Description

After a near decade hiatus from Value Investors Club, years of media scorn, and an onslaught of regulatory headwinds, I hereby present to VIC members, for your consideration: UTI, a stellar value play in the for profit educational space (the Oscars are showing right now, so why not).  This is the highest quality business at the lowest price that we are finding in the market today, and is totally under the radar.  I realize that the phrase for profit education might immediately cause your body to erupt into convulsions and/or nausea, but I urge you to read on as I present a tale of compelling value and Wall Street neglect.  I think we are reaching the light at the end of the tunnel in the for profit education space and UTI is both well positioned and a great bargain.

So, what is UTI? 

UTI is a postsecondary educational institution, founded in 1965, that trains students to become auto and truck mechanics.  The business model is fairly straightforward:  there are 11 campuses, with a total of 14,500 students, who pay approximately $25,000 per year on average for their education at UTI.  Multiplying the student count by the average annual tuition gets you to the top line number.  The Company does a good job at detailing its cost structure in SEC filings, where you can get a good sense of the various components of cost of running the business.  Courses typically run from 1-2 years, after which students typically go to work for automotive dealers, aftermarket service companies, truck fleets and other industrial companies that require mechanics.  Approximately 65% of revenues come from Title IV programs (the federal government), 20% from veteran’s programs, and the remainder out of pocket.

Why do I want to own a postsecondary stock - a noted deep value abyss famous for financial treachery?

-          There is a fundamental shortage of automotive technicians and we think this shortage will ultimately pull additional students through UTI.  Cars have and continue to get more complicated, which is driving a need for technicians with a greater level of sophistication.  There is a fundamental shortage of trained mechanics with this skillset and as a result UTI students typically have a very easy time finding employment upon graduation (most recently an 88% employment rate).  In fact, more frequently employers are beginning to help pay off UTI students’ loans as a financial incentive for them to accept employment.  We think that this fundamental demand for UTI graduates will eventually lead to a rebound in student population at UTI – while it is not clear exactly when this will turn, we don’t think you are paying anything for that optionality at today’s price.  Here are a few articles that describe the shortage in automotive technicians:

http://www.ccjdigital.com/technician-shortage-fleets-dealers-shops-face-growing-gap-for-qualified-mechanics/

http://www.post-gazette.com/auto/2014/04/10/Automotive-technicians-are-in-high-demand-can-t-be-outsourced/stories/201404100125

http://www.successfuldealer.com/?p=19462&__hstc=125864786.5beab93357cf18f0bb744aac80f29c6b.1424278517745.1424278517745.1424278517745.1&__hssc=125864786.1.1424278517746&__hsfp=3217233370

http://usatoday30.usatoday.com/money/autos/story/2012-08-28/shortage-of-auto-mechanics-looms/57414464/1

http://www.autonews.com/article/20140519/RETAIL05/305199975/sputtering-auto-education-leads-to-skills-breakdown

https://www.youtube.com/watch?v=k6-igqIPaJo

-          The business is countercyclical and has enormous operating leverage.  UTI has struggled with student population in recent years as the economy has rebounded and as the business model has adapted to the new realities of operating in the postsecondary space.  We think it is more likely that student population stabilizes and begins to grow from here and that there is enormous upside leverage.  Incremental margins on an additional student are 75%, so round numbers you can multiply incremental students by $18,500 ($25,000 tuition * 75% flow though) to get the EBITDA impact.  An increase in student population of 1,000 would have an $18mm flow through to EBITDA.

-          We don’t think you are paying very much for this potential leverage to the upside at a 3.3x multiple of LTM EBITDA – which we think will increase from here.  We would note that management has guided for EBITDA to increase in F2015 from the F2014 levels.  This is far too cheap for the UTI franchise.  Further, as we look out to 2016 and model the positive impact from the ramp of the Long Beach campus, we think that EBITDA can see a nice step up as we move into F2016 and beyond.  In short, we think we are buying today at <3x EBITDA, and see the LTM number as a bottom with substantial upside.  There are some nuances to the UTI balance sheet which we think obfuscate the valuation opportunity – we will discuss this in more detail later in the writeup.

