|Shares Out. (in M):||24||P/E||14||13.6|
|Market Cap (in $M):||2,348||P/FCF||17.3||13.1|
|Net Debt (in $M):||-645||EBIT||216||234|
|TEV (in $M):||1,703||TEV/EBIT||7.9||7.3|
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Overview and Opportunity
Strategic Education (STRA) is a $2.2B market cap operator of for-profit universities created in late 2018 through the merger of Strayer University and Capella University. Shares sold off 30% following 2Q earnings due to a nightmare guide on 3Q new enrollments (-28%), dilution for an acquisition of LAUR’s Australia/New Zealand portfolio, and growing regulatory concerns heading into election season. Since then they have continued to trickle lower, and today are down ~50% from July highs. Despite that, we believe STRA has two durable franchises in US higher education that are building sustainable differentiation on student value (time to degree and cost) and quality of online offering. As such we believe the Street has missed the mark on this business due to temporary headwinds and see 42% upside in our base case.
Strategic is made of two US colleges that merged in late 2018. Strayer University teaches ~54k students, 95% in an online format. 80%+ of students pursue undergraduate degrees and the most popular courses of study are Business Administration (75%) and Criminal Justice (12%). 92% of students are part-time with an average age of 34, 72% are female and 75% are people of color, so they are educating historically underserved communities. Strayer also has 78 campuses nationally, primarily across the East coast and Southeast. Capella has 39k students and is 100% online, 74% of students are part-time. Studies are focused on graduate degrees, 50% of students are pursuing their Master’s and 22% are pursuing Doctorates.Demographics are similar across the two schools- Capella’s average age is 38, 81% of students are female and 50% are people of color. In 2019 Strayer did ~$0.53B of revenue while Capella did ~$0.46B, margins are similar across both schools with ~48% gross margins and ~20% EBIT margins.
Higher education as an industry has been quite challenging over the last decade. As concerns over the value of a college degree and the burden of student loans have grown, total post-secondary enrollment has declined 5-10% since 2010 and for-profit enrollment is about half of what it was then. The important thing to understand, however, is that this is primarily driven by institutional closures rather than general headcount reductions across all universities. From a high of ~400 for-profit universities in the US in 2012 we’re down to about 190 today. The major driver of this has been Federal regulation and state AGs targeting bad actors in the space. The poster child of this is Corinthian Colleges, which is now a pelt on Kamala Harris’s wall from her time as California AG.
Strategic has not been immune from these pressures but has adapted to the times and has steadily grown enrollment over the last 6-7 years. In 2010, Strategic was very much a box model, where the biggest driver of enrollment growth was new campus openings. Nearly 50% of classes were taken online, and like the rest of the industry tuition was growing at 5-7% per year. However, as the industry came under fire STRA realized they needed to pivot and shifted their strategy to focus on strengthening their online offering and delivering excellent student value, measured by time to degree and total cost. After bottoming out in enrollment in 2014, the business cut tuition by 10-15% (versus price inflation of ~30% at community colleges in the same time), shut down 20 of their ~100 campuses and grew online registrations to 95% of all classes. As a result of these initiatives Strayer has returned to steady growth, with enrollment CAGR’ing at 4.7% in that time.
Putting this together, we believe STRA is well-positioned to continue building on their success in a post-COVID world through their differentiated value proposition for students. Management is focused on continuing to build their lead on these vectors and the company’s key initiatives today include:
FlexPath: A Capella-exclusive offering that separates credits from time in classroom, allowing students to move through course at their own pace and pay by quarterly subscription rather than a fixed cost per credit.
40% of students move through FlexPath curriculum faster than peers in the traditional model and persistence is 23% higher. The fastest decile of the class finish their degree in one calendar year.
Sophia Online Learning: Self-paced, subscription model online learning focused on GenEd courses. Credits are available for transfer to 2,000+ universities.
130k total subscriptions after making the product free in March of this year. Management expects 300%+ revenue growth in 2021.
Graduation Fund: Undergraduate students at Strayer University earn credit for one free course for every three courses that they complete. These can only be redeemed in senior year. Few students make it that far but for those who do the last year of schooling is free.
~$50M accrued in deferred revenue for recognition during senior year of students progressing with Graduation Fund credits.
SEI Studios: Partnered with documentary filmmakers to increase engagement in the most commonly taken courses with episodic, documentary-style films.
Greater than 80% of students finish watching course materials vs ~25% in traditional recorded format.
Employer Solutions: Corporate partnerships with companies like Aetna, Best Buy and CVS to enable employees and their families to earn degrees with corporate sponsors.
20% of current enrollments, target of 30% for 2021, diversifies funding away from federal loan funding.
Point 1: The rapidly improving macro environment minimizes the impact of the miss on 3Q new enrollments.
