Think you're a contrarian? Then keep reading...


This post was written by a reader who I email back and forth with frequently.  The following idea is something we've tossed back and forth a lot, I asked them if they'd mind doing a post on it.  I made some minor changes and did some editing.  I want to say a big thanks to them for putting this together, and hopefully you the reader enjoy it (and make some money!)

One of the most unloved and despised sectors of the market is for profit education.  After all, everyone knows that if for profit education doesn’t already have two feet in the grave, one foot is in and the other foot is dangling over it ready to join its partner.  But the question is whether it’s in fact true that for profit education will go the way of buggy whip manufacturers.

Career Education Corp. (CECO) is an idea for those willing to be true contrarians.  It’s near its 52 week low and has seen its share of bad news.  The problems can be divided broadly into regulatory concerns and business concerns.  Even with all the problems CECO it's arguable that a lot of the issues are already priced in, consider the following:
  • Market cap of $472m against cash of $441m, with an Enterprise value of $31m (no debt)
  • The business generated an average of $263m in operating cash flow over the last three years.
  • Past three years average free cash flow of $151m.
  • EV/FCF of .2x


Regulatory Issues

The for profit education sector has tremendous headwinds at the present time.  Essentially, many of the for profit schools were accused of being nothing more than diploma mills.  That is, they take in tuition funds and churn out diplomas without any consideration for a “good” education or future job prospects.  There is some truth to this and there have been some egregious practices. 

Congress has made a point of showcasing the issues and coming down on the for profit schools.  Various regulatory schemes have been enacted over the years to “fix” the problems.  The regulatory schemes are in many ways onerous and quite difficult to comply with. 

Before listing those out, it’s important to understand that for profit schools receive the vast majority of their tuition funds from students who have received aid under Title IV.  That is, students typically take out government funded or sponsored loans to pay their tuition.  When they can’t repay their loans, it becomes the taxpayers’ burden.  Student loans have been in the news lately as they’ve reached the $1 trillion mark and with loan resets coming up on the horizon it could be a heavy burden.

The key to understanding the regulatory regime is that for each different scheme failure to comply can result in various consequences – anything from probation to fines and, the ultimate death penalty for for profit education, curtailment of Title IV funds.  Thus, in the event of the “death penalty”, these schools would be prohibited from receiving government funded or sponsored funds and that would essentially mean game over.
As for the major regulatory schemes:
1.      90/10 Rule – this rule provides that no more than 90% of a school’s funding can come from Title IV funds.  As with most of these rules, it is tested both on an individual school level and in the aggregate for all schools a company owns. 
2.     Cohort Default Rule – this rule provides that no more than a certain specified amount of students who are in their loan repayment period can be in default.  These rules have been changing of late.
3.     Gainful Employment Rule – this rule is new and provides that after graduating from a program for each student in repayment mode only a certain amount of their income can be used towards the repurchase of the loans.  I have thought and thought about this and have no clue how it will be applied in practice as it will require self-reporting from the individuals.  In any case, while it is currently in effect, there are no ramifications for a couple of years or so.
4.     Accreditation – in order to receive Title IV funds each school must be accredited by the applicable accreditation provider.

Business Issues
                  
Due to the regulatory headwinds and the poor economic environment, for profit schools have seen enrollment plummet.  But in many cases, students who attend for profit education schools would not usually be attending a four year university.  That is, for profits provide a useful skill for many people looking to improve their situation.

So this has been a lot of background.  CECO has suffered tremendously from all of these issues.  Enrollment is down and there have been problems as well with their accreditors.  Last year, CECO received a “show cause” directive from their accreditor as it related to their reporting of placement rates.  At the same time, CECO’s CEO resigned over some improprieties and the new CEO pledged to clean things up.  He immediately hired an outside law firm, Dewey & LeBouef, to audit their placement rates.  Upon receiving the report, they sent it to the accreditors and promised to rectify the situation.  The show cause directive was hanging over their head and they just received word that other than 4 schools being put on probation, there are no ramifications.

In terms of the various other regulatory schemes, what to say?  It would seem to be priced in at this point.  In my experience, take it for what it’s worth, Congress is a lot of bluster and not a lot of bite on these points.  That is, a lot of noise is made, but Congress isn’t really inclined in my view to shut down businesses that aren’t “harming” anyone, physically at least.  So while there will much wringing of hands, probation, fines even, etc., to receive the death penalty (i.e. not be able to obtain Title IV funds) would essentially mean that thousands of employees are put on the street and hundreds of thousands or even millions of students are left with a worthless education.  I don’t see that happening, but it’s possible of course.

