Description

This pitch is for a long investment in an underappreciated university bond, with both a long-term and event-driven angle.  Due to available associated bond volume of ~$200MM, this is only for smaller/selected accounts.  Additionally, as this was my (successful) pitch for VIC admission, the data is about a week old.

Introduction - Which University is University X?

1.       University X made $327.2MM in operating income in 2019, more than Harvard and behind only Stanford, UPenn, and NYU. 

2.       University X has 61,695 full-time students in 2019, more than any university in the U.S.

3.       University X has a 44.8% matriculation rate (enrolled / admitted students), higher than NYU, Williams, Caltech, or Rice. 

4.       University X has $1.7bn in cash and investments, which is similar to Georgetown ($1.9bn), and $3.1bn in total assets, which is more than Wellesley ($3.0bn). 

5.       University X reported the highest DSCR in the country out of any university in 2019, at 40.9x.

6.       University X reported the lowest liabilities / cash flow ratio in the country (of schools with >$200MM debt), at 1.1x

7.       University X reported the 8^th highest ratio of spendable cash and investments to total debt, at 8.3x  (of schools with >$200MM debt)

What is University X?  University X is Liberty University. 

Key Investment Highlight #1 – Liberty has a highly differentiated brand that has seen enormous success

A 2012 study of online dating found that of two profiles with the same average rating, the profile with the higher standard deviation in ratings generated significantly more engagement, clicks, and messages than the other.  In a world with myriad choices and increasing concerns about the value-add of higher education, being different is a strong tailwind for branding, and this branding serves as a competitive advantage.  To succeed, Liberty doesn’t have to be the best university, competing with schools like Harvard and Stanford.  It just needs to be the best university for a targeted subset of American students.  Liberty has not only realized this but embraced it, unlike most U.S. universities, which play the same game as Harvard but at a third-tier level.  Liberty, America’s largest university with a matriculation rate better than some of America’s most prestigious universities, has earned a world-class record of delivering value to a previously underserved niche, the 26.3% of Americans who identify as evangelical Christians. 

Liberty University was founded in 1971 by Jerry Falwell as “Lynchburg Baptist College”.   His son Jerry Falwell Jr. served as president upon his father’s death in 2007 until August 25, 2020, following allegation of impropriety (his departure is discussed further in Investment Highlight #6).      

Liberty’s University success and growth under Jerry Falwell Jr. has been remarkable.  From 2007 to 2019, he grew enrollment at a 9.2% CAGR, cash and investments at a 31.0% CAGR, but operating expenses at only a 12.4% CAGR.  Operating margins (excluding gifts) grew from 19.1% to 30.3%, now the fourth highest in the U.S. (behind Massachusetts College of Pharmacy & Health Sciences, Belmont University, and Savannah College, all of which have headcount <20% Liberty). 

Remarkably, despite its growth, Liberty has actually maintained or improved quality.  From 2009 to 2018, the average SAT score increased from 1009 to 1069, even as undergraduate enrollment increased +39% over the same time period.

Student retention (a proxy for student satisfaction) is well above the national average (83% vs. 72%) and compares with schools like the University of Oregon (87%), University of Iowa (86%), and the University of Kentucky (83%).

However, perhaps a better metric is the matriculation rate, or what percent of admitted students enroll.  For that, Liberty is the 41^st best in the nation at 44.8%, in a cohort of some of America’s most prestigious programs such as Johns Hopkins (46.1%), NYU (44.7%), Williams (44.6%), CalTech (43.8%), and Rice (40.6%).

Furthermore, a number of Liberty students are high academic achievers.  In evaluating schools by enrollment of National Merit Scholar winners, by combining publicly available information published by schools and the NMS Corporation Annual Report, it can be seen that, Liberty, with 35 winners, compares very favorably to schools like UVa (38), Georgetown (38), Ole Miss (32), and Ohio State (32).

After graduation, Liberty University graduates also compare favorably to its peer set.  They are less likely to default on federal loans (8.5%) than the national average (11.8%), the average of student borrowers from public institutions (11.7%), or the Virginia average (8.7%).  Contributing to the low default rates are the low levels of debt.  Based on data from LendEDU, Liberty’s Class of 2018 had an average debt per borrower of $22,836, placing students about $6,000 below the national average.  Finally, in terms of income potential, 10 years after graduating, the average Liberty graduate makes 14% more than the national cohort median. 

