| 2020 | 2021 | ||||||
| Price: | 82.93 | EPS | 5.35 | 5.95 | |||
| Shares Out. (in M): | 48 | P/E | 16 | 14 | |||
| Market Cap (in $M): | 4,018 | P/FCF | 16 | 14 | |||
| Net Debt (in $M): | -20 | EBIT | 280 | 316 | |||
| TEV (in $M): | 4,044 | TEV/EBIT | 14.3 | 12.8 | |||
| Borrow Cost: | Available 0-15% cost | ||||||
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Description
Grand Canyon Education (NASDAQ: LOPE)
Executive Summary
Grand Canyon Education (“LOPE”) is a publicly traded education services company. The Company has one primary client, Grand Canyon University, which it spun off in June 2018 into a private entity. Additionally, roughly ~10% of revenues come from newly acquired Orbis, which has GCU as well as small outside university partners. Specifically, LOPE provides technology and academic services which facilitate online learning / classes in exchange for a revenue split.
We are facing a struggle when evaluating the obvious shorts; the market understands their cyclical exposure and the stocks, though they’ve bounced somewhat, are still down 50%+ from their highs and the economic sensitivity is largely understood by the market. Therefore we believe the best performing shorts going forward, the “holy grail” so to speak, will be in identifying companies that are perceived as defensive / acyclical (and have traded as such) but will prove out (due to cyclical and structural headwinds) to be very impacted by the ongoing recession.
In other words, we are looking for securities (preferably underfollowed ones) where it will shortly be proven that the emperor has no clothes. We believe that LOPE fits this paradigm and represents a decidedly compelling short at current levels, with a highly skewed risk / reward.
Our thesis is predicated on short, medium, and long-term drivers which we will go through in depth. We will then walk through where we see the share price headed to on a scenario-weighted basis. Additionally, we will address each element of the bull case as written by a hedge fund holder of the security in their recent investor letter (which we will not name for their privacy). Finally, we will walk through potential risks to our investment thesis.
Contents
1) Company Overview
2) Our Thesis
a. Precipitous Near / Mid-Term Earnings Risk
b. COVID-19 – An Extraordinary Forcing Function
c. The 2020 Election – An Existential Threat
d. The Orbis Story – Hype or Real?
e. What Are Current Expectations?
f. Who is GCU’s auditor?
g. Recent Performance Highlights an Excellent Entry Point
3) Addressing the Bull Case
a. Enrollment More than Doubled Last Recession!
b. 2021 Consensus Earnings Expectations Are Too Low
c. The Stock Is Simply Too Cheap
4) Valuation
a. Scenario Analysis
5) Catalysts
6) Conclusion
Company Overview
Grand Canyon University went public in 2008, shortly after CEO Brian Mueller left University of Phoenix to lead the Company. Until June 2018, the Company’s structure was relatively simple; it was a publicly traded for-profit University which had both a ground campus (accounting for ~20% of students) and an online presence (accounting for ~80% of students).
On July 1st, 2018, the Company completed a transaction which spun-off the actual University into a private entity (“GCU”) and transformed the public Company into a services provider / online program manager (“OPM”) similar to TWOU, except with one client: GCU. In exchange for providing these services, LOPE receives 60% of all revenues (ground tuition, online tuition, housing, meal plan, arena ticket sales, hotel, golf course, etc.) from GCU. In January 2019, the Company also completed the acquisition of Orbis, a Company which works with outside university partners (and now GCU) to support them in setting up ground-based accelerated nursing programs.
Our Thesis
Precipitous 2020 Earnings Risk
LOPE is regarded as a defensive, with earnings expectations that will remain steady (or potentially go up!) as a result of COVID-19
We believe this is an extremely errant observation that overlooks the structure of the business
o As we mentioned earlier, LOPE receives 60% of all revenue from GCU as part of their Master Services Agreement
o While this is great in normal times as LOPE is receiving revenue streams from services which they are not incurring any cost, this is disastrous in the age of social distancing
§ We would refer readers to this article which highlights the inability for universities to operate as normal in the age of COVID-19
§ https://www.theatlantic.com/politics/archive/2020/04/will-colleges-be-open-coronavirus/610657/
§ Specifically, within this article, we thought this quote was particularly salient:
· If you were to design a place to make sure that everyone gets the virus, it would look like a nursing home or a campus,” Paul LeBlanc, the president of Southern New Hampshire University said
§ Common sense would dictate that college campuses will be among the last venues (likely second only to sports arenas) that will be safely allowed to re-open, likely not until 2021 and potentially even later. They represent a uniquely dangerous venue for virus transmission with thousands of young people living in tight quarters, re-using classrooms, at proximity with older age professors, etc.
