbying, and voting on party-lines were inevitably not the solution. Simply playing by the rules and genuinely putting the student, graduate, employer, and taxpayer first, were always on the table. Being a wonderful provider to these primary stakeholders can and should richly reward beneficiary stakeholders like shareowners and employees. In hindsight, the reversal of this pecking order enriched some in the short-term, at the expense of many in the long run. Consequently, the proverbial fan suffered a direct hit.
Investors and analysts in the space are not exempt from the industry's misstep as prior to 2010 they mostly ignored or wrote off the brewing regulatory issues as "already priced-in the stock" or "manageable events." But market cap destruction ensued in a subsequent industry meltdown.
In response to the slowdown in student enrollment, company executives pointed to broader economic concerns. But economics are often driven by regularly occurring business cycles, and thus carried limited weight in the blame game. Granted, following a record run-up in enrollment growth during the Great Recession of 2008-09, some cyclical fall-off was inevitable. Yet the removal of the so-called "safe harbor" areas of admissions regulations by the Obama Administration on July 1, 2011 is what ultimately brought the growth spurt to a grinding halt. Unable to motivate the sales team, without risking sanctions to the awarding of federal financial aid to its customers, suddenly put the industry in defense mode. Today, companies remain on that side of the ball.
In retrospect, regulatory compliance and student services are generally immune to business cycles. The lesson being investors must respect this exposure when calculating intrinsic value in education companies. And the companies themselves need to genuinely make clean regulatory records an integral part of their value propositions.
Quality academics, engaging student services, and high graduate employment are now vital pieces in every company's strategic plan. That is the simple part. Following the lead of Grand Canyon, Capella, American Public, Strayer, Lincoln Educational, and National American in producing consistently strong regulatory and accreditation records will benefit students, employers, taxpayers, and shareholders alike. Not doing so (or remaining so) may ultimately lead to an education company's peril, regardless of any otherwise attractive metrics.
Fundamentals, reasonable prices, value propositions, earnings projections, and technical charts may not provide enough data for investors to find wonderful companies in the post-secondary U.S. education sector. Regulatory track records, including acceptable cohort default rates and 90/10 ratios, in tandem with exceptional student outcomes have arguably become the central report card of the industry in its ever evolving and important contribution to our country's competitive economic future. And the recent release by the U.S. Department of Education of a renewed draft of the controversial gainful employment regulations is a reminder to all for-profit educators and their stakeholders that headwinds remain in the windshield, not the rearview mirror.
From a micro perspective, overweighting regulatory exposure when evaluating an education stock can put a savvy investor in position for a favorable margin of safety in a fundamentally sound, reasonably priced company. Likewise, ignoring the important role of this industry in America's workforce development of the 21st century solely because of a blanketed perception of regulatory risk, might squander potentially outstanding investment opportunities.