Why Strayer's Run Is Just Getting Started

Shares seem to be reaching an inflection point, fueled by a stop in student enrollment declines.

Apr 10, 2014 at 11:45AM

Strayer Education (NASDAQ:STRA) provides post-secondary education services for working adults. It offers undergraduate and graduate degree programs in various fields of business administration, accounting, information technology, education, health services administration, public administration, and criminal justice. 

Undoubtedly, the for-profit post-secondary (collegiate) education industry is one of the most out of favor areas on Wall Street. This is primarily due to substantial declines in student enrollments according to Securities and Exchange Commission filings, which in turn decimates revenues across the board for the industry. In addition, worries over high student loan balances have increased, discouraging attendance of the already costly collegiate programs. Matched with a lackluster employment market, college to some seems to have lost much appeal.

The opportunity is here
Some argue Strayer will continue to underperform the market over time because of continued declines in enrollments and plummeting earnings; however, as the United States jobs market makes a steady recovery, the demand for enrollment should start increasing, causing the education industry to outperform the broader market. Stocks in the for-profit post-secondary education industry in particular make great potential turnaround investments because they have sound business models, challenging but improving fundamentals, and an overly pessimistic view by Wall Street. 

Sound business models
To begin, Strayer has a sound business model given its typically high profit margins, strong balance sheets, low capital requirements, and growing student demand. Having a historical average operating margin near 20%, Strayer is well equipped to monetize its business. Net profit margins are also expanding as management decides to continue cutting costs and limit capital expenditures, along with the gradual stabilization and eventual increase of student enrollments. Strayer's balance sheet is quite strong, as well, something not seen by most small- and mid-cap companies. 

The abundance of cash on hand that can be utilized by management gives Strayer an opportunity to invest for growth as enrollments recover. Another aspect of Strayer's sound business model is the company's low capital requirements. Since Strayer leases its campuses, it doesn't need to spend large amounts buying buildings. Their major costs are paying teacher salaries and developing curricula, which are expensed each year. The cost of curriculum development actually decreases over time, as the curriculum only needs to be updated instead of being remade.

Cost structure improvements
Furthermore, despite having a sound business model, in recent years, Strayer has encountered challenging but now improving fundamentals caused by a difficult regulatory environment, bloated cost structures, and declining student volumes, all of which seem to be reaching an inflection point. Over the course of the last several years, the government has been increasing regulations on educational companies.

This is in response to how the admissions process had become so distorted that the general standards were held quite loosely. As a matter of fact, several of Strayer's business rivals, including ITT Educational Services, Career Education, and Corinthian Colleges, are actually currently being investigated by the SEC. Because of how administration is paid based off upon the number of students admitted, they began to care less about student achievement and program completion.

Indeed, education companies have low capital requirements; however, declines in student enrollments have resulted in the industry having a bloated cost structure. The companies are paying for services, curriculum, and teacher salaries that are no longer required. Cutting costs will lead to the conversion of headwinds into tailwinds, in addition to increasing net margins and profitability. Student volumes have taken quite a hit over the last several years, being decimated over the course of the last three years. 

A huge validation came to my thesis of an inflection point recently, in Strayer's last reported quarter. In it, new student enrollments only dropped a mere 2%, showing that this scenario is truly starting to turn around. 

An incredible amount of pessimism 
Nonetheless, despite seeming to have reached an inflection point, Wall Street still has an overly pessimistic view on education companies, as evidenced by institutional analyst ratings, their valuations, and recent stock market performance. With the exception of JPMorgan, who recently upgraded DeVry, institutions have downgraded most of the education industry, including Strayer.

Clearly, Wall Street has taken a "half empty" approach to these companies, and by the inflections in many aspects of education companies shown above, one can argue that the psychology on these stocks is overly pessimistic. Combine this with the large amount of short interest Strayer has, and a turnaround scenario could prove to be especially lucrative very quickly.

Final foolish thoughts
Albeit most investment firms have only downgraded education companies to neutral, indicating a scenario that lacks an overly bearish side to it. The largest indicator that the education industry is out of favor is depicted by decimations in share prices over the last five years. This has been exacerbated even further by Wall Street's response to the education industry's current earnings skydive. From a value standpoint, however, Strayer in particular appears to have the capability to make a potential turnaround into a multi-bagger over the next three to five years.

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Daniel Segundo owns shares of Strayer Education. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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