From 2006-09 Strayer posted average new enrollment growth of +20% per quarter. As a result of these excellent results, the Street viewed this as a countercyclical business where working professionals would return to their education in times of economic distress. Due to this perception, the stock greatly outpaced the broader market during the COVID trough (-25% vs SPX -35%) and recovered much more quickly (back to pre-COVID price by beginning of May vs SPX -15% at the same time). The -28% guide then completely blindsided investors and drove the violent sell-off that created this opportunity. In reality, from ’06-09 Strayer growth was primarily driven by opening new boxes as they doubled their campus footprint (40 to 80 locations) in this time. The new enrollments were just a result of positive comps not countercyclicality.
To better understand this business we need to understand their students. Most are women with full-time jobs and potentially family obligations. They are attempting to further their education on the side, but this is not their top priority. The degree is a discretionary purchase that is worth the investment only if their employment is stable. As a result, the most important driver of the new enrollment picture is the macro environment- new enrollments have a -0.81 correlation with unemployment on a one quarter lag. Today unemployment is down to 6.7% from almost 15% when that negative print was cut. In previous periods of 6-7% unemployment, STRA has printed enrollments in the range from -5% to +10%, so we believe investors have fled from STRA precisely as the story is turning.
Break that down a step further, we first need to discuss the enrollment model at STRA. The university (like all for profits and community colleges) sees very high churn in its first year (according to the Department of Education’s College Scorecard nearly 2/3rds of students at similar universities churn in their first year) but those who make it through tend to stick around, which leads to long enrollment tails from prior quarters. This minimizes the impact of any single quarterly miss on enrollments. Additionally, the 3Q print came in STRA’s summer term, which is the smallest term and we believe just 18% of annual enrollment. These factors combined with the rapidly improving macro backdrop lead us to believe that STRA new enrollment results will bottom out in 3Q/4Q and the business will be back to growth by 1H22. As a result, we are 3-5% above consensus enrollment in the next six quarters.
Point 2: STRA is an experienced operator in the current regulatory landscape and the ‘Biden plan’ is boundable based on recent history.
We believe regulatory concerns around the for-profit education industry are overbought. Stayer and Capella are Title IV schools (eligible for federal student loan funding) and as a result are overseen by three regulators: the Department of Education, state regulators and their accreditation bodies. Strayer is accredited by the Middle States Commission on Higher Education and Capella University is accredited by the Higher Learning Commission, these are two of the six recognized national accreditors and are unquestionably legit. Other schools they oversee include Columbia, Penn and Georgetown to cite a few examples. In terms of DoE oversight, the criteria for eligibility for federal funds includes a handful of specific regulations:
3 year cohort default rates must be below 30%
No more than 90% of revenue can come from federal financial aid (the ‘90/10’ rule)
Maintenance of capability to disburse and manage federal student loans
Maintenance of sound balance sheet
Cannot pay bonuses based on student recruitment
The two most important rules in the current framework are the 3 year cohort default rates (percentage of students who default within three years of graduation/departure) and 90/10 rule on funding. STRA is safely operating within both boundaries. Default rates are just ~7 and 10% respectively at Capella and Strayer and have been trending downward in recent years. On the 90/10 rule, neither school has derived more than 82% of revenue from financial aid in the last eight years and this should continue to trend downward as employer sponsored enrollments grow. For what it’s worth, Strayer has been accredited for nearly 50 years and we found no evidence of any sanctions during that time.
Obviously there are some concerns about the go-forward regulatory environment, but investors have a clear blueprint for what the base case should look like. The first point of Biden’s plan is a “return to the Obama-Biden Borrower’s Defense Rules’ which were put in place in 2016. The major changes of these rules included additional coverage ratios on debt payments vs students’ income, and the ability for students to contest their loans in the event that they were materially misled in their enrollment decision (called the Borrower’s Defense to Repayment). The Trump DoE did repeal these rules, but didn’t get around to it until 2019. As a result, STRA lived under those restrictions for 3+ years without issue. The DoE tested the 2015 cohort on the coverage ratios and all Strayer and Capella programs passed; three programs fell into the warning zone, but in order to face any sanctions a school must fail for multiple consecutive years, and the further progress on cohort default rates gives us confidence that outcomes have likely improved in the last three years. On the BDTR, neither Strayer nor Capella have had any incidents.
The only potential new regulation that Biden’s plan mentions is eliminating the ‘90/10 loophole’ through which VA funds are excluded from the 90% calculation. Historically unscrupulous universities have abused this loophole by packing their student body with veterans to maximize federal funding, but Stayer and Capella have made conscious efforts to diversify funding from veteran programs. The schools don’t report how much funding they derive from the VA, but according to our estimates ~7.5% of Strayer’s students and 14% of Capella’s students would have to be veterans for an amended 90/10 rule to come into play. The share of veterans by university is actually disclosed in the DoE Scorecard, and Strayer is at 1.4% with Capella at 4.5%- plenty of headroom however you look at it.
