Apollo Group - A Growth Story

What is Apollo

Apollo Group  is believed to be the largest for-profit educational institution in the United States. The student population is approximately 458,600 students, approximately half of which are working adults. Apollo was founded in 1973 by John Sperling who foresaw that lifelong employment with one employer would go the way of the buggy whip  and that working adults would need continuing education to meet the challenge of a career change or just to get a degree at night when most institutions were catering only to the 18-22 year old day student.

Today, through subsidiaries  University of Phoenix, Western International University, Apollo Global, College of Financial Planning, Institute for Professional Development, and Meritus University, Apollo offers diverse education in such fields as finance, arts and sciences, criminal justice, nursing, education, psychology, and business. There are more than 30,000 faculty members, talented leaders in their fields with advanced degrees and real-world experience. In 2009 over 90 percent of the student respondents to a survey were satisfied with faculty effectiveness, curriculum effectiveness,  academic aid, and financial aid at the University of Phoenix.

Thesis for Trend

A weak economy could boost the demand for greater education as workers find it necessary to obtain additional education for career changes, new employment, lack of job opportunities,  or need for advancement.   Unmet need of education due to high cost can be met by online facilities, of which Apollo is a leader. The prospect of continuing high unemployment, rapid technology changes, employee turnover, an ever-increasing global economy and prospects for a slow economic recovery will support this demand for some time in the future. This thesis may find proof in the rapid enrollment growth at Apollo during the last two years. Of course, there will always be uncertainty as to the continuity of the pace of growth. If job placement rates decline, prospective students may rethink the need for further education.

Corporate Strategy

Apollo's former strategy was to expand its associate degree programs and enrollment. However, it found that bad debt expenses rose as did default rates because associate degree students generally did not find better paying jobs, if they found them at all. Accordingly, the college is focusing more on 4-year degree and advanced degree students and on international expansion. It purchased three international school systems through a joint venture with Carlyle Group. The main goal is to capitalize on its position by increased penetration of target markets, enhancing current product offerings and delivering high value experience to students both domestically and internationally.  Apollo will acquire existing institutions and or partner with them to achieve growth.

Growth Statistics

University of Phoenix degreed enrollment for the quarter ended August 31, 2009 was 443,000. It was 362,100 in the YOY quarter August 31, 2008, a 22.3% increase. Revenue increased 26.5% from $3,140,931 FYE August 31, 2008 to $3,974,202 for FYE August 31, 2009 and 45.9% from $2,723,793 in FYE August 31, 2007.  Earnings increased 25.6% in FYE August 31, 2009 while per share earnings increased 30.7%. Apollo provided $80 million for estimated loss on litigation. Hopefully,  Apollo and its CPAs got that one right. But for that, earnings would have increased 42.5%. For the year ending August 2010, estimated EPS range from $4.93 to $5.19. With $2.31 EPS for the six months ended February 2010 and estimated EPS for the second half ranging between $2.62 and $2.98, Apollo would seem to be on track to come in line with the Street's estimates.

The Balance Sheet

Long-term debt and liabilities at August 31, 2009 amounted to $283 million or 8.7% of total liabilities and shareholder's equity. The debt to equity ratio was 62% as Apollo had $1,755 in current liabilities as of their latest FYE. Student deposits and deferred tuition revenue made up $824.7 million of the $1,755 million in current liabilities.  Cash, cash equivalents and marketable securities amounted to $987 million. Interest expense of $4.4 million was exceeded by interest income of $12.5 million. Goodwill of $522 million is made up of excess purchase price of acquired businesses over net asset cost.

As long as the acquired businesses are profitable, we assume goodwill will not need to be written off. However, we are a little skeptical of retaining the goodwill related to the Insight Schools, as that unit is being held for sale, according to Apollo's annual report. However, the $12.7 million of goodwill  (we don't think is material in the overall scheme)  was written off in the second quarter of 2010. Apollo increased their allowance for doubtful accounts to $110 million against $408 million in receivables in FY 2009 which is pretty hefty in our judgment. Overall, we think the balance sheet reflects a healthy financial picture.

Low Leverage

As of February 28, 2010, Apollo had $980 million of tangible asset costs less $407 million in depreciation on its balance sheet. Of the $980 million, the original cost of land and buildings was only $242 million.  One of Apollo's key themes for the next seven years is to produce a high return on capital. Lack of expensive and expansive classrooms, sports facilities, dorms, and similar grandiose structures commonly associated with Ivy and other high class colleges is one of the reasons why Apollo has a reasonable shot at maintaining its historically high rate of return on capital.

