A For-Profit Education Disaster

by: Leigh Drogen

Last winter I was heavily long for profit education names Capella Education Company (NASDAQ:CPLA) and DeVry Inc. (DV). I took some excellent money out of them, and pretty much sold out at the top. No, I didn’t sell out because I saw this catastrophe coming, although I was well aware of the shaky ground they were standing on. I sold out because they had become overvalued and extended from major moving averages, they needed a rest. I had all the intention in the world to buy back in if and when they formed good bases going in to the spring.

Then the market melted down, and with it down went the education names. They got thrown off my watch lists because of broken charts. In early July a few started to pique my interest again, notably CPLA and Grand Canyon Education (NASDAQ:LOPE). These stocks had made their way back down to important levels of long term support and bounced quite strongly. Institutions had stepped up to the plate once again.

Let’s back up a little though. The for profit education sector is a secular growth story, and what made it even better was the very low correlation most stocks had to the overall market. Some of these stocks enjoyed large institutional participation. The government was the driving force of this for profit education boom, they gave easy money to students in the form of loans and grants to retrain themselves. As the jobs picture got worse and worse, the government poured more and more money into these programs thinking that getting a bachelors degree from a community college would increase the chances of the unemployed.

Newsflash, it didn’t. Not only were these people not getting jobs out of school, they weren’t getting a good education to begin with in community college. They weren’t learning practical skills, they were learning liberal arts, which unless you are studying at a top 50 university or college, is rather useless to employers. Even then, I’ve seen amazingly smart kids graduate from Ivy League schools with liberal arts degrees, with majors in subjects like anthropology and English get no job offers because of the fact that they have no practical skills which are useful to employers on day one.

If there is anything that Europe does right, it’s schooling. They realized long ago that not everyone is meant to do anything, people are good at what they are good at, and thus, should start training for those things early on in the education. This means that not everyone is put on the track to be a scientist or mathematician, some people are welders and mechanics, some are teachers. A student's path to his career is carved out far sooner in France where the gifted are put on a certain track, and those who don’t score as high on tests are placed on others. Yes, this does lead to a class system where those who grow up in wealthy families, or just those with a culture of education have a better shot down the road, and those who don’t fall behind quicker and are placed in certain buckets. The Europeans aren’t as concerned with, shall we say, affirmative action, in whatever sense you would like to use that term.

I’m not making a moral argument that they do it the right way. Far from it! In fact, I think it’s rather cruel and perpetuates the cycle of the poor staying poor and the rich staying rich, much like how a lot of idiot kids graduate from Harvard and get placed right into the Goldman Sachs analyst program because daddy is a Senior VP. They didn’t earn a damn thing, but frankly, they are just cogs in the wheel anyway and most of them wash out after a few years. Still, they get a shot at the big time, whether or not they waste it is not the point, they get their shot just because of their position in life.

Forget that for now though. The point I’m trying to make is that the Europeans are much more efficient at training students for the real world, instead of filling their heads with liberal arts and telling them they can be scientists and doctors. They have excellent vocational schools, and many attend, and it’s not shameful in any way.

Now, back to the United States of America. All of those students who were told that they would get a better shot at high paying jobs if they went to community colleges got screwed, well, most of them anyway. First off, they had to take out a ton of loans, federal loans. Then, when they got out of school with their just about useless bachelors degree, there were not jobs for them. I don’t feel the recession is the major cause of this, even in the best of times many of these people are not going to get the salary they were told they would get. So now they have no job, and a ton of debt.

Of course the schools don’t care one bit, their job is to get the students in and out the door, because their performance after graduation is not tied to getting paid back. Why, you ask? Because the schools have already been paid by Uncle Sam. Now whether Uncle Sam decided to look the other way, or was just completely ignorant to the fact that repayment rates for these loans were somewhere in the 30-40% range, I’m not sure. But just stop and think about that for a second, the bar for these schools to qualify for these federal loan programs was at a 40% repayment rate? You’ve got to be kidding me. Who loans money with the goal of getting 40% of it back, AT BEST!

So we’ve got two problems here. First, the students aren’t getting jobs, and second, they can’t repay their loans, the repayment rate for some schools was around 20%. You tell me, does this sound like a sustainable business model, where students invest a certain amount of money, effort, and time, and their return on investment is, well, you get the point.

Back to the stocks. There were heavy short positions all through the run up of many of the education names in March and April. The shorts were getting squeezed for sure, but the short interest just kept piling up, they weren’t giving in. They knew that it was only a matter of time before the whole house came crashing down, similar to the housing mess. In fact, it was so similar that many of the hedgies who made a killing on the short side of the housing collapse were back for round two and were targeting the education names for many of the same reasons. Easy credit and a negative return on investment don’t add up well. The main character of Michael Lewis’ book The Big Short, Steve Eisman, was one of them. And when this guy takes aim at an industry, you don’t want to be in his way.

It all started falling apart back in May, when the Department of Education began to dig deeper into what was going on with lending practices at the schools. They smelled fraud, and that’s just what they found. It turns out that these schools are encouraging their prospective students to lie on their applications, and in some instances they even told them outright lies about their future earnings potential based on the education they would receive.

The fundamentals of a business might be flawed and the stocks will still attract value players who believe they can turn it around. But when you introduce a healthy helping of government and the word fraud, investors run for the hills. Michael Burry and other shorts pressed and destroyed these stocks, and rightfully so.

Many of these companies deserve to be out of business, today if possible. The scams they are running are out of this world. But, there are for profit education companies out there which run a clean ship, so to speak. It seems that Apollo Group (NASDAQ:APOL) and LOPE are the cleanest of the bunch, we think - based on repayment rates, although the justice department said that all 18 of the major for profit education firms committed fraud.

Today feels like capitulation day for the whole space, the volume on many names is 4 to 5 times average and some stocks are down 10-20%. I’m not saying this is the bottom, it’s completely possible that the whole space is completely FUBAR and that many of them go bankrupt in the months and years to come. As well, those companies which might be clean will see their share pries decline with the rest of the group if there is more pain to come.

But if you are a value investor and believe you have done your homework, and I mean really done your homework on these companies, today is the day to start taking positions.

Author's Addendum: A Mea Culpa, see here.

Disclosure: No positions