By: Ryan Lee
Covestor model: Long-Term Conservative
Disclosure: Long APOL
A few months ago I was talking with one of those guys, you know the type, who told me that he hated the public markets and prophesied “We will see a 20% drop in the next six months.” I reminded him there was a way to make money if that were the case and asked if he was short. He said no.
At this point, a wise man would have realized, “I don’t have a damn clue where the market is headed in six months and if I did, well, remember Biff in Back to the Future 2?…” We value investors are in a unique position: we don’t need to concern ourselves with where the market is headed in the next six months because if the market goes up we can sell our positions and if it goes down we get to buy more at better prices. For this reason, many of us prefer the market to go down at times. Unless we have an end of the world scenario, value investing principles remain solid. They would work on the moon, they would have worked 500 years ago in Kyrgyzstan, and they work in today’s markets.
Articles about investing are no fun with no analysis, however, so rather than leave you with nothing more than a testimonial of value investment principles, I will write a little about an idea that I have enough confidence in to take a position: Apollo Group (Nasdaq: APOL).
Here is a little background information from Apollo’s site:
Apollo Group, Inc. was founded in 1973 in response to a gradual shift in higher education demographics from a student population dominated by youth to one in which approximately half the students are adults and over 80 percent of whom work full-time. Apollo’s founder, John Sperling, believed — and events proved him right — that lifelong employment with a single employer would be replaced by lifelong learning and employment with a variety of employers. Lifelong learning requires an institution dedicated solely to the education of working adults. Today, Apollo Group, Inc., through its subsidiaries, University of Phoenix, Apollo Global, College for Financial Planning, Institute for Professional Development, and Meritus University, has established itself as a leading provider of higher education programs for working adults by focusing on servicing the needs of the working adult. (Source:
In the last 10 years, revenues, cash flow, and earnings have all grown strongly. Projecting growth is notoriously imprecise; for this reason, I’ve never been a big fan of discounted cash flow analysis. There are too many variables and assumptions involved to put a lot of faith in a DCF valuation, but here is the range anyway: at 10% cash flow growth (with capital expenditures remaining reasonable) for the next 10 years, and a price to cash flow multiple of 10, I calculate a current per share value right around $40. The multiple of 10 is pretty conservative if they manage 10% growth, but we are just looking at range here. If they manage 15% growth in the next 10 years with a price to cash flow multiple of 15, I calculate a current per share value right around $100. Who knows what the future holds, but according to DCF it is at least reasonable to assume that the value of APOL is somewhere between $40 and $150. (Current cash flow data: MSN Money)
A favorite quick metric of mine is Owner Earnings Yield, which is Owner Earnings/Enterprise Value. The process for calculating Owner Earnings (also known as distributable free cash flow) was introduced to me in the writings of Warren Buffett, shown below:
Owner Earnings = net income + depreciation and amortization + other non-cash charges – average capital expenditures.
This metric is much more useful than the pet of private equity, EBITDA, because maintenance and growth capital expenditures are accounted for and, after all, somebody does need to pay them.
Most are familiar with Enterprise Value but, if you are not, here is the calculation:
Enterprise Value = market cap + total debt – excess cash
We will consider all cash for simplicity’s sake. Remember that intrinsic value is not a precise number, but rather a range.
APOL has an Owner Earnings Yield of about 25%, based on APOL data as of F1Q 2011 (period ending 11/30/10 – Source: SEC filing via MSN Money http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?lstStatement=Balance&Symbol=US%3aAPOL&stmtView=Qtr). Though it’s not an exact parallel, think of this like buying a bond with a coupon rate of 25%. It’s the amount of cash the company throws off relative to the price you paid originally. A 25% yield is large. If you don’t like earnings because they can be fudged, then take comfort that their cash return on invested capital (owner earnings/ total assets – non interest bearing current liabilities – excess cash) is also very high – above 30% (anything above 12% is pretty good) for the last five years, based on APOL data as of F1Q 2011 (period ending 11/30/10 – Source: SEC filing via MSN Money http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?lstStatement=CashFlow&Symbol=US%3aAPOL&stmtView=Ann)
So the numbers look good, but the question remains: why is a company that can generate such great returns on capital selling so cheap? The explanation lies in the qualitative analysis.
There are a few good, if unfortunate, reasons. Congress has decided to investigate APOL and all of its competitors in the for-profit education arena on recruitment and loan practices, and this has struck the stock prices of for-profit educators. (Source: “Harkin Delays Senate Hearing on For-Profit Colleges“ Bloomberg, 2/8/11 https://www.bloomberg.com/news/2011-02-07/harkin-delays-scheduled-february-hearing-on-for-profit-colleges.html)
Regardless of the outcome of this investigation, for-profit education is arguably a better business model overall both for both students and investors. Students are able to make courses fit around their schedules and are not locked into the firm yearly schedules. The nation will need these schools if we are to achieve President Obama’s ambitious higher education goals. The for-profit schools don’t have to pay for sports teams, dorms, or large well-groomed campuses; this explains a substantial portion of those strong returns on capital. The barriers to entry in the for-profit space are tall due to strict government accreditation requirements that take a long time to acquire. In addition, customer captivity is strong.
There are risks to investors associated with APOL:
1. Washington may deal them a serious blow. By my calculations, even given this risk, the stock price is low enough to remain compelling. Unless the government’s response is harsh beyond precedent, I believe this company is worth more than where it trades today.
2. The whole system of for profit-education could be found a fraud. If this proves to be the case we can all have a good laugh at my expense.
We all know that investing is a probabilities game. APOL will most likely not be the growth company it once was, and may suffer a fair amount in the short-term, but I believe that it will be able to adapt to the new regulatory environment and continue to thrive. I think the probabilities are stacked in my favor at APOL’s current price and I’m comfortable holding it as a piece of a reasonably diversified portfolio.