Litigation

We don't profess to understand the notes to the financial statements regarding litigation.  We did note that in many of the cases, the school was vindicated. However, in the incentive compensation false claims case, the school recorded a $80.5 million charge for FYE 2009 on the basis of what a settlement would cost. The court date was March 2010 and we have not found further information about the case. In the second quarter results ended February 28, 2010, Apollo added another $33.0 million to the allowance for settlement. The company noted that cash and cash equivalents declined during the quarter in part due to settlement of this case, but did not disclose the exact amount which we find a little troubling. The Company also disclosed a settlement (no disclosure of the amount) with the Internal Revenue Service over various tax issues, against which the Company appears to have had a reserve of $85.7 million in current liabilities in FYE August 2009. Uncertain tax positions were fully disclosed, it appears, although only the CPA auditors know for sure. Back in 2006, Apollo was audited by the SEC for backdating stock options, but came up clean.

Competitors

As many of Apollo's programs are offered online and the school has very little investment in facilities relative to campus colleges and universities, its main competition comes from other online schools. Career Education with $1.8 million in trailing revenue, DeVry with  $1.6 million in trailing revenue, Corinthian Colleges with $1.5 million in trailing revenues, and ITT with $1.3 million in trailing revenue are the main competitors. We did not compare these reports (and we should have, frankly, as a matter of rigor) as it is our intention to invest in the leader in revenue and student enrollment, relying on Apollo's scale and efficiency, plus the cash to expand internationally. Apollo with $4.4 million in trailing revenue meets our criteria, we believe.

Management

Dr. John Sperling, the founder of Apollo, is Executive Chairman of the Board. Geogory Cappelli is Co-Chief Executive Officer, becoming such in April 2009. He has had experience with Apollo as Ex VP of Global Strategy and Assistant to Dr. Sperling prior to that. His prior experience was as a research analyst, some of the time with Credit Suisse. He earned a BA in economics from Indiana University and an MBA from the Brennan School of Business at Dominican University. Charles Edelstein is the other Co-Chief CEO. He had experience in the CEO office and as a BOD member. He joined the Company in August 2008 after a 20 year stint at Credit Suisse as managing director of the Global Services Group. He also founded the bank's education industry advisor practice. He earned a BA from University of Illinois and an MBA from Harvard Business School.  Four of the other executives in top management have had less than five years experience with Apollo. We are little concerned with the lack of experience in the education industry by the Co-CEOs and other executives, but Dr. Sperling still provides a captain's role for the Apollo ship.    

Valuation

Morningstar analyst Todd Young estimates revenue growth for the next five years 2011 to 2014 to be 11%. Consensus estimates for revenues for YE 2011 are estimated to increase by 12.4%. How much flows to the bottom line is a little more difficult due to certain risks such as bad debts, merger & acquisition costs, and litigation. Consensus estimates place the increase at 17%. Morningstar has it at a more conservative 16.1%. Historically, the increase from 2007 to 2009, a two-year period, has been 45.9%. At the $5.91 EPS estimate for 2011 and the stock price of $63 gives us a 10.6 forward PE.  At the current year EPS estimate of $5.05, the current year PE is 12.5. Since the growth rate of EPS is projected in the range of 16 to 17%, the PEG is less than 1.00. Book value per share is $7.25 in the FYE August 2009, giving us a ratio of 8.7 compared to the industry of 5.1 and the S&P 500 of 7.3. Price/EBITDA we compute to be 8.75 as of August 31, 2009 compared to 15 for the industry and 7.3 for the S&P 500. Apollo certainly qualifies as a growth stock with  net income at 15.0% of sales, return on assets of 18.3% and return on average equity of 60.0%. Our discounted cash flow calculation came up with an intrinsic value of $80 per share, but we did not enter any amount for cost of future acquisitions, net of financing, and we assumed a weighted cost of capital of 20% for colleges and universities from an Ibbotson Yearbook, which seems high because Apollo has low long-term debt. We should have computed our own cost of capital, but did not in the interest of time. Morningstar came up with an instrinsic value of $106 but did not disclose the details of computation. A weighted cost of capital of 16% with projected growth rate of 16% gives an intrinsic value of $110.

Even with a wide range of estimated values, we think the stock is undervalued based on fundamentals, excepting the outcome of the SEC investigation into revenue recognition issues.