Key Investment Highlight #2 – Liberty’s financial success and financially prudent leadership has led to world-class credit metrics

Between 2005 and 2019, Liberty grew assets faster than any other American university (+35.0% vs. national average of +5.0%).  In 2005, with $174.5MM, Liberty was 192^nd in assets, with Linfield College (191) and Taylor University (193).  In 2019, with $3.1bn in assets, Liberty is ranked 40^th. 

As a thought experiment, if you assume that every U.S. universities grows assets at a +5.0% CAGR (the 15-year national average) and add to it operating cash flow (grown only at inflation), Liberty will become the 23^rd largest U.S. university by assets within 20 years.

However, despite this growth in assets, debt has actually declined in recent years, from $228MM in 2012 to $203MM in 2019.  Total liabilities are $435MM, with nearly all of the other liabilities comprised of deferred revenue of students’ tuition that is received ahead of the academic year. 

Liberty’s balance sheet is unusually clean.  Because it has a 401(k) retirement plan, it has no pension liabilities.  By comparison, for example, UPenn has $1.7bn in pension and post-employment healthcare liabilities. While UPenn is worse than most, in my set of comparables, 55.6% (138/248) of universities had pension and post-employment healthcare liabilities

Next, defining ROIC as operating cash flow / (PPE + total liabilities - non-interest bearing liabilities), Liberty University has the second highest ROIC (+22.7%) out of all U.S. universities.  The leading university, Massachusetts College of Pharmacy & Health Sciences, rode the pharmacy bubble that is about to / is currently popping.

These factors contribute to Liberty’s world-class credit metrics.  Liberty has the lowest debt-to-cash flow ratio out of U.S. universities (0.5x), highest DSCR (40.9x), and 17^th highest cash and investments to debt (8.4x).  These metrics easily exceed not only its ratings peer group (Aa3 / AA) but even AAA universities.  Of the 30 universities rated Aa3, the average total debt-to-cash flow ratio is 6.1x (+5.6x higher than Liberty), average DSCR is 5.2x (-35.7x lower than Liberty), average cash and investments to debt ratio is 5.4x (-3.0x lower than Liberty), and average operating margin 5.9% (-24.4% lower than Liberty).

Key Investment Highlight #3 – Liberty has a highly favorable and differentiated relationship with its labor pool and offers best-in-class protection for bond holders

Highly unusually for a well-endowed American university, Liberty has a flexible pool of instructors.  It does not offer tenure (except at the law school, where it is required for accreditation) and renews all faculty on a year-to-year contract.  This structure is highly favorable for prospective bond investors and no other university bond issuer has this relationship with its labor pool.  I believe that this is the most underrated credit-positive for Liberty. 

First, Liberty will never end up with a large pool of overpaid but underproductive elderly tenured faculty that drain resources without contributing value.  This issue, widely known as “dead wood”, is a common problem at traditional universities.  It can often be the result of universities over-hiring in academic areas that were once en vogue, such as in the liberal arts, and then, as tastes change, are left with few resources available to pivot to emerging fields such as data science and computer science.  Liberty will always be able to adjust its faculty to best meet the didactic needs of its student body on a year-to-year basis. 

For example, in 2018, 14 professors in the School of Divinity (~20% of the department) did not have their contact renewed as the school pivoted away from that field.  Liberty management stated that the reason was that students are less likely to work full-time for churches and more students were shifting to a divinity minor instead of a major.  Indeed, there had been a rapid decline in interest in the divinity major – the program went from 13% of the residential student body in 2013 to 6% by 2018 (with a similar trend in the online program).  As an additional example, in 2019, 12 professors in the Education department did not have their contracts renewed for a similar reason.  These pivots would be nearly impossible at other universities. 

Secondly, Liberty will be able to flexibly adjust salaries instead of having labor that is locked into long-term salary contracts.  This reduces the bargaining power of faculty and helps to keep labor costs in check.  Using publicly available data based on H1-B visa salaries, I estimate that Liberty University faculty members are paid about 11% less than the national average. 

Third, this has given Liberty tremendous flexibility to price labor more effectively that at other institutions.  Liberty often pays instructors per course-hour, allowing instructors some variation in their desired level of workload.  It also provides the university the ability to very quickly to respond to demand for new classes by paying the extra hourly rate to existing professors; by comparison, peer universities would often have to hire new people for which they may not have the approvals or long-term budget.  

