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In this analysis, I am looking at Apollo Group (NASDAQ:APOL) as a long investment opportunity. A quick review of APOL’s financials attracted me to the company:

  • High cash flow generation

  • High returns on equity and assets

  • Strong Balance Sheet

  • Relatively low valuation (on a cash return and P/E basis)

  • Strong level of share buybacks

The analysis will first evaluate the company’s performance which in turn informs a discounted Free Cash Flow model, coupled with the determination of a reasonable margin of safety and likely intrinsic returns of the company.

Company overview

Apollo group is the largest for profit education company, with more than 450,000 students in its core school (representing >95% of revenues) the University of Phoenix. Programs (on line and off line) range from associate to doctorate degrees in areas such as business, education, healthcare, technology and social sciences. The company was founded in 1973 on the realization that education would become “lifelong” and that 50% of students in the future would be (working) adults. APOL has experienced strong growth recently, partially because of the weak economy over the last couple of years but also as a result of a long term trend in lifelong education.

Apollo and the for profit education at large have been in the news quite often following the U.S. Department of Education (“DOE”) release of a notice or proposed rulemaking on gainful employment. The initial proposal could have limited for-profit school student access to financial aid. However, through the summer the proposal was revised and it is now estimated that only 5% of the programs in the U.S. would lose access to aid if the rule was currently in place (per DoE). The criteria for eligibility are based on students’ ability to pay down their loans as well as tests on debt/income.

Even before the multiple discussions and revisions to the DoE’s proposal, APOL proactively put in place a 3-week orientation program required for students with fewer than 24 credit hours. The program, which is free, lets student “try out” classes for 3 weeks before taking on any debt. As most “drop outs” usually leave school early in their curriculum, this program should reduce the long term drop-out rate. It may also, in the short term, slow down growth in enrollment. (~80% of students complete the orientation program).

While there has been significant noise around the industry, it seems that APOL has taken good steps to improve its student’s understanding of their financial options and APOL should comfortably meet the loan requirements from the DoE going forward. The “noise” could lead us to increase our requirements for margin of safety, but could also have created a good opportunity for a patient investor.

Profitability and Growth

While APOL’s growth has been high (15% over the last 5 years), APOL has also experienced a decrease in its margins. This has led to operating and net income growing at a lesser rate of 8% – 9% on average over the last 5 years. Margins remain healthy at 22% operating and 13% net.

Over the last 5 years, free cash flow (“FCF”) has improved 17% on average and FCF/Sales remained in a 17% to 20% band. On a 10-year basis, FCF growth has been even more impressive, with a 26% average! In addition, FCF’s have been rather stable with a standard deviation vs. regression trend-line of 23% and only one down year over the last 10 years. Earnings have also been stable, with a similar standard deviation vs. trend line and EPS have increased consistently in all but one year (decreasing by 1cts/share!) in 2006.

$ millions, except per share data

Growth Rates

2005

2006

2007

2008

2009

TTM

3-yr

5-yr

10-yr

Revenue

2,251

2,478

2,724

3,141

3,974

4,753

20.8%

14.7%

22.7%

Op. Income

713

650

626

749

1,039

1,059

28.8%

9.4%

25.3%

Net Income

445

415

409

477

598

605

20.9%

7.6%

24.6%

OCF

566

551

589

726

960

955

27.7%

14.3%

23.5%

FCF

462

440

484

621

833

814

31.2%

16.5%

25.5%

EPS

2.39

2.36

2.35

2.87

3.74

3.98


,

26.1%

11.5%

26.3%

Note: Growth rates calculated using log-normal regression and exclude LTM

Looking forward, I will be using a growth rate of “only” 8% over the next 5 years, which is below historical revenue performance, but in line with Net Income growth over the last 5 years. This rate of growth is also quite a bit less than analysts’ consensus of 13.8%. As a starting point for 2010, I will be using 2009’s FCF of 833 (i.e. using a flat year) which is conservatively below the regressed trend line due to the current TTM performance, slightly below 2009’s FCF.

Turning to returns, APOL’s performance has been strong with ROE’s and ROA’s of 60% and 28% over the last 5 years, respectively. These are extremely high levels and I will be using a “more conservative” 40% ROE (in line with APOL’s 10-year average) going forward as an input to the sustainable growth rate calculations.

Based on APOL’s strong returns and cash generation over the long term, I believe APOL has a business moat. However recent “news” and a – somewhat moderate – recent slowdown in FCF generation couple with ~20% volatility vs. trend line suggest that I should be using a higher margin of safety than the 25-30% I would use for a strong stable business. I will use 40% as a margin of safety in order to evaluate the attractiveness of the stock.

I will post the rest of this analysis tomorrow, covering financial health, uses of cash and intrinsic returns/valuation. If you are curious you can also check the rest of the stock analysis on my blog, Margin Of Safety Investing.

Disclosure: Long APOL

>> Continue to Part 2

Source: About Apollo Group's Strong Balance Sheet and Wide Moat, Part 1