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Many education stocks are trading near their 52-week lows. Though education is considered as a counter-cyclical industry, education stocks were hammered because of declining enrollments.

We recommend that investors stay away from Apollo Group (NASDAQ:APOL), DeVry Inc. (NYSE:DV) and ITT Educational Services Inc. (NYSE:ESI) because of an expected decline in enrollments and a potential violation of the "90/10 rule". However, we are recommending a long position in Capella Education Co. (NASDAQ:CPLA), as it is riding a secular boom of a shift towards online education. CPLA has out performed its peers and has a strong operating environment and the lowest default rates.

Industry Introduction

The Education Industry is composed of institutions that provide various educational programs and training courses on a wide range of subjects. These include 'for profit' and 'not for profit' institutions. Moreover, it is a countercyclical industry, benefiting in an economic downturn in terms of high enrollments.

Industry Drivers

  • Secular drivers: Enrollment growth, demand for education in developing countries, availability of online educational programs, regulations, and a transition from manufacturing to service-based economy.
  • Cyclical drivers: Level of interest rates on cohort loans.

Enrollment growth: There has been a declining trend in enrollments across the industry and the major factors contributing to this decline are continued economic turmoil and persistent unemployment.

Enrollment Declines in Major Educational Groups (click to enlarge)

High demand for education in developing countries: Demand for higher education in developing countries can become a source of competitive advantage for educators, with strong demand coming from Asia.

Online education programs: With the current economic slowdown and rising tuition fees, students are finding it more convenient and cost-effective to enroll in online programs as compared to the conventional brick-and-mortar educational system.

Regulatory challenges: The industry is subject to the Higher Education Act. It is critical for educators to follow the provisions laid out in the Act in order to maintain their accreditation. One such provision is the 90/10 rule, under which an educational institution can become ineligible to stay in the Title IV program if, for two consecutive years, it derives more than 90% of its revenues from Title IV programs. This percentage is close to the set threshold for many education institutions, and if revised downwards, it could result in major business changes for them.

Transition from Manufacturing to Services: Largely, the industry has benefited from the fact that the U.S. economy is transitioning from a manufacturing-based economy to an economy that is more concentrated on the services sector. This has improved the revenue streams for educational institutions that offer highly specialized and technical educational programs related to the services sector.

Level of Interest Rates on Student loans: Industry profitability is directly linked to the level of interest rates on student loans. Higher interest rates have an impact on student enrollments as it becomes more expensive for a vast majority of students requiring financial assistance to afford education, especially at the post-secondary education level. Relatively lower interest rates on student loans have helped the Education Industry in terms of high enrollments; however, their sustainability at these levels is doubtful because of upcoming legislation. As Congress addresses the increasing U.S. budget deficit, educators may see a cut in student aid programs. In February 2012, President Obama submitted his Fiscal Year 2013 Federal Budget request. If enacted, the President's budget request would maintain the 3.4% interest rate on undergrad loans for another year, which is expected to revert to 6.8% in July 2012.

APOLLO GROUP INC.

The company offers educational programs and services, both online and on-campus, at the undergraduate, masters and doctoral levels through its wholly-owned subsidiaries, University of Phoenix, Institute for Professional Development and College for Financial Planning Institutes Corporation. The company offers various degree programs in arts and sciences, business and management, criminal justice and security, education, healthcare, human services, nursing, psychology, and technology through its campus locations and learning centers. (click to enlarge)

Close to Violating the 90/10 Rule: The company is subject to the requirement of the Higher Education Act, which lays down provisions for educational institutions, commonly referred to as the "90/10 Rule". Under this rule, the educator will be ineligible to participate in Title IV programs if, for any two consecutive fiscal years, it derives more than 90% of its cash revenue from Title IV programs. An institution that derives more than 90% of its revenue from Title IV programs for any single fiscal year will be automatically placed on provisional certification for two fiscal years. A Title IV program covers the administration of various financial aid programs. The 90/10 rule for the company has increased significantly over the last years and is currently very close to violating the threshold.

Increasing Loan Default Rates: APOL'S loan default rates have consistently increased; in 2009 they were almost 19%, substantially higher than the year before. An increase in default rates by students can make the company ineligible for the Title IV program. It is already in violation of the Act, which provides that if an educational institution's two-year cohort default rate exceeds 10% for any one of the three preceding years, it must delay the release of the first disbursement of student loan for 30 days.

Two year Cohort default rates

2009

2008

2007

University of Phoenix

18.80%

12.90%

9.30%

Western International University

9.30%

10.70%

18.50%

All post secondary institutions

15.00%

11.60%

11.00%

Quarterly results: According to the latest results reported by APOL, revenues declined by 7.5% in the second quarter. The decline was primarily due to lower enrollment numbers in University of Phoenix, decreasing by almost 12%. The company reported EPS of $0.58, beating the consensus estimate.

Market Performance: The figure given below illustrates that APOL underperformed compared to the market benchmark as well as its peers over a six month period, losing 35% of its value.

Source: Google Finance

Valuation: Based on an EPS estimate of $3.40, we arrive at a target price of $35 by applying a P/E multiple of 10.5x.

