Description

Universal Technical Institute (UTI)

Summary

Given liquidity constraints, this is an idea for smaller funds or personal accounts.

Ten years into an equity bubble it has been difficult to find compelling, non-cyclical value investments. In our view the investment landscape today offers a few choices, none of which are great:

• Highly cyclical investments ahead of a probable recession.
• Ultra-expensive “growth” stocks, many of which have never generated profits (e.g., UBER, PTON, etc.).
• “Quality” factor stocks which trade at some of the highest market valuations ever ex-dotcom (e.g. PG, MCD, CTAS, etc.).

UTI offers a compelling alternative to overpriced stocks for the following reason:

• A current valuation of ~7.0x forward FCF assuming unconverted preferred shares and a common share price of $7.22/sh.
• Counter cyclical earnings growth that has already inflected before the recession starts – growth should continue based on internally driven catalysts even if a recession is avoided.
• Clearly defined reasons for the mispricing including essentially the absence of sell-side coverage, a market cap too small for inclusion in the Russell 2000 and the Vanguard bid, ugly trailing financials, until recently a share price below $5 preventing many institutions from buying, and a misplaced degree of investor skepticism based on Obama-era hatred for the for-profit education industry.
• EBITDA that could easily double or significantly more in a recessionary scenario, resulting in ~200% share price appreciation.

The UTI thesis is simple; after a decade of regulatory and economic headwinds, the company has undergone an unnoticed transformation over the last few years including: 1) a campus rationalization; 2) a marketing overhaul; 3) a fixed capital structure; and 4) a new management team with an improved Board. UTI investors today own a company with an increasing student population, rapidly growing EBITDA and FCF trading at a low multiple of future profits, and a best-in-class trade school with minimal regulatory risk. Furthermore, we believe the FCF can realistically double within the next two years and owning it today at ~7.0x FCF multiple, in front of a forced-buyer wave in a thinly-floated market, offers a very attractive upside potential.

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Brief History

Trade school attendance tends to follow counter-cyclical economic trends. When job-switching costs are low the need of additional education for a prospective employee are also low. As the economy turns and jobs get more competitive, education and prerequisite experience become a desirable edge in a more competitive pool of potential employees. The previous recession illustrated this phenomenon in UTI’s attendance. In the period beginning September 2008 and ending September 2010, the company’s average enrollments swelled +33%. Management mistakenly believed the good times were here to stay and aggressively pursued growth opportunities via campus expansions. This strategy proved to be ill-fated. By September 2016, average enrollments declined -40% from September 2010 to ~11,700 and its financial profile significantly deteriorated.

The company made a series of financial and operational changes to undo the damage caused by the failed growth initiative. The company shut down some of its struggling campuses and divested, downsized, and leased its real estate exposure to reduce its footprint. In June 2016, Coliseum Capital injected $70 million of capital via preferred equity to ensure the company remained compliant with its regulatory covenants and enable management to execute on proactive initiatives.

Since the financing arrangement closed, management made several key changes. They opened several “commuter-friendly” campuses, added new welding and machining programs, and revamped its marketing efforts towards high school students. Due to ongoing “teach-outs,” enrollment continued to decline and masked the company’s progress. The changes were very successful, and management outlined logical tactics to achieve modest topline growth and additional cost savings in the proceeding years.

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Opportunity

In terms of the mispricing, these factors are either now or will soon be in the rearview mirror:

• The Norwood, MA campus is the last of the campus teach-outs, which stopped accepting new students in March 2019. Given the strong enrollment reported in September 2019, the negative impact was more than offset by the success from other initiatives. Per Management, the campus will be entirely closed in FY 2020 and the cost savings are expected to add $4m—$5m of EBITDA in FY 2021. Additional cost savings of $1m—$2m are expected from the successful renegotiation of its Exton, PA campus.
• Campus enrollment troughed in September 2018 at ~10,500 and FY 2019 was the first time in years the company experienced y/y growth. Two consecutive years of strong student start growth indicate the company’s revamped marketing strategy was successful and there is strong demand for the company’s educational offering in an environment with historically low unemployment.
• The company made a few changes to its Board of Directors and executive composition. The following professionals were added to the Board over the past three years: 1) Robert DeVincenzi (current Chairman); 2) Jerome Grant (current CEO); and 3) Chris Shackelton (Coliseum Capital). More recently, the company changed both its CEO and CFO. Troy Anderson, UTI’s new CFO, will be attending investor conferences in the near-term and is working on gaining additional sell-side coverage for the company which should raise institutional awareness of this left-for-dead equity.

Also, at its current market cap of ~$170m, UTI should easily clear the inclusion criteria for the Russell 2000 next June (a moving target but typically around $130m). Given that the top 10 holders of UTI own nearly 75% of the company, including 25% held by two members of the Board, index-linked ETFs are likely to have a difficult time finding supply to buy when the rebalance starts ~4 months from now (typically around April). This is likely to create a “squeeze” in the share price (there is no short interest). Assuming UTI does make it into the Russell, the volume and trading dynamics should significantly improve.

The trailing financials of the company look awful with significant net losses and revenue declines until recently. Much of this weak performance is explained by a 10-year economic expansion with recent unemployment prints near 50-year lows. UTI’s core student customer of the early 20’s male does not typically go to school when demand for manual labor jobs is high and easy to obtain, so much of UTI’s enrollment decline was due to the macroeconomic backdrop. The company has now inflected to profitability and is generating cash, so this aspect of the mispricing has started to fade, but the equity remains deeply undervalued.