Valuation

The best valuations are the most simple valuations.  As I write this the stock price is around $6.80.  Book value is $11.93 and tangible book value is $6.72.  The market cap is around $472 million and enterprise value is about $31 million; there is a lot of excess cash and no debt, although there are operating leases.

Interestingly enough, with all of these headwinds (and note too that much of this isn’t really new, but has been ongoing for quite some time), revenues have been fairly stable for the past 8 or 9 years.  The 4 year average is approximately $1.87 billion and the 8 year average is about $1.86 billion.  So more stable than one would think. 

Free cash flow margins have been relatively stable as well, although have been nipped a little bit recently with all of the overhang.  The FCF margins for the past 4 years have averaged about 8.6% while for the past 8 years it has averaged about 9.7%.  Using a value destroying multiple of 8, the stock on a FCF basis would be worth somewhere in the $21-23 neighborhood. 

There is a lot of margin of safety in that.  Think revenues will plummet?  Cut them in half.  The stock is still worth in $12 area.  Margins will come way down?  Cut them in half along with half the revenues and the stock is probably worth around what it’s at today, but if the multiple was higher obviously that could still work out.

At the end of the day, the stock is being priced as if it is going under.  If one thinks that’s the case, it isn’t worth an investment at any price.  But if they survive, it will almost certainly be in somewhat the form they currently are in.  This isn’t a stock without risk and a lot of it.  No recommendation is being made as to whether CECO or any other for profit education company should be purchased, held or sold.  Do your own due diligence and speak to whichever experts you feel is necessary.

Further resources

Disclosure: The author of this post is long CECO, Nate is also long CECO

19 comments:

  1. Why would you want to invest in something as socially destructive as "for profit" education?

    Most of these schools are a blight upon society. They are harming their students by saddling them with tremendous debts that they won't be able to pay off.

    There is a HUGE problem with "regular" education, but "for profit" schools are ten times worse.

    How much longer is Congress going to allow funding to schools with graduates who can't pay the debts?

    This is simply a transfer of wealth under the rubric of "education".

    The problem with education is going to get worse before it gets better.

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  2. Hi Nate,

    Love the blog.

    I've been looking at CECO for a couple weeks now. Actually, I ate lunch at one of their Cordon Bleu teaching restaurants on Tuesday. I don't have any firm opinion yet - and I've been looking at other for-profit education companies.

    One question that I haven't been able to answer is: Who are the bad actors in the for-profit education industry? Most of the companies that I've looked at seem to be trying to provide a reasonable education. Strayer gets about 25% of its revenue from companies, rather than the title IV. Presumably, companies are going to spend their own money on a useless education for their employees.

    Another question is: How will the internet affect for-profit schools that have a physical presence? The general consensus seems to be that online learning can be as effective as classroom learning. But, presumably online education can be provided much more cheaply than classroom education. In addition, an online education can guarantee that you have the best instructor giving the lecture to 100,000s of students.

    I'd love to hear your thoughts. I haven't been able to pull the trigger on buying a for-profit educator yet.

    Cheers,
    Tom L

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    Replies
    1. Tom,

      Good comments, I'm not sure about the bad actors. I know CECO's previous CEO would probably qualify, he left and there's someone in there now cleaning things up. I agree these schools provide a trade education, or ongoing education. This is something that has to be and will continue to be done in the future.

      The internet's a good question as well. I think things like cooking (Le Cordon Bleu) can't be done online. I know CECO does things like Vet Tech, I see the students walking animals, so obviously not online. Other things are tougher, there's a stygma about the online degree, but there's also a stygma about getting a degree from a for profit as well. So maybe the internet will canabalize a portion of their revenues. I'm really not sure, but at this price I'd say there's a reasonable margin of safety.

      Nate

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    2. Nate,

      Yes, Cordon Bleu will always need to be done in a physical classroom. Other kinds of training also require a classroom. So, there is an argument for having real classrooms.

      Another question that I ask myself is: Do I think CECO is cheap OR do I think the for-profit education industry is cheap? I'm not sure what my answer is. Have you looked at other for-profit schools that you decided to take a pass on?

