I researched and wrote on Career Education Corp (CECO) in passing in June. My conclusions then were essentially that I really liked Scott Steffey as the company's new CEO, but that there was way too much uncertainty surrounding any potential turnaround for me to invest at that point. 6 months later, a lot has happened:
- Steffey has proven himself extremely competent.
- Steffey and another insider bought a significant amount of shares.
- There is a clear trend of improvement in enrollments and retention.
- The company got a much needed cash infusion by divesting its international operations.
- Existing litigation has largely been handled.
In addition, I believe shares are still very attractively priced. I've also gained some confidence from seeing that others in the SA community are finding shares attractive here. Put this all together and I am very seriously considering making a small initial entry early next week.
CEO Scott Steffey took over the struggling company in April and has done a fantastic job thus far. I'm very impressed with him. He worked at Strayer (STRA) for about 3 years beginning in March 2001. He came on board at the same time as Strayer's then-CEO and current executive chairman, Rob Silberman, and worked directly under him as COO. Strayer is a company I follow closely, and though the company is certainly struggling right now, I really believe Silberman is one of the most candid and competent men in for-profit education. I wrote an article exclusively on him a few months ago, but the main points are:
- Silberman led a decade-long year 'Golden Age' at Strayer of both high growth and high profitability
- Before Strayer, he worked at MidAmerican Energy (when it was called Cal Energy) when Warren Buffett acquired the company for Berkshire Hathaway (BRK.A, BRK.B). His boss at Cal Energy was David Sokol, who would become one of Buffett's most powerful underlings at Berkshire until the well-documented scandal and break-up.
- He was named Morningstar's (MORN) 2007 CEO of the Year.
- He was featured and portrayed as the model CEO in The Investment Checklist by Michael Checklist.
Silberman has an impressive resume and Steffey was his right hand man at the beginning of the 'Golden Age,' developing and implementing the business model that led to almost a decade of enviable impressive performance:
He left Strayer on his own terms to expand his education consulting business, Symposium Ventures. Prior to his tenure at Strayer, he notably worked as Vice Chancellor of the SUNY system (State University of New York) with 400,000 students, 75,000 faculty and administrators, and 64 campuses at the time.
So that's why I was impressed with him 6 months ago, but now it's even more clear to me that he is talented and capable of turning CECO around. Rather than speak about the same things twice, I'll discuss he and his team's accomplishments throughout this article and by the end you'll likely agree that he is deserving of trust and confidence.
Insider Buys (and Lack of Sales)
On November 19th, Steffey bought 25k shares @ $4.41 per share, totaling $110k. There are a couple reasons why I find that very meaningful:
- Steffey is the CEO- he should understand the business and its prospects better than anyone.
- It was the first insider buy since March 6th, and even that was only a measly 1000 shares by a director.
- It was around the price shares are at now, not the much lower range of the stock prior to the sale of International.
- It's a large enough transaction that it's safe to say it wasn't trivial. Steffey wouldn't risk that much money just to get investors talking.
In addition, just a few days ago on Dec. 12th a director bought 5k shares @ 4.74, or $24k worth.
What's also significant, is Blum Capital, after gradually dumping 3.1mm shares from March 5th to September 17th, hasn't sold since. I suspect this selling may have weighed on shares for those 6 months, and now that force isn't there anymore.
I've painfully learned from experience that investing in speculative turnarounds is not a good idea if you hope to achieve consistent and impressive long-term returns. I've drawn a line in the sand and essentially determined that I will only invest in turnarounds when they turn- when I can look at the numbers that matter from the past few quarters and identify an obvious trend of improvement, giving me reason to be confident in a continued turnaround, not the emergence of one.
Enrollment, specifically new student start growth, is the single most important leading indicator to look at in education. An education company's revenue is determined by two components: revenue per student and total student population. While companies have limited wiggle-room on revenue per student, they can expand capacity to take in more students and are constantly prone to enrollment declines. This makes it critical to look at enrollments in assessing the health of the business. Indeed, much of Career Education's poor performance in the past few years is attributable to falling enrollment and an inability to stop the decline. Looking at the last few quarters though, I can clearly see that things are improving and that's very encouraging.
