By Todd Young
Over the summer, negative stories about the for-profit education industry were not hard to find. A government study showing misleading sales tactics, congressional hearings that painted a negative image of the industry, and stricter industry regulations proposed by the Department of Education all fed into the anti-for-profit education story being pushed by short sellers.
Throughout the summer, the industry was rather quiet--rarely defending itself. We believe most companies and various industry groups were in a holding pattern, waiting for the DoE's official proposal on gainful employment before firing back and defending themselves fully. As the public comment period came to an end in September, the industry finally started its counterattack. After taking their time to digest the gainful employment proposal, education companies, industry groups, and other interested parties sent a barrage of comments to the DoE, explaining their concerns with the proposal. Given the vast number of public comments--estimated to be over 100,000 in number--the DoE recently delayed the publishing of its final gainful employment regulation until early next year (Nov. 1 was the original deadline). It will also hold various meetings and public hearings in the near future to further discuss the issue.
While the delay could be construed as an increase in the likelihood that the DoE will once again soften the regulation, we caution investors that it could be nothing more than the DoE needing extra time to sift through the large number of public comments. We continue to believe this policy is not the best way to address the issues surrounding education. However, given the DoE's hard-line stance toward regulating for-profit schools, we question the DoE's willingness to make further concessions, even if they are in the best interest of the public. That said, a change to the proposal is not out of the question.
In our opinion, the current proposal fails to look at traditional, not-for-profit schools, which undermines the issue that student debt loads and a tough employment market are problems that affect all students and not just for-profit ones. Additionally, the rules create many unintended consequences, potentially harming quality schools as opposed to just impacting the bad actors, which is the intent of the regulation. Also, the regulation seems abruptly put together as it uses different data than what will actually be used when the regulation is implemented. This means that the DoE's current impact analysis could be significantly different than the actual results.
After reading through various comments from the companies as well as industry groups, we believe they have made a good case for why the regulation, as proposed, is bad policy. The Association of Private Sector Colleges and Universities, or APSCU (formerly the Career College Association), even argued that the DoE doesn't have the legal authority to institute the rules in the proposed regulation. The APSCU argues that Congress already addressed student debt levels and institutional default rates in the Higher Education Act and it has not given the DoE authority to override or augment the current requirements. The APSCU also points out that the regulation violates due process because it does not allow institutions access to the data used in its calculations. We have heard other industry insiders question the legality of the regulation. While it would be in everyone's interest to resolve this issue without a legal fight, if the regulation goes through as proposed, we would not be surprised to see legal challenges.
Congress could preempt any legal challenges by passing new laws. However, we don't think there is the political support to make that happen. The Republican Party is cautious of over-regulation, and they could potentially gain additional congressional seats in the upcoming elections. Additionally, many Democrats oppose the regulation as they fear it could limit educational access for minorities and lower-income students.
So what does all of this mean for investors? We believe the majority of any regulatory impact is already factored into most of the education companies' stock prices, creating investment opportunities within the space. In our opinion, many stock prices reflect an overestimation of the impact and also imply a near 100% probability that the regulation goes through as currently proposed. One prominent short seller openly admitted that he would not be short this industry without the regulation. Given the political and legal headwinds facing the regulation as well as pricing that already reflects a dire scenario, we question why anyone would still be short many of these stocks.
One example of where the market appears to be overestimating regulatory impact is Apollo's (APOL) stock price. The company's $50 stock price implies an almost 50% hit to its earnings. The company even recently traded as low as $39 before the industry started to fully defend itself. This approximate 50% earnings drop was first promulgated by a short seller before the most recent gainful employment proposal was issued. However, when an updated proposal was issued, it created two additional ways to remain eligible for financial aid access. Additionally, Apollo scored relatively well (a 44% repayment rate versus a 45% threshold for full eligibility) on one of the DoE's preliminary tests. Despite the fact that the likelihood of a sever earnings impact has decreased significantly, it appears the market is still factoring in a 100% probability of a massive hit to earnings. Also keep in mind that the 50% hit to earnings was an estimate that we believed was overly bearish even under the initial, more stringent regulatory proposal.
Instead of a 50% hit to earnings, we believe a more likely scenario for the higher-quality education names is a slight dip in their enrollment followed by decreased growth opportunities. A recent study from an independent, nonpartisan think tank that favors the regulation, Education Sector, supports our opinion. Education Sector concluded that only 6% of programs at the 14 publicly traded education companies would be ineligible and 21% would fall into the restricted category. Restricted programs would face enrollment caps, limiting growth but not necessarily causing an enrollment decline. The remaining programs would fall in one of two categories: fully eligible, or requiring a debt warning. Programs in either of these categories should see no material impact on their growth prospects. We even believe that providing incoming students with aggregate debt levels is a good thing for all programs, not-for-profit and for-profit alike.
To put this impact into perspective, let us compare the potential impact from this analysis to our original growth estimates before any regulation. Our original growth estimate for the industry was 10% compounded annually over the next few years. Assuming Education Sector's estimates hold, our new growth estimate drops to 1.3%. This scenario of limited to almost no growth is a far cry from the massive earnings losses that are baked into many education companies' stock prices.
Here is how the math works. If we assumed a 100 student population index, our estimate for the following year with 10% growth would be 110 students. However, given 6% of programs would be ineligible, that index would decrease to 94 students. An additional 21 students would be in programs that could not grow. But the remaining 73 students would be in programs that can continue to grow at our original 10% estimate. Growing these 73 students by 10%, and adding back the 21 students that are still in restricted programs, results in 101.3 student index.
We are cautious to give too much weight to the exactness of the impact analysis that studies like Education Sector's provide. As is the case with the DoE's impact analysis, the use of estimations and substitute data sources (like using the Bureau of Labor and Statistics versus the Social Security Administration to estimate student earnings) make any calculation just an approximation. However, we believe it gives a good ballpark figure as it relates to the potential impact.
A common theme in Education Sector's study echoes what we have been saying. Higher-quality education companies will likely see a more limited impact than others in the industry. In fact, this study suggests that Apollo, Strayer (STRA), Grand Canyon (LOPE), DeVry (DV), Capella (CPLA), and Bridgepoint (BPI) will have no programs that fall into the ineligible category. So while the exercise above gives an indication of the industry impact, these schools should experience a milder decline in growth. This study even indicates that Apollo will only see 10% of its programs in the restricted category. Therefore, a 50% decrease in earnings potential is a vast overestimation, in our opinion.
Finally, it is important to remember that this impact analysis is by no means 100% accurate. One of the key flaws in this proposal is that it lacks the detail and data needed to fully analyze the impact. Additionally, the downside industry scenario described above is only likely if the regulation goes through as proposed, which is still a big if. Given the market's overreaction and the excessive fear surrounding increased regulation, not to mention the potential for a favorable change in the proposal, we believe there are numerous investment opportunities in the industry. However, we would advise investors to stick with the higher-quality names as the eventual impact should be less detrimental to their operations compared with the rest of the industry.
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