Student Loan Worries Overblown: ESI Is A Buy

Education stocks have been hammered over the last few months. I’ve looked into many stocks in the industry, but this article focuses primarily on ITT Educational Services (ESI) as I like it’s current valuation relative to its primary competitors Apollo Group (University of Phoenix) and Devry (DV), both of which are looking more and more attractive each day as well.

The for profit education industry is highly regulated by the Department of Education. They impose strict requirements on recruiting, marketing, educational offerings, ability to add new institutes, and the financial condition of the company (must maintain certain financial ratios, debt levels, etc.). All this aside, the primary industry risk these days is all about student financial aid, the primary vessel all of these companies thrive and rely on. Without it, their businesses would not be the same. The uncertainty that exists appears to only concern the private lending sector (for the time being). Federal aid should continue without any major impact. This has all come about from Sallie Mae's (largest private lender, no longer government sponsored) announcement last January that it is terminating its lending arrangements with many of the companies (if not all of them) within the industry.

Approximately 63% of ESI's revenues come from Federal student financial aid programs (Title IV programs --- comprised primarily of Federal Family Education Loan Program (FFEL) loans but also in part by work-study programs and pell grants). These revenues should be safe. Remaining revenues come primarily from private loans (~29%, historically all from Sallie Mae), and the rest from student/family savings, scholarships, etc. In order to remain eligible to participate in the Title IV programs, companies must not earn greater than 90% of their revenues from the programs. So, ESI is well within the buffer zone and gave guidance on their 4th quarter conference call that they expect this percentage to stay around the same levels in 2008. In addition, the default rates on federal student loans must remain below 25% to remain eligible. Three consecutive years with rates above 25%, or one year with default rates above 40% would cause ESI to lose eligibility to participate in the program (at least temporarily). The range of default rates on federal loans among the various campuses have increased from 4.5 - 10.2% in 2003 to 5.5 - 12.9% in 2006. No major cause for concern here...still well below 25%.



In January 2007, Sallie Mae announced it was changing its private lending strategy and was effectively terminating its lending agreements with ESI in late February. So, from above, that places 29% of ESI's revenues at risk if students cannot find alternative sources of financing. In an 8-K filed late Friday after the close, ESI revised it's earnings guidance to the downside for 2008 to a range of $4.10-4.60 from $4.50-4.60, and stated that Sallie May has disclosed that 16.7% of the loans made in 2007 are now being classified as, you guessed it, subprime loans. So, that translates to 4.9% of the company's top-line that is relying on sub-prime borrowers to pay back. ESI announced in January that it has made arrangements with 3 major financial institutions (BAC, Chase, Citi) to provide loans to students that traditionally would have received loans through Sallie Mae. The 8-K also states that one of these three lenders has already begun making loans to students, but that it does not have any data yet as to how many of the students applying for these loans are actually qualifying for the loans. The lenders have no contractual obligation to lend money, but at the same time ESI will not have to pay for the underwriting or share any of the default risk on the loans that are made (the Sallie Mae agreement that was just terminated DID share default risk, so this is actually an improvement in my mind). It will however, in all likelihood, have to extend it's own loans to students that have traditionally and historically been able to acquire financing but no longer can in the current credit environment (so when students don't qualify for loans by BAC, Chase, or Citi, the company itself will now provide the financing). They stated this on their 4th quarter conference call, when they mentioned they expect they will have to "fill the gap" between loans that their students could have historically obtained but can no longer do so through traditional methods. They stated that they have 20+ years of solid data reflecting student loan default rates, who quality candidates are, who they are likely to retain, who is most likely to succeed, and who the most likely candidates are to be able to pay back their loans. They did not provide guidance on what they think this gap will be. I think this fact that bodes very well for ESI --- they probably know better than the banks themselves (and who trusts the banks' judgments these days) how to determine who the risky candidates are and so it theoretically shouldn't matter what is going on in the credit markets (and trust me, there IS still a market for these loans) if they truly are willing to "fill the gap". They themselves will pick up the slack and hopefully allow business to continue as usual. True, they will now be taking on some credit risk, but it does not mean in any way that it will be sub-prime credit risk. If the banks are too scared or not willing to take on more student loan exposure for some external reason, the company will step up and do so itself (if and when their own stringent lending requirements are still met). That said, I would bet the banks still approve the majority of these loans to qualified candidates. In the end, it is a risk weighing game and would you rather loan money to a student with a short but decent credit history who is trying to better themselves (and who will probably get a job out of the deal and be able to pay you back), or loan money to someone with equal credit trying to buy a house they probably can't afford and that will probably be worth less next year than it currently is today.



So, what has happened in the last two months? All of the stocks in the industry have taken a beating and ESI itself has lost nearly 50% of its market value. I agree that these stocks should be valued lower than they were 3 months ago in light of this new development...but 50% is pushing it. Fundamentals still appear to be very strong almost across the board for most companies in the industry. They all have their own differentiating factors and unique situations, but all-in-all business still seems to be pretty good. Underlying industry trends and the long-term outlook for continued growth in the for-profit education space still appears intact. These companies continue to grow their businesses and most are generating steady and increasing cash flows / earnings streams.



