The Post Secondary Education Market Is Post Its Growth Phase

The post secondary education industry has continued to grow rapidly over the past two years but has lagged in stock performance.  But while this sector looks enticing from a growth investor's perspective, the majority of the companies in this industry could be "growth traps."  That is, past growth will be unable to be replicated in the future and the valuation multiples will compress making it difficult for investors to make money in the group. 

Several factors have weighed on the stocks in the past two years.  First, and foremost, the companies in the sector have come under heavy regulatory scrutiny from the Department of Education, state and local authorities for numerous violations.  Chief culprit among the companies is Career Education (CECO), which has been tagged with about every potential violation possible and has cast a negative pall over the entire industry. 

Second, the competition in the industry has increased significantly over the past five years.  Driven by the increased need for computer technicians, three or four publicly traded education companies took advantage of a greenfield growth opportunity to expand their campuses across the country in the 1990s.  However, since the Internet bubble burst, these companies have had to increase recruitment efforts to attract students.  On top of less interest in IT education, many more companies are vying for students.  Currently, no less than twelve public companies are competing in similar areas such as IT, healthcare, automotive, and criminal justice.

Finally, the industry has typically done well during a weaker economy as individuals who cannot find a job chose to enter school instead.  The economic recovery in the past two years has been a drag on enrollment growth. 

These trends can be clearly seen in the enrollment growth figures compiled from Jeffery Silber at Harris Nesbitt in a report published in September 2005.  Silber has written some of the most comprehensive reports on the industry and I would encourage you to take a look at them if you have access to Harris Nesbitt research.  The charts I have used are all from a comprehensive report written by Silber in the Education and Training market. 

The enrollment growth has dramatically slowed from a median of over 30% in 2003 to less than 15% in the June 2005 quarter.  These trends have continued with relatively anemic growth in the past quarters from the likes of Lincoln Educational and Devry.

This slowing in growth has led to the poor stock performance in the sector.  The sector has traded sideways since topping out in the middle of 2004 despite the fact that earnings (as shown in the top half of the chart via the dot line) have continued to increase. 

Source: Baseline

Despite these headwinds, the company fundamentals the industry is still growing fairly rapidly compared to the rest of the economy.  Thirteen percent organic growth is nothing to sneeze at. However, given the relatively high earnings multiples in the group, it's probably not worth making a big bet on these stocks.  That's because the trends that have weighed on the group show little signs of letting up.  If growth continues to slow, earnings multiples will continue to compress and the stocks will continue to underperform.   Right now the industry is trading at an average 22x next year's earnings and 3x sales.  Several of the top performing stocks in the sector such as APOL and STRA trade at much higher multiples which make them particularly vulnerable to multiple compression if the industry continues to slow. 

Source: Baseline and First Call

The negative trends that have affected the industry will most likely continue to put pressure on the multiples of the fastest growing companies.  The group's earnings estimates for 2006 have already started to fall, which is never a good combination with high multiples. 

Source: Baseline

The main negative trend affecting the industry now is the strong economy.  The post secondary education market is very countercyclical.  The following table shows that as the economy enters a recession, enrollment expands and as the economy comes out of a recession, the enrollment trends begin to slow.  When the economy is strong, as it is now, enrollment declines.  So unless you are betting on an economic slowdown beginning in 2006, the enrollment trends could remain weak.

Second, the large amount of capital that has flowed into the industry has increased competition.  It seems that the post secondary schools are expanding as quickly as Subway franchises.  The number of new campus openings, expansions and relocations has dramatically increased in the past four years. 

In addition, the companies in the industry have been ramping up capital expenditures building new campuses.  That's despite the fact that on-line education continues to grow more rapidly and shows a higher return on investment.  The table below reveals that in 2004, the group spent more on capital expenditures as a percent of revenues than they have in the past three years.  Of course, this could be a blessing as well as a curse.  If enrollment growth resumes its prior growth trajectory, the companies will reap increasing leverage from the capital expenditures.  The companies have essentially expanded ahead of the growth and incurred lots of expenses doing so.  If growth reaccellerates, the margins for all the companies should expand. 

Finally, I would start to expect margin compression from many of the companies in the sector because of increasing sales, marketing and advertising expenses.  The companies have started fighting each other aggressively for new students as shown by the increased sales expenses.  The two tables below show that sales and advertising expenses as a percent of revenues have continued to grow rapidly over the past five years. 

According to my analysis, it certainly seems the post secondary education companies are facing slow enrollment trends from a strong economy and decreasing margins from fighting each other for the remaining students.  Earnings estimates in the group have already begun coming down but multiples remain high.  While some companies in the industry have interesting growth models, I believe the majority of the post secondary education stocks will remain stagnant until the economy begins to show signs of slowing. 

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