CFAs Eric Brugel and Jeff Erber are co-founders and managing directors of Grey Owl Capital Management, an RIA firm based in Falls Church, Va., pursuing an investment strategy they refer to as focused, tactical, and growth-oriented.
If you could only hold one stock position in your portfolio, what would it be?
We are owners of Apollo Group Inc. (APOL), which is the parent company of the University of Phoenix.
The University of Phoenix is the largest university in the United States with over 450k enrolled students. The school offers associate’s, bachelor’s, master’s, and doctoral degrees across numerous disciplines. Apollo Group also owns several other schools primarily focused on international education.
How does your choice reflect your fund's investment approach?
We make a number of different types of investments, but in every case, the investment is based on our estimate of the security’s intrinsic value. We will invest in a great business with high return on capital that we think has a sustainable business moat, opportunity to reinvest capital at similar high returns, and a solid balance sheet if we can buy the business at a modest discount to our estimate of intrinsic value. We will invest in an OK business (lower returns, weaker moat, cyclical, more leveraged balance sheet, etc.) at a much greater discount to our estimate of intrinsic value.
Less frequently, we will invest in businesses that are changing based on some macro factor or a new strategic direction if we think the business will be able to improve its return on capital going forward and the market doesn’t yet recognize or believe it. Finally, we’ll invest in a broad range of special situations: merger arbitrage, stub securities, restructurings, spin-offs, etc. In every single case, we are focused first on our “margin of safety.” We are more concerned with downside protection than upside opportunity.
We believe APOL is a rare case where we can invest in a great business that is trading at a very steep discount to our estimate of intrinsic value. We also like the idea that APOL’s growth is not tied to a recovering economy. We are skeptical of making investments predicated on a “V-shaped” recovery.
Can you talk about the sector? How much is your selection based on the company's industry, as opposed to a pure bottom-up pick?
For-profit education is a high-return business (APOL had 28% operating margins in 2009) with a strong moat. The businesses are able to earn high returns because for-profit schools are the low-cost providers in an industry where traditional schools (both public and private) set the price based on their much higher-cost, lifestyle-oriented infrastructure: dormitories, sports complexes, health clubs, and student unions.
Scholarships also play a factor. For-profit schools can offer a product better suited to the needs of their particular audience (mostly working adults) at a lower price point. We think these businesses will be able to continue to earn high returns on existing and incremental capital (i.e. they have a strong “moat”) because they are the low-cost providers in a business with a very large untapped audience. Apollo Group executives see their market as the 50 million-60 million working adults without a college degree.
While the industry has very favorable economics, there are significant differences across the publicly traded, for-profit universe. Schools that focus on degree programs (like APOL) are less cyclical than trade-based schools that see enrollment spikes during economic downturns. So, we like APOL better than some of the other options.
How is Apollo Group positioned with regard to competitors?
At the end of the day, the most important fact about the competitive environment is the vast number of working adults who don’t have a college degree (estimated between 50 million and 60 million) and the growing need for such degrees (and the skills they represent) as the U.S., and the entire world, moves to a more information-based economy. With such a big untapped market, competition is not a primary issue for these firms.
Further, proprietary research from Morningstar estimates that traditional schools increased enrollment at an annual rate of just 1.6% from 1998 to 2008. With a 2009 base of 19 million students, mostly in traditional schools, the small number of large, for-profit universities are the only institutions that can absorb the increasing demand for education.
Simple logic explains why the low growth rate for traditional schools will likely persist. First, with state budgets under pressure and endowments hurt from the stock market correction, traditional schools don’t have the budgets to expand. Second, with a focus on exclusivity, traditional schools have not shown a willingness to lower SAT and GPA standards to appeal to a broader clientele.
That being said, we do think APOL has some advantages over its specific for-profit competitors. Within the for-profit space, APOL is the largest, so it obviously has some scale advantage that the others don’t have. Interestingly, it uses that scale advantage mostly on the marketing front, as it attempts to keep both campus and online classes at 14 students. (They really are focused on providing a quality product.) We also think the Apollo Global business provides investors with a call option on international education, which has the potential to be a high-growth area.
How does APOL's valuation compare to its competitors?
The for-profit education sector isn’t a homogenous group, so it is hard to say company A has a lower P/E than company B and is thus cheaper. As we discussed above, trade schools are far more cyclical than schools that focus on degree programs. Schools that have more students enrolled in bachelor degree programs are more profitable than those that are weighted to associate degrees. Smaller schools will likely grow at much faster rates than APOL's larger schools.
