YCG Investments
“If you buy above average businesses at below average prices, on average, we believe you should come out ahead.” — Brian Yacktman

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In the last few months, for-profit education stocks have flunked, in many cases dropping 50% or more from their highs. The negative headlines have been focusing on increased scrutiny over two main issues: recruitment procedures and gainful employment.

A couple weeks ago, the Government Accountability Office (GAO) released a very disturbing report detailing several deceptive recruiting practices. For example, undercover applicants were encouraged to falsify information on their financial government aid applications and were told inaccurate salary expectations coming out of school (see video here). In 2004, safe harbors were created that loosened the government’s incentive-compensation rules. The Department of Education (DoE) wants to remove all the safe harbors which would open up these schools to all sorts of litigation and place more restrictions on recruiting procedures. Senator Tom Harkin, Chairman of the U.S. Senate Committee overseeing education, will be conducting more high-profile hearings regarding these deceptive marketing practices, and so we expect more negative news to plague the industry in the ensuing months.

The second issue is related to the “scam” stigma that some of these instituions are garnering, i.e. taking tuition and handing out a worthless certificate, leaving students saddled in debt and unable to secure employment or receive enough pay increase to service their debt load. During the recession, enrollment skyrocketed as people hoped to get a leg up in a struggling economy. While this created a tailwind for the industry in the face of a declining stock market, it also put them under the microscope when graduating students entered a deteriorating workforce and defaults on loans increased.

In order for an institution to qualify to receive federal financial aid, the DoE is proposing a school prove they are adequately preparing or “gainfully employing” their students by demonstrating a 45% repayment rate or that students do not spend more than 12% of their income in repaying their loans. Since government aided loans can make up the bulk of these schools revenues (up to 90%), it would be devastating if a school is found not eligible to receive funding. Last Monday, the DoE released loan data that was much worse than anticipated, with nearly all for-profit schools failing the repayment test (see repayment loan data here). If these new rules pass, many schools will likely need to cut tuition in order to meet the threshold requirements that would regain access to federal funding.

Several companies have disputed the government’s complicated formula saying it is flawed and misrepresents their students’ repayment rates. Apparently, part of the issue is when loans are consolidated they are often made into interest only loans, and the calculation dings these loans as not being repaid. This would help explain why Harvard medical students have a surprisingly low repayment rate of 24%. If some of these interest only loans will be repaid eventually, it seems shortsighted to penalize them simply because they are not being paid down immediately out of school. We would expect they would fix the methodology behind the calculation to more accurately reflect the quality of the programs, but we’re not going to count on a rational government in our analysis.

When considering these companies, one thing that needs to be taken into consideration is any internal lending. States have faced revenue shortfalls, and so schools have stepped in to provide the shortfall in lending. If the certificate or degrees being issued turn out to be less valuable than thought, or if the economy is struggling and graduates can’t get employed, some of these schools will be on the hook for the secondary loans they made. In other words, the revenue they would have been recognizing all this time was in actuality losses coming down the pipeline. In most cases, their loan loss reserves seem quite ample, but the gravity of this problem wouldn’t really be exposed unless a severe recession hits.

We researched 14 stocks in the for-profit education space, and we find several extremely attractively priced. I heard that there was a Credit Suisse report out there where an analyst ignored her estimate of $1.2 billion cash that she estimated would be on ITT Educational Services balance sheet in a few years by assigning zero value for that cash, and discounting cash flows at a 30% WACC simply to achieve what would justify the current stock price. When analysts are making such extreme assumptions, surely we’re at or very close to the bottom. On a risk-adjusted basis, our favorite in the industry is Apollo Group (APOL) which operates the University of Phoenix. They had an estimated repayment rate of 44 percent. One downside here is that they’re such a behemoth, growth is more difficult. But amongst the higher quality programs, they are the cheapest stock in the bunch.

The industry is currently involved in a so-called “negotiated rule making” process, so there probably won’t be much clarity until November 1st, the deadline for any new rules to take effect. Clearly, the new rules can significantly impact the companies’ revenues and margins, but the “bell curve distribution” is very favorable for some of these stocks. While the range of outcomes is wide (with the government being the wildcard), we believe the odds are stacked in our favor. Even in worst-case scenarios, the quality programs will survive and continue to make profits. When you’re paying 5 times cash earnings (or even less in some instances), there’s plenty of room for things to go wrong. So, buckle your seatbelt, because until November 1st, you’re in for a wild ride on these stocks.

Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Past performance is no guarantee of future results.

Posted by: Brian Yacktman | August 18, 2010 | Permalink

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