|Shares Out. (in M):||88||P/E||9.2x||8.0x|
|Market Cap (in $M):||1,200||P/FCF||6.3x||NA|
|Net Debt (in $M):||200||EBIT||220||250|
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I am recommending a long position in Corinthian Colleges (COCO), which I also wrote up as a long in 2004. The for-profit education sector is as well-known as it is controversial among the value investment community and VIC as several industry players have been posted in past years (e.g., APOL, ESI, STRA), mostly on the short side. I will address the principal criticisms of COCO and the industry below. I believe many of the critiques are quite valid, but I believe COCO is a buy simply because its stock price more than reflects all of the extant bad news and headline risk. In short, it is simply too cheap notwithstanding the issues surrounding the industry.
COCO is one of the largest for-profit, post-secondary education companies in the United States and Canada, with more than 105,000 students enrolled. The company operates 100 schools in 25 states and 17 schools in Canada. COCO serves the large and growing segment of the population seeking to acquire career-oriented education, with an historical emphasis on diploma programs and associates degrees. COCO also offers students the opportunity to take classes online through Everest College in Phoenix and Everest University in Florida. Historically, a little over half of COCO’s students have been enrolled in health programs such as medical assisting and dental assisting, fields expected to grow robustly. COCO recently completed the acquisition of Heald College, a privately owned provider of associate programs in business, legal, technology and healthcare. Heald provides a solid brand, strong presence in the Pacific Northwest and further diversification in degree programs as roughly two-thirds of COCO’s students historically were in non-degree programs below the associates level.
On an LTM basis through September 30, COCO generated approximately $1.4 billion of revenue with EBITDA, EBIT and EPS of $212 million, $167 million and $1.12, respectively. Heald added $180 million of revenue and approximately $38 million of EBITDA for 2009. Thus, on a pro forma basis using reasonable estimates for COCO’s December quarter, COCO generated approximately $275 million of EBITDA in calendar 2009 (the company is on a June fiscal year). Thus, based on the current trading price [$13.62], COCO has an enterprise value of approximately $1.4 billion and is trading at 5.2x EBITDA with a mid-teens free cash flow yield. Given the current momentum in the business, these valuation metrics should only improve through the end of the company’s fiscal year in June. This dynamic, coupled with the strong secular growth dynamics for the industry (and especially for COCO’s healthcare oriented programs) make these multiples very attractive entry points, even with the risks and headwinds facing the company, which I discuss below. Moreover, these multiples represent a dramatic discount to private market value. For example, EDMC went private in 2006 at 13x EBITDA. I’m not suggesting that this bubble-era multiple is appropriate today (and EDMC does deserve to trade at a premium to COCO), but it does highlight the current disconnect with private market values at high single-digit to low double-digit EBITDA multiples for businesses like COCO.
Most for-profit education companies rely substantially on federal financial aid programs for funding their student’s tuition payments, which subjects the companies to regulation by the Department of Education (“ED”) pursuant to the Higher Education Act of 1965 (the “HEA). Under the HEA, regulatory authority is divided among each of the following components: (i) the federal government, which acts through the ED; (ii) the accrediting agencies recognized by the ED; and (iii) state higher education regulatory bodies. The issues facing COCO and other industry players that are addressed below include: (i) cohort default rates; (ii) the “ability to benefit” issue; (iii) internal lending; (iv) the countercyclical nature of the business; (v) potential restrictions on marketing practices; and (vi) the general value proposition offered by for-profit education companies.
As disclosed in COCO’s 10-K, the HEA and ED regulations require the company’s institutions to: (i) maintain a rate of default by its students on federally guaranteed loans that are below a specified rate; (ii) limit the proportion of its revenue (on a cash basis) derived from the Title IV programs; (iii) comply with certain financial responsibility and administrative capability standards; (iv) prohibit the payment of certain incentives to personnel engaged in student recruiting, admissions activities or the award of financial aid; and (v) achieve prescribed completion and placement outcomes for short-term programs. Each of these requirements is the source of some actual and perceived risk for COCO and other companies in the industry. I will address the ones that receive the most attention and present the most risk for COCO.
