Strayer Education: A Good Company for a Fair Price

Feb.24.11 | About: Strayer Education, (STRA)

Strayer (NASDAQ:STRA) is a for-profit education provider, which serves 60,000 students across 87 campuses in 19 states and online. Strayer is arguably the highest quality enterprise in the for-profit education sector, although it is not the biggest, nor the most profitable.

The for-profit education sector is going through a potentially disruptive change. President Obama's administration initiated reforms against questionable practices in recruiting new students and against offering a low value education with high costs. These practices have resulted in many students never graduating or not finding a good enough job after graduating, which has caused high default rates on the student loans.

Strayer's management has consistently demonstrated a commitment to maintaining high recruitment standards and to delivering a high quality education with a reasonable cost. Strayer has not engaged in the questionable practices and it did not have to change anything in response to the reforms. In fact, if the rest of the industry would have been like Strayer, there wouldn't have been any need for the reform.

Strayer suffered a 20% reduction in the Q4 2010 new enrollments because of the bad press and the uncertainty over the reform. Strayer's share price has taken a bigger hit than its competition because Strayer announced that the company will prioritize the quality of the education over the short-term profitability. This decision demonstrates Strayer's management's focus on the long-term success and will be highly beneficial once the dust settles.

Strayer's management believes that the reforms cause turbulence in the short-term, but will not have a substantial impact on their business in the long run. They have been buying the company shares during the last two months.

Strayer's shares have been trading in the range of 35x P/E until about a year ago. STRA still remains depressed, although it is arguably the highest quality company in the sector. The company may still lose value in the short-term, but has a high probability of being a good investment within the next 2-3 years.

Strayer can be bought at 18 x the worst case P/E 2011 or at a 22% discount to the fair value.

MANAGEMENT

Strayer has an excellent management team. Roughly 50% of the board members' compensation is made up of restricted stock. Management focuses on the return of the invested capital as a primary metric in the investment decisions. Management has continuously demonstrated discipline in returning the excess cash to the shareholders.

The company has increased its revenue 13-fold and its earnings per share 11-fold, since it was listed in 1996. The total free cash flow generated since 1996 is 600 million dollars. Strayer has invested 150 million back to the business and returned the rest to the shareholders through share buybacks and dividends.

CEO Robert Silberman, who joined the company in 2001, was selected as Morningstar's CEO of the year in 2007. Silberman is an independent strategist, who has repeatedly communicated that although the company has to produce profit to its shareholders, the company has to serve its customers to make it successful. A high quality education at a reasonable price is a key competitive advantage in this sector and I couldn't agree more.

The management could easily add more students by lowering its recruitment standards. However, the management realizes that by allowing students who are incapable of completing their studies would only hurt the reputation and the quality of firm’s programs over the long-term. As a result, over 90% of Strayer's 2009 graduates were employed, at an average annual salary of over $60,000.

SUSTAINABLE COMPETITIVE ADVANTAGE

Strayer focuses on the non-traditional working adults, which gives a structural cost advantage over the not-for-profit rivals. This business model can eliminate infrastructure generally associated with traditional campuses, such as dormitories and food and health-care services and facilities. The not-for-profits tend to offer programs to non-traditional students as add-ons, which are not in their core offerings and do not see similar investment levels as the core.

Stayer's advantage against its for-profit rivals is the quality of the education and a disciplined admission criteria. The graduates from Strayer's programs find a profitable employment much more frequently than from the competing schools and hence Strayer delivers a higher value to its customers. Strayer's management has shown a consistent focus on maintaining a high education standard. Strayer's decisions of how to handle the current crisis further widen the quality gap.

Strayer has delivered average returns on the invested capital of 40% over the past decade, which supports the existence of a substantial moat.

IMPACT OF OBAMA'S REFORMS

President Obama's administration initiated reforms against questionable practices in recruiting new students, which have resulted in many students never graduating and causing losses to the state, because the students are not able to pay their loans back. Government Accountability Office published on 15th August a report of Fraudulent, Deceptive, and Otherwise Questionable Marketing Practices of the for-profit colleges.

Apollo (NASDAQ:APOL), Education Management (NASDAQ:EDMC), Corinthian Colleges (NASDAQ:COCO) and Kaplan were on the list of the accused from the top 10 for-profit education companies. Strayer was not investigated and has not used any of the questionable practices, but nevertheless, it has suffered from the bad publicity.