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Risks

The hatred of for-profit schools is well deserved in most cases and we applaud the Obama administration’s efforts to clean up the industry. That said, many of the bad actors were weeded out. Most assuredly UTI is one of the *good* actors remaining in the industry. The company has high graduation and employment rates[1], high loan repayment rates, a long-term successful graduate profile[2], and industry-leading strategic relationships with major OEMs like Caterpillar, Audi, BMW, etc. that actively hire UTI graduates. All told, UTI is almost certainly the best trade school in the country for students looking to enter the automotive industry.

The immediate pushback will be that everyone knows Elizabeth Warren hates for-profit education. First, we doubt very sincerely that Warren will win the Presidency or even the nomination. But let’s say she does – her specific comments about the for-profit education industry are related to PE-backed schools with poor student outcome metrics.[3] Based solely on the data provided by the National Center for Education Statistics[4] and UTI’s aforementioned strong graduation rate and median earnings, we believe the company would remain outside of Warren’s purview. Additionally, UTI is not PE-backed, and it has best-in-class metrics along with best-in-class industry partnerships. This last point is important because major OEMs have been involved in the lobbying process with the goal of preserving an important supply of labor for their businesses. Headline risk aside, it seems highly unlikely that even if Warren wins it will be a material fundamental negative for UTI.

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Valuation

UTI recently reported blowout forward guidance for FY 2020, representing a significant positive inflection even without macro tailwinds. FY Guidance (Sep 2020):

• Revenue $338-345M
• Adjusted EBITDA $26.5-31.5M
• Adjusted operating income $13-18M
• Operating cash flow $28-33M
• Adjusted FCF $23.5-28.5M
• Capex $8.0-9.5M
• Average student population growth +1.0-2.0%

UTI has a preferred equity class in its cap structure held by Coliseum Capital, which sits on the board. On an unconverted basis, UTI trades at ~$185m of market cap, or about 7.0x the mid-point of the company’s 2020 adjusted FCF guidance. We use the unconverted math because we believe Coliseum is unlikely to convert to common given a historically long holding period, their position on the board, and a shared belief (based on our conversations with them, for what it’s worth) about upside potential in the stock – why convert when you can get paid to wait? While the preferred dividends of ~$5m annually are a negative for the common (we typically hate complex cap structures), there is so much upside to EBITDA and FCF on a multi-year basis that this doesn’t really matter in our view.

UTI’s P&L has tremendous operating leverage even with mid-single digit percentage increases in student starts resulting in substantial flow-through to the bottom line. This is true for two reasons. First, UTI operates a mainly fixed cost business. As shown below, both educational costs and SG&A declined y/y absolutely and as a % of revenue despite the increase in enrollments:

We expect to see additional benefits of UTI’s operational leverage with modest enrollment growth. As previously mentioned, we also expect to see margin improvement once the Norwood teach-out and Exton downsizing efforts are complete.

Secondly, the company possesses a significant NOL balance to offset future tax obligations. All told, the company has guided the Street to a 70-80% flow-through to net income from each incremental dollar of revenue. That is not a typo.

At ~7.0x 2020 FCF guidance, you don’t have to believe much will go right for this company for UTI stock to make a good investment, particularly ahead of a wave of forced buying by index-linked ETFs. That said, the 2009-2011 period should be instructive for any investors with a cautious stance on the current macro backdrop. Personally speaking, we expect a recession to start soon. If we are correct about that, it’s possible, if not highly likely, UTI could earn between $50-70m of EBITDA within two years.

In order to achieve the low end, we assume the economy starts to rollover in 1H2020, causing an uptick in student starts for 2H2020, bringing y/y average enrollment growth to +2.8%. The momentum would continue into FY 2021 and cause a y/y enrollment to increase +12.8%. We would also expect to see small leverage from educational service and SG&A costs. For reference, enrollments grew +6.1% and +17.3% in 2009 and 2010, respectively, and EBITDA margins were 9.9% and 15.2%, respectively. After discussions with the company, we believe our EBITDA assumptions are conservative given the recent cost-cutting and campus rationalization measures:

To achieve the higher end of the EBITDA range, we assume a more aggressive 2020 and 2021 y/y enrollment growth of +5.4% and +19.8%, small leverage from educational service costs, and moderate leverage from SG&A costs. The resulting EBITDA margin would come in slightly higher than 2009 and 2010 levels:

What’s it worth in this scenario? The stock topped out at about 8.5x EV/EBITDA on peak EBITDA during the 2010-2011 period. If you assume a similar multiple, the stock should trade between $17 – $23 of our low end to high end estimate, offering several hundred percent upside on a multi-year basis from the current level.

[1] https://www.uti.edu/disclosures

[2] FY 2019 Q4 investor presentation, page 8

[3] https://pitchbook.com/newsletter/elizabeth-warren-zeros-in-on-pe-backed-for-profit-colleges

[4] https://nces.ed.gov/programs/coe/indicator_ctr.asp

Catalyst

Profitability inflection, index inclusion, forced ETF-buying, low float, counter-cyclical business drivers, sell-side coverage