Apollo: Good Opportunity With a Margin of Safety, Part 2

Oct.15.10 | About: Apollo Education (APOL)

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This section covers financial health, past uses of cash, valuation and intrinsic returns.

2.3 Financial Health

Liquidity

Apollo's (NASDAQ:APOL) working capital management is acceptable, with a current ratio of 1.3x as of last reporting quarter. This ratio is in line with the company’s past practices and does not worry me as most of APOL’s current assets are very liquid vs. educational obligations and student deposits in current liabilities. APOL carried ~$50M in short term debt as of 05/2010.

Apollo has a very short cash conversion cycle as it – by definition – does not carry inventory. The company usually gets paid within 25 days (days sales outstanding) and itself pays its obligation within 15 days (days payable).

Debt

$ millions, except per share data

2005

2006

2007

2008

2009

TTM

Total Debt / Equity

0.1

0.0

-

-

0.5

0.1

ST % of Total Debt

20%

100%

-

-

78%

31%

Total Debt / FCF

0.2

0.1

-

-

0.7

0.2

Op. Income / Interest

-

-

-

-

259.8

132.4

Click to enlarge

APOL only carries $166M in debt which is very low, representing less than a couple of month’s worth of free cash flow. In addition, APOL does not appear to have any pension liability.

APOL’s strong credit position is also reflected in its Altman z-score of 6.8. APOL’s Piotroski score is 7, missing a ‘perfect score’ of 9 due to an increase (to 0.04x!) in Long term debt / Assets as well as a decrease from 1.55x to 1.50x in asset turnover.

In conclusion, APOL is in a strong liquidity and cash position (un-restricted cash was almost $900M as of May 2010 vs. debt of $166M). Given this strong situation, I will not increase my margin of safety requirement of 40%. As the company is still a “growth” company carrying some amount of risk and volatility due to its legal environment and global expansion through acquisition I will use a cost of capital of 12%.

2.4 Historic Use of Cash

Dividends

APOL does not pay a dividend, unfortunately. However its use of retained earnings has been satisfactory as APOL has been able to gain strong returns on its retained earnings. On a 5-year basis, APOL retained $13.8 per share and increased its EPS by $3.0, a 21.5% return. On a 10-year basis the return has been equally strong, at 19.3%.

$ millions, except per share data

Click to enlarge

Growth Rates

2005

2006

2007

2008

2009

TTM

3-yr

5-yr

10-yr

Payout Ratio

2.39

2.35

2.35

2.87

3.75

3.98

26.3%

11.6%

26.9%

Retained earnings per Share

2.39

2.35

2.35

2.87

3.75

3.98

Diluted Shares (M)

186

176

174

166

160

152

-4.1%

-3.5%

-1.4%

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

Click to enlarge

Buybacks

APOL has regularly purchased its stock back, retiring 3.5% on average over the last 5 years.

As of May 2010, APOL still had $660M available under its current repurchase plan, enough to buy back almost 10% of its outstanding stock.

3. Valuation

3.1 DCF

To evaluate the value of the company I am relying on a discounting cash flow calculation with the following assumptions:

  • 2010 Free Cash Flow of $833M (cf. Profitability and Growth section above)
  • Growth for next 5 years: 8% (cf. above), declining to 5.5% years 6-10 and then 3.0% years 11-20
  • Cost of capital: 12%
  • Terminal value in year 20 with no growth

This leads to a DCF value of $11.2 billion for the company, before accounting for net debt. Using a 40% margin of safety on this valuation leads to a per share entry price of $44, to which I am subtracting APOL’s net debt position of ($300M net cash position) leading to a price threshold for investment of slightly over $46.

I believe this evaluation of APOL’s value to be conservative, using last year’s FCF as a starting position, a forecast growth rate of less than half of historical FCF growth rate and below analyst growth consensus by less than 2/3rds.

APOL has recently traded in the $46 to $49 range and could provide for an adequate investment opportunity. However, in addition to knowing that I can invest with a good margin of safety – providing protection and potential upside – I also like to know that the company’s “intrinsic returns” will be satisfactory.

3.2 Expected returns

In addition to a potential re-valuation of the company’s multiple, its returns for an investor will be driven by: growth and share buybacks / improvement in cash position (given that there is no dividend)

APOL will use 20% of its earnings at 40% ROE to fund its estimated growth rate of 8%, leaving $3.18 for share buybacks/increase cash. At the current price of $46, APOL could buy back almost 7% of its shares back.

Adding these returns together leads us to a total intrinsic return of 15.0%. While this is high, I don’t believe that APOL would be buying such a high level of stocks back, but on the upside could be growing faster.

4. Conclusion

Despite the current noise around the company/industry, I believe that APOL is an attractive investment with a potential for reasonable/high growth and a high level of cash generation which the company will use to buy back its stocks. Based on my evaluation of an entry price with an important margin of safety I am planning on investing into APOL’s stock

Disclosure: Author long APOL