Trading the “For-Profit” Education Sector

The for-profit education industry was thrown into a further tizzy last Wednesday when the largest player in the space, Apollo Group’s (APOL) University of Phoenix, reported a big drop in its expectations for student enrollments. This coupled with general industry concerns surrounding graduation rates, high student-debt levels, and an extremely uncertain regulatory environment means the stock has become too risky for most investors. For others, this uncertainty spells opportunity to make money on the stock over the next few years.

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Fourth Quarter Review

Net revenues grew 17.4% to $1.26 billion. Year-over-year enrollment increased 6.3% as total students enrolled at University of Phoenix reached nearly 471,000, while a smaller acquisition of a UK educator boosted growth further. However, new degree enrollment fell 10%.

The vast majority of the top line continued to stem from students seeking associate and bachelor’s degrees. Combined, these two degree types accounted for 77.5% of revenue. The rest consisted mostly of students pursuing master’s degrees, with doctoral students accounting for a minor 2% of revenue.

A hefty goodwill and intangible impairment charge sent reported operating income down 27.2% to $140.6 million, though this was still a very healthy 11.2% of sales. Higher taxes sent reported net income down more than 55% to $41 million, or 28 cents per diluted share. Excluding charges, Apollo said that earnings would have been $1.31 per share.

Full-Year Recap

Full-year revenue increased 24.6% to $4.9 billion as degreed enrollment again experienced double-digit growth. Operating income fell 6.2% to $1 billion as the impairment charge and a litigation charge stemming from a class action lawsuit in relation to a dispute over how Apollo compensates enrollment counselors ate into reported profits. Net income fell 7.5% to $553 million, or $3.62 per diluted share. Free cash flow came in at $876.9 million, or approximately $5.73 per diluted share.

Outlook 

Management refrained from offering specific guidance, but instead offered a more ambiguous discussion that it “Expects fiscal 2011 to be a year of continuing transition in its operations as it implements initiatives, primarily at University of Phoenix, aimed at enhancing the student experience, expanding student protections and shifting the mix of enrollment to more experienced students who have a greater likelihood of succeeding in the company’s programs.”

The statistic that sent the stock price swooning was that Apollo expects a 40% decline in new degree enrollments for the first quarter. It expects to return to positive growth “At some point during 2012.” This sent the share prices of for-profit rivals, including Devry (DV), Career Education (CECO), ITT Educational Services (ITT), and Corinthian Colleges (COCO), down significantly as well.

Bottom Line 

During the earnings conference call, management also detailed that its period of transition is very likely to be financially challenging. For starters, for the coming year, it expects capital expenditure to double from the just-completed year. Its goals are to offer “A more experienced student mix with higher retention rates over time.” On the regulatory front, Apollo expects a publication in the next couple of months from regulators that will better spell out the regulatory changes.

Overall, Apollo’s outlook has become even more uncertain. The likely outcome is slower growth and profit levels. The wild card is how much lower they will be. Overall, though, Apollo generates impressive amounts of free cash flow. At current share price levels, free cash flow could be cut in half and the price-to-free-cash flow multiple would still be pretty reasonable at less than 13. It is also the largest and most profitable firm in the industry, which means it has perhaps the highest likelihood of coming out an uncertain industry environment with its business model intact. Smaller players leaving the space would also help sharpen its competitive edge.