Description

Apollo Group, Inc. (APOL) is the largest company in the for-profit postsecondary education industry.  There has been a lot of change going on at APOL for the last several months, including senior management turnover, slowing enrollment growth, changes in strategic direction, cessation of short-term financial guidance and investigations into stock option practices.  Amidst all these changes, the company’s stock price has fallen steadily from a high of $96 in April 2004 to prices in the $40/share range in the last several weeks, closing today at $49.67. 

The ownership base seems to be moving from high-growth shareholders to GARP-oriented shareholders – and the stock is now probably caught somewhere in a middle ground, still seemingly too expensive for traditional value investors yet without enough growth for traditional growth investors.  Many people on this board have probably tended to avoid APOL in the past because of its high valuation and perceived shady business practices throughout the for-profit education industry.  However, if investors can look past the current noise (and there is a lot of it), then they may be able to pick up shares of a company with very high quality financial characteristics for a reasonable price.  At a minimum, it is worth learning more about this company in case the price falls even lower.

APOL operates through four subsidiaries: the University of Phoenix, The Institute for Professional Development, the College for Financial Planning Institute, and Western International University.  The schools have regional accreditation, which is the “gold-standard” of education accreditation in the United States.  APOL currently has students seeking associate (73,400), bachelors (168,600), masters (77,300) and doctoral (3,800) degrees.  These degrees are in the areas of business, criminal justice, education, health care, human services, IT, management and nursing.  University of Phoenix accounts for approximately 83% of revenues and the other schools account for the remaining 17%.  Importantly, federally funded student loans (Title IV programs) comprise 63% of APOL’s revenue, and 45% of University of Phoenix students receive employer tuition assistance.  While the regulation creates risks that may scare away some investors, it results in a less price-sensitive customer.

Given APOL’s historical financial performance, it is no surprise that the stock had been a rocket until recently.  If we look at the history of APOL, we find that the company has grown revenues at 20% and 30%+ rates for years and has achieved significant margin expansion.  Specifically, revenues have climbed from under $300 million in the late 1990s to nearly $2.25 billion last year, and EBIT margins have expanded from the high-teens in the late 1990s to 31.7% last year.  Total shares outstanding today are approximately equal to what they were in the late 1990s.  Returns on capital have also been stellar.  Pretax returns on capital were 63% in 1997 and 224% last year, and after-tax returns on equity were 27% in 1997 and 63% last year. 

In January, however, the company announced the abrupt resignation of chairman and CEO Todd Nelson (after an apparent rift with founder Dr. John Sperling) and the appointment of Brian Mueller, a 19 year veteran of the company, to the position of president.  Dr. Sperling, who is 85 years old, became interim executive chairman of the board and, not surprisingly for a company founder, has vowed to re-energize the company’s growth trajectory.  Enrollment, which had averaged well in excess of 20% per year for the last several years slowed to a single digit rate in fiscal 2Q ended in February.  In addition, average revenue per student began turning negative after years of mid single digit increases.  An investigation into stock option granting practices is ongoing, which while disconcerting is probably not going to result in the destruction of major shareholder value over the long haul.

The APOL growth story is obviously slowing way down.  But that does not mean that APOL will not continue to be a very good business.  According to management, it appears that enrollment growth is settling down at the 9% level and may pick up from here over the next few quarters.  In addition, it is important to understand that while average revenue per student is down, that is largely due to mix shift toward Axia College students (targeting younger students 18-24 years old with little or no college experience) and continued migration of business online.  Even on dramatically reduced growth expectations, APOL is highly likely to be a good business and a good stock for investors with a multi-year time horizon. 

Investors can run their own models on what they think the future will bring.  But despite all the controversy surrounding this company, there is little reason to think that it will not continue to grow at above average rates with high returns on incremental capital.  In particular, I would draw your attention to the prospects for continued expansion of University of Phoenix, stepped up growth of Axia College, new international growth focused on Brazil and Mexico followed by China and India, and improved lead selection (as the company has signed new deals with AOL’s Advertising.com and with Monster).  To give a general idea of what we can reasonably expect over the next few years, if we assume that revenues can grow at 9-10% and that margins stay flat at the runrate 29.5% level, APOL is likely to produce earnings per share growth of roughly 15% per year, including share repurchases; it could do even better if growth takes off the way management believes that it can.

At the current $49ish share price, APOL has a market capitalization of $8.7 billion and an aggregate value of $8.4 billion (there is over $350 million of net cash on the balance sheet, excluding an additional $245 million of restricted cash).  Investors can now buy into this business at reasonable multiples for the first time in years.  Specifically, the company is selling for 16x earnings and free cash flow and 10x EBIT.  A company with these outstanding financial characteristics is probably more likely worth closer to $60 rather than the current $49.  Interestingly, the holders list indicates that well-known value investors began buying shares at prices above the current quotation.  There is nothing to ensure that the price will not trade down in the near-term given the various controversies swirling around the marketplace, but I would expect a very satisfactory return from current levels.

Catalyst