· Even if they were to open just in time for the next flu season to be upon us, how much student attrition would occur as students (and their parents) are forced to decide whether to go back to the campus and almost assuredly fall ill with COVID-19
o As we alluded to above, a shuttered college campus has disastrous financial consequences for LOPE. In terms of the specifics, it is helpful to analyze each of the lost revenue streams. These include 60% of the following revenue streams:
§ Room & Board for ground-campus students (~13k students at $7,700 per student per semester)
· This accounts for $100.1mm of revenue in back half 2020, of which LOPE’s portion is ~60% or ~$60mm
§ Tuition Rates for ground-campus students (~21k students, 8k of which are commuter students, that do not pay above room and board, at $8,700 per student per semester)
· This accounts for $182.7mm of revenue in back half 2020, of which LOPE’s portion is ~60% or ~$110mm
· This will be somewhat offset by a negative mix shift from these students paying the ground-campus tuition rates to the online tuition rates, which are ~35% cheaper (net of scholarships)
· The net headwind from this mix shift from ground to online tuition rates (ground charges more due to in-person instruction etc.) is therefore ~$40mm
§ Other Ancillary Revenue (hotel, arena ticket sales, golf courses, etc.)
· ~$40mm (per management guidance) on a full year basis, or ~$20mm per half year. LOPE’s portion is ~60%, or $12mm
§ These headwinds in aggregate represent $112mm of potential back half 2020 EBIT headwinds that drop through at an almost 100% decremental margin as LOPE does not provide any incremental services for these revenue streams (i.e. gets the revenue at no cost to LOPE) relative to a $163mm Consensus EBIT forecast
· In other words, if and likely when GCU’s campus is not allowed to reopen in the fall, earnings expectations will likely have to come down by over 60%, making this one of the most COVID-19 sensitive stocks in the market as opposed to the market’s perception of this being among the least
· Even under an overly optimistic / unrealistic scenario where college campuses reopen in the fall / flu season of 2020, we believe LOPE would see significant earnings attrition as parents and their students will simply elect to not go
o As a parent, I find it would be extremely difficult to make the decision to send my son to a university knowing he would likely be infected with Coronavirus and have even the slightest chance of death
§ This analysis is supported by the CFO recently and quietly walking down the (tightly controlled) sell-side analysts covering this name on Q
· Mr. Bachus has communicated that just one month of campus closure and associated headwinds will represent an $8mm headwind in Q2 (15% of quarterly EBIT), with an almost 100% decremental
o Importantly, this does not even include most of the headwinds listed above as, despite the campus being closed for the last month of the semester, LOPE only refunded a portion (~$300 or roughly 40% of the month’s room & board costs) of the already paid for but unable to be utilized campus after an uproar amongst the student base
o Additionally, GCU charged their campus students full campus tuition rates despite having to transition them to the GCU online platform
Bottom Line: We believe that the current negative Q2 estimate revisions are only the tip of the iceberg based on partial refunds and the full scope of the earnings deleverage from COVID-19 will prove out once a new semester is underway
COVID-19’s Effect As A Forcing Function
We believe COVID-19 represents perhaps the strongest forcing function we have encountered in our investing careers
o What we specifically mean by this is virtually all universities and colleges will be forced over the summer to migrate (or at least develop a system) to online education. While universities did this in a haphazard way over the last two months, over the summer we will see a concerted effort by most universities to develop an “omni-channel” approach to their curriculum – namely being interchangeable between online and in-person schooling
o We believe this is a transformational moment in the history of Higher Education which will result in an almost immediate flood of online schooling options coming in the fall of 2021, which will immediately compete with and erode GCU’s core online product
§ https://hackernoon.com/how-covid-19-may-forever-change-the-way-professors-teach-8keh328c
We believe this will exacerbate the already rapidly decelerating trends we have seen in enrollments over the last 4 years and we forecast LSD to potentially negative enrollment growth in 2021E
Bottom Line: It is hard to overstate the level of change currently occurring within Higher Education. Universities must prepare to teach their students remotely, potentially even until 2022. This will result in a proliferation of online courses at a speed and scale that will likely be far in excess of any change experienced in the past.
