Thursday, April 25, 2013

Strayer Education - Quality Educator For Sale

The for-profit education industry has been beaten down considerably in the recent past. I am almost sure that many value investors have done some research in this section of the market in search for bargains. There are numerous articles on companies such as Apollo, ITT Education, Career Education, Corinthian Colleges, Capella University and etc. Most articles conclude that for-profit education stocks are cheap based on valuation metrics but the regulatory risks are also very high. I will not repeat what has been widely known by the market participants. My thesis is built more on the qualitative analysis. 

I started my research on the for-profit education a few months ago. My goal was to find a company that combines quality and value in the for-profit education industry. My initial list includes Strayer Education, ITT Education, Apollo, Career Education, Corinthian Colleges and Capella University. After reading some 10ks, earnings call transcripts and articles, I've narrowed it down to Strayer Education and Capella University. I eliminated the others mainly based on qualitative issues. For example, while reading Apollo's annual report, I noticed that management claims that Apollo has "aligned our admissions practices to better support our students's success by eliminating enrollment measures as a factor in the evaluation and compensation of our admission advisory teams."  This sounds like a good intention. However, new regulation specifically states that "a school participating in Title IV programs may not pay any commission, bonus, or other incentive payments to any person involved in student recruitment or admissions or awarding of Title IV program funds, if such payments are based in any part directly or indirectly on success in enrolling students or obtaining student financial aid." If a management team blatantly writes misrepresenting statement in the annual letter to shareholders, I don't think there is much integrity in the business. Other examples include ITT Education's abysmal reviews from its students, Corinthian Colleges' officials' engagement in a no-holds-barred campaign to drive down their schools' rates by pushing former students to obtain temporary forbearance and deferments on their loans. The for-profit education industry is one in which greedy management can take advantage of the underprivileged students even though education in general is supposed to have noble intention.  No wonder the regulators have been more stringent. Unsurprisingly, on a quantitative level, such as manifested by the cohort default rate, schools with questionable management also score very low. The 3 year cohort default rate for the 2009 class is 26.4%, 28.8% and 34% for for Apollo, Corinthian College and ITT education whereas for Strayer and the Capella, the rates are only 13.9% and 9.70%. 

The more research I've done, the more Strayer Education stands out from its peers, both from a qualitative perspective and quantitative perspective. So after months of research, I've decided to select Strayer Education within the for-profit education industry as my recommendation. 

Business Description:

Strayer Education, Inc. was founded in 1892. Strayer University is an institution of higher learning that offers undergraduate and graduate degree programs in business administration, accounting, information technology, health care, education, and public administration at over 60 physical campuses. The Company is a for-profit post-secondary education services corporation. Its mission is to make post-secondary education achievable and convenient for working adults in today's economy. It works to fulfill this mission by offering a variety of academic programs through its wholly-owned subsidiary Strayer University, Inc., both in traditional classroom courses and through Strayer University Online. Strayer University makes post-secondary education accessible to working adults who were previously unable to take advantage of higher education opportunities. Strayer University provides access to higher education to working adult students. Marketing activities include direct mail, Internet marketing, marketing to its existing students, print and broadcast advertising, student referrals, and corporate and government outreach activities. Strayer University maintains booths and information tables at appropriate conferences and expos, as well as at transfer days at community colleges. It has a total of 92 campuses in various stages of growth. As an institution of higher education accredited by Middle States and operating in multiple jurisdictions, Strayer University is subject to accreditation rules and varying state licensing and regulatory requirements.

Quality of Business:

Strayer Education's moat fundamentally comes from a top-notch management team. The current Chairman and CEO Robert Silberman (will step down as the CEO but will remain Chairman of the Board), worked as the COO of Cal Energy, which was owned by Berkshire Hathaway, before he was recruited as the CEO of Strayer Education. He has done a remarkable job building up Strayer Education's moat in the for-profit education business. In his book The Investment Checklist, Michael Shearn enumerated various instances where Robert Silberman showed integrity and great leadership. Here is an excerpt from the book,  "When Robert Silberman took over as CEO of Strayer Education in 2001, he said he was not going to focus on any of the metrics that generally drive public company valuations, such as revenue growth, operating income growth and margin expansion. The only thing that was going to drive real sustainable long-term value of owners was the intangible value of Strayer University and the to increase the intangible value, you increase the level of learning outcomes."  

