OVERVIEW

Grand Canyon Education (LOPE) is a for-profit education provider whose stock has appreciated rapidly to an unsustainable valuation due to fast growth in its online student population: 43x 2009 PE, 110x 2009 P/FCF, and 31x my estimate of 2010 earnings.  The school derives over 80% of revenues from Title IV student loans--a set of heavily regulated, federally-subsidized student loan programs--at a time when that program is undergoing extensive scrutiny.  LOPE itself is under investigation for the methods they use to recruit students, including an investigation by the Office of the Inspector General of the Dept of Eductation and a whistle-blower "qui tam" lawsuit.  In addition to headline risk, the company could face headwinds in its ability to grow its student base.  Although growth exploded in 2008 (67% YoY growth) and 2009 (53% YoY growth), that growth rate is already slowing.  Management expects 25-30% YoY growth in 2010, and anything less than that will be disastrous to the valuation.  Growth has also shifted over time from graduate-level students (62% of the student body in 2007) to bachelor's degree students (58% of the student population at the end of Q1 '10), showing that LOPE is finding it harder to recruit high-quality students.  Although growth is slowing, management forecasts that EPS will more than double in 2010 (to $1.21-1.27/share), and consensus analyst estimates mostly use the management estimates, hence justifying LOPE's high valuation.  In fact, I think LOPE is likely to end the year closer to $0.80-.85. in per share earnings, which at a 20x PE would value the company at $16-17, 30-35% below its current valuation.

COMPANY

LOPE offers graduate and undergraduate degree programs in three main core disciplines of education, business, and healthcare.  They market themselves as a "Private Christian College" and the vast majority of their students are age 25 or older.  70% of students study education or nursing, but they also have a business school and a liberal arts program (which mostly provides general education courses to people focusing on Education, Healthcare, or Business degrees).  Their business school is called the Ken Blanchard College of Business, a name they license from the author.  I wasn't familiar with Ken Blanchard's books so I looked them up on Amazon (see: http://www.amazon.com/Ken-Blanchard/e/B000APV1I0/ref=sr_tc_2_0?qid=1273454244&sr=8-2-ent ). Some gems: Whale Done!, Lead Like Jesus, and The One Minute Manager.  I find it hard to imagine that companies find an online MBA from the Ken Blanchard College of Business to be a huge value-add, and this suggests to me that it will be hard for LOPE to expand its student base successfully beyond people preparing for nursing and teaching careers.

The company uses a web-based online learning system which they call the ANGEL Learning Management Suite.  To access the demo click here: http://angel.gcu.edu/frames.aspx and use: password: gcuguest01 / login: gcuguest01.  In my opinion, the system did not seem very sophisticated (especially compared with what many web-2.0 companies are doing currently) and the course materials are very basic and dry.  Each course is separated into modules with each module include a list of Readings, Assignments, and Discussion Questions. In other words, the product offering is standard and undifferentiated.  There is very little multimedia or interactive content that would encourage a higher student retention rate.  Furthermore, LOPE licenses the ANGEL product from ANGEL Learning Inc, which was acquired by Blackboard and is being marketed to many online educational institutions.  Given that LOPE does not control their own IT they cannot use technology to differentiate their product offering.

REGULATORY ISSUES

LOPE is highly regulated and a detailed overview is covered in the most recent 10k section on "Regulation" so I will not cover the full background here.  Key points:

• In order to operate effectively LOPE must be accredited by the The Higher Learning Commission, one of the six regional accrediting commissions approved by the Dept of Education. This is vital to the business since LOPE must be accredited in order for LOPE's student to receive Title IV funding -- the primary way to get student loans.
• In March 2008 LOPE submitted an application for recertification of its right to participate in Title IV programs, but the Dept of Education did not make a decision by the usual June 30, 2008 deadline, instead extending the authorization on a month-to-month basis, pending the Dept of Education's final decision.
• In Aug 2008 the Office of Inspector General of the Dept of Education started an investigation in to LOPE's student recruiting practices that is not yet resolved.
• In Sept '08 LOPE faced a whistleblower lawsuit for the same subject.  They recently reached a $5.2 million settlement with the whistleblower, but the government has not yet approved the settlement.
• 90/10 rule.  According to the 10k: "an institution loses its eligibility to participate in the Title IV programs, if, under a complex regulatory formula that requires cash basis accounting and other adjustments to the calculation of revenue, the institution derives more than 90% of its revenues for each of two consecutive fiscal years from Title IV program funds... Given the level of complexity of such a calculation we are unable to quantify precisely the benefit [or penalty] that we would derive in the 90/10 percentage from these revisions. As such, our reported rates below exclude the benefits [or penalties] from the recent revisions. Using the Department of Education's formula under the '90/10 Rule' that was in effect prior to the August 2008 reauthorization of the Higher Education Act, for our 2009 and 2008 fiscal years, we derived approximately 82.5% and 78.6%, respectively, of our revenues (calculated on a cash basis) from Title IV program funds."