-          UTI is an extraordinarily high quality institution that will be one of the survivors in for profit education.  Student outcomes are excellent, and the relationship between UTI and employers is extremely close.  Students start planning their careers early in the course of their education and are employed at an 88% rate after graduation.  As a result, UTI is respected by regulators and will be largely immune from the ills that are impacting other players in the postsecondary space.  If you have your doubts about this, I would strongly recommend doing a campus tour – what these guys do is fairly remarkable.  I guarantee that you will leave the tour with the sense that this is an extremely high quality, and nearly impossible to replicate business. 

-          One of the Company’s key competitors, WyoTech (a subsidiary of now bankrupt Corinthian Colleges), is retracting from the business – shuddering at least two of their campuses, eliminating competition/capacity from the market.  WyoTech has a student population of approximately 5,000.  As noted above, even a swing of 1,000 in the student population would have a huge financial impact on the Company.

-          High barriers to entry – in short, nobody is going to try to get into this business.  What UTI does is so specialized and requires so much in terms of partnership with the OEMs, specialized equipment, large physical campuses, industry connections/credibility that UTI has created over the past 50 years, it is difficult to imagine someone trying to replicate the business.  Further, just to head off this question before it is asked – the nature of becoming a mechanic is such that it can’t be taught online, it is all about working on physical automobiles, trucks and engines.  So we think the quality of the business, despite being dumped into the “for profit education category” is really quite high due to the defensible nature and strong niche focus.

-          Though left for dead, management is seeing some signs of life in the business.  Of note, I would draw your attention to the recent uptick in “show rates” that were discussed on the most recent analyst call.  Show rates refer to the percentage of students who have applied and been accepted for one of UTI’s programs, who then actually show up for the program.  Show rate is crucial not just because it means incremental student starts /revenue, but also means that the organization is converting inquiries at a higher level, which drives efficiency/profitability (lower cost of customer acquisition).  This is a key reason that revenue is expected to decline this year, but operating income will increase modestly.  We think that the business is adapting to the changes in the market and getting more efficient at pulling students through the funnel, which will bode well for increasing profitability going forward.

-          In 2015 UTI is launching a campus in Long Beach which we think will be highly successful.  In 2010 the Company launched its Dallas campus, which has been an enormous success and is the template for the new Long Beach campus.  The concept behind Dallas was fairly straightforward – a smaller campus (1,000 student campus vs. a traditional campus with capacity for 2,000+ students), located in closer proximity to where the Company is seeing inquiry volume.  The Company has very good data, going back for literally decades showing where the highest levels of inquiries are coming from and where there is demand for trained students from employers.  What the Company has experienced in the last 10 years as the market has changed is that students are less willing to relocate in order to attend UTI.  So, the strategy on Dallas (and now Long Beach) was to place the campus close to where the inquiries are coming from and to target a smaller student population.  The economics of Dallas are fairly straightforward – it is a 1,000 student campus running at near capacity.  It generates about $25mm in revenues to UTI and given the high utilization, we believe that the contribution margin (pre corporate allocation) is running well in excess of 50%.  If you are familiar with Southern California, you know that we have a lot of a) people, b) cars and c) traffic.  I don’t know this for a fact, but I am fairly sure it is the largest local automotive retail market in the US and likely the world.  The Long Beach campus is designed to serve the local “west of the 5 (freeway)” population and network of auto dealers.  Like Dallas, the campus will have a 1,000 student capacity.  The Company underwrote the Long Beach campus based on the level of inquiry volume coming from this geography and based on the large number of interested students in the area who showed interest in Rancho Cucamonga but did not want to commute there or relocate to that area. Side note to readers who are not familiar with the local geography: Rancho Cucamonga is fairly close to Long Beach as the crow flies but not as a car crawls along the Los Angeles freeway system.  I would also point out, as an LA native, that there is a car culture in and around that particular location in Long Beach (which is distinct from Los Angeles).  For instance the Grand Prix of Long Beach is the single largest event annually in the city, and draws attendance of over 200,000 people.  A drive through the region will reveal a car culture that manifests itself in tuned suspensions, modified mufflers, and custom paint jobs.  In short, cars are cool here, and that culture drives kids to want to get into the automotive industry.  We think that Long Beach will be a big success and has potential to drive similar economics as Dallas.  Again, we think that these are opportunities that you are not paying for at today’s price.