Fourth, many other universities are mired in bureaucracy because of a disproportionate balance of power given to tenured faculty members.  In highly prominent example, Larry Summers lost his job as President of Harvard in 2006, largely because of issues associated with a dispute with the faculty.  As quoted in a New York Times article covering the episode, one former member of the Harvard Board of Overseers said, “How can anyone govern a university where a fraction of faculty members can force a president out?”  This threat serves to provide a chilling effect on bold leadership and results in inertia and decline.  Fortunately, this will never happen at Liberty. 

Finally, Lynchburg, VA has a reasonable cost of living (-11% the national average) that is even cheaper when compared to the metro areas in which many of its competing institutions are located.  Liberty is able to arbitrage a low COL area but charge tuition (both residential and online) that is set based on national trends.

Overall, this advantage is a critical benefit for bondholders and severely underappreciated by the market.  Note that this benefit has never once been mentioned in a ratings agency report (by either S&P or Moody’s).  In a true downside scenario, in which enrollment were to decline, Liberty would just cut faculty and would be able to maintain positive operating margins.  By comparison, for nearly every other major university with traditional tenure systems, they’d bleed out slowly with negative FCF and be forced to try to engage in headcount reductions via costly buyouts or costly and controversial legal maneuvers.  Liberty has a modern system of human capital management in a world with rapidly changing tastes whereas competitors are stuck with a system that was institutionalized in 1940 when colleges were headed into a post-WWII boom.

Key Investment Highlight #4 – Liberty is a leader in online education, with a first-mover and branding advantage

Liberty is, by some accounts, the largest non-profit education provider in the U.S. (by other measurements, a handful of others, especially Western Governors University and Southern New Hampshire University are in the same cohort).  How did Liberty have such tremendous online success?  Liberty has two meaningful comparative advantages in online education.  The first is a best-in-class nearly 50-year-long track record in distance education.  The second is its distinctive branding in evangelical Christianity.

First, what is the future of online education?  I think it is likely that online education will shake out the same way the online media has shaken out.  In online media, you have a few large players consolidating national platform (e.g. WSJ, NYT), some sector-specific players (e.g. Politico, Barstool), and then various freelancers across social media (e.g. Twitter).  The newspapers that have really been hurt are those like The Buffalo News (owned by Buffett from 1977 – 2020) in second-tier cities that lack the national brand of a WSJ but lack a sufficient content moat or specialty.  

I believe that education will shake out in the same way.  There will be room for premium players like Stanford and Duke.  But for the rest, how will customers decided between a host of schools with significant online presences, such as Western Governors, Southern New Hampshire, Arizona State, and Liberty University?  That’s where Liberty’s two comparative advantages come into play.   

Liberty University was perhaps the very first mover in distance education out of American universities.  In the 1970s, customers could buy videotapes that would be distributed by mail.  At first, the education focused on Bible Studies, but by the mid-80s included diverse and accredited coursework.

This long track record is a large competitive advantage for Liberty.  As Falwell Jr. said, “It took us about 20 years to perfect [online education], but when we did…we were the only non-profit poised to serve that huge adult market of people who had not finished college or needed a master’s degree to get a promotion.”

Today, Liberty now has a well-honed machine for getting new leads.  They pay ~$20MM per year to Google for advertising and they have a call center with ~300 people.  It is the largest operation of its kind in the non-profit education space. 

Perhaps the closest comparable, especially historically, was in the for-profit space, with the closest being University of Phoenix. However, as scrutiny has increased in the for-profit sector, the comparative advantage of Liberty has continued to increase on a relative basis.  Ben Miller, a former senior policy adviser in Obama’s Department of Education, said that the crackdown on for-profits offered Liberty a “marketing advantage.”  In 2019, University of Phoenix settled with the Federal Trade Commission for $190 million over deceptive advertising practices.  Although University of Phoenix is now privately held by private equity (Apollo), from 2004 to 2017 (when it was taken private), its stock price lost 92% of its value. 

The second key advantage that Liberty has is its distinctive branding.  A Liberty survey revealed that 83% of the university’s online students have a faith-based, religious connection to the university and chose Liberty because it is faith-based.  Furthermore, 26.3% of the U.S. population self-identifies as evangelical Christians, and for these, Liberty University has a clear branding advantage. 

This branding also helps to provide increased switching costs.  The first classes for students typically include an orientation class and three Bible-studies courses that typically cannot be transferred to other universities.  Thus, students are often compelled to continue out their education with Liberty or risk losing credit for their first credits. 

