Why I Missed Out on a 24% Day for This Stock

This article is part of our Rising Star Portfolios series.

Just a few weeks ago, I passed on American Public Education (Nasdaq: APEI  ) for my Rising Star Portfolio. Last week, after the company reported earnings, shares jumped 24% in one day.

That's never fun, but these situations make great learning opportunities. The question I must ask myself, of course, is whether I made a good decision with the information I had at the time. For the sake of Foolish education, I'd like to let you in on my reflective process.

What I liked
I was initially attracted to American Public Education after a hunt through the for-profit education industry in general. The industry has taken a beating over the past year, mostly for good reason. Many of the industry players have been or are flirting with disaster -- be it in questionably ethical recruiting practices or in bumping up against legal limits on how much revenue they can draw from federal student loan funding.

Just as in any industry, though, not all companies are created equal. The market was painting the for-profit sector with a broad brush, but I thought it was worth looking for educators who didn't really fit the industry mold.

That's how I found American Public Education. Unlike general educators such as industry big dogs Apollo Group (NYSE: APOL  ) and Corinthian Colleges (Nasdaq: COCO  ) , which each offer a range of degree programs, American Public Education has a well-defined and attractive niche: the military. Founded by a former Marine, the company offers flexible degree programs -- which is key when their student constituency can be deployed at any time -- and military-specific subjects. The degrees that military service members receive from American Public Education are vital in military career advancement, and, even better, the military pays for them. No -- or at least very little -- cash out coming from students' pockets means prospects are more likely to sign up and less likely to struggle with heavy debtloads after graduating.

What I didn't like
The one part of the American Public Education's business I didn't like was its recent foray into catering to what it calls "public service" students. These are publicly employed civilians, such as police officers, firefighters, and teachers. It seems to me that the expansion into this market has been fueled by a desire to keep growth near its recently explosive levels; as the company captures more and more of the military market, less potential growth remains there.

The problem, though, is that American Public Education doesn't have any real edge in this "public service" market. I disagree with management that it is a natural extension of the business. Public service students aren't having their degrees funded by the military, the costs of recruiting these students are higher than for military students, and there is a ton of competition in this space, from Apollo to Strayer Education (Nasdaq: STRA  ) to a myriad of community colleges across the country.

If the goal was to keep growth high, so far American Public Education has succeeded. In 2010, course registrations increased 31%, which was the big news that caused the pop last week. But I wonder how sustainable that is, and I would rather have the company accept slower growth and devote its resources to strengthening its position in the core military market.

The nail in the coffin
On the whole, I like American Public Education's business. I'd rather it stay out of the public sector, but at the end of the day, the majority of its students are military, the company is well-run, and, with $81 million in cash and no debt, the financials are clean. For me, the straw that broke the camel's back was the company's valuation.

According to my model, the business had to double its student base between 2009 and 2014 just to justify its stock price. In other words, if the company didn't grow that fast -- but still grew -- the stock should drop in value. Doubling in five years entails pretty aggressive growth. True, the company has been adding students at a breathtaking rate over the past three years, averaging 41% annual growth since 2007. But that was off a much smaller base -- 30,000 students in 2007 versus 83,700 today -- and the company has done such a good job signing up military students that there is a diminishing opportunity for growth going forward.

Also, as the company has already picked much of the low-hanging fruit in the military market and branches out into the public service market, the cost of recruiting new students is climbing. The cost of signing up a new student has already jumped from $226 in 2007 to $410 in 2010 and should continue to rise. The company has great benefits of scale -- that's what almost entirely online operations will do for you -- but this selling cost should combat the margin gains associated with scale. In fact, 2010 was the first year since 2005 that operating margins decreased, in large part due to higher selling costs.

The takeaway
It's never pleasant to watch a stock you passed on reach for the stars, especially just a few weeks after you made your decision. But there is always something to be learned from these scenarios. A 24% pop in one day is mouth-watering, but it's a very short-term outcome. This company's strategy has some minor imperfections in my book, but overall it's a great, well-run business.

Ultimately, I decided it was simply too expensive. Every model you (and I) build is inherently flawed, but even in various scenarios, I just couldn't justify paying the price. Only time will tell if my decision was a good one -- and it is good to compare the outcome to what I did buy -- but for now, I believe my decision was a solid one.

To stay current with my stock picks, commentary, and reflections, follow me on Twitter.

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios) here. 

Alex does not own shares of any company mentioned. The Fool owns shares of American Public 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.


Read/Post Comments (3) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 25, 2011, at 12:08 AM, ozzfan1317 wrote:

    For me I think For profit education in General is Undervalued I hold shares of ESI myself.

  • Report this Comment On February 26, 2011, at 2:14 AM, bhalvers2002 wrote:

    Your comment about needing to double the student base in 5 years is incorrect. If you understand the business it is net course registrations (number of classes taken) that drive revenue. Civilian students stakes 4-6 courses / year vs. 2-3 courses / year for military. APEI can grow student base at moderate rate, but achieve much faster revenue growth.

    I also did not see any comment about the Wal-mart partnership. While just ramping now, should enough WM students sign on, the marketing costs will go down (now incremental marketing to attract WM sponsored student) - a point of huge leverage.

  • Report this Comment On February 26, 2011, at 2:28 PM, XMFPapester wrote:

    bhalvers,

    Thanks for your comment. Of course, what the company needs to do over any period of time to justify today's price depends on how you build your model.

    My model does indeed flow from registrations, and I have number of students in there as a reality check. I'm not sure if your courses/year for military vs. civilian students are accurate (though they do make some intuitive sense). The last four years, APEI has reported that its student base has been 80%, 80%, 75%, and 50% military. Over those same four years, the number of registrations per student have been 3.16, 3.27, 3.26, and 3.25. If civilian students are taking twice as many classes as military students, you'd expect registrations/student to be growing more rapidly.

    The Wal-Mart thing doesn't make much strategic sense to me. There is no obvious leverage with their core niche (military), and it is not even capitalizing on "public service" professionals. Don't get me wrong, it's not a terrible idea for a for-profit educator, but to me it just looks too much like another way to juice growth. I'd rather they invest on strengthening their competitive position and not worry about growth as much.

    Cheers,

    Alex

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