-          From a timing/trading perspective, there is a significant shareholder - a long only fund, who has been indiscriminately dumping the security.  I will not name names, but you can probably reach your own conclusion by looking at the shareholder list.  As of this writing, I believe that shareholder is nearly out of the stock – though perhaps not completely – which should remove what has been a significant amount of downward pressure on the stock.

-          As a sign of the extremely high level of Wall Street interest in UTI, when they opened the most recent earnings call for analyst questions, all we heard was the beautiful sound of nobody else listening – not a single question.  Crickets.  We do not think the level of interest in UTI could be lower than it is today, which generally means that the interest level will go up (you can’t have less than zero questions asked on the next earnings call).   

Discussion of Valuation

As noted earlier, there are a few nuances to the valuation discussion on UTI that are quite material.  There are hidden assets at UTI and also false liabilities, which obfuscate value.  Your favorite purveyor of packaged and sometimes accurate financial information might tell you that UTI’s enterprise value is $178mm.  Upon further inspection, we calculate the enterprise value to be $104mm on a F2014 EBITDA figure of $31.4mm (more to come on the nature of these calculations); thus you are buying at a mere 3.3x multiple of EBITDA.  We think that the healthy players in the for profit space are currently garnering more than 2x that multiple and that UTI should trade at the high end of the valuation range in for profit education.

Proprietary Loan Program.  In an effort to boost affordability of their programs, UTI developed a loan program to help finance a portion of students’ tuition.  The loans amount to about $5,000 each, representing about 20% of the annual cost of a student’s education.  What is interesting about this program is that the Company does not recognize revenue from the portion of tuition that is financed by a loan (e.g. the Company would record $20,000 in revenue for $25,000 tuition that is financed with a $5,000 loan from the Company).  In 2014 for example, the Company extended $26 million in credit to students to help them finance their education, none of which was accounted for as revenue (that would have dropped entirely through to EBITDA had it been accounted for that way).  Similarly, the Company does not create an asset on its balance sheet for the loans made to students.  The only time that the program impacts the financials is when the loan principal/interest is actually collected in cash from students.  Perhaps more simply put, for a $25,000 annual tuition, a student will pay $20,000 upfront and agree to pay the last $5,000 over a period of 10 years.  The Company takes the most conservative accounting position possible related to the Proprietary Loan Program, which in effect creates an off-balance sheet asset that will be recognized over time as students pay off their debt.  The Company provides pretty good disclosure regarding its loan program in the notes to financial statements.  The total value of loans outstanding (money owed to the Company by past students but not recorded on the balance sheet as an asset) is $70.8mm.  That $70.8mm figure includes amounts written off but does not include an estimate of future writeoffs on these loans.  The loans are modeled after Title IV programs and have experienced similar trends in collections as Title IV loans.  Based on our assessment of the $70.8mm in outstanding loans, we think there is about $25mm in value in the loan program.  The Company is now collecting a little over $1mm a quarter in principle an interest on this balance – so while one can argue whether there is $20, $30 or $40mm in value in the loan program, it is undeniable that there is some value there that must be taken into account.  For purposes of our valuation we mark the $70.8mm in receivables at a conservative $25mm, more than a 50% discount to a figure that already includes sizeable writeoffs.  To be clear, when a “loan” is made under this program, there is no cash that is funded, this program could easily be described as a deferral of a portion of tuition payments by students.  Further, there is no revenue recorded and no asset on the balance sheet related to this program, there is no potential for future writeoffs, there is only upside as some amount of collections take place.

