The Overleveraged University: The Inflection Point In Higher Education

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Includes: APEI, EDU
by: Kyla Scanlon
Summary

Both universities and their students are becoming increasingly more indebted.

Public and private universities have different exposure risks, with public schools more reliant on tuition fees and private schools reliant on market returns.

Alternatives to traditional higher education are on the rise.

The higher education industry is long overdue for an operational overhaul.

The Debt Crisis: How Higher Education Operates

Universities and colleges for a long time have operated on a very successful business model. They provide an incredible resource to each generation of students, enabling development from both a personal and professional perspective. They operate as non-profits and essentially have control over their own universe of supply and demand.

With the advent of cheap credit, more and more students began to enter the university business model. To gain their credentials, students participate directly for 4 to 5 years, often taking out student loans to do so. The idea of the necessity of a college degree for life success perpetuates the increase in enrollment, as the college path is drilled into students from elementary school, despite the fact that it is not always the best path for some students.

student debt crisis continues to grow

Source: Bloomberg

The student loan debt crisis is several articles of information within itself. However, many universities are also experiencing their own debt crisis, increasing their own leverage to try and attract more and more students. As this "double-debt" issue grows, it becomes more apparent that something must give within the system.

As average tuition as a percentage of median income continues to increase; despite stabilizing recently, more and more families are beginning to question the value of a hundred-thousand dollar degree plus interest payments. Federal funding has also been slashed in recent years, which exacerbates the debt problem for universities. Students are increasingly seeking out non-traditional routes, which exist primarily online and some of which don't require students to pay until after they secure a job.

student loan debt crisis

Source: Student Debt Crisis, FRED

Traditional universities require payment upfront for the goods that they provide. This model has been in practice for years and years, and it has worked. But the top universities are not as reliant on that up-front payment, as they are able to rely on their endowment return model, which compounds tax-free.

The Disconnect Between Private and Public Schools

Colleges and universities have four main revenue streams: "state appropriations, research funding, gifts and endowments, and student tuition", tuition being the only one that can be freely utilized. As a business operation, universities want to maximize this unrestricted revenue, and that involves increasing the price of tuition. But there is a point of maximization, as once a product has reached past its maximal market value, no one will want to buy that product anymore.

Endowments are the treasure chests of top universities, with investment returns generating much more revenue than tuition. Princeton, for example, generates 911% more on their endowment as compared to their revenue from what they charge students for attendance. Harvard generates 529% more from their endowment. MIT is 118% more, Stanford is 115% more, Brown is 29% more, and so on, and so forth.

However, there is a divide between the income generation of public and private universities, with private universities generating much more in terms of endowment, and public universities are more reliant on tuition income.

The University of Michigan, regarded as a proxy for other public research universities, receives approximately 32% of its overall revenue in the form of tuition and ~30% in the form of research funding, together comprising 2/3rds of its entire budget. Endowment and the returns generated make up ~11% of its overall budget.

university of michigan

Source: The New Inquiry

On the other hand, a university like the Massachusetts Institute of Technology (MIT) only gets 10% of their revenue from tuition. They get much more from research, totaling 48% of their overall revenue. They get 22% from their endowment returns. Over 70% of their overall revenue amounts from research and endowments alone.

mit revenue as compared to public

Source: Conrad Bastable

Public universities are much more exposed to slashes in federal funding and tuition price freezes. Private universities, using MIT as a proxy, are able to fall back on research funding and endowment returns. However, the industry as a whole is expected to contract in growth in the coming years.

Moody's downgraded the growth of higher education from stable to negative this past year, expecting expenses to outpace the annual change in revenue. Over 50% of private universities are expected to experience greater than 3% revenue growth. For comparison, less than 20% of public universities are expected to achieve that same growth metric.

research funding over time

Source: Inside Higher Ed

As federal funding flattens out, universities will have to enter into the private sector in order to maintain research revenues, which will put further pressure on institutional funds. Public universities gather about ~25% of their revenues from governmental sources, so they will feel the squeeze more than their private counterparts. Private universities do have some reliance on federal funding through loans and grants for students, tax preferences, and research subsidies, but public universities are more reliant in general on governmental funding. This puts a squeeze on many of the colleges and universities, requiring them to become overleveraged in order to maintain operations.

The University Debt Crisis

The number of aid-eligible institutions fell by 5.6% from 2016 into 2017. Schools closed, and the number of closures each year is expected to grow. It's getting more and more expensive to maintain a university, as equity, endowments, and growth are decreasing for most schools. Liabilities, debt services, and expenses are increasing. Back in 2012, 24% of universities saw a decrease in their equity ratio and a bump in their expense ratio.

leverage ratios

Source: The Sustainable University

When faced with this problem in the past, universities would simply hike tuition rates. But now, there is a growing backlash as graduates find themselves underemployed or unemployed after graduation. The basic college degree no longer holds the same promise that it used to.

Beyond that, universities still have to "keep up". Build more. Do more. Spend more. In the face of budget cuts, institutions are taking out debt, growing at a clip of 12% per year, with interest expense on top of that. It's expensive to maintain a campus, which can sometimes be the size of an entire town, as well as the administrative aspects of running a college or university.

