Value in the for profit education industry
In a not so distant future, the United States was the country that could boast the highest ratio of college degree holders relative to the general population. Unfortunately this is no longer so. The US ranks number 11 right now, far behind counties such as Russia, Korea and even Spain.
As a country’s economy develops and shifts from manufacturing to services, the level of higher education becomes a critical factor in productivity and success. Accordingly, the value of college education has been steadily increasing over the years and the average salary gap between college educated and non-college educated workers clearly reflects that. Higher educated workers earn more and increasingly more so over time.
This tendency has translated in a steady increase in demand for higher education. Of course, most people earn their degrees in universities, most of which are either public or non-profit organizations. Unfortunately, these two entities alone cannot possibly meet the enormous existing demand (only about 28% of US citizens have a college degree) and the gap is currently being filled (partially) by other players: for-profit education institutions. These are exactly what they sound: profit seeking corporations whose product is education and whose clients are students. Typically, but not exclusively, these institutions tend to cater the needs of adults students, which prefer evening, online or evening classes and do not necessarily need on-campus accommodation, dining and extracurricular activities.
These companies have benefitted handsomely lately from increased demand, not least because of the economic downturn and its stubborn unemployment rate: when there is no work out there, it is a good time to go back to school.
The entire for-profit education sector has been under the spotlight for the past year or so. In order to understand why we need to first understand how the typical education is financed. While a minority of affluent students can pay their tuition out of their own pockets, a majority takes out student loans. These loans have a typically high default rate and banks would not be as forthcoming without an existing federal guarantee that effectively reimburses the bank in the event that students fail to meet their obligations. In practice, the system uses taxpayers money to subsidize the tuition of students who default.
So far so good. However, given the latest financial difficulties of the US government, politicians are trying hard to reduce expenses and their watchful eye has fallen on the education sector as well. In all fairness, it must be said that, at least in some cases, the system has been abused. Encouraged by strong demand and lucrative gains some for-profit universities have embarked on an aggressive marketing campaign trying to recruit as many perspective students as possible regardless of their academic qualifications or their chance of finding employment post-graduation. Some have even resorted to compensating admission officers with bonuses tied to the number of students they admit. This phenomenon has led to the sad result of having many students burdened with debt and unable to obtain a job. The response of the government has been to threaten a large-scale reform limiting access to the federal loan guarantee only to those schools that meet certain parameters such as the percentage of students who default after graduating or the percentage of students who started repaying their loans after a number of years.
Obviously the threatened reform has had a tremendously negative impact on the stock prices of companies in this sector, that suddenly saw their survival in jeopardy (in most institutions the percentage of students benefitting from such loans is above 70%).
After years of investing in the stock market, I have learned to pay close attention to the arising of situations where there may be a “baby thrown out with the bathwater”. In other words, a state of affairs where all stocks of a given subgroup are sold indiscriminately by the market because of some perceived threat regardless of the quality of individual issues. This situation usually presents juicy profit opportunities for those patient and brave enough to dare.
According to this line of though, I reasoned that it was highly unlikely that the department of education would put the entire for-profit sector out of business, as the huge need to increase the education level of the average American still stands. Rather, the new legislation would likely aim to weed out the less efficient as well as the dishonest players. Following the reform then, with some competitors out of the way, the surviving companies would find a free field of action in a rapidly growing industry.
Among the many players in the for-profit segment, I think I singled out one of the most impressive institutions: Strayer Education. I particularly liked the company for a number of reasons: first, it enjoyed the widest profit margins and return on capital of the entire industry. Second, it has a strong brand image deriving from its being in the business for over one hundred years. Third, it focuses on BA and Masters degrees, unlike some of its competitors which concentrate on two-year professional degree (students enrolled in four year programs tend to have higher graduation rates and higher subsequent salaries). Fourth, unlike some of its peers which have already nationwide presence, Strayer operates in roughly only 20 US states, leaving plenty of room for future growth. Fifth, he company can boast a strong balance sheet with plenty of cash reserves. And last, the quality of the management team. I have come across few companies with better leaders. The CEO is Mr. Robert Silberman. I was very impressed with the clarity with which he described Strayer’s business model, corporate strategy and the threat of reform from the department of education. Additionally, rather than wasting cash on dubious projects, the management has been returning as much as 80% of cash to shareholders, further proving the high profitability of the company which has been growing at double digit rates with only 20% of reinvested cash. In short, we have a rational, honest, transparent leadership that seems committed to the long term profitability of the company.
The threat of DoE reform caused Strayer’s valuation to drop at a multiyear low with a P/E ratio of only 12.5 and EV/Ebitda of roughly 6.5 (both measures suggest undervaluation for a company expected to grow at double-digit rates).
The reform eventually did go through, but it did so in a highly watered down version. Rightly, the stock prices jumped across the board on the news. Fortunately for new investors the recent market correction means that most of these stocks lost a good part of their recent gains. Perspective buyers have the opportunity to buy in a growing industry at a good price point without the overhang risk of the DoE regulation.
DISCLOSURE: the author is long Strayer Education