With that said, maybe we can answer the question this way. We think Strayer University (STRA) is the gold standard in for-profit education. They have higher operating margins than APOL (32% in 2009). With just over 55,000 students, they will likely be able to grow at a much faster rate than APOL. STRA doesn’t have the same historic baggage that APOL has related to an option back-dating issue that occurred under previous management. They also lack some of the current regulatory issues that APOL continues to be faced with (i.e. SEC inquiry into APOL’s revenue recognition process, although all publicly traded for-profit firms use the same process).
In our estimation, APOL is a target due in some part to their size. Finally, as a reasonable measure of the quality of their offering and the institution’s ability to enroll qualified students, STRA has a lower cohort default rate (CDR) than APOL, meaning fewer of their students wind up defaulting on their student loans.
However, STRA trades at a free cash flow yield (based on 2009 cash flow) of a little more than 3%. APOL, on the other hand, trades at a free cash flow yield of 11%. Sure, STRA is going to grow more quickly than APOL, but at this price even if APOL didn’t grow at all this could be an OK investment. If you want to look at it on a P/E basis, APOL trades at a P/E of 12.5 on trailing twelve-month earnings, whereas STRA trades at over 30 times. By most metrics, STRA is one of the most expensive for-profit education companies and APOL is one of the cheapest; and this includes the more trade-based schools.
Does your view on Apollo differ from the consensus sentiment?
The overall industry has been the subject of significant headline risk. There have been a number of recent stories in Barron’s, Bloomberg.com, and The New York Times that (from our perspective) make broad generalizations from anecdotes. These articles tell of situations where graduates were unsatisfied with their career options after receiving a degree, individual enrollment counselors (recruiters) demonstrated bad behavior, and even where whole (albeit small) schools used unsavory recruitment practices.
There are also a significant number of prominent hedge fund managers who are very publicly bearish on the for-profit education sector. Steven Eisman presented a comprehensive case at the Ira Sohn Conference in May 2010. The bears argue that for-profit universities, in general, don’t deliver value to their students. They paint a picture of an industry where an excessive number of students drop out of programs and the ones that complete their degree can’t find a job with sufficient income to pay the debt they took on in order to fund their education. We obviously disagree, particularly as it applies to APOL.
Can you elaborate on what's wrong with the bearish sentiment?
Let’s walk through the data to see why we think the shorts are wrong. The most telling metric from our perspective is the cohort default rate (CDR). This tells us how many students from a particular year (cohort) default on their student loans. Broadly speaking, if the education received provided sufficient value it will allow a graduate to get a job earning enough income to pay interest and principal on their student loans (in addition to funding their other living expenses). Reviewing the 2007 cohort, across all secondary education institutions 11.8% of students had defaulted on their student loans after three years (i.e. through 2010). As one might expect given the ongoing recession, this number is elevated compared to 2005 where the total default rate after three years was 8.4%. For the 2007 cohort, for-profit schools averaged 21.2%, whereas Apollo’s University of Phoenix was 15.9%. The public university average was 9.7% and the nonprofit, private average was 6.5%. Interestingly, the average for both two-year public and nonprofit, private schools (essentially community colleges) was 16.2%.
Clearly, nonprofit private school defaults are better than public schools, which are better than for-profit private schools. If you think about the distinct demographics that each of these education systems serve, this makes perfect sense. What we find particularly interesting is that the University of Phoenix actually has a lower default rate than the average community college. This was the case for 2005 and 2006 cohorts as well. Are the community colleges also “churning and burning” students at the students’ and the taxpayers’ expense, as Mr. Eisman suggests of the for-profit schools?
The idea that these costs are “at the taxpayer’s expense” leads to another interesting analysis. In its 2009 Academic Annual Report, the University of Phoenix provides an analysis that shows the University is a net taxpayer when considering corporate tax paid by APOL against the cost of defaulted loans and the implicit interest rate subsidy that the government provides. The net payment per student is $140.82 per year. Contrast that with the average cost to the taxpayer per student at public universities of $14,722 per year. Despite the higher default rate on student loans, the University of Phoenix appears to be a far better user of government subsidized loans than the public university system. Nonprofit private universities are even worse. According to the University of Phoenix’s analysis, these schools cost the taxpayer an average of $20,643 per student, per year. The details can be found in Table 13 on page 29 of the report.