The sum of all these issues is regulatory uncertainty that, since it has been going on a long time, seems to have become increasingly ignored by the market and is not priced into the stock. 

The fundamental issue is that companies like LOPE have an incentive to recruit students aggressively, push the students to take out low-cost government loans, and then provide a fairly easy curriculum so that student drop-outs don't go too high.  The challenge for the government is to ensure that standards of educational quality are maintained, student can get decently-paying jobs after they get their degree, and that loans are paid back.  The basic conflict between the interest of the for-profit educational institutions and the government is likely to continue to create ongoing issues for the industry until the regulations fundamentally change.  In either case-continued regulatory scrutiny or fundamental regulatory change-LOPE is likely to face increasing challenges to its growth as the government seeks to keep educational quality high and LOPE faces increasing challenges finding qualified students. 

MANAGEMENT

Brent Richardson, the Chairman, joined in 2004 as CEO of LOPE and has been the Executive Chairman since July 2008. Prior to LOPE, he served as CEO at Masters Online. Christopher Richardson has been General Counsel since 2007 and as a Director since 2004 and prior to that served as the chief operating officer for Masters Online.  At the time of the IPO the Richardsons controlled 43% of the voting power via their stock and as of April 2010 they together own (directly or via 3^rd parties) 7.7 million shares and control voting on 14.1 million shares.

A new CEO, CFO, and President were recruited by the Richardsons in July '08.  Brian Mueller, the current CEO succeeded Richardson in July 2008. Prior to LOPE, he worked for Apollo group from 1987 to 2008 serving there as President and Director since 2006. He also served in Apollo as COO from 2005 to 2006 and as CEO from 2002 to 2005. He owns 0.2% of total shares outstanding in LOPE.  Daniel Bachus, a CPA, joined LOPE as CFO in July 2008. He worked for Loreto Bay Company as CEO from 2006 to 2007 and Chief accounts officer for Apollo from 2000 to 2006. He was employed by Deloitte and Touche prior to 2000. He holds 10,000 shares of LOPE.  Finally, Kathy Player has been president of Grand Canyon University since July 2008 and also served as the company's Provost and Chief Academic Officer. Prior to this period, she served in various capacities in the company's university.

Insiders have been selling recently.  See: http://www.insidercow.com/history/company.jsp?company=LOPE

In particular:

• Kathy Player sold 1000 shares (all she owned) in Nov 2009
• Chris Richardson sold 741,666 shares in Sep 09
• Brent Richardson sold 741,667 shares in Sep 09

INDUSTRY

LOPE operates in a big but competitive industry.  There are 11 public education companies including LOPE. Both in terms of revenue and no of students, 9 companies are ahead of LOPE in terms of revenue. Market leaders like Apollo and Career Education Corp have net cash in their balance sheet that gives them enough resources to make acquisitions, invest in their technical infrastructure, and invest in course development.  Typically in online businesses you see consolidation around 2-3 top performers, as consumers are free from geographic boundaries to pursue the best service providers.  There are also free alternatives in online education, like MIT's decision to make much of its course materials available free online.

In terms of the overall market, it's also worth noting that rising interest rates could also make it harder for students to borrow the funds required to attend.  Finally, with the recent pickup in the economy as employment possibilities increase LOPE may find that older students (the majority of LOPE's target) opt to focus directly on employment rather than additional schooling.

CATALYST

In May of '09 the Dept of Education started a process called "negotiated rulemaking" to update Title IV regulations, but negotiators were unable to reach agreement with the industry.  The result is that the Dept of Education will issue the new rules unilaterally.  Those rules are to be announced at latest Nov 1st 2010 and may have a major impact on industry recruiting practices, making it harder for LOPE to meet their lofty student recruiting goals.