Description

Action: I recommend shorting DeVry (DV). The company is trading at 26x June 2005 consensus EPS yet a) the core business (undergrad IT education) has not yet and may not rebound as expected, b) operating margins have been declining and improvement is limited, and c) current 2005 EPS consensus estimates are vulnerable.

Description: DV owns and manages higher education systems throughout North America. DV operates under the DeVry University (undergrad and grad management and technology programs with a network of 25 campuses and 39 centers), Ross University (recently acquired medical and veterinary school located in the Caribbean, though clinical rotations are completed in the U.S.), and Becker Conviser Professional Review (CPA, CMA, CFA prep courses at 250 locations). DV has recently begun to offer programs online.

Background: DV has been public since the early 90s. The stock performed well in 2000 as interest for IT education grew along with the technology industry only to disappoint in 2002 with the downturn. The company’s main business (undergraduate, mainly IT, 75% of its business) has had difficulty adding and maintaining enrollments and DV has increased advertising to strengthen the brand and to target adult students. Recently, DV also initiated a transition away from its “big box” campus models to smaller, more flexible centers.

In May 2003, DV acquired Ross University to diversify away from technology. DV paid $310 mm in cash (funded with debt). 2002 Ross revenues were $62 mm, EBITDA $25 mm and income $18 mm. The price was 12.4x trailing EBITDA, which an analyst at the time expressed as “steep” and “perhaps the most expensive acquisition in the group’s history.” The analyst questioned the timing, stating that DV should first focus on fixing its primary business, and doubted management’s claim that Ross has meaningful brand equity in the U.S. - given its Caribbean origin. The acquisition is estimated to be accretive by $0.12 in fiscal 2004.

In April, DV missed 3Q04 estimates. EPS was $0.23 vs. consensus of $0.25. The company attributed $0.04 of the shortfall ($6 mm of revs) to a change in the CPA exam schedule and a new computer-based program. Though the new student undergrad enrollment comp (key metric) showed improving trends, up 3.9% y/y, it was still below some analyst’ expectations. Plus, management indicated that demand for IT remained weak in the spring term and that most new student undergrad enrollments were coming from DV’s business programs at its centers and from online and not from DV’s IT programs. In addition, though marketing costs maybe stabilized, they remain high and the operating margin was down y/y for the seventh straight quarter.

Key Points:
• Core business is weak and its rebound is questionable. After four consecutive academic terms with sequential y/y improvement in new student and total undergraduate growth rates, DV reported spring 2004 enrollment rates that were essentially in line with the previous academic term. The rate of growth apparently remains below historical levels and has not bounced back as quickly as management had hoped. Plus, management indicated that most of the new student enrollments came largely from business degrees offered at DV’s centers and its online service and not from its core business of IT programs at its campuses. In comparison, though DV’s primary competitor, ITT, also had flat new student growth in its recent quarter, its metrics have been better than DV’s metrics since also bottoming in 2002.

Undergraduate Student Enrollment (Y/Y % Chg.)

Devry Sprg 02 Sum 02 Fall 02 Sprg 03 Sum 03 Fall 03 Sprg 04
New -12.80% -14.20% -12.30% -3.60% 2.50% 3.20% 3.90%
Total -2.10% -8.60% -7.20% -6.00% -5.20% -4.00% -4.40%

ITT 2Q02 3Q02 4Q02 1Q03 2Q03 3Q03 4Q03 1Q04
New 0.00% 6.10% 11.20% 7.20% 15.80% 20.70% 29.30% 28.30%
Total 6.90% 6.20% 6.00% 4.70% 6.60% 10.80% 14.60% 19.00%

While DV’s attempt to move away from its traditional, campus-based IT business through growing the number of centers, adding non-IT programs (such as with Ross and business), targeting working adults and increasing its investment in online may ultimately prove successful, at the very least, the realization of the strategy will take time. IT and the campus model remain central to DV’s strategy and will for some time. Given secular trends such as offshoring, lower post-boom salaries, and faster equipment replacement cycles, the rebound in IT demand is questionable.

• Limited revenue growth (ex Ross) and ongoing high marketing costs impede operating margin improvement. In order to support the new initiatives, DV’s marketing budget has increased dramatically. In the past quarter, selling and administrative costs were 34.1% compared to 33.5% in the year ago quarter and 28.2% in the two year ago quarter. Sequentially, the ratio has modestly declined, though it remains high. In comparison, ITT’s ratio has remained flat at roughly 29%.

S&A Expense Ratio

Devry 4Q02 1Q03 2Q03 3Q03 4Q03 1Q04 2Q04 3Q04
29.75% 32.13% 32.03% 33.49% 35.16% 35.91% 35.29% 34.07%

ITT 2Q02 3Q02 4Q02 1Q03 2Q03 3Q03 4Q03 1Q04
30.19% 29.02% 24.80% 31.09% 29.58% 29.39% 24.14% 29.25%

Until DV’s campus business improves and the new businesses show material benefits, the trend of high marketing costs will continue. DV’s operating margin is estimated to end 2004 at 11.4%, down from 17.1% in 2002 and 12.9% in 2003, (DV began increasing its marketing efforts in 2003). In the last reported quarter, operating margin fell 182 basis points yr/yr, representing the seventh straight quarter of yr/yr operating margin contraction. With limited visibility on revenue growth and the belief that marketing expense will remain high for now, a marked improvement in the operating margin is unlikely at this point.

Devry Operating Margin
4Q02 1Q03 2Q03 3Q03 4Q03 1Q04 2Q04 3Q04
16.61% 11.42% 13.79% 14.37% 12.02% 8.90% 12.08% 12.52%

• Current 2005 EPS estimates are vulnerable given revenue growth, operating expense and interest expense assumptions. As discussed, DV’s increased marketing expenses have had a major impact on its financial results. 2003 EPS was down 21% from 2002 ($0.95 to $0.75), with higher S&A expenses accounting for the entire decline (S&A/revenues was up 410 basis points). 2004 consensus EPS is $0.83 (excluding Ross, EPS would be roughly $0.70 or down 7%).

2005 consensus EPS of $1.01 assumes 10% revenue growth vs. 2004 growth of 5% (excl. acquisition) which is probably too high given the weak enrollment trends. It also assumes 170 basis points of S&A leverage (S&A/revenue ratio falling to 33.5% from 35.2%). If sales do not pick up as planned, it is unlikely that management will be able to lower marketing costs. Finally, estimated interest expense assumes that DV pays down over $100 mm of its $250mm and is dependent on free cash flow generation. If DV misses on revenues or operating margin leverage, then the cash will not be available to pay down the debt and lower the expense.

Valuation/Recommendation: DV currently trades at 26x 2005 consensus EPS. DV traded at similar levels in 2001/2002. However, the operating margin was 16-17%. Then and the consensus 2005 operating margin is 12.6%. Plus, a 12.6% margin is likely too high as 2005 consensus EPS may be too aggressive as explained above.

DV has been a favorite among short sellers for some time. However, the stock remains at high levels. Investors have been patient with the recovery in DV’s core business and the extent of the weakness in the business has been partially mitigated with the mid-2003 Ross acquisition. As time passes and the acquisition is anniversaried and there is further evidence of the core business not turning around, DV will disappoint. Current 2005 EPS estimates assume a meaningful recovery.

Catalyst

Earnings report indicating continued modest or down enrollment growth and a lack of expense leverage leading to consensus estimate reductions.