|Shares Out. (in M):||24||P/E||3.8x||4.0x|
|Market Cap (in $M):||759||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||-17||EBIT||0||0|
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This recommendation is as much about a sector as it is about a stock. I have been shorting the for-profit education sector for a long time. Now it is time to buy it.
ITT Technical Institute, as everybody has heard of, is a leading provider of postsecondary degree programs in the US, with 66,000 students currently enrolled. They have 150 college campuses across the country offering master, bachelor, and associate degree programs. ITT Technical Institute has been providing career-oriented education programs since 1969.
You can buy an established, 43 year old, stable, geographically diverse, brand name business with high margins, low cyclicality, no foreign exposure, a defensible market position and a network of established campuses across the country, in a growing industry for 3x earnings. Earnings are all cash and, except for the last couple years, have grown every year, forever. (Even including the recent pull back in results, earnings have grown 800% since 2000.) They have a net cash balance sheet, earnings are all cash with no cap ex or working capital requirements, and they spend 100% of their net income on share repurchases. Plus, the earnings will very likely prove to be a secular and cyclical low.
This is a really cheap stock.
My experience with the industry goes back a decade and a half to the Computer Learning Centers and Sylvan frauds, right up to the current batch of for-profit education stocks. Up to now, I have only been on the short side of these POS’s. I certainly can’t say I haven’t left some money on the table on the short side, but regardless, I know the sector well, and I know a perfect stock opportunity when I see one. And I know when the stock market becomes blind to a perfect opportunity, after years and years of bad news. (What was your reaction to the name?)
The companies in this sector seem to always succumb to the temptations inherent in a system where “someone else” (the Federal Gov’t) pays the bills and results didn’t really matter much. With low accountability, and an often ignorant consumer who doesn’t need to put up much or any money, the sector was rife with dubious business practices and fraud.
However, these things have changed or are changing. The government has cracked down on suspect business practices and put new regulations in place to ensure proper accountability -- like loan default limits, debt/income metrics limits and guidelines for recruiters. Student retention has also come under scrutiny by regulators and accreditors. Also, after a lot of bad publicity, consumers are now very wary, appropriately, of these schools and of taking on student loan debt.
The result of the regulatory changes and negative media attention has been a dramatic drop in enrollment across the industry, margins have compressed, competition has intensified, and many programs have closed or are in the process of disappearing. The sector has clearly been split into winners and losers, with the losers still trying to adapt.
Here is a link to the recent Congressional report criticizing the industry. (Two years too late of course. The political debate already happened and the new regulations haven already been put into place.):
Here’s an old baron’s article about ESI:
Here is a link to useful background info on recent events:
“These schools are all a scam”: False. Unless you are also saying that all second and third tier universities in the country are all “scams,” in which case I would agree with you, on both counts. Yes, there have been frauds in the industry -- many. Yes, they have admitted students who weren’t prepared for school and had no real chance of graduating, have passed students who didn’t deserve it, because they have financial incentive to do so. Yes it’s wrong, fraudulent and a waste of taxpayer money. Is it entirely the school’s fault if someone who wasn’t prepared for the work wanted to go to their school? Is Weight Watcher’s a “scam” because they don’t refund your money when you don’t stick to the diet? Does it matter? No, not really, as long as these schools stay within the new regulations, which address these and other issues. Ultimately, the schools must do a decent job in order for them stay within the default and job placement targets, plain and simple.
Too much regulatory risk: False. This was true three years ago. Given the new regulations that were finalized last year, after many years of intense political and media scrutiny, this is no longer a “risk.” Right now, we actually have full clarity on the regulatory landscape. The new rules were proposed three years ago and were slated to go into effect July 1, 2012, though a judge struck down part of the regulation. The department of education will probably appeal. Either way, when the rules do finally go into effect, we know what they will look like and it will take three years of performance before schools are even evaluated for violations. The regulatory landscape is clearer for the foreseeable future than it has been in many years.