The next item that the shorts point to is the very low graduation rates exhibited by for-profit universities. Most analysis on this topic comes from data supplied by the Department of Education, National Center for Education Statistics, Integrated Postsecondary Education Data System (IPEDS). Using this data, a recent Barron’s article showed that only 34% of for-profit bachelor degree candidates obtained their degree within six years, versus 45% at public universities and 52% at the nonprofit private schools. One could immediately ask why the 7% difference between the nonprofit private schools and the public universities is OK, but the 11% difference between the for-profit schools and the public schools isn’t OK, however, that would be missing the bigger point. There is a flaw in using the IPEDS data to make an assessment of whether or not the for-profit schools are preying on “unqualified” students.
The IPEDS data only counts first-time students. A large percentage of students who graduate from for-profit universities have transferred credits from community colleges or other traditional programs. There is also a flaw in looking only at the six-year window, as studies have shown that students who restart college later in life take almost eight years to complete their degree.
The final point we will make on graduation rates is that even some college is better than no college. Just look at the May 2010 Bureau of Labor Statistics Employment Situation report and you will see that the unemployment rate for high school graduates with no college degree is 10%, whereas the unemployment rate is 7.8% for those with some college or an associate’s degree.
There are two strong counters to the “churn 'em and burn 'em” critique as it applies to APOL. First, APOL has stated that students who drop out early in a program are unprofitable because their acquisition cost is not fully amortized. Second, APOL is leading the way in introducing orientation programs paid for by APOL that are designed to filter out unmotivated or unqualified students. Targeting unqualified students isn’t in the company’s financial interest, so why would it be an important part of their recruitment strategy?
While there is no doubt that improvement is needed across the entire education spectrum, the negative focus by journalists and prominent investment managers on the for-profit space in general strikes us as the result of a narrow worldview and a misdirected desire to right wrongs.
The biggest negative overhang for the for-profit space is the anticipation of new regulations designed to limit student debt burdens. Preliminary language from the Department of Education proposes to limit student debt burdens to 8% of the average salary for the typical job that a degree recipient could obtain, assuming a 10-year payback period. Here’s an example for context: If the typical job in a particular industry pays $60,000/year and student loan interest rates are at 5%, then the maximum debt a student could take on would be $37k.
If implemented, this would clearly impact some of the degree programs at most for-profit universities. Here is our perspective: First, even if implemented as is, we don’t think it will have as broad an effect across APOL’s degree programs as Mr. Eisman indicates. Second, even if it had the full impact Mr. Eisman is looking for, APOL currently trades at fair value - it might not be a great investment, but is it really a short? Finally, based on Secretary of Education Arne Duncan’s positive recent comments on the for-profit space and no clear method for implementing the proposed rules, we think cooler heads will prevail as the proposal goes through the review process.
Does Apollo Group's management play a role in your selection?
In this case, we haven’t focused on management as much as we might in a turnaround situation or in an industry where uses of incremental capital are less clear. That being said, we think APOL’s new management team is doing a good job improving the quality of their product, making smart capital allocation decisions, and communicating well to prospects, students, alumni, and regulators the unique value proposition of a University of Phoenix degree and the important role for-profit education companies can play in efficiently improving the overall education level of U.S. citizens.
What catalysts, near-term or long-term, could move APOL stock significantly?
We think the regulation overhang will lift in the next few months.
So is that as much of an upside catalyst as a risk factor? In other words, what's priced in now? Could there be an upside move of significance if some of the uncertainty around loans is cleared up?
We believe that APOL is pricing in a scenario that is even worse than what the current proposals around “gainful employment” would create. However, we recognize there is significant uncertainty and this will remain until an update of the proposed regulations is released for comment (now scheduled for “later this summer”). The deadline for publishing a final version is Nov. 1, so at that point the uncertainty should dissipate.
We think that even if the “gainful employment” proposals are enacted as they stand, there is still some modest upside to APOL’s current stock price. However, we don’t think the current proposals can be implemented from a practical standpoint and we also don’t think the current administration wants to hamper access to educational opportunities, which the current “gainful employment” proposals would likely do. If the proposals are modified, we think there is significant upside to APOL’s stock price.
What could go wrong with your pick?
Despite the overwhelming evidence that APOL and other for-profit education firms are providing a valuable service, the government could decide to introduce draconian regulations. Though even in that case, we think we have a sufficient margin of safety to protect our downside and that really is the name of the game as far as we are concerned.
Thanks very much for sharing your thesis with us.
Disclosure: Grey Owl Capital Management is long APOL.
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