Apollo Still Searching Out The New Normal

By Stephen D. Simpson, CFA | June 25, 2012 AAA

One of the most dangerous investment plays for value-oriented investors is an apparently cheap stock of a company that is seeing a serious and significant reordering of its business and industry. That covers for-profit education company Apollo Group (Nasdaq:APOL) rather well, and I admit that I got sucked into what looked like a low valuation combined with a quality company built to last. The stock is down almost one-third since my late January optimism, and though the long-term outlook for the company is still solid, it's clear that this story is going to take time to work.

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Fiscal Third Quarter Results Aren't all That Strong
While Apollo Group did surpass analyst expectations for its fiscal third quarter, that doesn't mean the results was strong. Revenue fell 8.5% and the company saw a double-digit decline in enrollment (down 13%) and an 8% reported decline in new starts (while underlying new starts were down about 5%).

Profitability was also much lower. Apollo Group is increasing its spending on student advisory and career counseling services, and instructional/advisory costs increased almost 3% from last year despite the lower enrollment figures. That pushed gross margin down four and a half points, while operating income fell by one-third.

SEE: Zooming In On Net Operating Income

GE Data not Likely to Matter Much
The Department of Education released its gainful employment (GE) data early Tuesday morning, and the data seems broadly positive for the sector. Education Management (Nasdaq:EDMC) has already pointed to what it believes are errors in the data (inaccurately low debt levels), and it's probable that analysts and companies are going to find additional objections. That said, for companies like DeVry (NYSE:DV), Education Management and ITT Educational Services (NYSE:ESI), the data is at least a "no bad news is good news" situation.

For Apollo, the data doesn't really matter all that much. Analysts expected the company would be in good shape, and it looks like there was only one problematic program out of the 100 or so that was part of the evaluation.

When will the Growth Return?
Clearly there has been a big shift in the for-profit education industry. While some may point to the scandal and kerfuffle over poor graduation, employment and debt repayment rates (which spurred a widely-publicized government investigation), I don't know if many prospective students paid close attention to that.

What I do think is relevant is the high unemployment rate, the resistance of some banks to issue student loans and the growing skepticism about the value of for-profit degrees. Unemployment may offer up the time to take classes, but it takes away income and also the confidence that investments in career development are worthwhile. Moreover, I suspect that a lot of for-profit education is undertaken with an eye towards promotion and improved earnings potential as opposed to finding a job.

Whatever the case, enrollment rates are not good in the industry. That could play well for American Public Education (Nasdaq:APEI) with its orientation towards the military and its low tuition costs, and perhaps Grand Canyon Education (Nasdaq:LOPE) with its greater focus on nursing and healthcare (which has seen lower job loss in the recession). I'll also be curious to see how this works out for Universal Technical Institute (NYSE:UTI); this stock is not well-liked by sell-side analysts and analysts have been coming down, but I wonder if a company that skews younger will do better.

SEE: Student Loans: Loan Repayment

The Bottom Line
The boom in for-profit education is certainly past, and it remains to be seen whether the industry will yet need to go through a wringing-out process where companies close up shop or pursue survival-by-merger strategies. Certainly there is no shortage of programs and providers out there.

I still believe that Apollo Group will be one of the survivors, but its status as the largest company may make sector-leading growth more difficult. Improving employment and worker confidence would help enrollment, but it looks like 2012 is going to be another year of readjustment and reestablishing expectations for the "new normal."

These shares still look cheap, but then they did 15 points ago as well. Certainly these are not shares for the risk-averse, but even low single-digit free cash flow growth would suggest that these shares offer above-average potential over the long term.

At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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