      For me, once I looked at STRA, CECO didn't seem as cheap in comparison. Or, maybe BPI will beat up on both STRA and CECO with its online offering at lower prices. BPI is trading around a 7x p/e. Do you think they are all cheap? Or, do you think that CECO has an attractive valuation relative to other for-profits? I'm not sure - which is why I've held off investing for now. But, I'd be interested in your thoughts.

      Cheers,
      Tom L

      Delete
    3. Why not buy the for profit school that offers the highest quality education.

      DeVry

      They offer real degrees in tech and health care
      They grew profits right thru the recession like nothing happened
      They don't have any issues regarding 90/10, etc, etc because they operate one of the best programs
      approx 1/4 of market cap is cash on the balance sheet

      I'll be the first to admit your company is WAY cheaper, but who needs the risk when the best in breed for profit is also cheap

      Delete
    4. Tom L,

      I think all the companies in this space are cheap but CECO is especially cheap. Honestly if you're willing to plunge into the for-profit sector and a company doesn't have any or much debt, and low fixed costs I think you'll do fine.

      Nate

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    5. tonyg34,

      You raise an interesting point, is it better to buy quality cheap, or buy the cheapest? I'm not sure, I often will do both, I don't see why you couldn't in this situation either.

      To me the issue of risk is the same for all of these companies so it makes sense to go with the company that has the most upside.

      Nate

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    6. Tom L:

      I would suggest to you that CECO and Le Cordon Bleu is most definitely one of the "bad actors".

      Why do I say this?

      Le Cordon Bleu is notorious for charging TREMENDOUS amounts of money to attend their school. We are talking about TENS of thousands of dollars. For example, a certificate of "Pastry & Baking" can be as cheap as $21,000. At the higher end, you have can get an associate's degree in culinary arts for $43,000. Of course, these costs do not include room or board, nor do they include books or supplies.

      How do I know this? It was disclosed in the lawsuit & settlement between CECO "Le Cordon Bleu" and it's students.

      Please see: http://www.dailyherald.com/article/20110906/business/709069661/

      This is just one of DOZENS of articles on this subject.

      This quote from the lead attorney sums it up nicely:

      “It is a ridiculous business decision to attend one of these schools,” said attorney Ray Gallo, who represents plaintiffs suing the California Culinary Academy. “The whole thing doesn't make economic sense. They know it and they don't tell you.”

      CECO (Le Cordon Bleu) settled with 8.500 students offering rebates of $20,000. Please remember, THIS WAS JUST FOR THE SAN FRANCISCO LOCATION. How many other of their schools are eventually going to give rebates to students? I would argue that eventually all of them are.

      How is the company going to be able to defend this? How is it going to make all the eventual payouts?

      Two other Le Cordon Bleu schools — the California School of Culinary Arts in Pasadena and the Western Culinary Institute in Portland — also face lawsuits from former students who say they were duped by deceptive advertising, particularly the schools' job placement rates.

      This article just hits the surface of problems with the "for profit" schools.

      Le Cordon Bleu is NOTORIOUS for selling students on it's education. Once those students graduate, they find the degree holds almost no value in the field. If (remember, most DO NOT) they can find placement, it is frequently for $8 or $9 jobs.

      Le Cordon Bleu stated that 48% of it's graduates got jobs in the field.

      The problem is that most of those 48% aren't earning much more than minimum wage.

      HOW CAN YOU PAY BACK STUDENT LOANS ON A $9/hr. JOB? Student loan debt is not dischargeable in bankruptcy. These student are ruined because of this debt. Most of them come from modest situations.

      Delete
  3. On prominent mutual fund manager from Finland has been investing in the education industry in US and his pick was Strayer Education. Altough he is more concerned about quality of management than price he is paying, there might be some interesting facts about the education market in his blog for the investors:

    http://www.seligson.fi//phoebus/blogi/show_item.asp?itemID=205 (first post)
    http://www.seligson.fi//phoebus/blogi/show_item.asp?itemID=206 (first post)
    http://www.seligson.fi//phoebus/blogi/show_item.asp?itemID=219 (first post)

    It is in Finnish but you should get something out of them with google translator :).

    I don't know if there is anything useful there but those who are interested might want to give it a shot - he really has beaten the market hands down at least for last 10 years.

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  4. Nate - another great post.

    For me, I think this article highlights why most of us are not contrarian investor in practice - it is difficult to read the facts on such an ugly/corrupt industry... let alone invest in it. Peraps we are tainted by the recent bad PR they have been getting, but cigarette companies are held in much higher esteem in the Public's view (just my opinion).