Key Investment Highlight #5 – Two key technical factors help explain why Liberty bonds are underpriced and why the underpricing can be resolved

First, a 2015 paper published on university bonds by professors from Notre Dame and NYU found that the size of the student body was statistically significant in predicting the issuance spread and trading costs (with smaller schools having wider spreads and higher trading costs).  The undergraduate student body at Liberty has grown at a +10.5% CAGR between 2005 and 2019.  Admittedly, the magnitude of the effect predicted by the academic paper is fairly small, but they did not look at spreads in the secondary market or changes in student body size over time.  I think it is reasonable to believe that the strong growth rate in the student body at Liberty is a considerable tailwind for the universe of potential buyers for the bond over time.  There is likely some lagged effect for which it takes 10-20 years for a graduate to become a potential bond purchaser.  Fortunately, there was a key inflection 10-15 years ago, as between 2005 and 2009 the undergraduate population increased +158.8%.  I think this growth over time will contribute to the bond’s liquidity in the years and decades to come.

Secondly, investors tend to invest in what they know.  For example, Ivković and Weisbenner (2005) in the Journal of Finance found that investors tended to have 30.0% of their portfolio in stocks with headquarters within 250 miles of their household, a +20.0% overweight to an evenly distributed portfolio.  The same bias has been shown of institutional investors. 

Liberty University graduates, despite being more successful than the average U.S. college graduate, are severely underrepresented in investment circles.  For example, on LinkedIn, if you search “Investment Analyst” for Liberty University graduates, you find only 44 results.  As an example, if you do the same for NYU or USC you get 938 and 606 results, respectively.

While anecdotal, I believe “home bias” or the “local bias” effect is even more magnified in university bonds than in other asset classes, and the lack of Liberty University graduates in professional investment circles has caused a dearth of investment analysts eager to study the investment.  The growth in Liberty University’s student population over time and the growth of its finance program in particular should help to partially ameliorate this.

Key Investment Highlight #6 – Recent events provide an attractive entry point and are a long-term credit positive

On August 25, 2020, Jerry Falwell Jr. stepped down as president following allegations that he acted in a manner that was incongruent with the evangelical Christian values of the university.  I believe that this is a long-term credit-positive and that it has presented an attractive entry point into the investment.

Governance at Liberty was always fairly weak.  Technically, Falwell Jr. reported to a board but the board only met twice a year and effectively gave Falwell Jr. free rein.  The board disproportionately consisted of elderly pastors who were friends with the Falwell family. 

I believe that there were a number of positives with this structure; for example, it allowed Falwell Jr. to engage in bold leadership that drove the financial success of the university. 

However, I think that the weak oversight allowed a number of excesses to creep into the university.  For example, Falwell Jr. had an unscrupulous habit of grift. Multiple members of his family, including his two sons and daughters-in-laws, were on the Liberty payroll.  Additionally, contracts tended to go to personal friends and a gym facility was transferred to his personal trainer.  Furthermore, he tended to act unprofessionally in regards to a string of personal feuds.  For example, Falwell Jr. had a personal feud over Trump with Mark DeMoss, who served on the board and whose father was a major donor.  Eventually, Falwell Jr. had him removed from the board and renamed DeMoss Hall to distance it from Mark.

Market segmentation analysis would likely conclude that it’s a net positive to be the one university in the country that is allied with a political party supported by ~40% of the population.  However, I think that branding can continue under the leadership of a more independent board and president who can avoid the personal pettiness and grift introduced by Falwell Jr. 

Although this is likely a long-term credit positive, the price has sold off following the Falwell Jr. news, perhaps as a result of forced sellers (a number of the holders are have religious affiliations, including The First Catholic Slovak Union, Baptist Life Association, and The Catholic Union of Texas). 

Between 7/13/2020 and 8/31/2020, the YTM of Liberty 5.1% notes due Mar-2042 increased 14bps relative to a set of comps (Pepperdine 59s, GWU 46s, Wesleyan 50s, and BC 47s).

There is precedent for university bonds selling off when universities are hit by unsavory news.  In November 2011, the price of Penn State munis sold off about 300 bps when the Sandusky news emerged.  However, the notes fully recovered by January 2012.

Investment Summary – There is a quality/price discrepancy that can yield an +8.1% return in one year (+661 bps over the benchmark)

I believe that there is a discrepancy between the quality and price of Liberty bonds.  My analysis focuses on the Liberty 5.1% notes due Mar-2042 ($100MM outstanding) but the same analysis applies to the Liberty 3.338% notes due Mar-2034 ($86MM outstanding).  Note that my analysis and comp set focuses on the taxable bond universe.

