Education Services: Investing Essentials

Perhaps no industry has gone through as much turmoil as education services.

Aug 7, 2014 at 10:30AM

One of the most profitable and controversial industries over the last two decades has centered on providing education services.

The industry has gone through so much change--so quickly -that investors need to understand all of the variables at play before putting their hard-earned cash behind any education company. 

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A Strayer University campus in North Carolina. Photo: Igor Sagdejev, via Wikimedia Commons 

What are education services?

For the purposes of this article, we'll be primarily focusing on for-profit and publicly traded companies that provide an education and/or diploma upon completion of course materials. These can range from two- and four-year colleges -- both abroad and here in the States -- to elementary, middle, and high school programs. 

How big is the educational services industry?

According to the National Center for Education Statistics, "[B]etween 2000 and 2010 ... undergraduate enrollment at private for-profit institutions quadrupled (from 0.4 million to 1.7 million students)." None was bigger than that of Apollo Group's University of Phoenix, which peaked in 2010 with nearly a half-million students, and revenues totaling nearly $5 billion.

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An ad included in an Apollo Group investor presentation. Source: Apollo Group

K12 takes a different approach, focusing on the elementary, middle, and high school markets. Last year, the company provided an education for roughly 150,000 students worldwide, and brought in $850 million in revenue.

Many domestic for-profit institutions also own subsidiaries that operate across the globe. The largest company providing for-profit education solely abroad is New Oriental Education, which focuses on mainland China.

The company is primarily in the business of offering English language lessons, as well as test preparation for English-proficiency exams. Last year, the company served a total of 2.5 million people, while bringing in $960 million in revenue.

How do education service companies work?

For-profit colleges and universities obtain the vast majority of their revenue from the federal government. Usually, students are recruited to join for-profit schools. Once students make the decision to enroll, they fill out financial aid forms. Because many of these students come from lower socio-economic demographics, they qualify for significant tuition assistance.

The money then flows from the government -- often through federal student loans -- to the schools. The student must pay back the government after he or she graduates (or drops out of the school).

Some schools -- especially American Public University -- focus heavily on recruiting military personnel, and rely on GI Bill monies for a bulk of their revenue.

In the case of K12, the company forms regional subsidiaries to provide educational services across the country. When a student's family elects to use K12, the money typically allocated to the local school district is funneled toward the company -- coming at no cost to the actual student.

New Oriental, on the other hand, usually obtains its money directly from students--there is no government aid involved. The bulk of New Oriental's students come from wealthy Chinese families looking to send their students to American colleges and universities. New Oriental helps students become more proficient in English and, subsequently, increase scores on SAT, ACT, TOEFL exams.

What are the drivers of the educational services industry?

Although for-profit education companies showed incredible growth in the 2000s, the same hasn't been true in the following decade.

Between 2010 and 2012, total enrollments at for-profit colleges and universities declined by 12% in the United States. The drop was largely set off by a scathing undercover report conducted by the Government Accountability Office. The investigation showed recruitment directors at at least four for-profit schools using highly questionable tactics to sign up students for classes.

Since then, state and federal authorities have come down hard on for-profit schools. Some are essentially going out of business. Others, like ITT Tech, are being taken to court for allegedly using deceptive recruiting techniques.

The rules that the U.S. government sets for for-profit schools will continue to be an important driver for the industry. Already, there are regulations about how much money a school can get from the federal government (no more than 90%) and how many former students can be in default on their debt payments (no more than 30% three years after leaving school).

The Department of Education has also proposed a Gainful Employment rule that would have three parts. First, at least 35% of a school's former students must be actively repaying their loans. Second, averaging across all former students, no more than 12% of average annual earnings can be used to repay school loans. And third, debt repayment cannot exceed 30% of the average former student's discretionary earnings.

Even without government regulations, however, there are several headwinds that have caused the for-profit sector to contract.

The first is a recovering economy. While that may sound odd, for-profit schools tend to do better during tough economic times. That's because there are more people with time on their hands looking for ways to get ahead. But going back to school isn't nearly as enticing when jobs are plentiful.

Just as importantly, the necessity of for-profit schools may be waning. On average, for-profit schools cost more than their state-school counterparts. The two main reasons students were persuaded to pay up was because their entrance was virtually guaranteed, and for-profits offered on-line and weekend programs that were more flexible.

With new regulation, however, for-profits are being more stringent about who they let attend. And more and more public colleges and universities are now offering the same kind of flexibility that for-profits do. If this trend continues, it could be a serious blow to the entire industry.

Brian Stoffel has no position in any stocks mentioned. The Motley Fool recommends American Public Education, K12, and New Oriental Education. 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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