Description

Investment Overview

Perdoceo (PRDO) is an online for-profit college (95% of students enrolled online) with an $800 million market cap and a solid balance sheet.  I think the market has overly punished PRDO for the unfavorable political environment and has created an interesting risk/reward opportunity for investors.  At $11, PRDO is trading at 2x EV/EBITDA multiple, pricing it like a distressed asset despite having $450 million of cash on balance sheet (>50% of market cap) and growing at a rate of $115 million a year ($1.60/sh).  At this pace, cash will be 75% of current market cap in 2 years, providing today’s investors an opportunity to buy the operating business at a significant discount. 

This opportunity exists due to an uncertain political environment with the new administration.  The Biden administration is expected to be tough on for-profit education as both Joe Biden and Kamala Harris have histories of pursuing for-profit colleges in their prior roles.  Joe Biden was VP during the Obama administration when they aggressively pursued for-profit colleges, and Kamala Harris led the charge against the now defunct for-profit Corinthian Colleges as California’s attorney general.  The administration has already passed a bill to change the 90-10 rule to include VA funding in the Title IV measurement.  This raises the bar for PRDO to receive more revenue from non-Title IV sources in order to receive government student aid.  Therefore, since Biden’s election, market has been punishing for-profit colleges in fear of regulatory changes that could hurt the industry. 

However, I think PRDO is well-positioned to weather through this environment.  It has proactively transformed itself over the past 10 years by selling and closing underperforming schools that could be targets of regulators.  At its peak in 2010, PRDO had 17 schools and over 100k students including international and culinary schools, but today it has only 2 universities with 44k students in strong majors, such as business, health care, and IT. 

Also, PRDO has time and cash on its side.  The new 90-10 rule will not affect PRDO until 2026, which gives it enough time to improve the ratio through non-Title IV programs, such as corporate partnerships and workforce development training programs.  PRDO can also utilize cash on balance sheet and future free cash flow to acquire non-Title IV targets to further improve the ratio.  PRDO doesn’t need a large acquisition, but anything small should be enough. 

I think a mixture of share repurchases and acquisitions would be highly accretive for PRDO.  PRDO will have roughly $500 million it can deploy in the next 2 years.  Through prudent capital allocation, PRDO should improve its 90-10 compliance and trade closer to its peers at 7x EBITDA or $27/sh.  If political environment improves, shares should trade at 10x EBITDA or $37/sh.  At the least, if PRDO maintains status quo, cash will be worth over $10/sh by 2023, creating a conservative floor valuation.  Thus, investors are provided a 2-3x upside potential with a substantial margin of safety.

Business Overview

Perdoceo operates two universities: Colorado Technical University (CTU) and American InterContinental University System (AIU).  Together, these two schools teach 44k students in business studies (76%), health education (13%), and information technology (11%).  Approximately 95% of students are enrolled in fully-online academic programs and over 60% of students are pursuing bachelor’s degree, 20% associate degree, and 10% Doctoral or master’s degree.  Both CTU and AIU are accredited by the Higher Learning Commission, which is one of the six recognized national accreditors and an important qualification to participate in the Title IV federal aid program. 

PRDO serves a segment of the postsecondary education market that has not been fully addressed by traditional public and private universities.  PRDO’s students are mostly working adults, typically female learners who are working full-time or have dependents.  60% of the student is over 30 years old while only 4% is below 21 years old.  This is markedly different from a traditional 4-year college where students usually attend right after high school and are full-time students.  PRDO’s fully online programs allow adults to work flexibly around their schedules whenever and wherever they want. 

There are 20 million college students in the US and for-profit institutions serve less than 6%.  During the pandemic, while public 4-year colleges experienced significant declines in student enrollment, PRDO was able to grow due to its use of technology and online courses.  As such, in spite of regulatory and other challenges facing the industry, for-profit colleges continue to have significant opportunities to address the demand of working adults. 

Political Risk

For a long time, for-profit colleges have been targeted by critics who claim that these institutions take advantage of students through malicious marketing tactics and leave them with insurmountable amount of debt.  The Obama administration acted to punish for-profit colleges through prosecution and regulation.  PRDO was not immune to this environment.  It was involved in multiple lawsuits and paid $170 million in cumulative legal settlements since 2010.  Currently, PRDO has no outstanding litigation or regulatory overhead. 

An important regulation for for-profit colleges is eligibility of Title IV funding, which allows schools to receive federal financial aid.  Any changes to eligibility rules for Title IV can have large implications on PRDO’s revenue, because 74% of students and 80% of cash receipts are from Title IV federal aid programs. 

One of the main requirements of Title IV is the 90-10 rule.  The 90-10 rule caps the percentage of revenue for-profit colleges can receive from federal financial aid sources to 90%.  If the school does not comply with this rule for 2 consecutive years, it will lose eligibility to participate in Title IV programs.  In the current rule, student aid from the US Department of Defense for service members and veterans does not count as federal education fund.  It counts toward the 10% minimum and critics have long complained that this incentivizes for-profit institutions to aggressively target and enroll veterans.   But the American Rescue Plan Act, signed by President Biden in March 2021, closes this loophole and now requires VA funds to be categorized in the 90% bucket. 

This is a critical change for PRDO, because the ratio will move unfavorably and put PRDO at risk of breaching the 90% threshold.  Both CTU and AIU are compliant with the current 90-10 rule at 82% and 86%, respectively, but they will move higher if VA funds are recategorized.  I think the market is pricing in the risk of PRDO losing Title IV eligibility, but this is a misjudgment of timeline and an assumption that PRDO will remain static.   I believe that odds of losing Title IV is highly unlikely as they have many levers to pull and a big window to make change. 