While the discussions still go on about student debt, and the data keeps coming out about defaults, there are no new significant regulatory changes being considered. The only things being talked about right now by lawmakers are “ensuring borrowers have the tools to manage their debt.” At this point, the lawmakers are waiting to see how well the new rules work at keeping schools accountable, and that will take many years. Plus, some of the new regulations could potentially even be undone under a Republican administration.
What if they cut funding to these schools? That won’t happen. Nobody wants to prevent the millions of legitimate, current and future students of these schools from having access to education. These schools are too valuable to our educational system, as indicated in the government’s own report, and serve too many students to be targeted for more fundamental changes.
Enrollment is declining: Yes, it has been declining for the past couple years. The new rules and the schools’ new focus on student retention and student outcomes has obviously made it impossible to take all the students they were taking before -- which is for the best. And the recession has made potential students much more reluctant to invest in a new career without known job prospects. However, enrollment declines have already stopped at some of the best schools. APOL actually grew last quarter, and ESI thinks they will flat line next quarter, or at least be close to it. As we anniversary last year’s and this year’s declines, we can already see where the winners are going to level out. Others, like some of the offerings from COCO and EDMC for example, without defensible market positions, brand names, physical locations, or economic product offerings will disappear, as intended.
The new regulations will hurt their profitability. Yes. The results actually already reflect it though – keeping in mind that each year’s enrollment class shows up in results for several years.
Existing schools are starting to compete more, especially online: Their offerings are simply not significant, especially for trade skills.
But student loan data keeps getting worse: Yes, that is true for everybody, not just for-profits. As long as unemployment stays high, many people won’t be able to pay their loans, regardless what school they went to. The problems in this country with expensive tuition are in no way unique to for-profits. Not to mention, that on a static pool basis, the last couple years of loan delinquencies at for-profits are much better than three years ago – which appears likely to remain the industry’s worst.
What’s to like now?
It turns out, for the winners, right now, pretty much everything.
1) Industry: Lost in all the noise about the problems with the industry, is the bigger picture: this is a growing, dynamic industry that is at the forefront of a revolution in education in this country.
- Not only do these schools have a place in education, they are actually the future of it in many ways. The high price of many universities in this country has spurred a reassessment of priorities for many people, and for-profits are filling the enormous holes in our educational system.
- A large and growing population of students entering the education market – particularly working adults, part-time students, and students with children – are increasingly demanding the kinds of services offered by these schools: flexible scheduling with year-round enrollment, online options and better use of technology in every aspect of student life, small class sizes and convenient locations.
- More students are recognizing the need for real world trade skills and are getting increasingly “realistic” about education and job prospects. ESI offers trade skills and job specific programs not available at “normal” schools, e.g. homeland security, health IT, drafting and design, corrections, and electronics technology.
- Growth at ESI and other for-profits has not just been about “deceptive marketing.” Enrollment has been growing about 6% annually at for-profit schools for the past 20 years – 225% cumulatively. Today these institutions enroll about 12 percent of all postsecondary students, about 2.4 million as of 2010-2011 academic year. It’s actually the expensive, undistinguished, mostly liberal arts universities that face an uncertain future.
- Even in the most critical government reports about these schools, they acknowledge the indispensable role for-profits are playing both in educating students and in shaping the industry.
2) Product: despite all the negative publicity, most of these schools have a great product and their students tend to be extremely pleased with their degree and their schools. Talk to employers. Read the surveys conducted of different schools’ graduates.
3) Competitive Tuition: despite the mostly misguided criticism of their high tuition, they actually charge way less than most private universities. These schools are generally priced “around” the cost of state universities, about $18K per year. This is much lower than the $50K per year it costs for a potentially equally “worthless” degree from all the second- and third-tier private non-profit universities in this country. Yes, more expensive than community colleges, but that’s not a fair, or relevant, comparison most of the time.
- For all the criticism about student debt problems aimed at these schools, it seems strange not to mention the millions of people in this country burdened with the same debt from State Schools or from even more expensive “non-profit” schools. Few have been so critical of the annual double digit tuition increases we’ve seen at practically every university across the country for the past decade.
