Timeout CornerIn ITT's case, what happened was a federal investigation into its business practices. On Feb. 25, U.S. Postal Service inspectors and local county sheriffs executed search warrants and shut down the company's corporate headquarters and 10 of its 77 campuses. ITT, the largest U.S. operator of post-high school technical schools, said that grand jury subpoenas issued by the U.S. District Court in Houston sought data on student placements, retention, salaries earned by school graduates, recruitment and admissions. So far, U.S. Attorney Michael Shelby of the Southern District of Texas has said only that charges have not yet been filed against the company. Class-action lawyers have drawn their own conclusions in lawsuits they've filed against ITT Educational Services. The lawsuit filed by Milberg Weiss Bershad Hynes & Lerach alleges that the company has committed securities fraud by falsifying enrollment, graduation and job placement rates; by using those falsified records to secure federal grants; and, finally, by reporting inflated revenue thanks to those falsifications. Welcome to the wonderful world of investing in for-profit education, where the very real promise of the sector is exceeded only by the potential that an individual stock will blow up. I think the potential of the sector is so huge, though, that it's worth trying to find a way to navigate your way through the minefields. First, though, here's the big picture that makes it worth going to the trouble of figuring out this sector in the first place.
Blackboard JungleLet's start with market size. UBS Financial Services has calculated that for-profit, post-high school education companies can count on a potential market of about 17 million adults in the U.S. According to UBS, the market is made up of adults 25 to 44 with incomes between $35,000 and $75,000 a year. They're married and often have children, they work full-time and they have Internet access. These workers are considered the target market because they face the full brunt of the changes now sweeping through the economy, from outsourcing to the continued move away from manufacturing. In addition, they have the incomes to afford the training in business, education, nursing, technology, criminal justice and the like. But they don't have the luxury of quitting their jobs to enroll in full-time education programs. Internet-based instruction, which can be tailored to the pace of an individual student, is particularly appealing to this group. And it's the economics of the Internet that make the stocks in this sector so attractive to investors. The traditional bricks-and-mortar college or training school must increase its investment in classroom space and other physical facilities and hire more teachers to serve more students. Internet-based educational programs do add costs as enrollment rises for things like additional Internet infrastructure and for additional instructors to interact with students and monitor their performances. But the variable costs of Internet-based instruction rise much more slowly with increased enrollment than they do in the bricks-and-mortar model. Expansion for Internet-based education is a route to increased profitability. That produces some eye-popping numbers. UBS projects that revenue at Career Education ( CECO) will grow at a compounded rate of 55% annually over the next five years. The economics of the Internet, however, will drive profit margins from a current 31% to a target 45%. The increase in projected profit margins is even larger at other companies, UBS projects. At Corinthian Colleges ( COCO), it will go from 20% now to 40%, UBS estimates. At Educational Management, profit margins will go from 10% to 40%.
The Virtual WorldOne reason for this big difference is that education companies such as Corinthian Colleges and Education Management have just begun the transition to Internet-based programs. According to Lehman Brothers, only 1.9% of Corinthian's students and 2.4% of students at Education Management are online students. Compare that to 15% at Career Education and 41% at Apollo Group ( APOL), the Phoenix company that operates the University of Phoenix and related colleges. Of course, many assumptions are baked into this plum pudding. For example, to pay their tuitions, most of the students attending these schools borrow from the federal government. That means changes in federal regulations can easily roil this market. The likely repeal of the 50% rule (which requires that an educational institutional have 50% of its students attending classes on an actual campus to qualify for federal loan money) would benefit a company such as Strayer that, at 45% online, is now brushing up against the limit. But the repeal would also attract more competitors into the field by making it easier to set up Internet-only programs. (Apollo and Career Education are currently exempt from the restriction under a special waiver.) Even something as straightforward as an increase in the federal money available for loans under Title IV, the basic federal student aid program, can have unexpected consequences. Another rule, the 90/10 rule, requires that an educational institution get at least 10% of its revenue from non-Title IV sources. Corinthian Colleges, as of its last fiscal year, was near the limit at 82% of revenue. More money borrowed by more students might push the company over the limit.
The Real WorldBut perhaps the biggest assumption in any projection of the potential market is that customers -- students -- will find the education and training they purchase from these companies valuable in the marketplace. Here the jury is still out: There's no reason that Internet-based educational offerings have to be of lesser quality, but the for-profit educational sector continues to be plagued by problems of overpromising and underdelivering in the opinion of some students. On March 1, a former Corinthian Colleges student in Florida sued the company, claiming she had been misled about her school's accreditation and her ability to transfer credits to another school. Any projection of the market's size or the growth rate at these companies clearly depends on customers' opinion of the quality of the product. That's the macro picture. Now let's get down to how to judge individual companies in the sector. Here's my list of the six most interesting companies in the sector:
|Six 3-R Stocks to Consider |
There's high risk and big potential rewards in these names
|Company||March 29 Close||P/E Ratio|
|Career Education (CECO:Nasdaq)||57.59||48.6|
|Corinthian Colleges (COCO:Nasdaq)||31.65||38.5|
|Education Management (EDMC:Nasdaq)||31.43||36.1|
|Source: MSN Money|