The new policy is subject to negotiated rulemaking after October 2021 and the earliest effective date for the measurement is 2023.  From there, PRDO needs to fail 2 consecutive years to become ineligible for Title IV funding.  Therefore, it has until 2026 before federal financial aid is at risk of shutting off.  That provides 5 years to take action and PRDO is not sitting around. 

PRDO is focused on expanding the corporate partnership program, which is non-Title IV revenue and has a material impact on the 90-10 ratio.  This program is also low cost for students as they are partially paid by the employer and awarded grants.  Revenue per student might be lower for PRDO, but student acquisition cost is lower and these students tend to be more persistent in their pursuit of long-term learning, resulting in higher life-time value per student.  Overall, it’s an efficient program for all parties involved and tackles outcome and cost, both of which are important to regulators. 

As of December 2020, corporate partnerships represented 20% of CTU’s and 5% of AIU’s students.  Management has commented in the latest earnings call that they have been hiring corporate partnership teams.  The new hires will be fully integrated in the second half of 2021.  With the drive and focus of management, it is reasonable to expect the share of corporate partnership to increase at both universities.  Also, there is no reason why AIU’s share of corporate partnership should be below CTU’s.  The two universities have very similar profiles and the same institutional accreditation, so the gap should narrow over time. 

Another program PRDO is working on is workforce development training programs.  These are shorter duration non-degree online courses that help adult learners obtain additional credentials and prepare them for changes in the workforce.  PRDO identified several courses in the technology and health care space and expects to begin offering these programs in 2Q 2021.  AIU has already started taking enrollment, and if successful, will be expanded to CTU. 

Lastly, PRDO can acquire non-Title IV programs.  Anything that leads to professional certification is eligible, such as boot camps, certificate companies, or educational institutions.  PRDO will not add programs just for the sake of improving the ratio, but it will diligently search for strong programs with great fit.  PRDO doesn’t need to make large university acquisitions, but small add-ons are enough to benefit.  Assuming PRDO retains $200 million of cash balance to ensure it can deal with any twists on the regulatory front, PRDO will have roughly $500 million of cash to deploy in the next 2 years, including 2 years of free cash flow.  This provides a lot of flexibility to pursue external growth. 

For these reasons, I feel comfortable PRDO will remain well within compliance of the 90-10 rule and I believe the stock will reprice higher as PRDO executes on these programs and acquisitions. 

Other regulations that need to be monitored:

·         85-15 rule: There have been proposals to change the 90-10 ratio to 85-15.  Final legislation does not include this policy and it seems unlikely to change in the near future, but if enacted, PRDO’s current path to diversify away from federal sources will keep them safe. 

·         Student loan default rate: if the 3yr cohort default rate exceeds 30% for 3 consecutive years or 40% on any given year, the institution will not be able to participate in federal student aid program.  CTU and AIU’s default rates are roughly 19% and have improved 100 bps over the past 3 years.  This is higher than the national average of 10%, but still significantly below the 30% threshold.  As part of the CARES Act, federal student loan payments were suspended from March 2020 through September 2021, so the rolling cohort default rates will have a favorable impact for the next 3 years.  I don’t expect any regulatory changes on this metric. 

·         Gainful Employment: To punish schools for programs that lead to low-paying jobs and unmanageable amount of student debt, Obama administration established the “gainful employment” rule.  This requires any program with graduate’s loan payment exceeding both 8% of total income and 20% of discretionary income to improve or lose access to federal financial aid.  “Gainful employment” came into effect in 2015, but was rescinded by Trump in 2020.  It is likely to be reinstated under the Biden administration, but it doesn’t pose a risk to PRDO because it has been satisfying this rule for years.   

·         Free community college: White House is proposing free community college for 2 years in the American Families Plan.  This will be a very expensive policy and has a lot of pushbacks from the Republican party.  If enacted, I think it will have limited impact on PRDO.  Majority of PRDO students are working adults while community college is oriented to younger full-time students, so PRDO has little overlap with community college.  In fact, this policy could increase potential students for PRDO’s bachelor’s degree as free community college increases students pursuing 2-plus-2 progression where they attend 2 years of community college and transfer to complete their degrees elsewhere.  PRDO’s online presence could be a strong sticking point for these students and they tend to be more dedicated individuals to complete the degree. 

Valuation

PRDO generates around $160 million in EBITDA and $115 million of free cash flow against an enterprise value of $350 million.  At this pace, cash balance will be $530 million ($7.40/sh) by the end of 2021, $650 million ($9.20/sh) by 2022, and $760 million ($11/sh) by 2023.  In 3 years, investors will get all their money back and have the operating business for free. 

PRDO has been very conservative in spending cash to prepare for the new administration.  However, in the future, I expect them to use cash in a mixture of acquisitions and share repurchases.  Buybacks are highly accretive at current prices (2x EBITDA multiple) while acquisitions are less accretive, but beneficial to regulatory compliance.  According to recent comps of American Public Education buying Rasmussen University at 8x and Adtalem buying Walden University at 8x, I assume 8x EBITDA for future acquisitions.  

It is difficult to predict the right mix, but I model $450 million of cash (available for allocation by the end of 2022 after leaving $200 million on balance sheet) is distributed $150 million to share repurchases at $12/sh and $300 million to acquisitions at 8x EBITDA.  This approach decreases share count by 20% and increases EBITDA to $200 million.  Applying a 7x EBITDA multiple values the company at $27.  I think this is a reasonable valuation as peers are trading at 7-11x EBITDA.  Additionally, I haven’t included organic growth, which could lead to a higher price or better margin of safety.

If political environment improves and investor sentiment turns positive, PRDO should trade at 10x EBITDA.  In this scenario, operating business will be worth $2 billion with $200 million of cash, valuing PRDO at $37/sh. 

Catalyst

• Buybacks, initiation of dividend, or acquisition          
• Change in political environment