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Big profits, big risks in 6 education stocks
A rapidly changing job market means more time-crunched adults are looking at online degrees. As stocks, though, these for-profit colleges require close study.
By Jim Jubak
Investors who jumped on surging education stocks earlier this year may have received a painful lesson from the school of hard knocks.
Education stocks -- more precisely, the shares of for-profit companies specializing in using the Internet to deliver post-high school education -- posted blistering returns from late February last year to late February this year. During that period, the Nasdaq Composite ($COMPX) climbed 51%, but the shares of three education stocks did even better than that:
But the last month or so has been a very different story. ITT Educational Services has plunged 47%. Education Management has dipped 6%. Strayer is up slightly. The Nasdaq, by comparison, fell about 2.3%.
What happened?
In ITTs case, what happened was a federal investigation into its business practices. On Feb. 25, U.S. Postal Service inspectors and local county sheriffs executed search warrants and shut down the companys corporate headquarters and 10 of its 77 campuses. The company, the largest U.S. operator of post-high school technical schools, said that grand jury subpoenas issued by the U.S. District Court in Houston sought data on student placements, retention, salaries earned by school graduates, recruitment and admissions. U.S. Attorney Michael Shelby of the Southern District of Texas so far has said only that charges have not yet been filed against the company.
Class-action lawyers have drawn their own conclusions in lawsuits theyve filed against ITT Educational Services. The lawsuit filed by Milberg Weiss Bershad Hynes & Lerach alleges that the company has committed securities fraud by falsifying enrollment, graduation and job placement rates; by using those falsified records to secure federal grants; and, finally, by reporting inflated revenues thanks to those falsifications.
Welcome to the wonderful world of investing in for-profit education, where the very real promise of the sector is exceeded only by the potential that an individual stock will blow up. I think the potential of the sector is so huge, though, that its worth trying to find a way to navigate your way through the minefields.
First, though, the big picture that makes it worth going to the trouble of figuring out this sector in the first place.
The big picture
Lets start with market size. UBS Financial Services has calculated that for-profit, post-high school education companies can count on a potential market of about 17 million adults in the United States. The market, according to UBS, is made up of adults 25 to 44 with incomes between $35,000 and $75,000 a year. Theyre married (and often have children), they work full-time and they have Internet access.
These workers are considered the target market because they face the full brunt of the changes now sweeping through the economy, from outsourcing to the continued move away from manufacturing. In addition, they have the incomes to afford the training in business, education, nursing, technology, criminal justice and the like. But they dont have the luxury of quitting their jobs to enroll in full-time education programs. Internet-based instruction, which can be tailored to the pace of an individual student, is particularly appealing to this group.
And its the economics of the Internet that make the stocks in this sector so attractive to investors. The traditional brick-and-mortar college or training school has to increase its investment in classroom space and other physical facilities and hire more teachers to serve more students.
Internet-based educational programs do add costs as enrollment rises for things like additional Internet infrastructure and for additional instructors to interact with students and monitor their performances. But the variable costs of Internet-based instruction rise much more slowly with increased enrollment than they do in the brick-and-mortar model. Expansion for Internet-based education is a route to increased profitability.
That produces some eye-popping numbers.
UBS projects that revenue at Career Education (CECO, news, msgs) will grow at a compounded rate of 55% annually over the next five years. The economics of the Internet, however, will drive profit margins from a current 31% to a target 45%. The increase in projected profit margins is even larger at other companies, UBS projects. At Corinthian Colleges (COCO, news, msgs), it will go from 20% now to 40%, UBS estimates. At Educational Management, profit margins will go from 10% to 40%.
Web-based training = bigger profits
One reason for this big difference is that education companies such as Corinthian Colleges and Education Management have just begun the transition to Internet-based programs. According to Lehman Bros., only 1.9% of Corinthians students and 2.4% of students at Education Management are online students. Compare that to 15% at Career Education and 41% at Apollo Group (APOL, news, msgs), the Phoenix company that operates the University of Phoenix and related colleges.
Of course, there are a lot of assumptions baked into this plum pudding. For example, to pay their tuitions, most of the students attending these schools borrow from the federal government. That means changes in federal regulations can easily roil this market. The likely repeal of the 50% rule (which requires that an educational institutional have 50% of its students attending classes on an actual campus to qualify for federal loan money) would benefit a company such as Strayer that, at 45% online, is now brushing up against the limit. But the repeal would also attract more competitors into the field by making it easier to set up Internet-only programs. (Apollo and Career Education are currently exempt from the restriction under a special waiver.)
Even something as straightforward as an increase in the federal money available for loans under Title IV, the basic federal student aid program, can have unexpected consequences. Another rule, the 90/10 rule, requires that an educational institution get at least 10% of its revenue from non-Title IV sources. Corinthian Colleges, as of its last fiscal year, was near the limit at 82% of revenue. More money borrowed by more students might push the company over the limit.
The jury is still out on value
But perhaps the biggest assumption in any projection of the potential market is that customers -- students -- will find the education and training they purchase from these companies valuable in the market place. Here the jury is still out: Theres no reason that Internet-based educational offerings have to be of lesser quality, but the for-profit educational sector continues to be plagued by problems of overpromising and underdelivering in the opinion of some students.
On March 1, a former Corinthian College student in Florida sued the company, claiming that she had been misled about her schools accreditation and her ability to transfer credits to another school. Any projection of the size of the market or the growth rate at these companies clearly depends on customers opinion of the quality of the product.