Strayer's annual reports also stand out from those of its peers. Each year's annual report contains a reprint of the Strayer's Business Model from the 2001 letter to shareholders, which clearly outlines
  • What Strayer does
  • How Strayer's business model generates both reported net income and owner’s distributable cash flow, and 
  • Strayer's strategy to increase the intrinsic value of your investment in Strayer Education. 
Robert Silberman also writes letters to shareholders every year and his writings are vastly different from the CEOs of Strayer's peers. The letter starts with the past year's result, detailing both challenges and accomplishments. Unlike his peers, Silberman goes in depth to analyze the reasons behind the challenges and accomplishments so that shareholders can get a clear understanding of the overall picture. Here is an example from the 2011 letter in which he offers his insights on the decline in student enrollment, which is very different from the public perception.

After  reviewing  all  the  data,  I  believe  that  the  most significant factor behind Strayer University’s extended decline in new student enrollments during 2011 must have  been  the  sustained  level  of  distress  across  the economy, and specifically the markedly higher level of unemployment in our target student population. Real unemployment in this country among 25–50 year olds without  a  college  degree  was  a  devastating  22%  in 2011, up from 6% in 2008. It is even higher in some of  our  newer  geographic  markets  in  the  industrial Midwest. We  know  from  surveying  our  students  that the large commitments of time and finances necessary to  succeed  in  our  undergraduate  academic  programs are  often  too  daunting  for  those  adults  who  have  no steady  means  of  income  (particularly  those  with dependents). We also know from our surveys that most of  our  undergraduate  students  have  contemplated returning  to  college  for  upwards  of  two  years  before making the final commitment. They have had to truly “screw  their  courage  to  the  sticking  point”  before actually enrolling. Therefore, in many ways, there is a lag factor to the effect of serious economic disruptions on our new student enrollments. As I have written in this letter  in  the  past,  while  some  level  of  economic insecurity  does  indeed  drive  working  adults  back  to college, sustained unemployment does not, at least not to Strayer University. 

Silberman also summarizes the capital allocation results from the prior year and lays out the plan for next year .Capital allocation is extremely important for any business yet rarely does a CEO of a public company present the result of prior year's capital allocation in a shareholder-friendly way. This transparency by Silberman is another indicator of management quality.

At the end each year's annual report, Strayer's Heritage reprinted from the 1912 student catalog is always attached. This section speaks the character of the business. Below is the full catalog:

This catalog was written with a view of setting before the men and women of this community some of the advantages of a business education, and of acquainting them with the superior facilities of this school for giving high-grade business training. 

The courses have been designed and presented to meet the needs of the business office of today. The teachers are men and women who are specialists in their respective subjects. The school rooms have been chosen and equipped with special reference to light, comfort and sanitation, so as to make it an ideal place for study.

We ask that the public, in determining which school it shall attend, to consider the facts in connection with this school, as are outlined in this catalog and supplementary literature. It is twenty years old. It has grown steadily  since  the  beginning.  It  attributes  its  growth  to  correct  ideals,  careful  management  and  successful, enthusiastic, and rapidly increasing alumni.

While it is essential to its success that a school should give thorough instruction in the subjects that comprise its courses, yet the school that does  only this, falls short of its full mission. The development of those traits of character which make for reliability in business and good citizenship are the peculiar province of the school as well as the home. This school, then, has nothing in common, can have nothing in common, with those so-called business schools offering cheap and superficial courses. Such courses, while inexpensive, and possibly of short duration, cannot result in anything but disappointment in the end.

This  school,  then,  stands  for  high  ideals,  it  courts  investigation,  welcomes  comparison,  and  stands by  its  promises.  It  is  a  school  to  which  you  may  attend  with  the  knowledge  that  you  will  be  in  pleasant surroundings, will be accorded fair treatment, and will be given thorough and painstaking instruction.

Finally, in presenting this catalog, we want to thank a discerning public for its support, and assure it that we shall endeavor to continue to merit the bountiful confidence it has heretofore placed in us. 

Regulatory Compliance:

Regulatory compliance is the biggest perceived risk in this industry. Although this risk is high for companies like Corinthian, Career Education and ITT Education, Strayer is probably one of the best positioned companies in the for-profit industry and I think it is a good thing that regulators are spending more time and effort addressing the questionable practice by a lot for-profit educational companies. Strayer's risk of non-compliance is very low in my opinion. The most recent 3 year Cohort Default rate is 13.9%, well below the 25% threshhold and the revenue% from Title IV loans is only 76%.