The 2020 Election
The market is currently myopically focused on COVID-19, but we believe over the summer the attention will turn to Trump’s re-election odds, approval ratings, and polling, which all currently triangulate to tell a grim outlook
o Whereas virtually every state governor has seen their approval ratings skyrocket as a result of COVID-19, Trump has seen no such bump as his public gaffe’s, combative personality, and late decision making have outweighed the typical “wartime” polling bump
o Furthermore, Trump is losing by considerable margins in key battleground states where the economic outlook has deteriorated (i.e. Michigan, Pennsylvania) as a result of the auto / energy / etc. industrial declines
The risk of a Biden win presents a list of outcomes for the for-profit industry that range from ”very bad” to an existential risk
o For example, at the very least one would expect more scrutiny on marketing and recruitment practices amongst
o Additionally, democrat plans for education range from free community college / public university schooling (Biden) to potentially outright bans on for-profit’s access to federal funds (progressive movement view), which account for the vast majority of their revenues (LOPE is the single highest recipient of federal student aid funds in the country)
§ https://www.nytimes.com/2020/03/15/us/politics/biden-backs-free-college.html
§ What this will do is result in a significant squeeze on Grand Canyon University’s addressable market as they will not be competing with free offerings at comparable / higher quality universities in the first case. In the second case, it will result in the University going out of business
In the face of such risks, we would likely see LOPE’s multiple compress to the ~7.0x EBITDA level it was trading at during the 2015 / 2016 Obama administration as opposed to the current lofty 13x EBITDA multiple
The Orbis Story
Management has highlighted Orbis as having as a critical third pillar to their growth story. For some context, Mr. Mueller on the fourth quarter 2019 earnings call said:
o “This was the strategy most misunderstood and most underestimated by investors”
o “I'm so excited about the Orbis thing because it's amazing to me, the number of people that we've talked to that have previous arrangement with OPMs that did not work”
o “Orbis' growth has been greatly accelerated as a result of GCE's considerable support. Since we bought Orbis, six university partners have been added. And as of to-date we are up to 23 total university partners”
We thought it would be interesting to take a closer look at the “new partners” that LOPE was signing up to get a sense for quality and if the Orbis story was hype or real
Using Wayback Machine, we were able to compare the current list of partners to those at the time of acquisition. Since the acquisition in December 2018, Orbis has added the following six partners:
o Grand Canyon University (themselves)
o Harcum College (small community college of ~1,500 students in Pennsylvania)
o Felician University (small catholic college of ~2,400 students in New Jersey)
o University of St. Thomas Houston (small catholic college of ~3,000 students in Texas)
o University of The Incarnate Word (catholic college of ~10,000 students in Texas)
o Notre Dame of Maryland (small catholic college of ~2,200 students in Maryland)
We would hardly classify this as booming momentum or a significant driver of future top-line or earnings growth. We would certainly not describe them as Mr. Mueller did on the Q4 earnings transcript:
o Every new location opened represents an opportunity for GCE that has greater potential than most other OPM contracts in the space
o For the most part, these are tiny no-name catholic schools with tiny student bases already that Orbis is working with to launch ground campus-based accelerated nursing programs
o Claiming that these programs have higher potential than say, TWOU’s partnerships with Harvard and Princeton, is… an interesting perspective
Moreover, Mr. Mueller claimed GCU has “greatly accelerated” Orbis’ growth but is projecting Orbis revenue growth of ~30% in 2020, compared to 45% in 2018 and 2019. That is not the definition of accelerate, much less “greatly” so
Bottom Line: We believe management has significantly overhyped the Orbis acquisition. They have already guided to decelerating growth and still negative EBIT margins for 2020
o We would expect this trend of a continued deceleration in profitless growth in 2021 as LOPE continues to sign up tiny colleges to prop up top-line growth, all the while claiming “accelerating growth” and “the highest potential OPM contracts in the space”
o Along the way, they will no doubt justify their decision to continue to invest in this loss-making and structurally unprofitable business by highlighting the amazing new partners they are signing up (while not actually mentioning them by name) and always highlighting the incredible future profit potential
What Are Current Expectations?
The CEO, Brian Mueller, is hyper promotional and has often overpromised and undelivered
o For evidence of this, see his repeated statements regarding signing up an outside university to the GCE platform over the last two years
o Rather than repeat promises that a new partner was right around the corner for the 9th consecutive quarter, Mr. Mueller’s tone changed on the fourth quarter earnings call where he said:
§ We are less and less likely to do a deal for the sake of doing a deal and launching something, because of how well we're doing with our other three pillars [of our strategy]. It's -- the chances that something, a new deal that is not a great deal dilutes our current momentum, we don't want to do that. And so our own success is working against that fourth pillar a little bit.