The overall new student enrollment decline for continuing operations (excluding transitional) was 10% in Q3 versus 19% in Q2 and 20% in Q1. The company is also receiving an increased number of applications and conversions are up in both Career and University. In the Q3 Call, Steffey guided to positive start growth in University and stabilization in Career in 2014. In addition, the company saw improvements in retention by 80 basis points in Q3 versus Q2, a 90bp improvement compared to Q3 2012.
I'd really like to see one more quarter of definitive improvements in enrollments before investing a large percentage, but what I'm seeing now makes me confident enough to make an initial entry.
Career Education has been burning through a substantial amount of cash for over a year now, and since the company expects to burn more cash in 2014, albeit half that of 2013, ample cash is really critical to the turnaround. The more cash, the more time the company has.
On October 24th, the company sold its international operations. The deal closed just a few days ago and the company received $276.5mm of cash. Steffey seemingly orchestrated a very appealing deal too; the unit was sold for 2.4x sales.
The company estimates $375mm of cash on hand going into 2014 and has about $372mm now with no debt. Cash burn in 2014 is expected to be about half of 2013, or between $40-45mm. Although with all the cash that is burned the value of the company declines, they could burn $40mm/year for 9 years and still survive. The company has a ton of time to execute now and yet Steffey is still stepping on the gas pedal 8 months into his tenure, with visible improvements.
Litigation Dealt With
The company has been plagued by a bunch of lawsuits but the most significant have been the New York AG investigation and shareholder derivative actions. The company already paid $10mm for the New York AG suit and insurance is expected to cover the shareholder derivative actions in full. There are still other cases outstanding, but these are major steps in the right direction.
Quite honestly, CECO is a really tough company to value precisely right now. In order to combat that, I used several methods and am demanding a large margin of safety.
The company has $372.1mm in cash and $85.8mm in deferred rent which I'll include to be conservative for a total of $286.3mm in net cash. With a market cap of $320.3mm, the company selling for just 12% more than net cash.
The stock sells for .24x sales or 10% of what the International operations sold for. That was far healthier and more attractive than the rest of the company's operations though and I'm not even going to pretend the company deserves a multiple anywhere near that.
The US education industry is extremely competitive, regulated, and suffering from a poor economic environment right now. If there is a turnaround, the increased regulations will force companies to spend more on education costs and competition will bid down prices. These will both cause margins to shrink across the industry. I think 10% is a good target for net margin for CECO. I also think that because of all the existential risks there are in the education industry, investors have good reason to avoid the space, and if they do invest, should demand an extra discount. It's probably being extra conservative, but I assume a fair P/E of 5. As far as sales, the trend is slowing, but sales are still declining. Based on what I'm seeing with enrollments, I think we see another 15% decline in sales before stabilization on top of the 9% decline relating to International. That gives me $1.027B in sales and with a 10% margin, $103mm in profits. With the multiple of 5, the company's operations are worth $513.6mm. Looking at the cash, if I figure half the net cash gets burned before things turn completely, there's still $143mm left. Adding that to the value of operations I get $657mm, about double market cap.
I also valued the company using an FCFF model. I assumed a cost of equity of 15% to account for the risk of bankruptcy and the small size of the firm. I got a value of $8.76 per share, or about 84% higher than where the stock is now. Despite the difficulty in modeling a firm in transition like CECO, I am confident in my model because my revenue growth inputs and other assumptions were extremely conservative and the output matched the guidance Steffey gave in Q3 for EBITDA to turn slightly positive in 2015.
I hate hearing the phrase 'asymmetric risk/reward' all the time; I think it is extremely overused and misapplied, but that's exactly what I think Career Education is right now. The turnaround is becoming apparent in the results, the company has bought itself a ton of time to execute, it has a great leader who's already bought into the turnaround, and the stock looks extremely cheap even when accounting for the risks and being conservative in the valuation itself. I know there have been a few other articles published recently on the company, but I just had to add my two cents because this is an idea I am very confident in and despite all the attention CECO has gotten on SA, shares are still really, really cheap.