Also, as noted in the 2012 annual report,

Senator Tom Harkin (D-Iowa), Chairman of the U.S. Senate Committee  on  Health,  Education,  Labor  and  Pensions (HELP). Senator Harkin’s committee staff conducted a two year investigation into tax-paying, investor-funded post-secondary  educational  institutions  and  concluded that, “Strayer’s  performance  is  one  of  the  best  of  any institution  examined,  and  it  appears  that  students  are faring well at this degree-based college.” 

For the last three years the Department of Education has reviewed the regulations that govern how for-profit universities qualify to receive the proceeds of Federal student loans as tuition revenue.
The Department ultimately adopted a number of new regulations, the most important of which (the “Gainful 
Employment  Regulation”)  measures  the  earnings  of 
graduates of for-profit universities and compares those 
earnings to the debt levels the graduates incurred to 
finance  their  education. There  is  a  rather  complicated
process for measurement, and the first full measurement

year  was  not  slated  to  be  until  2012,  but  the 
Department released in 2012 “illustrative” data for all 
for-profit  universities  for  the  year  2011,  so  as  to  give 
these universities an early look at their compliance. I am 
pleased to report that using the illustrative 2011 data, all 
of Strayer University’s programs passed the Gainful 
Employment  Regulation  with  flying  colors.  Although 
the regulation has since been declared invalid by a U.S.  
District  Court,  and  the  Department  has  not  yet 
announced its plans going forward, we remain confident 
in our ability to run our university in compliance with 
what we believe to be the Department’s intent.  


Based on my observation and understanding of the business, Free Cash Flow is probably best metric to be used to value Strayer Education. FCF per share was $3.93 10 years ago, peaked at about $10.45 during 2011 and dropped precipitously to just above $5 per share during 2012. On a statistical basis, if we take the lowest price of Strayer stock in the past 10 years,  divided by FCF per share, the average P/FCF using the lowest price is about 14.  If we take the highest price of Strayer's stock in the past 10 years, divided by FCF per share, the average P/FCF using the highest price is about 25.  Where does the P/FCF stand now? It's about 10 times, or more than 20% lower than the historical average using the lowest price during each of the past 10 years. Looking out 5 years, if the industry stabilizes and unemployment drops, Strayer can earn $8 FCF per share and apply a 14 times multiple, we get $112 per share. 133% higher than current price and ~18.5% compounded annually.

We can also use the P/S multiple as revenue fluctuate less than FCF and earnings. Again, on a statistical basis, if we take the lowest price of Strayer stock in the past 10 years,  divided by revenue per share, the average P/S using the lowest price is about 3.6.  If we take the highest price of Strayer's stock in the past 10 years, divided by revenue per share, the average P/S using the highest price is about 6.64.  Where does the P/S stand now? It's about 0.9, or more than 75% lower than the historical average using the lowest price during each of the past 10 years. Even if revenue per share stays the same at $50 per share and assume things revert back to the mean in 5 years, Strayer should be trading at $180 per share, 275% higher than the current price and ~30% compounded annually.

Strayer does look cheap from a statistical perspective. However, as Robert Silberman has candidly mentioned in the most recent annual report, things may very well not get better in the next several years. In this case, the return can be expected from shares repurchase (which is increased to $150 million). Assuming the shares are repurchased at $50 per share, resulting in a 3 million share (27% of total shares outstanding) shrinkage to 8 million shares outstanding, with  $57 million FCF, the per share FCF will be ~$7. Apply a 14 times multiple, we get $98 per share, or 15.5% compounded annually for 5 years.

Conclusion: At $48 per share, Strayer is a good combination of quality and value in the for-profit education industry.

Disclosure: Long STRA.

Friday, April 12, 2013

The Pareto Principle and Investing

The Pareto Principle states that 80% of the results, outputs, or rewards, are generated from only 20% of the causing inputs or efforts.

The implications for investing:

1. 20% of our best stocks will probably generate 80% of our overall profit.
2. 20% of the time we spent doing research usually generates the 80% most useful information.
3. 80% of the time we spent doing research is likely not very productive.