Other Items To Note:

* ESI had 5,000,000 shares remaining on its authorized buyback as of Dec 31st, 2007. Should help support the stock. From Jan 31st to Feb 15th of this year, ESI bought 810,000 shares back at an average price of $84.51. They obviously think the shares are cheap.



* A director purchased 1000 shares at the $83 level on Jan 31st. He bought 500 shares this time last year at $76 and 700 shares in May of 2006 at $65, so I don't read too much into this.



* ESI's student enrollment rates increased by 5%, 9%, and 13% in 2005, 2006, and 2007 respectively. They have also been able to increase tuition rates by about 5% annually it appears.



* ESI is presenting at a Credit Suisse conference on Monday. They plan to highlight their current perspective regarding the on-going availability of private student loans. With the revised guidance to the downside after hours on Friday, we may see more selling on Monday. Or maybe 4.9% revenue risk is less than the street was expecting and we rally...but I doubt it. In light of my above rationale and the valuation I describe below, Monday could be a great time to initiate a position in ESI if the shares gap lower. I'd probably advise waiting until Tuesday or Wednesday though to see if the shares can bottom and find some support as the selling subsides. Catching a falling knife can be difficult and bloody, so start small and realize that this may not be a trade you can flip for a profit anytime soon.



* A larger and perhaps more popular competitor, Apollo Group (APOL - University of Phoenix), reported last Thursday that it hasn't seen and does not expect to see any changes on the Title IV loan side. On the private loan side, it has started to see some tightening of lending standards, but so far students have been able to find the loans that they need. Apollo trades at 23.9X trailing 12 month earnings and has a 5 yr projected growth rate of 15% according to yahoo finance, putting its PEG ratio around 1.6.



* An argument can be made that this one of the more recession proof industries in the consumer services sector. Higher unemployment and/or lower wages could cause more people to decide to go back to school for a bit until the job market improves. It's sort of a stretch, but worth noting.



Relative Valuation:

ESI closed at $58.47, or 15.8X trailing twelve month earnings per share of $3.71, at the low end of its historical range. Analysts expect 2008 earnings of $4.54, and have five year projected growth rates that vary between 16 and 19% (19.3% according to yahoo finance). So let's use $4.30 for 2008 earnings, and a growth rate of 16%. Industry average multiples are around 20X currently, but historically have easily supported 23-25X earnings and have traded much higher than that at times as well. So a conservative estimate of 20X 2008 earnings of $4.30 would put the shares at $86, or 47% above current levels. Analyst price targets currently range between $100 and $120/share. At current levels of $58, we are trading at 13.5X 2008 earnings which is ridiculously low. At a 16% five yr growth rate, the current PEG is right at 1.0. Industry averages are around 1.5.



Absolute Valuation:

This is a good industry for free cash flow valuation because most of the companies within it do not pay dividends and they generate positive and consistent free cash flows on an annual basis (quarterly results can be impacted by seasonal enrollment trends). I'm not real big on complicated valuation models because tweaking one or two inputs in even a slight way can yield very different results. So, below is a graph with various long-term free cash flow growth rates based upon a basic single stage FCF model. If the firm only grows at 3% indefinitely, in-line with the overall economy, the shares would be valued at roughly $63. This assumes a capex to depreciation ratio of about 1.5 (historically levels are closer to 2.0). If capex were to eventually slow to a 1:1 ratio in order to just maintain the business, the value would jump to roughly $68 at a 3% terminal growth rate. If you assume elevated growth relative to the economy for several years, for which I think a strong argument could be made, and use a terminal growth rate of 4% or 5%, today's present value would be $81 or $105/share, respectively. So, take this for what you will, but understand that the shares currently trade at levels towards the extreme low end of probable long-term valuations. Most analysts would probably use a terminal growth rate of 4% for a company like this...the valuation would be $81 based on that assumption.




Summary:

Most competitors appear to be in decent shape as well, but ESI is currently the most undervalued based upon my analysis. It's obvious that I think the shares have been discounted way too much for the actual risk posed to the business. This isn't some black box bank with hard to value assets...it is a fairly transparent and easy to understand organic growth story. The business landscape is indeed changing, but it is not going to go away anytime soon. The technical picture is ugly, so I am simply going to ignore it --- this is a long-term investment and I expect it to take time to recover. I will be adding on further weakness and re-evaluating as the year progresses and as we continue to learn more about how the lending situation is playing out. My bet is that business will fare much better than the street is currently pricing in. The shares are likely to trade sideways or to the downside until some of the uncertainty around the private lending situation is cleared up, but I think the current levels offer a good risk/reward if you take a long-term view. My 12 month price target is $85 based upon both valuation methods, which I feel are fairly conservative.

Disclosure: Long ESI and will be adding below $58.