§ So now its not that they can not find a university partner who will agree to an egregious revenue split, it’s that they are just doing so well elsewhere that they can’t be bothered
· To support this assertion, in our conversations with management they apparently did have deeper level conversations with a university partner but that partner would not budge off of a 50/50 revenue split (more in-line with industry) on purely online tuition, and discussions fell apart
In terms of Mr. Mueller’s recent promises, while the CFO has recently been quietly asking sell-side to start taking numbers down for the forward quarter, Mr. Mueller in both investor conversations and in local newspaper interviews has said momentum is unchanged
o In a recent interview with local public radio station KJZZ, Mr. Mueller stated:
§ Mueller said GCU doesn’t anticipate any enrollment dips like other Arizona universities expect. In fact, he said GCU may even see an increase in its traditional and online students
These statements, combined with the stock’s recent performance, lead us to believe that the security is pricing in no change in top-line trends and even potentially an acceleration
o For context, their guidance is for 6-6.5% enrollment growth at GCU this year weighted towards the back half of the year (~7.5%+ in back half)
Who is GCU’s auditor?
GCU, in their response to short seller Citron’s report on the Company, published a link to the University’s financial results which can be found here
o https://harvester.census.gov/facdissem/SearchA133.aspx
Though we have read Citron’s presentation and do not agree with all of it, we believe this disclosure raised several new and potentially even more alarming red flags
The most glaring of these revolves around GCU’s auditor, Weworski & Associates
o Weworski & Associates is a little-known microcap auditing firm (~25 total employees according to LinkedIn) La Jolla San Diego
o Weworski’s largest client historically was Corinthian Colleges, which was sued for consumer and securities fraud (among other charges) and filed for bankruptcy in 2015 in the highest profile for-profit school meltdown to date
o The only other University we have been able to find which uses Weworski as their financial auditor was “Crimson Technical College”, which was acquired and renamed Spartan College of Aeronautics and Technology. The University has a grand total enrollment of… 849 students
o This begs the question of why Grand Canyon University, an organization which had contracted Deloitte already for their “transfer pricing study”, would choose to go with Weworski & Associates as their auditor? One would think that a University with over 100k students and pulling in ~$1 billion of revenue per year would be able to pony up the ~$100k it would cost to get an (typically simple university) audit by a somewhat reputable firm, especially one that doesn’t have the obviously scarred past of Weworski
o While we do not have proof, it’s easy to understand the red flag this raises and how this can be used to manipulate financial statements and profit splits between LOPE and GCU
o We do not want to spend much time on this as our angle here is a fundamental short thesis on LOPE with a potential fraud upside kicker, but one easy way to illustrate how this auditor can facilitate financial misrepresentations can be seen in GCU’s reported Intangible Assets on the balance sheet
For the fiscal year ended June 30th, 2019, GCU reported $131mm of intangible assets on the balance sheet, up from $1 dollar at time of spin
o Why is this important? Because this, along with property value asset write-ups was responsible for over 100% of the “Net Asset” growth which GCU touts as a symbol of the private entity’s financial strength (and is used for DoE Composite Score calculations)
o Here is a juxtaposition of GCU’s intangibles balance versus other large universities per form 990s and annual reports
o Also, whereas these other universities are typically capitalizing software as intangible assets, GCU’s definition is very different per their Harvester filing:
o GCU appears to value their trade name and accreditations (which every university has) at almost $90mm of incremental Net Asset growth in the last year, and their “student relationships” at $26mm. Sketchy.