4) Accountability: unlike a normal non-profit university, for-profits are now fully accountable for their results (and the trade schools tended to be the whole time). The value proposition is very clear to prospective students.
- The schools now have to tell prospective students the average salary and job placement rate for all recent graduating classes, for every major. I don’t know of many “normal” universities that tell prospective students these things.
- For-profits tend to have a much more comprehensive enrollment-to-job-placement system in place than most normal universities.
- For-profits continually design and offer classes based on specific jobs, and then cultivate local employer relationships. They continually monitor real world needs, and quickly and efficiently design and offer classes to fill those needs. How many non-profit universities offer courses for jobs in homeland security? And how long would it take to implement if they wanted to?
5) Positive Impact of New Regulations: While the new regulations governing for-profit schools have had a negative effect on enrollment, they are having the intended consequences. Schools seem to be getting more accountable, they claim that persistence is creeping up and defaults have been getting better across the industry the last two years. In time, these things will also help change sentiment toward the industry.
- Keeping dropouts down will also begin to offset some of the lost revenue from lower enrollment and added expenses of student support.
6) Enrollment trends. The new regulations have now been finalized for over a year, and the industry had been preparing for them for a couple years previously. For the industry winners with the right product offerings and student support, ESI and APOL for example, business is already stabilizing. Accomplishing this in the face of all the negative attention and still high unemployment is a remarkable testament to the strength of the industry. (Though other companies, like EDMC, may never recover.)
7) Business models. These schools produce an enormous amount of cash. They have low cap ex, and low or no working capital, so earnings are usually all cash. And when they are growing, due to the negative working capital created by the front-loaded tuition, they produce even more cash than earnings. And without any use for the cash, they tend to buy back a lot of stock or, like STRA, pay a big dividend.
ITT Technical Institute:
Shares Out: 23.5
2012 EPS estimate: $8.50
2013 EPS estimate: $8.00
P/E 2012 = 3.8x
P/E 2013 = 4.0x
I would also add “receivables” to cash. These are loans to students to make up the difference of what other loans and grants don’t cover. These are interest bearing and net of allowances. And even if you don’t want to give them credit for these investments as cash, it doesn’t matter, because they are in the process of finalizing a new third part loan facility that will be making these loans. Their receivable balance will then be sold for cash to this facility, or run off, and the new facility will be making these loans. Either way, this cash will show up on the balance sheet (and they will lose the interest income). They also made another $2/share in the quarter that ends September 30, so we can add that to cash too.
Adjusting for cash, receivables, and this quarter’s net income:
Adjusted Price: $26.50
Adjusted 2012 P/E: 3.2x
Adjusted 2012 P/E: 3.4x
ESI has bought back 38% of their stock in the last 2.5 years alone. They have literally spent every dollar of their net income for the past four and a half years buying back stock. But they haven’t previously had a chance to buy back stock at 3x earnings. So, the impact will be enormous if they keep doing it.
In one year, ESI will have 43% of its stock price in cash. In two years, they will have 68% of their stock price in cash. If they continue to buy back stock, they will have no shares left outstanding in just over three years. The stock could go up 25% tomorrow and the P/E would still only be 4x.
And all of that is before we consider the fact that we are probably at the secular bottom, cyclical bottom, political bottom, loan default bottom, job market bottom, publicity bottom, and earnings bottom.
And 35% of the float is currently short. Which keeps going up, simply with the buy-backs.
The valuation alone is the catalyst. Plus the cash piling up and share buy-backs.
Also, if enrollment flattens this quarter or next as expected, if the economy picks up, or if the media simply stops reacting hysterically every time new student loan data comes out, the stock will probably triple. If it ever comes out that these schools are actually doing a great job, all hell could break loose.
The valuation alone is the catalyst. Plus the cash piling up and share buy-backs.
Also, if enrollment flattens this quarter or next as expected, if the economy picks up, or if the media simply stops reacting hysterically every time new student loan data comes out, the stock will probably triple. If it ever comes out that defaults are actually improving, all hell could break loose.
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