There are few more challenged industries than the for-profit education space at the moment. Industry participants are exposed to significant regulation on both the federal and state level and must maintain institutional accreditation to participate in Title IV programs. Risks to federal student funding aid programs and "gainful employment" challenges pose additional threats to the business. In this light, let's take a look at Strayer Education (NASDAQ:STRA) and evaluate the firm via the Valuentum style.
For those that may not be familiar with our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Strayer Education posts a Valuentum Buying Index score of 6, reflecting our "fairly valued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technical. A score of a 6 is not poor, but it is not fantastic either. We typically prefer higher-rated firms in the Best Ideas portfolio and Dividend Growth portfolio. Once we add a highly-rated firm, we tend to hold it in the portfolio until it registers a poor rating, a 1 or a 2, which is equivalent to a "we'd consider selling" rating.
Strayer Education's Investment Considerations
• Strayer Education earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 65.2% during the past three years. Still, this performance has not come without a significantly challenging industry backdrop.
• Strayer is an education services holding company that owns Strayer University. The mission of Strayer University is to make higher education achievable for working adults. Though it has done so, significant risks to its business remain (not the least of which is affordability).
• Strayer Education has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 11% in coming years. Total debt-to-EBITDA was 1.8 last year, while debt-to-book capitalization stood at 75.8%.
• Strayer offers high-quality academic programs, with more than 60% of students declaring business/economics as their academic major. Roughly 50% of Strayer's students are enrolled in a bachelor's program. The firm has 2,600 full-time and adjunct faculty across ~100 campuses, mostly in the eastern U.S.
• Strayer recently suspended its $1 per share dividend, as fundamentals continue to move in the wrong direction. Investors should expect prolonged enrollment declines, continued regulatory uncertainty and ongoing affordability issues.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Strayer Education's 3-year historical return on invested capital (without goodwill) is 65.2%, which is above the estimate of its cost of capital of 9.5%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Strayer Education's free cash flow margin has averaged about 15% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow [FCFF], which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Strayer Education, cash flow from operations decreased about 46% from levels registered two years ago, while capital expenditures fell about 71% over the same time period.
Our discounted cash flow model indicates that Strayer Education's shares are worth between $35-$73 each. Shares are trading at $53 per share at the time of this writing. The margin of safety around our fair value estimate is driven by the firm's HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. We think this wide fair value range is informative for two reasons: 1) we think it highlights the significant fundamental risks related to Strayer's operations, and 2) we think, in light of these risks, it helps quantify the range of probable fair value outcomes of the firm's intrinsic value.
The estimated fair value of $54 per share represents a price-to-earnings (P/E) ratio of about 34.9 times last year's earnings and an implied EV/EBITDA multiple of about 8.8 times last year's EBITDA. These are fairly generous multiples. Our valuation model reflects a compound annual revenue decline of 4.2% during the next five years, a pace that is better than the firm's 3-year historical compound annual growth decline of 7.5%. Our valuation model reflects a 5-year projected average operating margin of 15.8%, which is below Strayer Education's trailing 3-year average. As enrollments decline, we would expect continued deleveraging in the mode.
Beyond year 5, we assume free cash flow will grow at an annual rate of 1% for the next 15 years and 3% in perpetuity. For Strayer Education, we use a 9.5% weighted average cost of capital to discount future free cash flows. We think both the long-term growth rate and discount rate are reasonable, though we note that a higher discount rate could be considered more appropriate given the significant risks to its business model. However, we capture these exogenous risks in the firm's rather wide fair value range.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Strayer Education to peers Apollo Group (NASDAQ:APOL) and DeVry (NYSE:DV).
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $54 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Strayer Education. We think the firm is attractive below $35 per share (the green line), but quite expensive above $73 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Strayer Education's fair value at this point in time to be about $54 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Strayer Education's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $73 per share in Year 3 represents our existing fair value per share of $54 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.