    I think this is why buying a basket of stocks that meet a "value" category is much more effective than letting human nature "try" to be contrarian. It is just hard to do.

    Again, great post and great comments by your readers.

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    Replies
    1. Thanks for the comment, you're dead on. Some of the best values or best contrarian investments are stomach churning. It's really hard to pull the trigger on something where the outlook is so negative and there's nothing but constant negative media attention.

      I thought long and hard about CECO, I recognized the undervaluation right away but I just couldn't get past the bad news. I mulled this over for two or three weeks trying to balance the valuation against what their future might be. I just came to the conclusion that this is silly cheap, yes there will be bad news in the future, probably very bad news, yes their business will be impacted, but it probably won't be as bad as the market thinks.

      I'd love to think I'm a natural contrarian, but I'm not. Even owning a small position in CECO makes me nervous, I'm going to stick it out because I believe the facts stand out, but it's tough.

      You mention buying a basket of stocks in a hated area, I think this is a very wise approach. I do this with my Japanese stocks, I don't care about finding the company that jumps 5x, I just want the average group return. For-profit education is probably another great area where just buying all of the companies would probably have a really nice return a few years from now.

      Thanks for the kind remarks on the blog, and the great comment.

      Nate

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  5. Questions I have after reading this write-up that seem central to judging your risk in the for-profit sector:
    1.) How often, historically, have for-profit schools lost their accreditation and/or Title IV funding, and what were the reasons for this occurring in the past?
    2.) Rules #2 and #3 are critical as they tie in to the macro-theme of social indebtedness now playing out. What kind of projections do we have for cohort default rates and why? What are factors that would contribute to higher cohort default rates? What are factors that would contribute to lower rates? Then, weight the potential for each factor to occur.
    3.) If a company like CECO lost its accreditation or funding status, what would be the WORST-CASE impact for the company? Would it just shut its doors, distribute cash and walk off into the sunset, and if so, what is our in liquidation recovery at that point? Or would they have substantial new liabilities in such an event, or de minimis value left over for shareholders?
    4.) What potential, if any, is there for a company like CECO to get bought out? Are for-profit companies consolidating in the face of bad news and bad attention? Are PE firms on the prowl for cheap for-profit education firms whose cash flows can be levered up? In other words, are there any potential white knights in the wings that could swoop down and thus tilt the value scales a little bit more toward "cheap"?

    The bleeding heart anonymous commenters here are not helpful, beyond pointing out the probable risk of some kind of class action fraud case against the company. Maybe the history of profitability and revenue stability was a part of the inflationary debt-build up paradigm that many of us now realize has passed, in which case consumers WILL be more careful going forward and won't get suckered into paying for "worthless" educations (then again, people keep getting college degrees and wind up with min wage jobs, so I am not sure what's different). And maybe a bunch will get pissed off and hire a lawyer and take all the company's cash in this litigious society we live in.

    But it adds nothing to the analysis to just point out the idiocy of the consumers and the duplicitousness of the suppliers. Those are human qualities that are present everywhere, they're not special to this situation and they don't add color to discovering and properly weighting the risk and value of the situation.

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    Replies
    1. There is not a PROBABLE risk of a class action lawsuit vs. CECO. There is a DEFINITE risk that is well defined.

      CECO has already given out a minimum of $40MM in refunds to students of JUST the S.F. Le Cordon Bleu location. The article states that there are TWO more class action lawsuits going.

      What do you want to bet that in the year to come their are MORE lawsuits filed?

      Le Cordon Bleu may be able to defend itself here and there. The more lawsuits, the greater the chance of a catastrophic result. Eventually some of them are going to get through (they already have).

      I am pretty "right wing" and not a "bleeding heart". How is being against fraud being a "bleeding heart"?

      Why should educators get a pass on fraud?

      Why should they be able to say that we have a 96% placement rate with an average salary of $50k for our graduates when they KNOW the real rate is maybe 40% placement and an average salary of $20k?

      You don't think that is fraud in the inducement?

      Do you think society is going to allow this to continue? It is simply a transfer of wealth from taxpayers to the companies with the students getting stuck in the middle.

      Taylor, I presume you are a taxpayer? Why would you want to support these institutions? For surely you are because the student loans are guaranteed by the government. The school gets the money whether the students can repay their loans or not. Look at the number of defaults. It is off the charts!

      If these lawsuits continue, there is not going to be anything left for the shareholders.

