Sector Focus February 2009 Education firms make the grade in a recession Jillian Batten, security analyst; Bill McVail, senior portfolio manager/security analyst; Halie O Shea, security analyst/portfolio manager; and Jason Schrotberger, security analyst/portfolio manager, who cover the consumer sectors A A close look by Turner's analysts at the market sectors they cover commonplace observation by the news media was that this year s corporate parties before Super Bowl XLIII in Tampa were less ostentatious and more subdued than in the past, reflecting somber times throughout the land: a worsening recession, rising unemployment, and a sustained decline in consumer spending. But the chief executive officer at one notably glitzy Super Bowl party cheerily told Sports Illustrated: We ve chosen not to participate in the recession. To us, there s something admirable about that kind of intrepid, willfully optimistic attitude. But choosing not to participate in the recession, alas, isn t an option for our team, which must still select consumer stocks for our growth portfolios even when the economy and consumer spending are slumping. So, what do we consider as candidates for investment in consumer stocks in these dour times, when everyone from the working class to the wealthy is choosing to rein in spending and personal consumption? We regard the for-profit education companies, for one, as especially attractive now. When times are bad for the economy and consumers, the fundamentals tend to be good for well-managed education companies like Blackboard, Capella Education, ITT Educational Services, New Oriental Education & Technology Group, and Strayer Education. In investment-speak, companies like these that do well when the economy is doing poorly are characterized as counter-cyclical. Need: upgrade credentials A big reason why education companies are counter-cyclical is that in a recession, working adults are worried about keeping their jobs or worried about their employment prospects after losing their jobs. So they tend to covet education as a means to upgrade their vocational credentials, resulting in an upward spike in enrollments at for-profit institutions of higher education. The Department of Education s National Center for Education Statistics has identified a positive correlation between an increase in the unemployment rate and an increase in enrollments in higher education programs of two years or less that are a forte of the education companies. And Wall Street analysts have calculated that
Education firms make the grade in a recession / 2 a one percentage-point increase in the unemployment rate translated into enrollment gains of more than two percentage points in education programs with durations of two years or less in past recessions. We think student enrollments by the education companies should prove counter-cyclical in the current recession, rising on average at least 12% annually this year and over the next two years as well. And we expect the education companies earnings should expand at double-digit rates on average over the same period. In short, we think the education companies are as good a haven as you re likely to find in the consumer-discretionary sector in the near term. An $18-billion market Altogether, the for-profit education market generates revenue of more than $18 billion annually and accounts for 7% of all undergraduates, or about 3 million students, according to JPMorgan Chase. The education companies are capturing market share from traditional nonprofit colleges and universities, and we think they will continue to do so for a number of reasons: Education companies have a profitable, cost-effective business model. They cater to the fastest growing student segment, working adults ages 25-34. The number of working adults enrolled in schools of higher education is expected to increase by 2.5% over the next decade, compared with only 1.3% for students of traditional college age, according to the Department of Education. As analysts and the education companies themselves have pointed out, only a minority of undergraduates now fit the description of traditional collegians -- students who live on campus, are younger than 25, and attend classes full-time. Today, most college students either work, are raising a family, or are doing both while trying to earn a degree. What s more, the education companies collect their payments from students up front, but they pay out many of their expenses only later. In the interim, they can invest the funds, known in the trade as the float. For instance, we estimate that Strayer Education s float has helped the company to produce free cash flow that has exceeded net income by an average of 30% over the past five years, and we expect Strayer and the other leading education companies to sustain that high level of free cash flow for years to come. Quick to aid students Education companies, with high levels of cash reserves and low levels of debt, have the means to help fund students educations -- and have more readily provided financial aid than nonprofit schools have. And it doesn t hurt, either, that the education companies loans pay for tuition priced at what we think is a sweet spot for
Education firms make the grade in a recession / 3 students: typically between the tuition of state schools and county community colleges at the low end of the spectrum and the tuition of private colleges at the high end. That sweet spot has helped the education companies to maintain a solid degree of pricing power. They should benefit from substantial federal aid to students. The Department of Education has indicated that, despite the credit crunch, it plans to continue lending to students under its direct-loan program. Those direct loans now account for 30% of all federal student loans, up from 20% a year ago, according to Bank of America/Merrill Lynch. Also, the Obama administration s $789- billion economic-stimulus package includes enhancements to needbased Pell education grants, unsubsidized student loans, the College Work-Study Program, and tax credits for low-income students, all designed to make higher education more affordable. (Consequently, we think the biggest financial risk for the education companies in the near term is that an important source of revenue, corporate education-reimbursement benefits for employees, might be curtailed or eliminated if the recession deepens. In our estimation, that s unlikely to happen widely. To date, only a few