Apollo Group, Inc. (NASDAQ:APOL) provides online and on premise educational programs and related services to undergraduate, masters, and doctoral students. The company offers various degree programs in arts and sciences, business and management, criminal justice and security, education, health care, human services, nursing, psychology, and technology through its campus locations and learning centers in 40 states and the District of Columbia, and Puerto Rico, as well as through its online education delivery system. (Source: Yahoo! Finance).
The company is best known for the University of Phoenix, which in 2011 constituted 91% of revenues. (Note: All Financial details referenced in this article can be found in the company's latest 10-K filing with the SEC.)
The remaining 9% of revenue comes from Apollo Global, which consists of 2 universities in Latin and South America and 1 in the UK. Since the majority of revenue and profits are driven from the University of Phoenix, I will focus on this for the remainder of the article.
The University of Phoenix was founded by now Exec. Chairman Dr. John G. Sperling (Ph.D), in 1973.
An interesting note is that Dr. Sperling is still at it - at the young age of 91! A former professor at San Jose State, he founded The University of Phoenix with a goal in mind to better reach out to students who had a desire to work and study part time, a trend that was growing significantly at the time. The traditional private and public non-profit universities in the US always had focused primarily on the full-time students continuing their college education directly after high school.
Below I've outlined my thesis and thoughts on Apollo as an investment at the current time, as well as some analysis of whether the recent negative press and downward pressure on for-profit education sector stocks in general is warranted. In short I believe that although there will be short term headwinds, the current price of Apollo is too cheap to ignore, and long term investors could be handsomely rewarded.
Note: For more information on my investing philosophy please check out my profile or website. I use a 10 point evaluation system to analyze companies. The two most important criteria in my 10 point system is the magic formula and my circle of competence for the business/industry. Each of these criteria has a maximum score of 2 points, where as the other criteria I evaluate are a maximum of 1 point each. A perfect score is 10 points, and I advocate to buy any company scoring 8 or higher.
The first criteria I typically check is whether the company is a magic formula screen stock or not.
For those who are not aware of what the "magic formula" is, this is a stock ranking system created by value investor Joel Greenblatt, and was first described in his The Little Book that Beats the Market. Details about his methodology including the screens can be found at his website. I won't go into detail here on the methods described in his book, but the basic premise is to find companies with a high earnings yield (measured by EBIT/EV) relative to the Return on Invested Capital (ROIC) that they produce. So you are screening for "good" companies at "bargain" prices. If you check out the website above you can sign up (for free) and view the current top 50 stocks over $50 million in market cap using this methodology, and you can also change the market cap to whatever number >50 million you want. Following my philosophy I check the 50 over 50 million and the 50 over 1 billion screens as a starting point for stocks to analyze.
The Apollo Group is on the 50 over 50 million screen currently, so using my methodology I give this criteria a full score of 2 points.
Note that as is sometimes the case with the magic formula screens, the "for profit" education sector is currently showing up with multiple companies in the top 50. Besides Apollo, there is Capella Education (NASDAQ:CPLA), ITT Education (NYSE:ESI), and Strayer Education (NASDAQ:STRA). Clearly there is a reason that this industry is depressed in the market. Apollo has a very low EV/EBITDA (2.71), and the other companies mentioned all are under 5.0. So why such low prices in this industry? More on this in my "business prospects" section below.
Circle of Competence
First a note on how I derive a circle of competence score for companies I evaluate (score value between 0 and 2):
- When looking at a company to determine whether it's within my circle of competence, I first do a very simple practical check - I go to one of the popular finance websites (e.g. Yahoo) and I read the Profile description of the company. It's almost always the first step I take. If I give it one or two reads and still have no clue what the company does or industry is, then I would score this a 0 and in 99% of cases move on.
- If however the description is simple and easy to understand from my perspective, I will score this criteria already at a 1 out of 2.
- I'll give a 1.5 if I feel I have some relevant practical experience in the industry to have sufficiently developed my own detailed perspective on it.
- A coveted 2 score I'll only give if I really have a deep understanding of the company through personal experience with it directly.
In the case of Apollo, I've scored this a 1.5. I have 6 years of practical experience in higher education (BS & MS), and several years of corporate job experience to understand the value and gaps often present in finding skilled workers.
One important aspect to understand about the University of Phoenix as well as other for-profit universities is that they receive most of their revenue from student financial aid, much of which comes from the US government.