Thats the macro picture. Now lets get down to how to judge individual companies in the sector. Heres my list of the six most interesting companies in the sector:
| Six 3-R stocks to consider | | Company | Price 3/26 | P/E ratio | StockScouter rating | | Apollo (APOL, news, msgs) | $85.94 | 59.9 | 8 | | Career Education (CECO, news, msgs) | $55.16 | 44.7 | 8 | | Corinthian Colleges (COCO, news, msgs) | $31.20 | 36.4 | 9 | | DeVry (DV, news, msgs) | $29.29 | 39.2 | 6 | | Education Management (EDMC, news, msgs) | $30.91 | 35.1 | 8 | | Strayer (STRA, news, msgs) | $111.87 | 49.6 | 7 |
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I think the best way to judge these stocks is to ask, If I were interested in acquiring one of these companies as a business, what would I look for? Heres my five-point checklist:
Steady or, better yet, rising placement rates. A company that is placing 85% or more of its graduates in jobs is delivering a quality product. The data should be available in a companys financial reports.
Steady or, better yet, rising retention rates. Schools should be keeping a significant number of students to the end of their course of study. The definition of a good retention rate will vary with the type of educational program, but look for a retention rate of 60% or higher in degree programs and 70% or more in certificate programs.
Solid organic revenue growth from ongoing schools. You want this rather than just growth from acquisitions. Adding more revenue by buying new business can cover up big problems with ongoing operations. Pay special attention to this when analyzing the stocks of companies that have a strategy of aggressive acquisitions, such as Career Education, Corinthian Colleges and Education Management. DeVry and Strayer dont seem to be in the acquisition mode right now.
Cost per lead. The cost of bringing in a new student is a critical factor in determining how profitable a for-profit educational company will be. The more it costs (and the lower the retention rate as well), the lower the profit margin. A rising cost per lead is a sign that the company has to spend more money to acquire students. And that wouldnt be a good sign in what is supposed to be a hot-growth market.
Conservative accounting. How is the company booking revenue from students who have signed up and paid for a program that they havent yet completed? A reasonable policy would be to assign some of that to an accounting category called unearned revenue. Ask similar questions about how the company accounts for tuition when a student has committed to a program but hasnt yet paid the full tuition. (A related category to look at is bad debt. Is the company having trouble collecting from customers, or is it keeping enrollment up by letting in financially marginal students?) Judged against this list, my choice in the sector for the short and intermediate term (the next three to four quarters) would be Strayer. (But please carefully consider the likelihood that the entire market is still in the correction that began in February. Id be cautious about buying anything here. My advice: Wait, especially on high price-to-earnings stocks. Even in this sector.)
Looking out beyond that, DeVry grabs my interest. The company has a long track record in for-profit education that gives an investor reasonable security on the product quality and accounting. And DeVry is really just making the transition to an Internet-based model. Online students rose to 9,100 in the fall 2003 semester from just 3,800 in the fall of 2002. J.P. Morgan estimates that about 11% of all DeVry students are now online students and projects that could hit 20% in 2005. That, J.P. Morgan estimates, could take operating margins to near 20% from the current 12.5%. The shares arent cheap -- nothing in this sector is -- but on projected 2004 earnings per share, DeVry trades at a slight discount to the group.
At least thats how I do the math for the stocks in this sector.
Changes to Jubak's Picks
Buy Engineered Support System
Engineered Support System (EASI, news, msgs) has pulled back more than 20% since the shares hit a high on Dec. 19, 2003, so Im adding the stock to Jubaks Picks. This military logistics and supply company was the best-performing stock out of five I identified in a June 2003 column as winners in a low-inflation, low-interest-rate world. Recent contracts have included crew armor for Army vehicles used in Iraq and a fuel transportation system for military and fire department use. At its recent annual meeting, the company identified $1.8 billion in new business opportunities -- certainly enough at a company with $572 million in 2003 revenues to justify growth projections of 20% annually in earnings per share over the next three years. Im adding the stock to Jubaks Picks with a December 2004 target price of $65 a share. (Full disclosure: I will be adding shares of Engineered Support Systems to my personal portfolio three days after this column is posted.)
New developments on past columns
Revisiting my 10 picks for a dangerous year
Continuing political turmoil in Brazil is creating a good buying opportunity in shares of iron ore giant Companhia Vale do Rio Doce (RIO, news, msgs). A corruption scandal that could force Jose Dirceu, chief of staff to President Luis Inacio Lula da Silva (known popularly as Lula), to resign and a slow economic recovery have driven the governments popularity to new lows. In a March poll, the governments excellent rating fell to 34% from 41% in December and its terrible rating climbed to 23% from 14%. The Brazilian stock market actually rallied on these results because many Brazilians had expected even worse. The New York Stock Exchange-traded ADRs of the Brazilian company have been as low as $50 recently: Im hoping to add them to Jubaks Picks in a range between $45 and $50.
7 stocks that like a falling dollar
Shares of BorgWarner (BWA, news, msgs) took a beating last week on fears that rising steel prices would crimp company earnings. Although theres no doubt that steel prices have climbed a lot so far this year and, I think, little doubt that theyll move up some more in the rest of 2004, I dont see a huge impact on BorgWarner. A March 22 report from Deutsche Bank that threw the automotive sector into a tizzy puts the damage to the companys 2004 earnings at about 13 cents, or less than 2% of the $7.25 a share that Deutsche Bank expected the company to earn before steel prices spiked. To keep this all in perspective, the average U.S. car contains about 2,000 pounds of steel, but steel accounts for just 4% or about $600 a vehicle of the variable cost of making a car. The price of the dollar and the rate of economic growth are much more critical to BorgWarners earnings, and those both still seem to be lined up in the companys favor.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: BorgWarner. He does not own short positions in any stock mentioned in this column.
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