Conclusion: Decline in enrollments is expected to continue in the current fiscal year, which will hurt the company's profitability. Moreover, anticipated changes to interest rates on various student loan programs will further bring about declines in APOL revenues. With no visible turnaround strategy in place, we are bearish on APOL.

DEVRY INC.

DeVry Inc. is a provider of educational services and the parent organization of Advanced Academics, Becker Professional Education, Carrington College and Carrington College California, Chamberlain College of Nursing, DeVryBrasil, DeVry University, and Ross University. These institutions offer a range of programs in business, healthcare and technology and serve students in middle school through postsecondary education, as well as accounting and finance professionals.

Declining enrollment and revenues: The company reported a third quarter decline in revenues this year of 4%. This was primarily due to weaker enrollments for the educator. Prolonged economic uncertainty and unemployment is pushing enrollments down. Medical and Healthcare segment revenues grew 13%, driven by a 20% growth in enrollments at Chamberlain's nursing programs, which were largely offset by a 28% decline in enrollments at Carrington College. The company's management has commented that FY2013 will be a transitional year with growth expected in FY2014.

Regulatory challenges: DV, along with its peers, is subject to extensive regulations set out by the Title IV program. The regulation requires the company to eliminate the use of incentive based compensation structures for its admission advisers and comply with the student debt levels as prescribed. The company has generally been in compliance with the provisions; however, some newly proposed standards have yet to take effect, and whether the company is in compliance with those metrics remains to be seen.

Better cohort default rates: As the national cohort default rates for major education institutions have continued to rise, DV has a relatively lower default rate. It has also shown an increase in its graduate persistence rate in four of the past seven semesters, as reflected in the table.

Market Performance: DV underperformed the market as well as its competitors, CPLA and ESI, losing almost 20% of its value over a six month period.

Valuation: Based on an EPS estimate of $3.00, we arrive at a target price of $35 by applying a P/E multiple of 9x.The company's focus on cost efficiency as well as a sooner than expected recovery in the economy may bring about improvement in its revenues, however we expect weak enrollments to continue into the next fiscal year.

CAPELLA EDUCATION CO.

Capella Education Company operates as an online post-secondary education services company in the United States and abroad. The company, through its Capella University, offers various doctoral, masters, and bachelors programs, primarily for working adults in public service leadership, behavioral health and human services, business management and technology. As of December 31, 2011, the company offered approximately 1,450 online courses and 43 academic programs with 140 specializations to approximately 37,000 learners.

Online Education - Fastest growing segment in education market

With an increasing number of students interested in online learning because of convenience and time saving, CPLA stands to benefit in terms of margins expansion.

Impressive revenue growth but declining margins: While the company's financial results for the most recent quarter were in line with expectations, CPLA has suffered much the same as its peers in terms of low enrollments and declining revenues. The company has shown an impressive growth in revenues over the years, but a declining trend in gross margins has been a negative for its bottom line (earnings taking a hit of almost 15% in FY11). Revenues, on a quarterly basis, also slumped 1.8% according to the first quarter results announced by the company.

Stabilizing Enrollments: Challenging market environment as well as increased competition has resulted in less than expected enrollment figures for CPLA. However, the decline moderated in 1Q2012 showing substantial improvement from 1Q2011 (1Q2012: -5% v 1Q2011: -36%).

Source: CPLA quarterly reports

The company continues to work on its brand marketing and product awareness, and is focused on managing costs through new and innovative learning technologies.

Strong Cohort default rates: Under the Title IV Program, an educator's cohort default rate can't exceed 25%. CPLA'S default rate is lower than most of its peers. (CPLA 6% vs. APOL 19%)

Strong Balance Sheet: CPLA has a strong balance sheet with no debt. The company generated $20 million in cash in 1Q2012 and used it to repurchase its shares for a total consideration of $13 million.

Market Performance: CPLA outperformed competitors like APOL and DV, losing only 6% over a period of six months.

Valuation: The stock is currently trading at a P/E of 10x, in line with the industry average. We think it deserves a premium valuation and can outperform as the multiple expansion happens.

ITT EDUCATIONAL SERVICES INC.

ITT Educational Service Inc. is a provider of post-secondary degree programs in the United States. It offers bachelors, masters and associate degree programs to approximately 73,000 students (Reuters). The company's revenues and margins have declined on a yearly basis due to weak economic environment. The company is in compliance with the 90/10 rule of the Education Industry, deriving almost 60% of its revenues from the Title IV program, beating most of its competitors. Changes to recruitment procedures of educational institutions have been made by the Department of Education. After the changes take effect in July, the company will likely see a decline in revenues.

Key Financials:

Gross Margin

Operating Margin

EPS

P/E

Qtr. Revenue growth

Op. cash flow

(TTM)

Y/Y

APOL

60.40%

22%

$4.60

7.47x

-7.50%

$1.15bn

$819mn

DV

55%

17.50%

$3.05

9.29x

-3.90%

$455.2mn

$278mn

CPLA

59%

18.20%

$3.32

9.57x

-1.80%

$89.4mn

$77mn

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: 3 Education Stocks To Avoid, 1 To Buy