Keeping Up With the Cost of Education

Total college US enrollment has increased almost 40% over the past 25 years. Median wages have increased by approximately 10%. The cost of education has increased 300% in the same time period.

median wage of individuals over time

Source: FAS

It is important to note that GDP increased 182% over this same time period, so it would be impossible for the cost of education to have remained stagnant. But education outpaced production by 118%. A lot of that is due to the increased value placed on a college education, but top universities have also gotten more selective. When the supply of a good is constrained, that will make that good that much more valuable to the marketplace.

The Disconnect: A Drain on the Student and the College

However, even the students at the top universities are not always safe from student debt. Over time, the number of searches looking for the term "student loan refinance" has increased quite dramatically. SoFi, an online lender, had a settlement with the Federal Trade Commission because they were misrepresenting how much borrowers were saving from refinancing.

student loan refinancing

Source: Google Trends

The FTC has sent out several "final warning" letters to other companies that are preying on student borrowers. The average graduate now leaves school with $30k in debt, which is a 3x increase from early 1990s. Refinancing federal loans with a private lender can sometimes result in less flexibility, restricting a student's financial freedom down the road.

College is a cradle-to-grave process, in the most extreme of situations. Families usually set up college funds for their children, relying on interest and market returns to compound that into an actionable amount. The student then goes off to college, using that money, which might not be enough to cover the cost of attendance. The student then takes out loans. Those loans and the interest they accrue can follow that student well into adulthood.

How to Trade Higher Education

New Oriental Education & Technology Group (EDU) has an interesting take on the educational industry, with exposure to textbook publishing and online education, among other things. It is headquartered in Beijing, so it is relatively insulated from the American educational system. It's also one of the largest companies in China. The company has an EV/EBITDA ratio of 21.23, which is a contraction from their June 2018 ratio of 39.90. They also have an EPS growth rate of 16.8% over the past five years.

Their revenue has increased pretty substantially into the latter half of 2018 and increased 54% from May 2018 numbers. They have strong cash flows from operations and posted a positive net change in cash for 2018. They are primarily institutionally owned at 82.07%. BlackRock, Wellington, and Oppenheimer own ~12% of the company. Davis Selected Advisers also owns about 5% of the shares.

American Public Education (APEI) is a group that provides both online and in-person educational opportunities. They were founded to provide educational services to the military, but have evolved to service adult learners. They have an offering of 108 degrees and 109 certificate programs, with a large concentration on nursing. The tuition costs are also 47% lower than other private for-profit institutions. The medical concentration of their programs will be a key advantage if we enter an economic downturn.

Also, they have several interesting partnerships with Walmart (NYSE:WMT) and the TSA to provide online educational opportunities to those employees. Also, their military focus and 27-year history in serving military learners should prove to be a stable revenue source.

They carry an EV/EBITDA of 5.7x, which is a relatively low metric compared to recent years, and have no debt on their balance sheet. They have a PE ratio of 19.4. Compared to their company group, they have a strong return on capital at 11.84% versus industry average of 6.54%, and a very strong gross margin, trading at 62.27% versus industry of 45.78%.

edu vs apei

Source: Capital IQ

When looking at the two companies side-by-side, EDU has had a more significant drawdown, whereas APEI has traded relatively flat. APEI is down about $15 from last year's high of $45. EDU is down about $30 from last year's high of $108 but has been trending upward since the beginning of 2019.

Conclusion: Growth in Alternatives to Higher Education

If the market recognizes programs like what EDU and APEI are producing in the same light as a brick-and-mortar university, then the cost of an in-person classroom experience will have to decline. It would not make sense to pay more for a seat in a physical space when the same education credential can be received for a lower cost online.

A change in the macroeconomic cycle could also support the above companies. When the economy tanks, people tend to go back to school, especially the older generations. In 2007, 1.9 million students between the ages of 40 and 64 were enrolled in college or university, and in 2011, that number jumped to 2.3 million.

Public universities are more exposed to a loss of federal spending, whereas private institutions are able to benefit from endowment returns. Public colleges made up 74% of enrollments in 2016. As federal and state spending continues to contract, public universities often have no choice but to attempt to raise their tuition prices. This further exacerbates the student debt crisis, as well as the university debt crisis.

Higher education is an industry that does a lot of good. As a personal anecdote, I have benefited tremendously from my education, and cannot imagine my life without it. But when discussing the university as an operational model, it is becoming more and more difficult for students to graduate debt free, which compounds into more problems down the road. The universities themselves cannot continue to operate on a debt-laden model.

Programs like the above two companies above are offering alternatives to the traditional route. College graduates for the first time ever, have a negative net wealth. They don't believe in or understand the stock market, with over 50% unable to define compound interest. This next generation is the most educated, the most indebted, and it is entirely necessary for them to have access to modes of wealth creation. It also entirely necessary to consider how dangerous it is to plunge an entire generation into a $1.5 trillion debt bubble.

Investing in groups that consider alternatives to traditional higher education should prove to be beneficial in the coming years, as more and more people shift out of the classroom and online. Universities will have to continue to focus on affordability and the quality of the programs. Flexibility is also a key metric, as universities that are able to offer platforms that can adjust to student needs will prove to be successful.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.