Investors Should Carefully Study the For-Profit Education Model

by: Matthew Green

Monday witnessed the biggest one-day rally that for-profit education stocks have seen this year, coming on the heels of the sector’s three-week old rally. The question of whether the rally can be sustained is complicated, however.

Not very much has changed with regard to the fundamentals, which have been driven by uncertainty since the middle of 2009. For-profit education stocks were some of the market’s best performers through 2008, when they were viewed as beneficiaries of the recession that has sent many back to school. But serious questions have been raised regarding the for-profit business model and the industry’s practices. As we know, questions ranging from the quality of the education they provide to the large amounts of debt their students incur have gotten the attention of Congress, and short-sellers have entered the fray. While it is unlikely that Congress will do nothing, the sector will inevitably continue to be volatile until the dust settles on Capitol Hill. Due to the recent rally and continued uncertainty, it would be wise to wait for another definitive down leg or at least until the technicals of the sector are overextended to initiate a short position.

Last month, Congress held hearings on the for-profit sector for the first time since 2002. Among those called to testify was Steve Eisman, who made waves at the Ira Sohn Conference in May with his presentation about the sector’s problems. In this presentation, he compared the for-profits and their growth to that of the subprime mortgage industry, and suggested that the outcome will be similar. Just like the housing market needed more people to take out mortgages to keep growing, the for-profit sector needs to continually increase enrollment (and revenue via federal loans) to beat earnings. One twist, however. Big banks aren’t going to be on the hook if it ends in a debacle; the taxpayers will. In fact, he suggested that up to $275 billion of federal loans made to for-profit sector students will end up in default over the next decade. In another alarming statistic courtesy of the Department of Education, while for-profit students make up only 10% of the U.S. higher-education student population, they constitute 34% of the defaults.

A clear divide exists among investors concerning the future of the industry and its business model. One of the reasons that Eisman’s thesis is notable is the fact that many other hedge fund managers, John Paulson and Stephen Mandel to name a few, have been long the sector.

It should come as no surprise that many investors are long. Since Apollo Group (NASDAQ:APOL), the parent company of the University of Phoenix, went public in 1994, it has produced a nearly 4,000% return for investors. However, it is currently down 50% since peaking in April 2004. By any measure, that is a remarkable run. As Congress has begun scrutinizing the sector this year, the stocks have fallen anywhere from 10% to 50%. Since April, the stocks of Apollo Group, DeVry (NYSE:DV), and Corinthian (NASDAQ:COCO) have declined 24%, 29% and 47%, respectively. Whether the current rally sustains or not will largely depend on whether Congress takes action this year to curb the for-profit’s lifeblood; federal Stafford Loans and Pell Grants.

Apollo Group July 2007-Present (Click to enlarge)

Corinthian Colleges July 2007-Present (Click to enlarge)

As early as 1990, congressional hearings were held with the same concerns that exist today. Back then, Senator Sam Nunn of Georgia characterized the industry’s primary business as “processing federal student loans.” Whether they are from 1990 or 2010, the numbers confirm that statement. In 2009, over 85% of revenue at Apollo Group’s University of Phoenix came from federal student loans. The rest of the industry operates with similar percentages of revenue flowing into their coffers from Washington. Any barriers that are raised to limit their access will further impede the industry’s ability to grow and meet investor expectations. As such, the industry has assembled an army of lobbyists, and the battle is just beginning.

One of the lobbyists’ victories thus far was the origin of Monday’s rally. The proposed “gainful employment” rule would require that for-profit students are adequately trained in order to attain a job sufficient to pay back their loans. A report from Signal Hill Capital that was released on Monday speculated that the proposed regulations will be “softened.” The other mission of lobbyists over the next year will be to maintain the “cohort-default rate.” This figure is the primary measure of student loan performance, but it only measures defaults within the first-two years of repayment. According to data from the Dept. of Education (available here), the default rate is similar among private, public, and for-profit schools within the first two years. The default rate among for-profit students rises much higher than the others from year three of repayment onward. Expect the lobbyists to oppose changes in this rule head-on, so ask to mask their true rate of default. If the true rate was more widely known, it would call into question the return American taxpayers are getting for subsidizing the education, or lack thereof, of students at these institutions.

Several for-profit lobbyists have implied or said that that it would be unfair for the government to penalize the for-profit sector because they serve a riskier sector of the population. That is akin to disgraced mortgage lenders saying that it would be unfair to penalize them for originating the “liar” and “ninja” (no jobs, no income) home loans to a risky sector of the population that clearly did not have the ability to pay them back. They further go into arguments that there are “good and bad apples,” within the for-profit industry and to penalize the entire sector would be counterproductive. That may be so, but in the case of the housing bubble, for every prudent lender who tried to do it right, like Bill Dallas, there was a Daniel Sadek or Angelo Mozilo who would eventually personify the problems of the entire sector.

As we all know, one of the main causes of the housing crisis was the fact that mortgage originators were paid based on the volume of loans they provided to the big banks. In the same way, for-profit school admissions counselors are paid based on the number of students that they enroll.

In the May 4, 2010 edition of PBS’s Frontline, former University of Phoenix admissions counselors reflected on the high-pressure sales tactics they were required to use to get students to sign off on loans needed for enrollment. One counselor reflected on closing individuals who were clearly not prepared to do college-level work. Despite having basic admissions standards (e.g. a high school diploma or GED), the lack of preparation of many students leads to a much higher dropout rate at the for-profits, and this drives defaults higher as these dropouts are stuck with the debt. For-profit institutions clearly want to maintain their image of providing a necessary service to working class students, despite providing a substandard level of instruction and then expecting them to pay back debts which they cannot handle with the jobs they end up working.

Therefore, one of several scenarios could result in an immediate drop in enrollment (translation: profits) at the for-profits. First, if the employment picture improves markedly the number of individuals going back to school will drop. Currently, many of those who are students at for-profits would normally enroll at lower-cost community colleges, but admissions standards have risen in that sector due to the higher demand for spots since 2007-08. If the situation improves, for-profits will no longer have as much overflow capacity to suck up. Second and more likely, if the government limits the for-profits access to federal loans, their enrollments will drop precipitously. The reason is simply because Congress is likely to take the case of predatory student lending much more seriously than some might think. Considering the current deficits being run in Washington, and the fact that U.S. taxpayers are subsidizing these institutions that produce a limited return on the taxpayer’s money, a thorough review of their business model and practices is warranted and, more importantly, prudent.

Disclosure: No positions