For-Profit Education Stocks Worth Monitoring Even As Government Implements Reforms

Shares of Apollo Group (APOL), the leading for-profit education company (think University of Phoenix), fell a stunning 23% Thursday to $38 after the company withdrew its 2011 financial outlook in light of upcoming changes to their industry. With the unemployment rate at 9.6%, enrollment at for-profit schools has been surging in recent years as people try to boost their resumes by completing online college courses and earning an associate, bachelor, or graduate level degree. As a result, the private firms running schools such as University of Phoenix have been minting money.

The interesting part of the story is that for-profit colleges typically get more than 80% of their revenue from Title IV student loan programs subsidized by the U.S. government. With taxpayers footing the bill for all loan defaults, the colleges themselves have absolutely no direct financial exposure whatsoever if students rack up thousands in debt and cannot repay the loans. As loan defaults rise, the U.S. Department of Education is finally taking notice and is set to release new guidelines for Title IV funding. As you may imagine, if lending guidelines are tightened, new enrollment at these colleges could drop off considerably. The new rules, set to be issued in coming months, are likely to set maximum default rates for schools who want to accept Title IV loans, as well as gainful employment guidelines to help ensure that students will actually have the ability to repay these loans based on the jobs they secure with their new degrees (a communications degree online, for instance)

The market’s violent reaction to the sector on Thursday was triggered when Apollo Group withdrew its 2011 financial guidance in anticipation of these new rules. For the first time ever, for-profit schools are going to have to scale back growth plans and actually become more than simply fierce marketing machines. Maximizing enrollment at all costs is no longer going to work. In fact, Apollo is now requiring all new students to attend an orientation program which spells out in more detail exactly what kind of financial commitment these degrees require. The company says that about 20% of prospective students voluntarily withdraw from the program after attending the orientation. In addition, the company’s admissions staff will no longer be compensated based on enrollment rates, as the company seeks to increase the quality of their students, thereby reducing loan default rates and boosting retention rates.

While there is no doubt that enrollment growth rates will tumble at for-profit colleges, it is far too early to pin down exactly how their businesses will be impacted by these changes. I think it is worth it for investors to monitor the situation carefully, as some values may ultimately be worthy of investment consideration at some point in the future (the stocks are already down a lot from their highs). In the case of Apollo, the company’s enterprise value of about $4.2 billion compares with fiscal 2010 EBITDA of $1.4 billion and free cash flow of nearly $900 million. At 3 times trailing cash flow, these stocks are already in deep value territory.

It will be important to see if scaled down marketing and increased financial awareness for students serves to merely slow down enrollment growth or also seriously cuts revenue and earnings for these companies. Exactly how much revenue is reduced and expenses rise will determine if and when these stocks reach a point where the risk-reward is worth an investment. At current prices it appears that the market is pricing in cash flow declines of 33-50% over the next 1-2 years. While possible, we surely do not know that kind of hit is a given at this point in time. If it proves overly pessimistic, shares of Apollo could become quite attractive, as the schools remain strong cash flow generators.

Full Disclosure: No position in APOL at the time of writing, but positions may change at any time.

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4 Thoughts on “For-Profit Education Stocks Worth Monitoring Even As Government Implements Reforms

  1. One can go on and on about how dirt cheap these stocks are…. but according to me, the reason they are cheap is the whole for profit school is a gigantic FRAUD.

    See the employment statistic put out by all these companies…. after that, compare them with the employment statistics of ivy league schools here:

    http://www.businessinsider.com/unemployment-by-mba-program-2010-10

    I am sorry, but no way Devry or University of Phoenix can have employment opportunities better than any any of the schools listed there (and they claim to be better to investors and prospective students). Isnt it a fraud that all these companies are goosing employment statistics to attract all those new students? Hey, wasnt Lehman, WaMU and likes trading at 3-5x before the collapse and the fraud they were committing got unraveled.

    If you want to go cheap go after MSFT or INTC or CSCO which trade at same multiples…

  2. Chad Brand on October 15, 2010 at 2:07 PM said:

    @Joe:
    I don’t think “fraud” is the right word. Were the marketing tactics these schools used too aggressive and misleading? Sure, we can assume that and the fact that the schools had an incentive to focus solely on maximizing enrollment undoubtedly contributed to it.

    Comparing a school to a leveraged bank seems like apples to oranges to me. The education industry will likely remain very profitable, it is just a matter of how much their businesses shrink after they actually take it upon themselves to be more forthcoming with prospective students and try to increase the quality of the enrollees.

    After it becomes more clear what levels of profitability these schools can attain, we will be able to better value them. I guess where I would disagree with your premise is that I actually think these schools have a place in the market, even though their degrees clearly are not worth the same as a top non-profit university, just not as pronounced as in recent years. It will be interesting to watch.

  3. According to me a student chooses a particular school coz
    a) Expertise in a particular area and Job prospects which come along with it
    b) Cost
    c) Location

    People strive to get in to Harvard MBA mostly for job prospects. If Harvard had 1% employment rate, with the best infrastructure, professors etc, would people be willing to shell out $100k/year? Absolutely not. If, however, Harvard gooses numbers and says every student has 3 job offers when they graduate, student will overlook all deficiencies and shell out $100k in a heartbeat.

    According to me, enrollment in all these for-profit will plummet if true numbers come to light. Not to mention all those lawsuits which will come up for misrepresentation etc….

    As a comparable situation, even Moody (MCO) is cheap…. Strong competitive moat and they have a place in the marketplace. they didnt do any fraud. So why is your guru dumping it?

  4. I’d agree with Joe here except for the last part about Moody.

    According to me the rating agencies are as responsible for the troubles in the financial sector as much as the banks themselves.

    They may not have caused it, but they were either aware of it and didn’t blow the whistle (red flag) or were not aware of it (tripple red flag!).

    Yes, the for-profit education here is having problems that are very similar in nature to the ones that the banks had. I don’t think it’s apples and organges.

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