Does Strayer University Make the Grade?
Magic Formula Investing (MFI) looks for stocks with low valuations (measured by high earnings yield) of excellent companies (measured by high returns on tangible capital). So it is no surprise that the formula is in love with the for-profit education sector. These historically high margin, high growth businesses have come under mortar fire from Congress and the Department of Education (DoE) over the past year over low student loan repayment and high dropout rates, with several potentially game changing regulatory proposals looming over them. In these conditions, stock valuations have plummeted and practically the entire sector has shown up in MFI at some time or another. Currently, the screens select a total of 6 for-profits: Apollo Group (APOL), Capella (CPLA), ITT (ESI), Career Education (CECO), DeVry (DV), and the one I want to look at today, Strayer Education (STRA).
Strayer is one of the smaller players in this business, with just 89 campuses in 21 states and D.C., and roughly 56,000 students. Compare that to Apollo Group (University of Phoenix) with about 405,000 students! The company's primary geography is in the mid-Atlantic states and the south. Strayer focuses on working adults looking to build on their prior education by offering most classes in the evenings or weekends, and online.
A key differentiator here is that the vast majority of Strayer's students (81%) are working towards 4-year bachelor or master's degrees. Many competitors in this space are focused on trade-based disciplines or 2-year associates degrees. In general, bachelor and master students are more likely to pay back their loans, more likely to stick with the program and not drop out, and are more profitable to the company. As an example of their desirability, Apollo Group recently switched strategy to try to drive increases in their higher level degrees after years of "churning and burning" associates students through Axia College (to a sub-10% graduation rate).
A discussion of these stocks has to begin with the headline risks facing them. The federal government's Title IV loan program accounts for the vast majority of sales at these firms. One rule in place for limiting the amount of student loans is called the "90/10" rule. Basically, it states that a proprietary (i.e., for-profit) educator cannot derive more than 90% of cash sales from the federal government for 2 consecutive years. If it fails, that company becomes ineligible for Title IV funds for two years - a virtual death sentence for any for-profit firm.
Strayer is in great shape here compared to peers. In 2008, the company derived only 77% of revenue from Title IV, and 78% in 2009. To put that in perspective, Apollo's percentages were 85% and 83%, respectively. 90/10 compliance does not seem to be huge risk.
The second risk is the "cohort default rate", basically the percentage of students who default on their loans after a 3-year period. If an institution exceeds a 25% default rate for 3 consecutive years, it could lose eligibility to participate in federal grant programs. Here again, Strayer is sitting pretty. For fiscal 2006-2008 (the three most recent years with data), Strayer's rate was 10.5%, 13%, and 14%. That's well under the threshold and much better than the proprietary school averages of 18.8%, 21.2%, and 25%.
Finally are the proposed "gainful employment" regulations. Under the proposed rule, schools where less than 35% of students are repaying the principal on federal education loans would essentially become ineligible for federal loans. Schools with 35-45% would face restrictions on their ability to receive these loans.
Last August, the Department of Education released preliminary data that showed Strayer falling well below the threshold, at 25%. This was shocking considering the general consensus of Strayer as a quality institution, and was one of the lowest of any of the publicly traded for-profits.
While gainful employment remains a risk, the rule has come under fire from many sides, including minority advocacy groups (Strayer's student population is 74% minorities) and even 100 lawmakers. I believe the rule, or at the very least the calculation of repayment rates, faces drastic changes before having any chance of becoming law.
These risks aside, Strayer is clearly one of the top choices in the space. With operations in only 21 states, there is plenty of room for growth, with the firm opening 8-12 new campuses a year. Compound growth in revenues and operating profits has averaged about 20% annually since current management took over in 2001. Management has been generous in returning capital to shareholders, with a 3.3% dividend yield and an average 2.5% decline in share count annually since 2006. Possibly most important of all, Stayer has an excellent reputation with accreditation bodies and many corporate partnerships with large firms including General Dynamics (GD) and Verizon (VZ).
So, is Strayer a good Magic Formula pick? I think it is. The next few years will be difficult as new rules are imposed, for-profit companies work through the bad press over the past year, and the economy improves (enrollment is counter-cyclical). Strayer is experiencing 20% declines in new enrollment growth, but this should level off. My fair value estimate is $165, about a 39% upside from current prices. I have a positive rating.
As for Strayer against its competitors, it depends on your appetite for risk. At a 13.5% earnings yield, Strayer is not as cheap as Apollo (27%), ITT (24%), or Career Education (20%). On the other hand, it doesn't face as great a risk on 90/10 and cohort default rates. For risk takers, there is probably greater upside in these other names. For conservative types, Strayer still offers solid upside with somewhat lower risk.
Disclosure: Steve owns APOL