Description

SLVN is significantly undervalued relative to the $1.30, $1.82, and $2.37 the company should earn in '04, '05, and '06. While the current price of 22.3x '04 estimates definitely puts SLVN out of the league of "low multiple values", SLVN is cheap relative to the intrinsic value of its future growth potential (which is highly visible & comes with powerful incremental margins). Due to historical factors, SLVN is a "show-me" stock. The "show-me" factor, combined with an underappreciation for the sustainability and the robustness of the company's business model, makes the stock interesting here.

Before I go into more detail, I would like to note that I wrote SLVN up in late 2002 when it was at $13.00. I actually like SLVN more today at $29 than I did back then because I have more visibility and confidence than ever before in the company's robust growth prospects. Back in 2002, SLVN was a complex amalgamation of 4 business units--> K-12 tutoring centers, international campus-based universities, US on-line post-secondary education programs, and a venture capital unit. As I explained back in 2002, this structure created a complexity discount that severely penalized the stock and is still responsible for the "show-me" discount that exists today.

Since 2002, SLVN has done a great deal to simplify the story. They got rid of Ventures & K-12 and now they have only two divisions-- international campus-based universities and US on-line postsecondary education. There is no-longer a need for pro-forma reporting, and the company reports their results based on GAAP EPS.

In 2003, SIU (Sylvan International Universities, the international campus-based segment) will represent $363mm of revenues and $61.5mm of segment profit. OHE (Online Higher Ed) will represent $92.6mm of revenues and $13.1mm of segment profit).

SIU currently has 92K students, of which 40K are in Mexico, 40K are in Chile, 7.4K are in Spain, 2.8K are in Switzerland (in a hospitality program that attracts a global student body), and 1K are in France. The company reports detailed total and new enrollment figures for each of these geographies, and the trend has been extremely powerful for the past 3 years. This is EXTREMELY important because the average length of stay in the programs is 4 years. This leads to the concept of "filling the pipe". You see, SLVN has been growing the size of the entering freshman class at an extremely powerful clip for the past 3 years (20-30% growth rates). This creates EMBEDDED growth-- if SLVN's new enrollments going forward were to be flat (which I do not believe will happen), total enrollments would still grow nicely as the current entering class run-rate fills the pipe. Based on what we know today, the revenues for 2004 are pretty much locked in (except for unexpected student attrition which has historically been very stable). There is also tremendous visibility on the "worst-case" for 2005 which isn't all that bad.

Not only will the filling of the pipe drive growth, but I believe SLVN can continue to grow new enrollments at a 10-15% clip over the next few years because the model has legs. SLVN is driving same-campus growth by adding new programs (specific courses, adult learning programs, etc). There is also a natural word-of-mouth factor that makes growth self-perpetuating (with limits, of course). As more students learn about the school and tell friends about their experience, more and more students come to the school. Also, SLVN has been good at using "best practices" and taking marketing programs from one geography where they worked and using them in another area. There is still more room to go on this. Most importantly, SLVN is investing in new campus expansion which provides a unit-growth element to the story that provides the true legs for really long-term growth (it is hard to grow same-campus enrollment at >5% over the VERY long term).

I expect total SIU enrollments to grow 18% in 04 & 05. Longer-term, I would be happy with SIU enrollment growth at 10%. Incremental margins in SIU are about 40% and the current operating margin is 17%. The long-term growth model would look something like this: 10% enrollment growth + 5% real pricing growth + 10% EBIT growth from margin expansion + FCF deployment (buyback or acquisitions) would drive 25% EPS growth. SLVN should blow this growth model away in 04 & 05 and be able to meet this growth model past 05 for a number of years.

The growth prospects and economics of the on-online higher ed segment are similar, but the visibility is a little less (due to a shorter average length of stay). 2004 growth on that segment will be somewhat muted in the 1st half due to a complex transition that I won't spend too much time here. Basically, they have a program called Canter that provides materials for graduate teacher-ed programs that were delivered through partners. SLVN bought a company called Walden that gave them their own distribution capability and then decided to prune some partners that were not carrying their own weight. This has set SLVN up well for long-term growth, but puts a damper on this segment's growth for the next 2-3 quarters (the segment will still grow nicely, however). I expect that after 2004, OHE will have 25%+ revenue growth and 30-40% EBIT growth (EBIT growth > rev growth due to inherent margin expansion). There is a chance that growth could be much higher than this due to the explosive new enrollment trends that have been demonstrated in the last two quarters, but I prefer to be conservative here because of the niche-orientation of SLVN's on-line programs and the high existing penetration of this niche.

SLVN recently conducted an analyst day that provided an extremely detailed overview of the various divisions of the company (a presentation for each country where SLVN operates as well as for the two sub-segments of the online business). I recommend that anybody who is intrigued by this idea either listen to the archived webcast or pull out some sell-side notes on this event.

One factor that keeps some investors away form SLVN is the political, regulatory, and currency risk that SLVN has by operating in Chile, Mexico, Spain, and Switzerland. As far as FX goes, SLVN's basket of exposures has historically netted out to a minimal overall effect. This risk is mainly that of translation as the bulk of costs are matched in the same country as the revenues (costs are local). Since the last quarter, the weakening of the $ against all the currencies except the Mexican Peso has created a positive net effect. I do not believe there is much political risk in these countries, and I think the regulatory framework is also benign.

Catalyst

1) Q4 03 results will "prove" the operating leverage that exists in the model, 2) 2004 EPS guidance is conservative and needs to be revised upwards-- this could happen on the Q4 03 EPS call, 3) company will give 2005 EPS guidance on Q1 04 EPS call (they can do this due to the high visiblity in their model). I believe this guidance will be close to the 05 numbers that I have (somewhat lower due to conservatism). Putting this number "out there" will allow people to drive their valuation off 05 figures.