A Bright Future for This Graduate

05/17/2010 1:00 pm EST

Focus: STOCKS

Paul Larson

Editor, Morningstar StockInvestor

Paul Larson, equities strategist and editor of Morningstar StockInvestor, and analyst Todd Young say the largest for-profit education company has great prospects ahead.

Apollo Group (Nasdaq: APOL) is a leader in for-profit education. Its University of Phoenix, which makes up about 95% of its total revenue, has had strong growth recently, partially because of the weak economy.

However, long-term secular growth trends in education and international opportunities bode well for Apollo. With the largest scale in the industry, efficient operations, price-inelastic customers, and corporate- and government-aided financing, Apollo has a wide economic moat.

Apollo is the largest for-profit education company, with more than 450,000 students in its core school, the University of Phoenix. The company offers classes online and through campuses in 40 states, as well as various international locations. Programs range from associate degrees to doctorates, in areas such as business, education, health care, technology, and social and behavioral sciences.

Increased financial aid limits have helped increase affordability, and therefore increased demand. The cost structure of a for-profit education firm is much lower than that of a traditional college or university. As long as financial aid limits are set according to tuition prices of the high-cost-structured traditional schools, Apollo should be able to earn sizable economic profits.

Additionally, competition should not be a significant factor any time soon, since the future demand for education far exceeds the current supply. Traditional schools lack the ability to expand their services to working adults in any meaningful way because of reputation and budget concerns, and there are limited incentives for for-profit schools to compete on price, given the supply/demand gap.

A focus on working adults allows Apollo to eliminate dorms, food services, sports stadiums, and health-care facilities from its universities. This helps the firm run a more economically efficient school than its not-for-profit rivals.

Apollo’s growth has been impressive despite its already large size. The company has grown by roughly 129,000 students during the last two years. While we expect the rate of growth to decelerate as the economy improves and the company gets larger, the need for education continues to grow. With traditional schools having limited ability or desire to expand their population size, for-profit companies such as Apollo will likely fill most of that demand.

Even with its solid growth prospects, Apollo is not without risk. The education industry is highly regulated, and increased oversight can be expected as student debt and the cost of tuition rise.

There is a large margin of safety today; our fair value estimate is $106 per share. We model that there will be compound annual revenue growth of 11% during the next five years, driven by roughly 7% average enrollment growth and 3% average tuition increases.

We estimate that operating margins will improve to 29% by 2014 from 28%, excluding a one-time litigation charge in 2009; we expect Apollo to leverage its fixed-cost structure as it expands enrollment. If we assumed only 7% revenue growth and operating margins of 26%, our estimate would drop to near $75. (The stock closed below $52.50 Friday—Editor.)

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