Lisle Lease Accounting.  You will notice a $33mm financing obligation on the Company’s balance sheet.   This is primarily related to the lease on the Lisle campus which does not qualify as an operating lease because of the Company’s partial ownership of the property (which is included in other assets as a $4mm JV interest).  So the Company pays rent at Lisle of about $2.9mm and also receives income from its equity ownership of $0.5mm.  For purposes of my analysis I just re-class the net $2.5mm as an operating expense and remove both the financing obligation and equity interest in the JV from the enterprise value calculation.  Note that the JV interest is buried in “Other Assets”, so most people do not even pick up on that.

Owned Dallas Campus.  While we do not put anything in our valuation for this, the Dallas campus is owned by the Company (the rest of their locations are leased including the new Long Beach campus).  This is one more lever for the Company to pull from a balance sheet perspective, if they wanted to do so, as the real estate at Dallas is worth somewhere in the range of $12-15mm.

Putting all of these numbers together, you are only paying about $104mm for a business that has generated LTM EBITDA of $31.4mm, and management is guiding to an EBITDA increase in 2015.  Further, looking into 2016E we estimate that the business can do closer to $40mm of EBITDA just based on starting to get some contribution from the new Long Beach campus and benefitting from the increase in student starts that management is expecting in the second half of 2015.

You are essentially paying a 3.3x multiple on trough EBITDA, and getting a ton of optionality for free.  As noted earlier in the writeup we see potential for a turnaround in student population due to the shuttering of Wyotech campuses or an increase in unemployment (potentially as part of jobs coming out of the energy sector).  Ultimately we also think the fundamental demand from employers for trained automotive technicians will eventually start to pull students through the UTI system and it is only a matter of time before that begins to happen.  There is a longer term opportunity – the ultimate upside scenario, if the Company can continue to replicate the performance of the Dallas campus in Long Beach and more new campuses down the road. 

The comp set in for profit education trades between 5 and 9x EBITDA – the range is wide because of the varying quality of the players in that set.  We think that UTI should be valued amongst the highest quality institutions in the space such as Strayer and believe that the current valuation reflects nothing more than a lack of interest in the Company, confusion regarding the numbers, and a large institution selling out of the stock.  As such, we have a one year forward price target of $16.00, representing 7x EBITDA on our 2016 estimates.  In short, we think that we can nearly double our money on a stock whose market capitalization reflects over 50% cash and receivables.

Regulatory Discussion

No discussion of for profit colleges is complete without a discussion of the regulatory maze surrounding the space -this topic alone could merit a lengthy discussion, so I will try to condense it into what I think are the most salient points that are impacting investor psychology.

Gainful Employment

The final rule with respect to gainful employment was published by the Department of Education (“ED”) on 10/31/2014.  The final rule is a fairly simple concept – it measures gainful employment based on a ratio of a) annual loan payment to b) annual income.  In order for an institution to maintain access to Title IV programs it must maintain these ratios above certain levels.  ED actually looks at two ratios – one based on total income and one based on discretionary income – for simplicity I will keep this discussion focused on the total income test, as a “pass” on either measure will satisfy the ED requirements and for UTI the total income test is the slightly easier hurdle.

The thresholds to pass the test are as follows:

-          Pass: ratio <8%

-          Zone: ratio between 8% and 12%

-          Fail: ratio >12%

There are a few important things to note with respect to the above:

-          In order to lose access to Title IV, you must either Fail for 2 consecutive years OR be in the Zone for 4 consecutive years.

-          Also noteworthy is that this test is calculated at the “program” level – based on a specific degree at a specific institution.  In the case of UTI there are 12 individual “programs” that are tested by ED

The data for UTI’s 12 programs as calculated by ED are as follows:

As you can see above, 2 out of UTI’s 12 programs fall slightly into the “Zone” as calculated by ED and 10 out of 12 programs are firmly in the Pass category.  None of the programs earns a Fail. 

Let’s put this into context to frame how big of a risk this is from an overall investment perspective.  Consider the following points:

-          Worst case scenario, UTI could reduce tuition for the 2 programs noted above (or increase the amount of Proprietary Loans extended) over a multi-year period in order to reach compliance.  This could be offset by very modest tuition increases in the 10 other programs – the Diesel programs in particular.  Note that the Company has already guided to tuition increases in 2015.

