ITT Educational Services (ESI) is a postsecondary education company of intense interest to me. I've covered the company in the past and been quite bullish. I recall originally finding shares at just $14.25 early this year and taking a sizable position, only to subsequently sell a few weeks later after an earnings pop for a ~10% profit. A week ago the company released its Q2 results. Just from how the stock has moved since the release, it would appear that the market has been rather baffled by the results.
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In this article I intend to recap and dissect the company's results to clear up the confusion, and also update my stance on the stock.
Earnings Recap
The most important metrics are shown below as YOY % changes.
Both new student enrollments and total enrollments improved markedly in Q2, a clear sign that the enrollment recovery is materializing. Total enrollments should follow the direction of new student enrollments and return to growth in the next 2-3 quarters. This is certainly very encouraging. On the other hand, the revenue decline accelerated in Q2 to a whopping 21.2% decline, very much because of lower revenue per student. Revenue per student dropped deep into the red in Q2, mainly because of the impact of the Opportunity Scholarship program. In case you missed it, a while back management identified affordability as the issue that was driving students away. In an effort to address the issue, the company instituted a scholarship program to not only lower cost and improve enrollments, but also to improve the company's mix of students by awarding the money largely based on academic merit. The program is intended to lower cost for 70% of ITT's students. The other 30% are either unprepared for a college education or well off enough not to statistic! ally need aid. Many for-profits have come up with some sort of program to address affordability or improve student mix. While this is certainly not the most creative of the bunch, scholarship programs are the go-to method of private non-profits and are effective. Management expects revenue per student to sustainably be 12-14% lower than FY12 because of the scholarship program.
Overall, I think the company reported pretty good numbers. Enrollments are clearly recovering nicely and if that continues, revenues will eventually follow suit. I'm surprised the stock didn't jump more. It is very significant that new student enrollments turned positive this quarter. The market doesn't seem to have acknowledged that though.
Nothing too significant was mentioned in the conference call other than a reaffirmation of the company's previous guidance of $3.50-$4 in EPS for 2013.
Short-Term Outlook
It's very clear to me that the upside on the stock in the next year or two will be dictated by what level of profitability the company can return to.
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The chart above confirms that thesis. FCF and stock price have stuck together in the last 10 years, more so recently. I think $100-150M of FCF going forward is a reasonable expectation and if that's the case the stock looks very cheap now. Current enterprise value is $579.2M, giving the stock an EV/FCF multiple of 4.6 times the midpoint of my estimate. In the boom years following the housing crisis of 2008-09, ITT was able to generate as much as $550M in FCF. Lower revenues and margins now make such a number unattainable and unrealistic for the foreseeable future, but $100-150M isn't such a stretch. I really don't think a short-term bet is all that risky at this point either. The turnaround is already clearly progressing. If sustainable FCF turns out to be lower than what I suspect, the company is still making $60M now. Even ass! uming tha! t number, shares trade for a single-digit multiple. Of course shares were more attractive when I originally found them at $14.25, but even at the present price of almost double that, I still see some nice upside for investors with a time-frame of no more than a year or two.
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Long-Term Outlook
While I am bullish about the stock now, I'm much less confident in ITT's long-term prospects. Management has done a nice job thus far getting enrollments back on track quicker than at most other for-profits, but ITT's business model remains questionable and eventually that will weigh on profitability and share price. There are many for-profit education companies competing in America and as such, many varying opinions on what cost-structure and business model will win the game of profit share. In the past, the general consensus was that a 'marketing first, education quality takes the backseat' approach would be most profitable. Companies that endorsed that view are now suffering tremendously. Not only is such a model morally questionable, but it leaves the school vulnerable to accreditation loss, cohort default rate violations, and reputational damage. I'm the last person to invest based on moral bias, but it appears that doing the morally wrong thing now is also financially unattractive for these companies. Poor education practices (along with a poor job market) is indeed what drove students away. Why would they come back if nothing's changed? I believe schools will have to offer strong value to students going forward. These select companies will not only avoid sanctions and regulatory risk, but become premier learning hubs with tremendous enrollment growth potential.
This has been a rather serious article thus far so here's some relevant comic relief to get you through to the end: Picture Kevin Costner in Field of Dreams pacing through the cornfields when suddenly, down! from the! heavens, come the inspirational words "If you rekindle your value proposition, they will come."
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Costner would probably be a little confused (he's an actor, not a marketing expert). But now in his place we put ITT CEO Kevin Modany. On a casual walk searching for inspiration and a way to bring students back to his struggling institution, Modany hears the fateful words. Dramatic, eh?
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That's really what would work though. It would save the company from a lot of potential trouble with the (educational) law and win back the hearts of students. Quality education at a reasonable price- that's what they want.
Some companies have listened to this calling and begun to convert. Some have even religiously followed this advice from the start. Strayer (STRA), Capella (CPLA), and American Public Education (APEI) are all companies I've covered that clearly have a commitment to proposing strong value. ITT Education's value proposition doesn't impress me, nor do the company's efforts to improve it, and that's why I'm not so bullish long-term.
Evidence of a poor value proposition is in the numbers. Like most admissions websites, ITT doesn't divulge tuition pricing unless you provide your contact information. I refuse to receive spam so I had to dig elsewhere. The following comes from the company's 2012 10-K:
Gross tuition for a student entering an undergraduate residence program at an ITT Technical Institute in December 2012 for 36 quarter credit hours (the minimum course load for a full-time student for an academic year consisting of three academic quarters) was $17,748 for all ITT Technical Institute undergraduate residence programs.
Quarter credits are typically worth 2/3s of a semester credit. So 36 quarter credits equates to 24 se! mester cr! edits. That gives me $739.50 per credit at ITT-Tech. The Opportunity Scholarship is expected to decrease revenue per student by 12-14%. That being the case, I'll adjust tuition down by 13% to $643.37. It's a start, but ITT-Tech is still ridiculously expensive compared to most other for-profits and state universities:
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So it's expensive. Students are paying a lot of money for an education from ITT. Is it worth it?
It's incredibly difficult to quantify education quality, but one of the better ways is to look at cohort default rates. After all, if students are truly receiving a quality, career-boosting education as promised, they should be able to get a job after they graduate and pay off their federal student loans, right?
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As you can see, ITT's default rates, while not at risk of exceeding the federal cap, do exceed national averages and are way above the bar for what I believe to be a model of education quality in APUS. If the education was cheap, the numbers may be a little more reasonable, but it's not. Students at ITT are paying an above-average tuition rate for a below-average education.
Students are clearly becoming more cost-sensitive, and while the majority of students don't investigate CDRs, they do hear the story from their friend who went to ITT and ended up defaulting. It's just bad business and it's been exposed by Congress and accreditors. It's pretty clear that a new breed of value-oriented schools will prevail in the years to come. Some schools have adapted or were never guilty in the first place. While ITT has taken steps to address affordability with the Opportunity Scholarship and tuition freezes, it's not nearly enough. I think this will eventually catch up with the company in the long run and that's why I wouldn't want t! o own the! stock long-term.
Conclusion
Last week, ITT Education posted very good results that show substantial progress in the company's turnaround. I think the stock is cheap enough to present a good deal of upside that will materialize in the next year or two when free cash flow and revenues stabilize. However, a poor value proposition makes me question ITT's sustainable presence in the years beyond that.
Disclosure: I am long STRA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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