      Delete
  6. Anon,

    I make no excuses for fraud. I certainly don't want to support these institutions. I shudder to invest in a coercively-financed institution like this just as I'd shudder to help fund the coercive financing arrangements of the US Treasury in general by directly buying the bonds.

    Why should they be able to say that we have a 96% placement rate with an average salary of $50k for our graduates when they KNOW the real rate is maybe 40% placement and an average salary of $20k?

    Yes, this would be fraud if they are knowingly misleading with knowledge of their true placement/salary ranges.

    Your (or somebody's) original comment just huffed and puffed a lot about how it's a ripoff. In my mind, there is a difference between aggressive marketing (playing up the value of your product or service) versus outright dishonesty (fraud, ie, "100% of our graduates make $100K their first year out!" when really, 0% of graduates make that money).

    It's not okay to engage in "theft by intellectual means" (fooling someone into parting with their values on terms different than what is actually taking place). It IS okay to hype the value of your product ("This is a great investment in your future!!")... buyer beware. Its up to everyone to evaluate on their own if the value is truly there in the exchange being offered. But if I tell you I am giving you 10 perfect apples for $5 but it turns out I gave you 10 rotten apples, that would be fraud.

    Your original comments didn't lead me to believe there was DEFINITE ongoing litigation, just that some litigation had occurred and therefore there was a precedent and therefore PROBABLE risk of future litigation. So, I stand corrected and will admit as much.

    I don't know if you're the first anon as well but that person contributed 0 to the discussion. Just whining and hand wringing.

    Ethically, I don't think I'd buy defense stocks or certain/all for-profit education companies. But the point of this exercise at the blog is to determine financial value, not ethical value. The ethical component is only relevant to the extent it introduces financial risk (such as, through the likelihood of litigation and legal fees).

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  7. Btw... "society" lets all kinds of atrocities and scandals go on, unconcerned. The Fed is looting us all to the tune of trillions. No one cares.

    The CONgress is getting its junkets and such. They're DEFINITELY not a bunch of bleeding hearts. They created this monster of a system. They have no personal incentive to end it unless it's lucrative for them and their supporters. Who can you think of that would pay them to do otherwise? That's the question there.

    As the OP pointed out, it sure would be a big mess up if the CONgress decided to revoke the charters of these schools and leave all the grads and current students with unaccredited degrees on top of everything else. Doesn't mean they wouldn't do that but that'd be a sticky situation.

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  8. Nate, what's your take on the earnings report? And how big is your portfolio position (%) in CECO? Thanks!

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  9. I was reading an interview with Jim Chanos @ http://www4.gsb.columbia.edu/null/download?&exclusive=filemgr.download&file_id=7310999

    And I'd say you certainly managed to find an idea that is contrarian, and I can imagine that this can create alpha, simply buying something that is very hated. But I don't think it's something for me, I'm totally clueless handicapping things like the potential legal liabilities and regulatory issues. I don't really have a problem buying stuff that is disliked, but don't like stuff I really don't understand.

    JC on for profit education:

    Ultimately defaults will go so high in the student loan area that the federal government will see mounting losses and will change the student loan program guarantee to force institutions to take a bigger chunk of the risk. Once this happens, the business model is broken. The only reason these
    companies exist is because of the federal loan guarantee on student debt.

    So maybe your valuation shouldn't be about cutting margins in half or revenues in half, but maybe you should assume that there is a high risk that there are no revenues at all anymore in a few years time?

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  10. OK:

    Thanks everybody for the discussion. This is the last comment I am going to make, perhaps it should have been my first.

    I am so worked up over this as I have seen people harmed by this first hand. Their lives are much worse for having been associated with these "schools". The more I learned, the more surprised & outraged I was.

    I would suggest that everyone who is interested in this read: "Subprime Goes to College" by Steve Eisman. I have seen some of what he discusses and know it to be true. He makes his case much more eloquently than I can.

    "Until recently, I thought that there would never again be an opportunity to be involved with an industry as socially destructive and morally bankrupt as the subprime mortgage industry. I was wrong. The for-profit education industry has proven equal to the task."
    -Steve Eisman


    Read more at : http://www.nypost.com/p/news/opinion/opedcolumnists/subprime_goes_to_college_FeiheNJfGYtoSwmtl5etJP/0

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  11. Stock down 50% since this article, but it seems that the company is breaking even on a cash flow basis. Time to revisit this company?

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