The number of new enrollments has dropped when the companies have had to change their recruitment practices. For example, the number of Apollo's new recruits dropped 42% in the Q4. The number of Strayer's new enrollments also dropped 20% in Q4, although the company didn't have to change their recruitment practices. The students are nervous because of the bad press and the uncertainties in the reform.

The Department of Education released calculations of the student loan repayment rates, which put Strayer in an unfavorable light. According to DoE figures, only 25% of the Strayer students repay their student loans, while Strayer claims over 50%. The difference is in the consolidated loans that DoE counts as not paid.

DoE plans to introduce legislation in June 2011 that would make programs with a loan repayment rate under 35% ineligible for the student loans and programs with a rate between 25%-45% would face restrictions. These limits would only apply to the for-profit colleges and the non-degree vocational programs in the nonprofit colleges.

The average rate for the loan repayment is 54% in the public institutions. The fact that the for-profit colleges focus on the working adults, minorities and women may have a higher influence on the repayment rate than the actual programs. For the 89 historically black colleges in the DoE calculations, the mean loan repayment rate was 20%, and a full 93% fell below the 35% threshold. Many top schools would also face problems. DoE's figures show a 24% repayment rate for Harvard Medical School.

According to Strayer, the DoE has admitted that its repayment rate calculations are indicative only and it is likely that the cohort default rates (CDR) will be used instead as they are a better measure of the student loan repayment. Strayer University has consistently experienced student loan default rates that are well below the rates for all the universities and are in line with the public four-year universities.

Strayer's two year cohort default rate for the fiscal year 2008 as reported by the DoE (the most recent annual period for which the data is available) was 6.7%, as compared to 6.0% for the fiscal year 2007. Nationally, the average two year cohort default rates for the proprietary institutions were 11.6% and 11.0% for the fiscal years 2008 and 2007, respectively.

The DoE proposed regulation is unlikely to become a law in its current form, not least because of the industry's intense lobbying effort. Ten education companies and their trade association spent $3.8 million on lobbying in the first nine months of 2010, up from the $1.5 million in the comparable period last year.

John Kline (R-MN), chief of the House Education and Labor Committee, received $56,500 from the educators and their families during his re-election campaign. He said on December 16th that he would try to block the Education Department’s gainful-employment proposal, saying he preferred a greater disclosure of costs, debt and quality by the colleges. Also, the Association of Private Sector Colleges and Universities (APSCU) already filed a Suit against the DoE.

VALUATION

Strayer announced a 20% enrollment drop in Q4 on January 7th and replaced its earlier 13% growth forecast for 2011 with four possible scenarios:

Enrollment
Growth %
Revenue
Growth%
Op Margin
Change%
EPS
-5 %
-1 %
-7.75 %
7.5
0 %
4 %
-4.75 %
8.8
5 %
9 %
-1.75 %
10.1
13 %
17 %
0 %
11.3
Click to enlarge

And those scenarios value Strayer in the following way in 2011:

P/E
EV/EBIT
FCF
Yield%
18
9.4
7.6 %
16
8.1
8.6 %
14
7.0
9.7 %
12
6.2
10.7 %
Click to enlarge

A DCF analysis gives a fair value of 175 USD, which offers a 22% margin of safety. The DCF analysis is based on the following forecast:

  • Enrollments decrease 5% in 2011
  • Revenue growth 2012 - 2021 is in the high single-digit range
  • Operating margins settle around 32%

RISKS

There is a risk that Strayer does not qualify for the Title IV student loans in the second half of 2011. Strayer generates 72 - 77% of its revenues from the Title IV programs. A lack of financial aid access would severely hamper the company's ability to provide educational services. The DoE proposed regulation is unlikely to become a law in its current form, and it is unlikely that Strayer wouldn't quality for the Title IV student loans.

The new student enrollment rate may become permanently lower because of Obama administration's reforms. It is very likely that the enrollment rates will be lower in 2011. After 2011, it is likely that Strayer's enrollment rate suffers less than the competitor's.

CONCLUSIONS

Strayer is a good company that can be currently purchased with a fair price. The DoE reforms, which were initiated against the questionable practices of Strayer's competitors, will not hurt Strayer in the long-term. Once the reforms have been completed, Strayer's position will be stronger than ever and its shares should trade nearer to the long-term valuation averages.

Disclosure: I am long STRA.