For Profit Colleges: Should You Go Long or Short?

Includes: APOL, COCO, DV, ESI
by: Mariusz Skonieczny

About a decade ago, if you were a working adult wanting to go back to school, you had to make hard lifestyle sacrifices because traditional colleges and universities did not make it easy for you to attend their institutions. You could not simply keep your job and take classes in the evenings or on the weekends. This unmet demand gave birth to for-profit education colleges and universities that targeted working adults and allowed them to take classes online and at off-peak times. Companies such as Apollo Group (NASDAQ:APOL), ITT Educational Services (NYSE:ESI), Corinthian Colleges (NASDAQ:COCO), and DeVry (NYSE:DV) filled in the gap that traditional post-secondary educational institutions failed to meet. Apollo Group with its University of Phoenix has been the pioneer of for-profit education. If you invested $100,000 (bought for $7.80 per share) in the stock of Apollo Group in 1999 and sold it in 2009, you would have had $1,153,846 (sold for $90.00 per share). Not bad for doing nothing. The kind of returns that some of these companies have generated are mind-boggling.

Returns on Equity
Apollo Group (APOL)
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
27.3% 22.4% 23.1% 24.1% 35.1% 62.9% 68.6% 64.5% 57.1% 58.0%
ITT Educational Services (ESI)
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
42.5% 43.1% 49.3% 40.3% 38.5% 35.8% 114.0% 214.8% 108.0% 191.8%
Click to enlarge

Source: ValueLine

Apollo Group went from generating a return on equity of 27.3 percent in 2000 to as much as 68.6 percent in 2006. Look at ITT Educational Services, Inc. – it generated as much as a 214.8 percent return on equity in 2007. This is absolutely incredible.

How are for-profit educational companies able to not only generate such high returns on equity but to increase these returns over time? They can do this because their businesses are very scalable. Once they get enough students to cover their fixed costs, each additional student generates a huge profit margin that flows straight to their bottom line. Also, they have much lower costs than traditional educational establishments because they do not need dorms, food services, and sports stadiums.

Are for-profit educational companies good investments today?

The stock prices of these companies depreciated significantly since their highs of 2009 and some might argue that this decline indicates a good entry point. However, the investment community seems to be divided on whether these companies represent good investments. The longs (investors who benefit from rising stock prices) say that for-profit colleges and universities face positive long-term economics because traditional colleges are overstrapped and are not able to serve the growing demand, the Obama administration wants more people to have access to college education, and current high unemployment encourages people to go back to school for more education to make themselves more appealing to employers.

Shorts (investors who benefit from falling stock prices), on the other hand, believe that the industry has reached an inflection point. Some even go as far as comparing the for-profit educational industry to another subprime mortgage crisis waiting to happen. Steven Eisman from FrontPoint Partners gave a presentation at the Ira Sohn Conference entitled Subprime goes to College. Eisman was featured in The Big Short by Michael Lewis because he correctly predicted and profited from the subprime mortgage meltdown. Eisman argues that the for-profit educational industry is as socially destructive and morally bankrupt as the subprime mortgage industry.

Over the last 10 years, the for-profit educational industry has grown five to ten times the historical rate of the traditional post-secondary educational system. In 1990, there were less than 1 percent of all college students attending for-profit educational institutions and by 2009, this number had grown to 10 percent. The industry’s phenomenal growth was made possible by easy access to government-sponsored debt via Title IV student loans because even though only 10 percent of all college students attended for-profit educational institutions in 2009, 25 percent of the $89 billion of Federal Title IV student loans and grant disbursements were claimed by the for-profit educational industry.

Running for-profit colleges in and of itself is not socially destructive. However, Eisman argues that for-profit educational companies are taking advantage of the student population with help from the government. These companies are presenting themselves as educators, but functioning mainly as marketing machines behind the scenes. When they first came into existence, it was easy to increase enrollments because there was this huge demand from working adults that was not being met by the traditional educational system. As competition increased, it became increasingly difficult to increase enrollment.

The for-profit educational industry had to spend more money than before on sales and marketing to satisfy Wall Street’s appetite for growth. After running out of good prospects, the next logical step was to go after less qualified candidates. This is similar to giving mortgages to people who should never be getting them – think “No Income, No Asset” loans. To achieve that, Eisman says that for-profit colleges advertise on billboards in the poorest neighborhoods in America and send recruiters to casinos and homeless shelters. They sell the needy the dream of a better life through higher earnings made possible with higher education. Eisman said, “But if the industry in fact educated its students and got them good jobs that enabled them to receive higher incomes and to pay off their student loans, everything I’ve just said would be irrelevant.”

However, in the end, many students find that not only are they unqualified for the careers they were pursuing, but that they are also stuck with unusually high student loans that they cannot repay. He believes that the government is going to do something because if nothing is done, we are going to experience another social disaster.

After learning about the points of view from both sides, do you go long or short? In the case of for-profit educational companies, I am not sold on either one.

Why don’t I want to go long? The success of the for-profit educational industry was mainly due to its easy access to government loans. Currently, the industry is under scrutiny from the federal government which could turn out to be disastrous for the entire industry.

Greg Perfetto, vice president for research and development at Admissions Lab, a higher-education consulting firm, authored the white paper titled The End of Higher Education Enrollment As We Know It. He said “Higher education is coming off the greatest ‘bull market’ that it has ever experienced.” According to the Western Interstate Commission for Higher Education (WICHE), the number of high school graduates increased from 2.4 million to 3.3 million from 1990 to 2009, which represents an increase of 37.5 percent.

This trend allowed colleges and universities increase enrollment. However, this trend is reversing, which will make it increasingly more difficult to increase enrollments. Perfetto said, “The 2009 peak of 3.3 million high school graduates is not likely to be seen again until 2020.” All existing educational facilities will be competing for a decreasing pool of students. This doesn’t sound like a good long-term trend in favor of the for-profit educational industry.

Why don’t I want to go short? In order for the short to work out, the government has to do something. Currently, the for-profit educational industry is being investigated by the government for its questionable conduct. I believe that the government is likely to establish rules that will make it more difficult for the for-profit educational companies to do what they did over the last 10 years, but I don’t think these new rules will be severe enough to make shorting worthwhile. Besides, the regulatory risk might already be priced in the stocks of for-profit educational companies.

For the reasons stated above, I will pass on going long or short. There are plenty of other opportunities in the stock market that offer much better risk and reward scenarios.