Why Barron’s Is Wrong About For-Profit Education Stocks

ITT Educational Services (ESI) is a for-profit education company, with over 79,000 students enrolled at its ITT Technical Institutes and Daniel Webster College, which was just acquired this past April. The company currently operates 112 ITT campuses, 9 learning centers, and 2 Daniel Webster locations, as well as online programs. Historically, ITT was focused on short, 2-year, technology-related degree programs. But more recently, ITT has expanded into both non-technology areas and higher level degrees. Currently, over 70% of locations offer bachelor’s degree programs in studies ranging from Criminal Justice to Business Administration. While most students are still in 2-year degree programs, slightly over a quarter of enrollment is in 4-year bachelor degree studies.

For-profit education is a great business that has been broadly sold off over the past month or so. The reasons for this are cloudy, to be sure. Industry leader Apollo Group (APOL) announced an informal SEC inquiry, and widely read trade publications like Barron’s and Bloomberg have run negative articles on the industry. Three of the top publicly traded for-profits are all currently on the Magic Formula screen (ESI, APOL, and Corinthian Colleges – COCO).

It seems like an irrational sell-off. All of these companies are growing sales, profits, and enrollments by 20% or more, as high unemployment has driven many thousands of people back to school to improve their education. In ITT’s case, sales grew 34% and net profit 50% year-over-year in the just completed third quarter. For 2010, the company is expecting another 25% increase in sales and profits. This puts ITT’s forward earnings yield at 16%, which is extremely cheap for the quality we are buying here.

This is a company that squarely meets the 3 points of investment: growth potential, competitive positioning, and financial strength. Growth will not be a problem over the near to mid-term. Over the next couple of years, higher enrollments due to high unemployment will boost margins. ITT continues to expand by opening new centers (6-8 a year), adding new programs (over 250 in 2009), and increasing tuition along with public schools (3-5% a year). The company has also shown a desire to growth through acquisition, such as the Daniel Webster purchase. Analysts forecast 17% annual profit growth over the next 5 years – quite healthy. I think it could do better than that.

From a competitive standpoint, all for-profit education providers enjoy great business advantages. These companies operate lean cost structures, but set tuition based on higher-cost traditional schools, which have to pay for services like dorms, food, sports, and so forth. Since government financial aid limits are set for these traditional schools, for-profits enjoy juicy operating margins over 25%. ITT is one of the best run, bringing in operating margins well over 30%. Also, barriers to entry are high, as government accreditation is a long and difficult process. Finally, the business model is highly scalable. Once the capital outlay for a campus is invested, that campus earns low-cost revenue with every student added, and each campus can be expanded with more programs as time goes on.

Financially, ITT is solid. Cash holdings are $275 million, debt just $150 million, and free cash flow is close to $200 million annually. Free cash margin is consistently in the high teen percentages. Returns on capital are out of this world, averaging 78% (traditional) and 148% (MFI) over the past 5 years. The company does not pay a dividend, but has been aggressive in repurchasing shares, reducing the share count by 4% annually since 2004.

So what are the risks? For-profits have sold off due to a few factors. First is the concern that the SEC inquiry towards Apollo could be industry-related, but I see little evidence to back this up. Secondly, some investors are worried about increased regulation of for-profit schools due to lower graduation rates. This again seems unlikely to me, as comparing these schools (which have largely working adult populations) to traditional schools (which are non-working young adults) is grossly unfair. It only makes logical sense that older adults, with full-time jobs and families, are less likely to complete a degree program than young people with few responsibilities.

One risk specific to ITT is the firm’s higher-than-average reliance on private loans to its students. In 2008, difficult credit markets reduced the percentage of these loans from 27% in 2007 to just 18% in 2008, and ITT took on a risk-sharing component to help fund them. As a result, the company has had to provision for bad debt expenses, which have risen to above 5%. While the rebound in credit has eased most fears here, I would prefer to see ITT get out of the loan business altogether.

Overall, ITT offers investors outstanding and reliable growth at a bargain price, with what amounts to mild risk, in my opinion. As such, this is a candidate for the MagicDiligence Top Buys list and a strong choice for a new MFI position.


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