Question 2: Is for-profit education destined for a slow death?
As of September 30, 2015, for-profit education stocks represented approximately 9% of the Fund. We think the sector will shrink from its current level, but leading institutions like Apollo Education Group (APOL, Financial) and DeVry Education Group (DV, Financial) will remain an essential option for non-traditional students.
We believe the following:
- Most traditional colleges are not equipped to service non-traditional students
- The leading for-profit institutions have already successfully survived multiple investigations and we don’t expect any new material findings to come to light
- For-profit schools are “high-grading” their student bodies and that involves shrinking enrollments; this process may take a year or more, but will lead to a smaller, but more stable, base of students
- When we put the negative headline aside and assess what we estimate these companies are actually worth, we come up with valuations that are substantially more than the current market price, even when using very conservative assumptions
Let’s look at each of those beliefs in a bit more detail.
For-profits serve non-traditional students best
There are many differences between the average student attending a traditional not-for-profit school and those attending a for-profit institution as shown below:
For-profit schools are keenly aware of the unique challenges that their students face and have rolled out programs specifically designed to increase retention and graduation rates of their students. Additionally, most for-profit schools, including the two we are invested in, APOL & DV, offer flexible programs that fit with working adults’ lifestyles. These programs include: online courses, night/weekend classes, and convenient locations. These options are often not available at traditional colleges. Furthermore, with many states reducing their funding for education as shown below, we believe for-profit education will continue to be a vital part of the U.S. education ecosystem for many years to come.
APOL & DV have been the subject of multiple investigations — no smoking gun has been found to date
Every day it seems like there is a new negative headline about the for-profits being investigated for wrongdoing. But the leading institutions have all been investigated multiple times by a diverse group of regulatory agencies and governing bodies and to date no smoking gun has been found. Below we summarize the outcomes of some of these various investigations for the two companies we own:
We have confidence that the real bad actors have already been identified and actions have been taken against those schools. While negative headlines may persist, time will eventually depict which institutions are here to stay and we strongly believe that DV and APOL will be among them.
High-grading students to increase retention means shrinking first
Both APOL and DV have begun to target better retention of students as it costs less to retain a student than it does to recruit a new student. To increase retention, both schools have to be somewhat more selective on who they admit. Inevitably, this means that both schools will shrink down to a smaller size. Having said that, the cost structures of both schools have shown to be quite flexible and we anticipate that both schools can still be quite profitable even at a much smaller enrollment level. APOL, for example, is now targeting total enrollment of 150,000 by the end of FY16 (vs ~200,000 today), but they also plan to take out nearly as much cost as they expect revenue to decline, allowing them to maintain profitability despite a declining revenue base.
“So What Are They Worth?” We think both APOL & DV are worth more than the current market does
Ultimately, our primary job as analysts is to estimate what we think a business is worth. As value investors, we look for opportunities to buy businesses for less than their ultimate value. These opportunities tend to present themselves when there is an easily articulated negative narrative around a sector and some investors opt not to do more detailed analysis on individual names. Our view is that negative narrative is what gives us the opportunity. Both of these stocks have net cash on their balance sheets and trade at below our downside case scenarios. For example, APOL’s stock price closed at $11.06 at the end of the quarter despite having over $7 net cash and over $4 of book value per share for their international assets, and the company’s guidance of at least $150 million of operating profits for their U.S. for profit education business during the next year.
In summary, we see substantial opportunity in both names. We fully acknowledge that to date these positions have been a real detraction to our performance, but our approach to investing has always been to continuously challenge and review our investment thesis and determine the merits of an investment based on the risk/reward at current levels, not based on recent past performance. In our view, both APOL and DV offer a compelling risk/reward from current levels and thus continue to merit allocations in our portfolios.
From FPA Capital Fund (Trades, Portfolio)'s third quarter 2015 letter to shareholders.