The current price is 136.0, an option-adjusted spread (“OAS”) to treasuries of 173 bps.  My one-year price target is 142.1 for an option-adjusted spread of 143 bps for a total return +8.1%.  Note that the ICE BofA Corporate Index for AA Bonds is 1.49%, so +8.1% is a considerably outsized return relative to its asset class and peer set (note the benchmark is not adjusted for tenor).

The 143 OAS target implies an improvement in the OAS of 30 bps, 14 bps of which is simply a recovery versus comps from the Falwell news fallout.  The other 16 bps I believe is best identified by an analysis of the comps set.  I am not expecting an OAS of sub-100 bps, similar to Harvard, Yale, Princeton, and UPenn.   

A 143 bps OAS is the average of Pepperdine 59s, GWU 46s, Wesleyan 50s, Lehigh 43s, BC 47s, and Holy Cross 49s.  Note that I did note include Lehigh or Holy Cross in the pre/post Falwell fallout comp set above because the Lehigh notes are a new issuance and Holy Cross had a pricing discontinuity event caused by its cotemporaneous announcement it was cancelling the on-campus fall semester from COVID-19.

To get a sense of relative credit metrics of Liberty vs. the comparables’ average, spendable cash and investment to total debt is 8.3x at Liberty (vs. 2.7x comps), total debt to cash flow is 0.5x (vs. 7.0x comps), and DSCR is 40.9x (vs. 2.8x comps).  It’s really just an extraordinary delta. 

Secondly, in terms of quality, I believe these names fall under the equivalent of “The Buffalo News” for newspapers – second tier players that can squeezed by better positioned competitors. 

For example, between 2005 and 2019, operating income actually declined at Pepperdine and Lehigh (from $14.9MM to $13.2MM and $15.4MM to $(5.6)MM, respectively).  Across the six comps, operating income grew at CAGR of only +3.9% (vs. +27.9% for Liberty). 

Nearly all of the comparables has been becoming less competitive over time (higher acceptance rates).  For example, from 2008, the acceptance rate increased from 37.4% to 40.8% at GWU, 27.9% to 32.1% Lehigh, 26.2% to 27.2% at BC, and 33.8% to 34.2% Holy Cross.   The rise of online education has caused mix-shift in the acceptance rate at Liberty, but controlling for that by looking at the transfer selectivity ratio, Liberty actually has gotten harder to get into over the same time period (43.8% to 42.2%).

Furthermore, every single one of the six comps has a worse matriculation rate than Liberty (comp average of 27.1% vs. 44.8% for Liberty).  And, while Liberty has seen an upward trend in its matriculation rate, all six comps have since a decline in the past 10 years.

Will Pepperdine even existing by the 2050s?  It’s seen a decline in its undergraduate population in the past 10 years.  By comparison, by the 2050s, Liberty should have a top ~20 endowment in the country.  Will Holy Cross or Lehigh even exist by the 2040s?  How many people, if any, would decide that they wanted to get an online degree from Lehigh or Holy Cross versus the other myriad options? 

In terms of investment downside, since 2019, the worst that Liberty 2042s have traded relative to the four best available comps with multi-year trading histories (Tufts 57s, GWU 46s, BC 47s, BU 45s) is 42 bps wide of where it is today, on a relative basis.  Thus, if the OAS spread were to widen to 215 bps (173 + 42), the expected one-year return would be -1.8%.

On an absolute risk basis, the largest risk is a change in interest rates, but the focus on this investment thesis is on relative value.  The biggest risk on a relative value basis is that the interim president and board appoint an ill-suited or incompetent new president.  Additional risks include Liberty University endowment losses, continued market share gains by public universities (especially Western Governors) in online education, and any pullback from the government around student loan availability (either in general or specifically targeted to Liberty, perhaps for quasi-political reasons).  Mitigants include that the CIO of the endowment, Don Moon, has done a successful job at Liberty for 30 years, that 83% of Liberty online students are attracted to the religious focus (which public universities legally cannot match), and that any disproportionate government scrutiny of Liberty vis-à-vis other universities is likely to cause a sharp response from Republicans broadly and especially the two Liberty alumni in the U.S. House of Representatives (Jackie Walorski and Adrian Smith).

Closing

 I’ll end with a quote from the 1920s: “Invest in Victory! Buy More Liberty Bonds Today!”

Comps Tables

Catalyst

Jerry Falwell Jr. stepped down as President on August 25, 2020.  Although the price sold off on this news, I believe this to be a long-term credit-positive.