Two Attractive Prospects in the Education Sector

Includes: CPLA, STRA
by: Robert Blumenthal

In keeping with Peter Lynch’s maxim, “Buy what you know,” I am always on the lookout for promising companies among the group of for-profit universities. So far, there has only been one company which has impressed me to the point of making an investment. This company is Strayer (NASDAQ:STRA).

As I have written before, I am convinced that the future of degree programs for working adults lies in the for-profit sector and I continue to feel that Strayer is an extremely attractive player in that sector. Its attractiveness is due to the company’s stellar fundamentals, its nearly flawless execution, and the fact that it has never been implicated in any of the misdeeds which plague the education sector.

Perhaps even more important than these factors is the underlying growth story. Strayer is a classic example of a company moving from a regional presence to a national one. It is just beginning to break out of the Southeast and has massive growth potential which will play out over many years. The attractiveness of investing in Strayer is the prospect of a decent level of sustained growth over a long period of time.

Strayer’s bread and butter is its undergraduate program, but it also offers graduate programs in which approximately 27% of its students are enrolled. Moreover, Strayer offers courses in a traditional on-campus format as well as online. The flexibility this provides to adult students is a very important factor in recruiting such students. No program aimed at adult students, whether in the for-profit or not-for-profit arena, can succeed if it does not offer some substantial online options. Having watched Strayer’s growth over the past couple of years, one of the things which immediately stands out is the phenomenal growth it has seen in the number of its students taking one or more courses online.

In its most recent earnings release, Strayer reported total enrollment of 31,656 students. Of these, 18,452 or 58% are taking 100% of their courses online. The total number of students taking at least one course online is 22,392 or 71%. In the most recent quarter, total enrollment grew 16% while the number of students taking 100% of their courses online grew 19%, and the number of students taking at least one course online grew 20%.

This trend toward online delivery has led me to take a look at another player in the education sector, Capella Education (NASDAQ:CPLA). What first piqued my interest is its laser-like focus. With an exclusively online delivery system, it offers primarily graduate programs in targeted professions. In this way, Capella has successfully differentiated itself within the industry, and it believes that such differentiation will be the key to its growth. I must confess that I find the purity and simplicity of both its mission and its business model quite appealing.

In its most recent earnings release, Capella reported total enrollment of 19,151 students, of whom 16,121 or 84% are enrolled in graduate programs (43% Master’s, 41% Doctoral). Total enrollment increased 21%, enrollment in Master’s programs increased 31%, and enrollment in Doctoral programs increased 15%.

Capella is accredited by the North Central Association of Colleges and Schools. Such accreditation is required in order for students to be eligible for federal financial aid. Having witnessed the accreditation process first hand, both from the point of view of an institution being reviewed as well as from the point of view of an evaluator, I can attest that gaining and keeping accreditation is a long and arduous process. This gives Capella a significant moat against potential future competition.

Capella has a healthy balance sheet with 90.8M in cash, no long-term debt, and 98.7M in shareholder’s equity. Revenue, net income, and diluted EPS over the last 5 years have trended as follows:

Revenue Net Income Diluted EPS
2002 49.6M (5.7M) (0.58)
2003 81.8M 4.4M 0.39
2004 117.7M 18.8M* 1.62*
2005 149.2M 10.3M 0.86
2006 179.9M 13.4M 1.06

*includes an income tax benefit of 8.2M

The company has a market cap of 721.7M and an enterprise value of 630.9M. With TTM revenue of 190.8M, this gives an EV to revenue ratio of 3.3. With TTM diluted EPS sitting at 1.15, the company carries a PE of 38. Analysts are looking for growth of 26.5% per annum over the next 5 years. Clearly the current valuation is not a bargain, although I did open a small initial position. Looked at from the perspective of free cash flow, the valuation is even less attractive due to very high capital expenditures. The high valuation is something which Capella has in common with Strayer. Strayer consistently trades at a higher multiple than its peers due to its excellent fundamentals and its strong growth prospects. Capella appears to sport similarly strong fundamentals and, like Strayer, appears likely to experience sustained growth over a long period of time.

It has been suggested that Capella is a potential takeover candidate. I’m wondering if perhaps Strayer might be interested. Strayer has a market cap of 1.85B and 151M in cash on its balance sheet, and one of the elements of the strategic plan developed by Strayer in 2001 is the careful “screening of opportunities to reinvest capital back into the sector through acquisitions.”

In my view, Strayer is the strongest brick-and-mortar player in the sector, and the acquisition of Capella would create an academic powerhouse by combining Strayer’s undergraduate programs with Capella’s graduate programs and by enhancing Strayer’s already successful online program via the addition of Capella’s online operation. On the downside, the integration problems would take time to work through and they would certainly have a negative impact on earnings and the fundamentals. Also, the resulting loss of focus in terms of programs and delivery systems could cause problems down the line.

Finally, I want to make a few comments about competition from the not-for-profits. Ask just about any faculty member or administrator his or her view of the for-profit education sector and you will most likely receive a polite sneer. The fact that an organization is operating on a for-profit basis makes it incapable of providing a quality education. I have previously discussed this very prevalent attitude and the resulting fact that the not-for-profits do not see the for-profits as a threat. The not-for-profits simply cannot fathom that they face a threat from institutions which are so unlike themselves. Thus, an institution like Strayer is not seen as a threat because, as a for-profit entity, it is summarily dismissed as just another degree mill.

Despite the political and social activism, and in many cases radicalism, which pervades so many American colleges and universities, these institutions are incredibly conservative when it comes to certain aspects of their operation. This conservatism is evident in the open contempt for online courses expressed by many faculty and administrators. Unless courses are offered in the tried and true traditional class-room based format, the resulting educational experience must necessarily be substandard. Thus, an institution like Capella is not seen as a threat because, as an online provider, it is summarily dismissed as a substandard degree mill.

Are there online courses out there which are not worth a dime? Of course, there are. But there are also lots of courses being offered in traditional format which are equally lacking in quality. In my years in the profession, I have seen instances of classroom-based instruction which I would not wish on my worst enemy. The delivery system alone does not determine the quality of a course. What matters is how the effort is mounted. Capella states that it is committed to delivering a quality education to primarily graduate learners in targeted professions and to doing so in an exclusively online format. I have no way at present to judge the quality of Capella’s courses. However, I will say that if they pay as close attention to quality issues as does Strayer, they stand a good chance of offering to investors the same kind of steady long-term growth that we see in Strayer’s future.

Full disclosure: I hold positions in both Strayer and Capella.