financially strapped major companies such as the automakers are cutting the tuition-reimbursement benefit; most companies still regard it as a fundamental employee benefit.) Accentuate the practical The education companies offer a broad range of online education and classroom education that accentuates the practical -- education that s vocationally oriented. Their curricula include subjects like marketing, computers, health care, and culinary arts that provide skills that can be applied in the labor market immediately, Bank of America/Merrill Lynch Research noted. Much of that instruction is provided online -- a specialty of the education companies that s growing at more than 10% annually, compared with mere 1-2% annual growth in classroom instruction, according to Bank of America/Merrill Lynch. Online education is more profitable than classroom instruction because the costs can be spread over a larger base of students. And the flexibility of online education is particularly appealing to married working adults who are on the paper chase for a degree while remaining on the job and caring for a child. UBS reports that 1.9 million students are currently studying online for an associate degree -- more people than for all other degrees combined. Here are brief sketches of the five education companies that we think have the potential to achieve above-average earnings growth in 2009 and beyond:
Education firms make the grade in a recession / 4 One with a different focus Unlike the other companies, Blackboard (market capitalization: about $760 million; headquarters: Washington, D.C.) delivers no education directly but provides software applications to the forprofit and nonprofit institutions that do; educational customers in the U.S. and abroad account for about 80% of Blackboard s revenue. The company s software, such as the Blackboard Academic Suite, helps schools with such tasks as integrating technology into the classroom and campus, managing educational Web sites, and sending communications via voice, e-mail, and text messages. The company spends 12% of revenue, or more than $30 million annually, on research and development. Capella Education (about $950 million; Minneapolis) educates more than 24,000 students, 83% of whom are pursing master s or doctoral degrees. Capella conducts intensive research to identify the most promising education markets and then seeks to serve those markets. As a result the company has targeted instruction in education, health care, human services, business management, and technology. In surveys by Wall Street analysts, Capella s students have generally awarded the company high marks for furnishing instruction that s a good blend of both the theoretical and the practical. ITT Educational Services (about $4.3 billion; Carmel, Indiana) offers associate and bachelor degree programs primarily in technical subjects such as information technology, electronics, drafting, and health sciences. Its 61,000 students receive their technical education mostly in classrooms. About 80% of those students are pursuing an associate degree, and historically about one-third of those who receive that degree subsequently enter the company s bachelordegree program. In this decade ITT Educational Services has increased its total enrollment 9% annually and revenue 13% annually -- a not unimpressive accomplishment, particularly since the company offers only limited online education and has made no acquisitions in the past 20 years. As big as San Diego New Oriental Education & Technology Group (about $2 billion; Beijing) is the largest provider of private educational services in China. Like seemingly everything in China, New Education is super-sized: it has 46 schools and 201 learning centers serving a student body of 1.3 million -- the equivalent of the entire population of San Diego. Signal Hill Capital Group, an investment-research firm, has called the company the ideal vehicle for investing in the emerging consumer economy of China. New Oriental offers classroom and online education to students of all ages -- even as young as five -- in foreign languages, test preparation, international
Education firms make the grade in a recession / 5 studies, and conventional academic subjects. Our contacts in the industry say that Chinese parents aren t all that different than America s much-caricatured helicopter parents in their propensity to hover over and obsess about their young children s education. A survey by CLSA Asia Pacific, an investment firm, found that nearly 70% of Chinese children over the age of three were taking courses of some kind, especially English classes, many of them from New Oriental. S trayer Education (about $3.2 billion; Arlington, Virginia) has about 44,000 working adults currently being educated on campus or online. Strayer s students tend to be older, more creditworthy, and finance their education via tuition reimbursement, courtesy of their employers. In Signal Hill Capital Group s estimation, Strayer is skimming the cream of working-adult students. A key pipeline of students for Strayer is a network of more than 100 community colleges nationwide; Strayer automatically enrolls any holder of a two-year degree from those schools in the third year of its bachelor s degree program. Explains Robert S. Silberman, the company s chief executive officer: We do not think of community colleges as competitors, but rather as important partners in our national expansion strategy. The views expressed represent the opinions of Turner Investment Partners as of the date indicated and may change. They are not intended as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell any securities. Opinions about individual securities mentioned may change, and there can be no guarantee that Turner will select and hold any particular security for its client portfolios. Earnings growth may not result in an increase in share price. Past performance is no guarantee of future results. Turner Investment Partners, founded in 1990 and based in Berwyn, Pennsylvania, is an investment firm that manages more than $15 billion in stocks in separately managed accounts and mutual funds for institutions and individuals, as of December 31, 2008. As of January 31, 2009, Turner held in client accounts 145,220 shares of Capella Education, 221,570 shares of ITT Educational Services, 100,880 shares of New Oriental Education & Technology Group, and 24,050 shares of Strayer Education. Turner held no shares of Blackboard.