-          It would take 4 consecutive years of being in the Zone for the 2 programs noted above to lose Title IV funding (note that they are just outside of being in the Pass category, so they are fairly close to passing already).  We are quite a few years away from these programs showing 4 consecutive years of being in the Zone (and there is no guarantee that does indeed occur for 4 consecutive years).

Overall, when I really dig into the numbers on this topic, it just isn’t that big of an issue – there are lots of splashy headlines, but for the few that take the time to actually pick through the data and the nuances/timing of the rule it just doesn’t seem to be a very significant issue for UTI. 

When you compare the metrics for UTI to some of its competitors, one can see why this is a bigger issue for others.  Wyotech for instance has 24 programs as measured by ED:  only 15 of those programs earn a Pass rating.  7 of their programs are in the Zone and 2 are Fail.  So, this is clearly a much bigger issue for Wyotech than it is for UTI.  Applying this same methodology across the for profit education space clearly paints a picture of those who will survive and those are going to face significant problems.  From a big picture perspective, I think the for profit space is weeding out the losers – those who have been “bad actors” or do not provide a compelling education.  ITT, Corinthian and Education Management Corp fall into this category – and they are going away.  Those who survive will be stronger as a result of eliminating the poor performers.

Before we put this issue to rest, I would also note the APSCU (Association of Private Sector Colleges and Universities) has sued the ED over the final gainful employment rule.  APSCU successfully challenged the previous gainful employment rule back in 2012 and there is a good chance they do so again, which would effectively short circuit this entire issue.

Other Important Regulatory Hurdles

While I believe the uncertainty associated with Gainful Employment is the primary factor that is impacting investor psychology in the space, there are a few other tests that I would mention:

90/10 Rule:  This rule states that no more than 90% of an institutions revenue can come from Title IV programs.  UTI’s percentage ranges from 63% to 68%, comfortably within the bounds.

Loan Defaults:  In order to remain eligible for Title IV, an institution must not have a “Three Year Cohort Default Rate” in excess of 30% (and up to 40% in certain circumstances).  UTI has typically run in the high teens on this measure, very comfortably within the bounds of the rule and again amongst the best metrics in the for profit education space. 

Regulatory Conclusion

Overall, while there has been an enormous amount of noise with respect to regulation of for profit colleges, in UTI’s case I distill the entire topic down to a few salient points:

-          The dust is settling and the survivors are being separated from those that will not survive.  UTI is clearly in the category of being a survivor.  Among those who will not survive the new rules include Corinthian, ITT, and Education Management Corp. 

-          The final gainful employment rule, should it go into effect, is navigable for UTI.  It will potentially affect a small subset of programs, which could be modified slightly to come into compliance, and even so there is a multi-year timeframe to get there.

-          Specific rules aside, the Company maintains a very favorable relationship with ED and student outcomes at UTI are excellent.  The employment rate for UTI graduates has ranged between 85 and 90% and the important “completion rate” (the percentage of those that begin study that follow through to completion) is in the high 60s, far above the mean in the postsecondary space.  One way or another, things are going to work out fine for these guys because they simply do a good job for their students and have successful outcomes.  Virtually any politician who visits a UTI campus sees this and subsequently becomes an advocate for the institution. 

-          Republicans are firmly in control of congress and as such we see the political environment as an improvement going forward compared to the landscape over the past 6 years.

Summary

Overall we think that we are paying 3.3x trough EBITDA for a strong niche franchise with high barriers to entry.  A combination of poor investor sentiment, virtually no Wall Street interest, a significant institutional seller, and a few confusing accounting issues have created a great purchase price with limited downside and enormous upside.  We think the dust is settling with respect to the regulatory environment and UTI is firmly in the camp of “survivors”.  We see the business starting to get better from here and see the successful launch of the Long Beach campus as a catalyst for growth and greater interest amongst investors.  

Catalyst

Investor interest increases from no interest to some interest.  Long beach campus, wyotech closures, and an overall bottoming out of student starts cause EBITDA to start going up on an already extremely low valuation.