Technicals

Looking at a weekly candlestick chart, the chart appears to be driven by news rather than any pattern because it is very choppy. On a daily chart, the stock took a huge gap down on October 28, 2009, settling at about $54 on November 13, 2009. Since then it has retraced a little over 40% of the move down. Gaps tend to get filled, but not always. If the gap is filled, it would bring the price up to $75 and change. Looking again at the daily chart, on the latest run from $55 and change to just under $66, it would appear that support is in the $61.30 area. On the weekly chart, support looks like it is in the $54 range. The stock on Friday April 24th completed a second red candle down. If it goes below $61, then it could go all the way down to $55 and change. Overall, we think the daily charts show advancing  price action, but we are not so sure, looking at the weekly chart.

Risks

As discussed above, there is a risk of price retracement, based on technicals. That risk would appear to be limited to a support price of $55.

The SEC has started an informal investigation into Apollo's revenue recognition practices. If the SEC found noncompliance with generally accepted accounting principles or industry practices, a restatement of the earnings would be required, and it's a good bet it would not be a positive outcome. Obviously, a company in business since 1973 would have gotten it right by now, but with rules constantly changing, Apollo's auditors might have missed something, and if they did, we think a change is in order.

A weaker economy could spell trouble for receivables collections. Apollo already has a high allowance against receivables, almost 25%.   There is some element of revenue increases attributable to tuition inflation. There is a risk that with a weak economy, those increases will drive away students.  There is also a considerable risk that Apollo continues to attract and enroll two year students who have been one of the reasons for the significant doubtful account problem. Co-CEO Charles Edelstein has announced intentions to control this matter, but we will have to wait to assess how effective any new policies play out.

There is risk of unccontrolled compensation increases as the Class B voting stock is 100% controlled by Dr. Sperling, Mr. Sperling, and two trusts. The Class A stock, the publicly traded stock, does not have the right to vote. As a result of death of the Sperlings, control of Class B stock would be exercised by a majority of three successor trustees and there is no assurance that they will act the same way as the Sperlings would.

U.S. and state regulations require a high degree of compliance. Failure can result in penalties, fines, termination of operations, revocation of licenses, limitations or loss of student financial aid, civil and/or criminal penalties, and other less severe sanctions.
The annual report contains extensive discussion of these matters which space and time does not permit expansion here.

If the student default rate equals or exceeds 25% for three consecutive years, Apollo could lose its ability to participate in student loan programs and that would have a material adverse effect on operations. In addition, loss of institutional accreditation would have the same effect.

Commissions, bonuses, or other incentive compensation based on securing enrollments or financial aid is not permitted. The rules and regulations are not clear and it is possible that the U.S. Department of Education could find a violation.

The Company must keep government aid, including loans, Pell Grants, and similar governmental program support below 90% of total revenue. At Apollo it is now approximately 86%. If the Company does not generate alternative sources of revenue to keep the governmental support below 90% of total revenue, the students will lose access to student loans.

There are various business and economic risks commonly associated with doing business that are enumerated in the latest annual report, including but not limited to further slowdown in business activity, adverse effects of litigation, inability to attract students and maintain profitability, systems disruptions and security breakdowns to computer networks, not being able to make acquisitions, etc.

What We Don't Like About Apollo

For the quarter ended November 30, 2003, Apollo had a total of 3,200 Associated degree students enrolled. For the quarter ended February 28, 2010, the total was 201,300. The YOY increase was 30,800 students or 18%. Associate students appear to be the main engine of enrollment growth because the Bachelors and Masters degree student enrollment has not increased anywhere near as fast. While the college administration makes noises about controlling the costs and expenses associated with 2 year students, we question whether their words have been followed by actions.

We don't like the effect on share price that the risk of the ability and power of the Department of Education to conduct investigations has in disrupting normal business activity. We understand the need, but the risks associated with furthering the quality of education will be a continuing cloud over the share price, a risk we are somewhat uncomfortable with and would be particularly diligent about using stop loss orders should we make a final decision to invest.

We don't like the fact that the voting control of the company does not rest with the investing public.

We don't like the continuing litigation that seems inordinately large for a company this size, questioning the effectiveness and the ability of the legal department to discover issues and potential problems before they develop into cases. We would be more comfortable with some changes in the legal department.

We are uncomfortable with the share repurchase plans announced in February 2010 as being inconsistent with the announced strategy to grow by acquisition and a poor use of cash that should otherwise be deployed in M&A activity. We would be more comfortable if Apollo were to sell the Treasury stock later this year at a gain, to finance acquisitions, but it's not clear that is their intention.

Summary

Despite the risks, we are inclined to be a buyer of Apollo in the coming days as the price reaches a support position technically, and we would keep a stop loss at a price initially allowing for no more than an 8% loss, thereafter moving the stop up as appropriate to mitigate the risks we would be assuming with this particular company. We hope the stock would double in a two year period, carried in part by market momentum, and in part by resolution of various problems mentioned above.