A simple business model with a proven successful past
Perdoceo (NASDAQ:PRDO) is a for-profit college operating in the US. They have shifted towards an almost-totally-online university, with more than 90% of students not coming to campuses. This allowed them to improve margins, build a simple, strategic platform where people can easily enroll and learn, and survive through the hard periods (like the pandemic). Although they proved themselves right and continued to produce tons of FCF and net profits, their stock is extremely cheap, because of regulatory concerns. Indeed, the market is clearly pricing in an apocalypse-like scenario where the Biden administration permanently damages the for-profit private colleges’ industry in the next 2-3 years. While risks are here and should be monitored carefully, the possible reward and solidity that PRDO offers compensate for the threats.
(Source: Seeking Alpha Charting, PRDO, EV/EBITDA)
This chart summarizes the point: getting cheaper and cheaper is PRDO’s daily routine. While they publish strong results every quarter, even during the pandemic, the market is clearly betting on the company going bankrupt because of regulation. But the good news is that the opportunity of an asymmetrical bet is here: If the company were to go bankrupt, they have so much cash that common stockholders would be left with half of their initial investment, whereas if they succeed and the democratic administration simply avoids the issue, the stock could return as much as 60%.
Improving quality, margins, and FCF while betting on strategic acquisitions
Perdoceo’s management is aware of the existential crisis beating down the stock’s multiples, and they moved to reduce the pressure on them. First, they improved margins, mainly through increased digitalization, and then they focused on diversification. They did so with some strategic acquisitions, like the most recent one of DigitalCrafts. Here’s an extract for the last earnings call:
Launched in 2015, DigitalCrafts has helped provide individuals an opportunity in the technology area through reskilling and upskilling courses within the areas of web development, web design and cybersecurity. The acquisition of DigitalCrafts fits well with our overall objective of extending the breadth of our academic program offerings while diversifying revenue away from federal student financial aid funding.
And while they are spending as little as 2% of revenues in Capex to diversify, their net margins are better than ever.
(Source: Seeking Alpha Charting, PRDO, Net Margin)
Management was able to increase net margin from as low as -5% 3 years ago, to more than 20% in the last 12 months. This is a remarkable achievement given the increase in competition during this period (Coursera is the perfect example). The FCF conversion rate is also a strength of this company, which is able to convert as much as 20% of revenues in pure cash (referring to 2021E results).
They currently have two main reportable segments: AIU and CTU, their main universities. In both of them, they have more than 95% of students online-based, and they progressively reduced the number of physical infrastructures needed to operate. Starting from 2020, they started focusing more on practical education that could attract already-employed people looking for an upgrade in tech skills. These new programs could act as game-changers and supply non-government-related revenue and thus reduce regulatory risk as well.
(Source: Author’s Chart created using 2020 10K data)
Also the demographics of their students are interesting. It is clear that the majority of people are workers trying to improve their skill set to get a promotion or change job (over 30 y.o.). Focusing on this niche and demographic could help Perdoceo diversify revenues and limit its dependence on government loans.
Looking at risk and assessing the regulatory framework
As said, the big question is regulation. Will the Biden Administration change the industry's rules and significantly impact the for-profit colleges? Or will it simply ignore the issue and leave things as they are? The answers to these questions will determine PRDO’s success or failure. So far, the administration is showing a non-aggressive approach to the sector, leaving the faith that it will not be too tough with it.
After 2008, the Obama administration applied many stringent rules about private schools, and Perdoceo was impacted significantly, but the company changed a lot, in order to apply to this new regulatory framework. In July 2015, the administration introduced stringent rules about for-profit colleges whose students couldn’t find well-paying jobs. From a Politico article about the rule:
The gainful employment regulation applies to community colleges and public universities as well, but for-profit programs fare worst under the rule’s key evaluation metric, a debt-to-earnings ratio. The industry, which collected about $22 billion in taxpayer loans and Pell Grants in 2013, says it’s being unfairly targeted, punished by the government for enrolling high-risk students
The regulation imposed that all courses with a high debt-to-earnings ratio would need to shut down operations, with clearly a major impact on certain colleges, and many of them had to shut down operations. Perdoceo was impacted as well, with their revenues declining more than 80% for the pre-crisis peak, at about $1.7 billion.
(Source: Seeking Alpha Charting, TTM Revenues)
Since then, they have been much more conservative in handling cash, and this is the main reason while they are keeping more than $400 million in net cash (after subtracting all liabilities). M&A too has been impacted by the choice of keeping more cash than necessary on the balance sheet, as reported by the CEO during the Q4 2020 conference call:
But again, I think with the opportunities that are out there, especially as we go into a new administration, we want to make sure that our strategy in an acquisition area is consistent with what or if they are going to be any types of changes. But I think hopefully that will develop soon or quickly as it has in prior administrations.
Since predictions about a political-based event are more of speculation rather than empirically-supported opinions, for PRDO the risk is limited by their positive net cash position.
Understanding the asymmetric nature of the opportunity
The biggest fact about this company is about having a defined risk (which is extremely low) outweighed by very high and generous upside potential. The best way to highlight this peculiar position and opportunity is a scenario-based model. Different scenarios with given probabilities and outcomes are assumed, and then the fair price will equal the weighted average of all fair prices. Scenarios will vary and they will impact margins, revenue growth as well as Capex as a percentage of revenues.
Low-case scenario: as simple as it could be, the company goes bankrupt, not because they won’t be able to pay debt holders, but because operating in the industry wouldn’t be convenient anymore. This could be the result of heavy, stringent regulation that cut both revenues (more public colleges available) and margins (need for PRDO to cut prices a lot). At this point, the stockholders will receive the remaining cash after all liabilities are paid off. Since they continued keeping more than $400 million in cash on the balance sheet, it is reasonable to think that they will continue to do so, and thus the residual value would be somewhere between $3 and $4. This scenario implies a downside potential of 60-70% and a probability of 40%.
Moderate-case scenario: in this case, Perdoceo experiences some headwinds in revenues growth, as competition grows more aggressively, but is able to keep decent margins (15-17%). This scenario is simply the maintenance of the “status quo”, so little to no regulatory impact is expected. Revenues will decline towards $600 million per year (from the current $700 million, 2021E) and FCF will not exceed $100 million per year in the upcoming decade. The fair price under this scenario would be $24 and the probability is 50%.
(Source: Author’s Chart from DCF model data, Medium-case scenario)
High-case scenario: PRDO faces no regulatory impact and it is able to grow students at record rates, as post-secondary education faces strong growth. Their tech-oriented courses will see the favor of employers and employees that will come numerous to study. In this case, revenues will experience some tailwinds from 2022 to 2026, and then restart to decline. The fair price, in this case, would be $35, and the probability is 10%.
The weighted average between these fair prices is $17, Perdoceo’s definitive target price. This number takes into account the considerably high regulatory threats by giving the low-case a probability as high as 40%.
Perdoceo is consistently getting depressed multiples because of its regulatory risk. Right now the superb cash position, constant cash generation, and a possibly soft administration created the asymmetrical bet PRDO is. The stock is weak enough to represent a buy and could return as much as 60% in the following months, as the market recognizes the overestimation of regulatory risk.