The above implications can be very  discouraging for investors who have never thought about applying the Pareto Principle to their investment research. In fact, I wrote this article because I was truly disappointed and bothered by the feeling that most of my time spent doing fundamental analysis is not targeting the most important things. Why? Because I often forget to write out the most important thing first before I even start my research. This article is trying to address implication 2 and 3 above.

 My investment research routine is

1. Research company background, read the most recent 3-5 10Ks and 10Qs of the company and those of its competitors to answer every question on my checklist.
2. Gather 10 years of financial statements and build the valuation model.
3. Calculate intrinsic value and  margin of safety.

I usually spent about 90% of the time performing step 1 and step 2 above. The intrinsic value and margin of safety calculation are the most important things but it usually takes about 10% of my time. Well, you can argue that step 1 and step 2 above are necessary as they build the foundation for step 3 but step 1 and step 2 frequently incorporate a lot of assumptions and each one of them may impact the ultimate result in step 3. Garbage in and garbage out. The majority of the information I gather in step 1 and step 2 end up being inconsequential. Therefore,  it's not the quantity of time you spend that will ultimately determine the quality of your research, it's the quantity of time you spend addressing the most important things that really matter.

Here is a most recent example. I have been digging into the for-profit education sector and have spent a massive amount of time just to gather all the financial data and incorporate them into the valuation model. I've also read the 10Ks for Strayer Education, Apollo, Capella and Career Education. However, just like someone driving around in a strange city without navigation, I wondered around for a while, lost and still not getting to the point. I read all the business description, all the risk factors and the regulatory environment but still have not put all the piecemeal information together in a meaningful way because I have already spent so much time and I feel justified to delay the ultimate intrinsic value calculation. To quote Michael Bauboussin "Most people do not find it natural to match ideas from their mental database to tricky situations in the real world. Our brains are not wired for the process of moving from preparation to recognition. Indeed, typical decision makers allocate only 25% of their time to thinking about the problem properly and learning from experience. Most spend their time gathering information, which feels like progress and appears diligent to superiors. But information without context is falsely empowering. if you do not properly understand the challenges involved in your decision, this data will offer nothing to improve the accuracy of the decision and actually may create misplaced confidence. "

He is exactly right. In doing fundamental research, we often gather information for the sake of gathering information, which feels like progress and create misplaced confidence because we tell ourselves that we spent a lot of time doing research and therefore, we should have confidence in our thesis. This fallacy is very dangerous, especially in the world of investing yet so many of us have been ignorant to it. In my opinion, the best way to cope with this is to begin our investment process by asking ourselves what are the most important things.

With regards to the for-profit education sector, the most important things are:

I.  How likely is an institution not in compliance with the regulation and can the institution go out of business if not in compliance?  Specifically, what is the institution's compliance status with regards to:

  • Cohort Default Rate
  • The 90/10 Rule
  • Incentive Compensation
  • Gainful Employment
  1.  At least 35% of students are in satisfactory repayment status with respect to their federal student loans three to four years after entering repayments. 
  2. If the annual loan payment of a typical graduate of the program for all debt incurred by the graduate for the program does not exceed 30% of the average or median discretionary income in the third or fourth year after graduation; or
  3. If the annual loan payment of a typical graduate of the program for all debt incurred by the graduate for the program does not exceed 12% of the average or median annual earnings in the third or fourth year after graduation; 
II. Is the headwind that the for-profit education sector facing structural issue or cyclical issue?

III. If the headwind is a cyclical issue, what will enrollment level be once things return to normal?

IV.What strategies are being executed to address both the current headwind and future development?

V. Given I-IV, what is the intrinsic value of the business?

I am absolutely not indicating we should abandon hardcore fundamental analysis. Diligent fundamental analysis is what defines value investors. What I am suggesting in this article is that before we start our research, we should take the time to define our focus points in our research. Once we lay out the most important things, we can direct our research to address them first. Once we've answered all these vital questions, we can dive into other things.Warren Buffett once said: The chain of habit is too light to be felt until it's too heavy to be broken. The habits we cultivated as teenagers inevitably affect how to behave as adults. In investing, in order to not lose money and generate superior return, we have to be cognizant of the habits we cultivated when we were young that could inherently lower the quality of our research and hence, the potential return of our investment. It takes time and can be against human nature to step back and question ourselves but that's how we become better over time.

By the way, here are two  much better articles on similar topic from Geoff Gannon.

As always, I welcome all constructive criticism.