Cohort Default Rates. A significant requirement imposed by Congress is a limitation on participation in the Title IV Programs by institutions whose former students defaulted on the repayment of federally guaranteed or funded student loans at an “excessive” rate (so-called “Cohort Default Rates” or “CDR”). An institution’s CDR is calculated on an annual basis as the rate at which student borrowers scheduled to begin repayment on their loans in one federal fiscal year default on those loans by the end of the next federal fiscal year. Any school whose 2-year CDR (ie the CDR for the two years post commencement of scheduled repayment) equals or exceeds 25% for three consecutive years may lose eligibility to participate in federal grant programs. In addition, an institution whose CDR for any federal fiscal year exceeds 40% may have its eligibility to participate in the federal programs limited, suspended or terminated. COCO h as announced that 10-12 of its schools are likely to breach the 25% CDR level when 2008 default rates are formally announced in September 2010. Another 5 schools are too close to call at this time but could also breach the 25% CDR level. The 10-12 schools that are expected to trigger the 25% threshold this year represent no more than 5% of revenues, and any penalties accruing to these schools wouldn’t occur until they actually tripped the 2-year CDR in Fall 2011.
Beginning with the fiscal 2009 cohort, the 2-year CDR metric will change to three years, and the 25% threshold will increase to 30%. Thus, the first year that this revised CDR test will be measured officially is 2012, and the first year it could result in sanctions would be 2014. This change is important because default rates increase with time, and CDRs are expected to be higher after three years than two years. The ED recently released to schools its illustrative calculation of historical 3-year CDRs for fiscal 2007, and COCO’s company-wide average CDR was close to 30%, with schools representing more than half its enrollment breaching the 30% threshold. These developments have largely caused the stock to trade off from the $18-20 level prevailing in late Summer into September to under $14 today despite otherwise very strong operating performance.
At first blush the illustrative 3-year CDRs are alarming, but let’s put them in context. First, neither COCO (nor other for-profit schools) have been managing against 3-year CDRs until ED revised the rules so the fiscal 2007 3-year CDRs were not managed at all. COCO concentrated its default mitigation efforts on the 2-year CDR because that was the relevant metric. COCO and other schools have ample time to refocus their efforts on default mitigation to include three years instead of two. Moreover, the management team at COCO was installed several years ago in large part to deal with earlier regulatory and compliance issues and has done an admirable job of turning around the business in this regard. They are well aware of the 3-year CDR issue and are devoting substantial resources to address it, including implementation of a new contact management system, enhanced entrance/exit counseling, an internal department focused on early stage delinquencies, and use of external resources to inform borrowers of alternatives to default. Finally, there is a huge amount of runway to address these issues before any sanctions would be imposed (2014 at the earliest), and even then there is an appeal process COCO could pursue before being subject to sanctions. Worst case, which the market appears to be discounting, COCO could slow enrollment to obtain a better mix of students (ie less likely to default). In short, on a probability-weighted, present value basis, this issue simply is not worth the $350-500 million of market cap it appears to have cost COCO.
Ability to Benefit Regulations. Although the CDR issue is clearly the most troubling one for the market, a secondary issue concerns the so-called “Ability to Benefit Regulations” (“ATB”). Under certain circumstances, an institution may elect to admit non-high school graduates into certain of its programs of study. In such instances, the institution must demonstrate that the student has the “ability to benefit” from the program of study with such a determination based on the student’s achievement of a minimum score on a test approved by the ED and independently administered in accordance with ED regulations. In addition to the testing requirements, the ED regulations prohibit enrollment of ATB students from constituting 50% or more of the total enrollment of the institution. ATB students currently represent a little less than 25% of COCO’s total student population. Ongoing negotiated rulemaking being conducted under the auspices of the ED have raised some concerns about changes to the regulations that could impact current ATP protocol. Though no specific regulation has been proposed that would negatively affect COCO, there is some uncertainty and concomitant overhang related to the issue.