The absolutes are obviously critical here but as a final point it’s worth considering STRA relative to the predatory universities that have been shut down. We compared STRA’s results to those from four universities that have since closed (including Everest, a Corinthian university, and ITT Tech), and it is clear that STRA is delivering substantially better student outcomes. STRA default rates were 14% vs 21% for the shut down universities and the median earnings of STRA graduates were almost double that of the shut down universities ($54k vs $28k). Finally it is worth noting that STRA has continued to improve, and default rates are down to 7-10%, while median earnings are up ~5% to $56k.
Point 3: COVID has served as a catalyst for changes that will drive upside to business-as-usual.
There are two specific vectors where STRA has seen business improvement in the wake of COVID. First, their Sophia Online Learning Platform saw a whopping 130k users sign up as they made it free in the wake of COVID. After re-monetizing the platform via a monthly subscription fee of $89, STRA has had 13k users continue. Management has guided to $12-16M of incremental high-margin revenue, which would be 300%+ growth in 2021. Sophia is a platform with broad appeal outside of STRA’s traditional customer base, it is yet another avenue where they can win through differentiated online capabilities and take share from community colleges.
The second vector is that Strayer has moved 100% of courses online, which greatly reduces the need for the existing real estate footprint. As mentioned earlier, today Strayer has 78 campuses. Management has announced $8M of cost-out through a reduction of that campus footprint, which covers just 22% of rent. By our estimates they are likely closing just 15-20 campuses. Given that even before the pandemic 95% of courses were taken online, we believe further reduction of the campus footprint is achievable and offers $6-10M of run-rate savings. In particular, the legacy campuses that date back to the pre-GFC era are large footprint buildings with lecture halls that our primary research indicates get little use. The newer buildings STRA has opened are 1/3rd to 1/10th the size of these facilities and are a far better fit for the business model today.
Free college for all- Has lost its teeth as it has evolved to focus on making two-year community colleges free. This would be a larger impact on Strayer than Capella, but today only 3% of Strayer students pursue Associate’s degrees. Strayer also boasts a high-quality fully online program which is a competitive advantage for serving full-time workers potentially with families. Finally a Democratic loss in either of the GA Senate run-offs likely takes this off the table for the next two years, and given the recent history of new president’s parties in midterms potentially longer.
Student debt holiday- This has been gaining steam in recent months and may be achievable via an Executive Order. We think this is a positive for STRA students and has little to no impact on the company unless packaged with broader reforms. If anything, this could accelerate demand if students’ concerns around debt are alleviated.
STRA’s capital allocation has by no means been a disaster, but there is room for improvement. Management has said that they aim to keep $10-12 of cash per share on the balance sheet for regulatory purposes, however, in the last three years they’ve consistently been between $15-22. They finally put some of that capital to use earlier this year by acquiring Torrens University from LAUR. Torrens is the only for-profit university in Australia and the forward guide for 2021 was extremely strong, but at 16.4x LTM EBITDA there are valid questions if that was the optimal use of capital.
There is reason for optimism on this front. First, management expanded the buyback facility in 4Q19, something they had not done in years. Second, management has consistently cited a desire to be strategic with timing as a reason for limited buybacks, today certainly represents an attractive opportunity. Finally, in a 13D earlier this month Jeff Ubben’s new fund, Inclusive Capital, disclosed a 5.6% stake in STRA, making them the fifth largest holder and largest non-passive/long-only investor. We like the risk-reward here even if we don’t unlock any value off of the balance sheet, but if we get positive inflection on capital allocation (which is more likely now than at any time in recent memory) we believe this turns into a no-brainer.
In our base case we believe STRA is likely to do around $8.10 of EPS in 2022, at a 16x multiple (the midpoint of 14.5x in Obama’s second term and the ten year average of 17.5x) this is a $130 stock, 40% upside inclusive of dividends. We’ve got topline up 21% in ’21 (-1% organic) and +4% in ’22 as STRA cycles the smaller enrolled classes in the back of ’20. It’s important to note that revenue is a trailing indicator for this business. The Street is already pricing in several quarters of -20% new enrollment figures, we think as we get results that surprise to the upside the stock moves higher in anticipation of the recovery in ’22.
In our downside case, which we view as very draconian, this is a $68 stock (23% downside). In this case we’ve assumed ’22 enrollment is 14% below our base case, which would be good for a ~21% decline in enrollment, similar to what Strayer saw in ’13 as they were shutting down a fifth of their campuses. We’ve also baked in 10% further pricing pressure at Strayer and have put a 12x multiple on our $5.70 of EPS. This is a multiple STRA only touched briefly at the height of regulatory pressure and uncertainty toward the industry’s future in ‘13.
In our bull case, we see a slightly quicker recovery in enrollments (topline +5.5% in ‘22) but most of the incremental upside is driven by capital allocation. We’ve modeled STRA buying back 6% of outstanding shares at an average price of $105, this leaves the balance sheet in a net cash position and the company with ~$11 of cash per share on hand, the midpoint of their stated target. On our new EPS of $9.27/share at an 18x multiple we get to 80% upside.
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