Under the 90/10 Rule as part of the Higher Education Act, for-profit educational institutions must receive at least 10% of their funding from non-governmental sources, and can receive a maximum of 90% from Pell Grants and federal student loans. If an institution breaches this rule 1 year, it must comply the following year or it will lose access to all financial aid. Many of these institutions are very close to the 90% threshold currently.
According to the recent 10-K, in 2011 the University of Phoenix generated 86% of revenue from Title IV financial aid program funds, coming very close to the limit.
Recently 3 smaller for-profits have lost federal funding due to breaching this rule for the 2nd year in a row.
The federal government has taken a hard line against for-profits, claiming deceptive marketing practices and other aggressive tactics to attract students. Increasing enrollments was a number one priority at many of these institutions, as this increased revenues (via federal loans) and thereby improving profits. The industry has responded by greatly increasing lobbying costs to make their case in Washington. The University of Phoenix spent just over $1 million in 2011 on lobbying.
Looking at the broader picture however and at the continuing challenges in America for higher education, recently the University of Phoenix released a very detailed report. In this report I believe the University has made a very good case that in order to continue to compete successfully in an ever increasing global environment, the US really needs to get serious about more focused education and to provide specific training to ensure students have the right skills. The University's strategy which focuses more on part-time adult students to help re-train and improve their skills to be more relevant in the marketplace is a logical method to help close the current gap. The report goes in depth to explain how America is behind other major developed nations by more than 100 million years of education, which is leading to a loss of economic productivity. This gap sounds huge in real terms, but put in perspective it can virtually be made up entirely if all Americans were to simply spend 1 extra year on higher education than they currently do.
Interestingly, if you read the Obama Administration's vision on higher education you will find striking similarities to the report referenced above from Apollo. The federal government also recognizes the skill gap, and President Obama has also set a goal that by 2020 every American should commit to at least 1 year of post secondary training or higher education.
Although there is a lot of criticism on for-profit universities including the University of Phoenix, the bottom line is that everyone seems to recognize there is a growing problem in America and a gap between the skills that workers have and what the increasingly demanding global economy needs.
If you ignore for a moment all the noise coming out of Washington politicians on this industry, I think it becomes clear that in order to reach these goals to improve education overall, the for-profit section including University of Phoenix will be part of the picture. This is especially true because the government is advocating every American to commit to "at least 1 year" of post secondary training. For many people this could be vocational type training or associates degrees which they might look to do online or in non-traditional manners. The University of Phoenix has one of the most extensive online education systems available, and is in the "sweet spot" so to speak in order to target and take on these types of students.
In my opinion, the company management is also listening to and learning lessons from the intense criticism the industry has received in the past few years. In their most recent conference call, they discussed in detail the strategic initiatives which the university is focused on to improve the student experience and help students find jobs. This includes initiatives like their interactive career portal, which 25% students are already using and they are adding employers to this portal aggressively in order to better connect students with prospective jobs after graduation. They also have a very unique learning management system, which is a platform that adjusts automatically to how each student learns. The emphasis seems to be clearly shifting away from just spending resources on marketing to lure in students (and their financial aid money), and really focusing strongly on improving graduation and drop out rates.
In 2012 the University has seen declining enrollment numbers and subsequent drops in revenue, which is due both to the negative publicity the industry is receiving but also because the University of Phoenix is becoming more selective.
In summary I see that the long term prospects of the higher education industry will remain positive, and the University of Phoenix is poised to be part of this. With more than 300,000 enrolled students, the University is a major force in education. The for profit industry as of 2010 had 2.4 million enrollments, which out of approximately 20 million higher education students in total in the US, this is greater than 10%. So this industry is not just going to disappear. However due to potential regulatory changes on their funding and continued negative perceptions, I do expect that some of the smaller weaker for profit institutions will continue to struggle and some will probably not survive.
Overall I've scored this criteria with 0.5 points out of 1, as the near term pressures in the sector are hard to ignore and it's difficult to predict when and if that perception will improve.