Countercyclicality. Another issue facing COCO and the other industry players is the countercyclical nature of the business, especially for schools like COCO’s that have a heavier vocational orientation. As the economy weakens and jobs are scarce, demand for education to increase skill sets improves. This dynamic has been a phenomenal tailwind as evidenced by the strong operating performance of the for-profit education companies in the past two years. However, with the economy on the mend and the jobs market expected to revive in 2010, the market expects this tailwind to become a headwind. This is undoubtedly true, though to what extent is a judgment call. We expect a very sluggish recovery with stubbornly high unemployment so we do not believe the headwind will be as great as the market may be discounting, but this is not really central to our thesis.
Internal Loans. Additionally, COCO and other post-secondary education providers have recently begun underwriting student loans to replace Sallie Mae and other 3rd party lenders that have exited the business due to high default rates, particularly amongst sub-prime borrowers. COCO, under its Genesis program, expects to provide $130mm in loans in FY 2010, with anticipated default rates of nearly 60% (i.e. COCO is accruing defaults at this assumed rate as discounts to revenue). While these “bad debt expenses” (which as an accounting matter are taken as discounts to revenue) have been a drag on earnings, marginal profit contribution remains positive, even at 100% default rates assuming this program facilitates the matriculation of students who might not otherwise attend a COCO school. Furthermore, as the Company seeks to address CDR issues with improved admission, job placement, and support services, the coincident default rates on internal lending should also see improvement.
Marketing Practices. The other issues that have been raised with respect to the industry and other players such as APOL and ESI involve marketing practices and the general value proposition offered by for-profit education. APOL in particular is receiving considerable scrutiny of its allegedly aggressive marketing practices. Several years ago COCO endured some of these same issues (and others), but today its marketing practices are within industry norms—which is not to say that such industry practices may not be subject to further constraints; in fact, they likely will. Investors are concerned that any such constraints on marketing will tend to slow growth. This is a generalized concern that I believe has been overblown, but only time will tell what constraints emerge and what impact (if any) they have on the ability to recruit new students. Although the market has taken this uncertainty to be risk, I believe the actual risk is de minimis.
Value Proposition. The final issue raised about the industry is a generalized view that it does not offer a value proposition and thus is doomed to failure. The reality is that for-profit education serves an essential need in a knowledge economy, a need that is only bound to grow given the extraordinary constraints and associated cutbacks facing publicly funded education. Moreover, private non-profit institutions continue to offer a massive price umbrella for the for-profit education industry. I am sure that there are cases in for-profit education where students are ill-served from a strictly ROI perspective, but the same is certainly true for many non-profit mediocre liberal arts colleges that cost over $200K for a bachelor’s degree. The reality is that for-profit education is a large, established business that employs lots of people and fills a real need in the market, a need that is likely to grow not diminish. This is not to say there haven’t been abuses in the industry, there have; but the government has shown absolutely no willingness to issue a “death sentence” for any of these institutions. Indeed, the penalties for past instances of wrongdoing have been relatively mild. Moreover, the politics of cutting education funding for disadvantaged students just aren’t appealing, particularly during challenging economic times.
In sum, I believe the risks and headwinds facing COCO have been overblown and more than reflected in the price of the stock. I’m not smart enough to know how the economy and jobs market is going to recover over the next few years, but even with very conservative assumptions for COCO that incorporate some degree of earnings contraction, the stock is just too cheap. Over the past ten years, COCO has generally traded at a double-digit trailing EBITDA multiple, and its multiple currently sits at the lowest level by far during this time period. Investors who have stepped into the space when headline risk is high and multiples are low historically have been well-compensated prospectively, and I believe Mr. Market is serving up just such an opportunity with COCO today. Given COCO’s cash flow dynamics, I believe its downside to be quite limited, with most bad news already priced in, while the upside could comfortably be 2-3x over the next few years with only moderate business performance and a modest rebound closer to historical trading multiples.
Strong earnings and cash flow
Absence of materially negative regulatory developments
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