Bottom Line: Again, we are positioning our thesis on the basis of fundamentals rather than a smoking gun type fraud but we would be remiss to not at least note in passing such blatant red flags and highlight how their auditor is rubberstamping aggressive (to put it lightly) line items on their balance sheet. This is having the real effect of inflating the Company’s financial position and enabling management’s narrative that GCU is “healthy”
Recent Performance & Short Positioning
Recent Performance: Since the “coronavirus” declines in the stock market began, LOPE has significantly outperformed both its peer set and the broader market. In fact, it is one of the few securities in the market outside of the tech megacaps actually up. We believe this is likely due to its perceived “defensiveness”, an underfollowed security, a promotional CEO aggressively highlighting no impact to fundamentals (which the CFO quietly has the Street cut forward quarter estimates), and LOPE being the largest cap player in the space
o Note: performance measured since 4/21, which roughly coincides with the beginning of the market decline (SPX 3,334 that day) and to normalize for LOPE’s decline on disappointing earnings on 4/19 AMC
Technicals: LOPE’s RSI is approaching overbought, just under 70, and it is trading 12% above its 50 day MA
Short Interest: Additionally, short interest remains relatively low at ~6% of the float, meaning that this is not a crowded / squeeze-out potential security
Addressing the Bull Case
Taken directly from a letter from an HF long in LOPE, we will address each of their claims and stipulations
1) Enrollment trends doubled last recession!
a. We have addressed why we believe the COVID-19 pandemic will result in significant structural headwinds through online education proliferation above
b. Addressing this specifically, this is a “fun with numbers” game. GCU was a tiny university back then during a time when it was basically free reign on marketing by for-profits before the crackdown. It grew from 10k students to 20k. In other words, it was tiny. Doubling from such a low base is not meaningful when viewed within the context of a mature university with over 100k students currently
2) Sell-side estimates for $6.10 next year are conservative given the growth potential of Orbis
a. See above for our analysis on the true momentum of Orbis versus the story management is spinning to longs
b. Management believes that Orbis EBIT margins will rapidly rise from 0% ex amortization to 30%+. This fund also thought they would be at 10% this year yet margins continue to be at 0 (and that is actually slightly worse than last year when accounting for intangible amortization). This fund also believed broader EPS estimates for this year of $5.70 were “conservative” as well, before management proceeded to guide below on the fourth quarter call.
3) At 14.0x Consensus for 2021, this is simply too cheap for a Company growing top and bottom line over 10% annually
a. We highlighted above why we believe the growth profile of this business is about to dramatically change, with potential existential risks from a Democrat election win
b. We would also highlight here that valuing this on earnings ignores the abysmal net income to cash flow conversion (~50% over the last five years) driven by cash outflows to the physical university (payables / capex loan) and elevated levels of capex needed to maintain the University’s appeal to prospective students based on amenities
i. We believe that a valuation based on EBITDA or free cash flow is much more relevant than earnings given this noticeably deficient cash flow conversion, in which case this does not screen cheap whatsoever
Valuation
1) Upside Risk: We believe upside risk is minimal here given that the stock has outperformed the SPX, peers, mid-caps, etc. by material margins. Should Consensus EBITDA numbers of ~$355 hold for next year, we could envision the stock trading to $100 (~15% upside) which would equate to a lofty 14x EBITDA multiple and would necessitate a Trump election victory
2) Base Case: In our base case, we see enrollment growth slowing to a LSD rate (conservatively), which, combined with a necessary stepped up marketing expense (currently ~20% of sales) would result in EBITDA of $300mm. 2019E would therefore represent the peak EBITDA number for this Company as it enters into a new environment of hyper-intense competition. We conservatively model an EBITDA multiple in-line with STRA’s 9.0x EBITDA, which yields at $50 stock, or ~40% downside
3) Democrats Win Scenario: A Joe Biden win (or even the market beginning to price in the probability over the summer) would send this stock down precipitously. In combination with our base case EBITDA outcome above and a lower forward multiple, we model a ~$35 stock, or 60% downside
4) The Existential Threat Scenario: If Biden wins the election and a progressive candidate is installed as Education Secretary, we could see the stock fall to potentially zero (if GCU is cut off from federal funds). LOPE being investigated for fraud (see auditor section above) falls into this scenario bucket as well.
I and/or others I advise hold a material investment in the issuer's securities.
Catalyst
5) Q1 Earnings Report: Though we believe management has significantly manipulated Q2 earnings expectations downwards, we see scope for further downside and management will likely be asked to sensitize to the earnings risk of the campus not re-opening in the Fall (which as illustrated above, is not pretty)
6) Focus Turns To Election: As the focus turns to the election, we would expect to see LOPE and the for-profit space in general begin to de-rate and trade down into the event risk
7) College Campus Closures: We believe over the summer you will begin to see universities move to either hybrid or purely online learning models for the 2021 fall semester, which will accelerate online competitive offerings into the space dramatically
8) Q2 Earnings Report: We would expect a substantial miss on forward quarter guidance (Q2 is not as relevant from a seasonality perspective) on both enrollment trends and earnings
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