The company does not pay a dividend, and has shown no signs of planning to in the future. The 10-K clearly states they have no plans to in the near term. As of May 31st 2012, the company repurchased 17.1 million shares of stock in the preceding 9 months. For a total of $736 million. The company continues to actively purchase shares, and the board regularly re-authorizes more repurchases when each program is completed. In the first 9 months of 2012 this represented 15% of outstanding shares (113m outstanding). The company also has 12% insider ownership, which is nice to see on a company with >$ 3 billion in market cap. The seemingly aggressive repurchases and presence of insider ownership is justification enough for me to score this criteria a full 1 point.
Interesting to note on this criteria, is that the company has 2 classes of shares, Class A and B. The common stock, Class A shares which are available for purchase on the open market actually have no voting rights. The voting rights are exclusively held by Class B shares, which are all owned by the Exec. Chairman Dr. Sperling and his son Peter Sperling (who is Vice Chairman of the board). If Dr. Sperling passes away, his voting rights pass to 3 trustees which are all current directors on the board (his son and 2 others). Despite the seeming loss of control here for common shareholders, I do think that this construction will more closely align the interests of management with major shareholders and I don't see evidence of this being a negative point on the "shareholder friendly" criteria. But I welcome reader comments on this point.
The University of Phoenix has some competitive advantages over peers in the breadth of programs that it offers. This paper explains well some of the advantages that the university has, in particular because it is the largest (by far) for-profit university. Being so large it is able to leverage access to hundreds of companies which brings network effects that have a positive impact on the competitive advantage of the University. This effect gives students access to larger numbers of perspective employers. According to the university website, the company partners with 1800 companies already. The company also offers over 40 full degree programs online (even doctoral programs), which is much greater breadth than almost all competition.
Therefore despite challenges in the industry, the University of Phoenix is clearly a leader and even with enrollment pressures and other issues I believe the university is for sure one of the best positioned to "weather the storm". From this perspective I've given a full score of 1 point in this category.
The company has over $600 million cash vs. $126 million of debt. With a debt/equity ratio of only 0.14 and an interest coverage ratio of over 100, the company is clearly in no near term risk of financial problems and is conservatively managed in this respect. I've given this criteria a full 1 point.
We can see here looking at the 10 year earnings history, that the company has seen a consistent rise in both sales, EBIT, and EPS. The average EPS annual growth over the past 10 years is over 13%, as EPS has risen from 1.30 in 2003 to 4.02 in 2011. However despite this consistent growth, sales have dropped from 2010 to 2011 and EBIT has also dropped. EPS was higher in 2011 but longer term EPS growth will inevitably only occur with higher revenues. Due to this uncertainty, I've scored this criteria at 0.5 points.
Margin of Safety
To calculate whether the current price constitutes a sufficient margin of safety, we have performed a simple DCF, using one my favorite DCF calculators that follows a Buffett style approach to keeping the valuation extremely simple. I compare the potential return of an investment to that of US treasuries, the ultimate "risk free" return. Since long term treasury rates are at all time lows, (1.65% for the 10 year at time of writing) I use as a minimum a discount rate of 6% in order to be more conservative.
In the case of Apollo, 12 analysts that cover the stock have a 5 year EPS growth estimate of 12.33%. With the negativity that surrounds the industry, I've taken a more conservative estimate of 5%. I believe the company will continue to have near term pressure on margins, but in the long run as stated above in the business prospects section, the overall push in America to increase high education levels will need to include the largest for profit institutions like the University of Phoenix. So I still believe the growth will be positive overall in the coming 10 years.
- Current Earnings: $4.18/share
- 10 year average growth of Earnings: 5%
- Growth after 10 years: 0%
- Discount rate: 6%
- How confident are we in our earnings estimate? : 75% confident
Using these inputs I get an intrinsic value of $77.29/share. With a current market price of only $28.88/share, there is an implied upside of more than 200%. Even if I lower the growth rate to 0% over 10 years, the intrinsic value is still $52.25/share, an upside of 80%. In either scenario I can feel very confident about the margin of safety. The company is currently "priced for dead" so to speak, and I cannot see how this is justifiable in the next decade with the push to increase higher education enrollment. This criteria therefore receives a full score of 1.
Total Score: 8.5pts.
Conclusion: The Apollo Group is a buy.
To summarize my position overall:
Although there is a lot of negative stigma around this industry, I believe the Apollo Group is just too cheap to ignore. If you stick with the strongest players with greatest competitive moats, such as Apollo, I believe you will be rewarded for your efforts in a few years time.
Remember as the most successful investor of the 20th century has taught us:
"Be greedy when others are fearful"