ITT Educational Services, Inc.
ESI
This is one of those companies that keep you awake at night not because it is in danger of missing a covenant deadline, but because its prospects are so exciting you just can't wait to see their latest quarterly earnings filing.______________
Introduction
For a company that has seen earnings grow at a compounded rate of 26.8% annually for the past 10 years, its stock has seen one of the most outrageous stock price in March 2008. Its price dropped to 45, and if you are one of those that look at a stock as owning a piece of a business, that meant that you are getting a 11.5% return with earning per share that year at 5.17.
Today, the stock trades around $92, and if this was a crappy company then it may not be the right time to purchase it. But this is a company with 1 - consistently growing earnings, 2 - higher than industry returns on equity and invested capital, 3- higher than industry profit margin, and 4 - almost no debt.
Briefly, ESI is a post secondary education provider, offering associate and bachelor program. Unlike its other competitors in the for profit education realm, ESI focuses in vocational areas like IT, computer aided drafting & design, criminal justice, and business. They also offer online programs that are a growing part of their revenue. With a student population of about 62,000, ESI serves 105 schools in 37 states and growing.
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The For Profit Educational Industry
While it is true in general to say that one of the best thing about education providers is that they operate in a countercyclical industry, people usually miss out on another salient point. We must first understand that in the case of education providers, their no 1 cash flow is the tuition fees paid by students. In fact, most of the time, students don't pay all the tuition fees. The government usually grants a certain amount of money to most students with qualifying background to pay for their tuition. In this case, government aid limits are usually set by referencing to tuition fees paid to higher cost structured traditional schools. Thus, the intense demand and government-set aid limits allow low cost structured schools like ESI to provided educational services at prices similar to traditional schools! With the availability of government aid, students tend to contribute little upfront, and this means ESI can raise rates without worrying too much about pricing out their main customer base.
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Earning Power
Looking specifically at ESI, it had an easier time hiking up their tuition fee in recently times even though it is already pretty expensive to get an education at their schools ($40,000 associate degree; $72,000 bachelor degree). This is because a degree from a ESI school is well worth the money. In fact, while new students earned $17,000 a year before they enrolled, they usually find work quickly after graduation and command annual salaries in excess of $30,000. As a result, ESI has considerable pricing power.
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Student Loan Credit Risk
However, as good as it sounds, there remains certain risks that investors have to be wary of. Because of the turmoil in the credit market recently, ESI has signed an agreement with private student loan lenders to ensure that all debts by students are paid off, or the debt will be passed on to ESI after a certain level has been breached. ESI has also increased internal lending to students, which may run the risk of increasing bad debt expenses.
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Profitability
In terms of profitability, ESI provides one of the best returns to shareholders amongst education providers. Return on shareholders' equity over the last ten years has been phenomenal and way above the industry rate of 36.3% in 2008. (99-08 ROE: 42.2, 42.5, 43.1, 49.3, 40.3, 38.5, 35.8, 114, 173.7, 157.1%). Some of us might prefer to look at returns on invested capital to get a better picture of the way a company funds its growth. Because debt reduces shareholders equity, a high-debt company would have a higher ROE than a low-debt firm. Return on invested capital (ROC) is similar to ROE, except it also considers long-term debt. In this case, ESI's performance has been stellar. Industry ROC average was 32% in 2008, ESI was at 60.8%.
A good sign of a sustainable growing company is its profit margin. The higher the profit margin, the higher the chance the company has a strong competitive advantage that allows them to price their products higher than their competitors. In ESI's case, net profit margin was 51.5% higher than the industry average (20.0% compared to 13.2%).
Furthermore, a key difference in the industry is that education services are very scalable. Each additional student helps improve profitability. And this is one reason why it has been able to grow without too much capital expenditure on assets or plants like other companies.
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Debt
Debt wise, this company never even had long term debt until 2006. In fact, its so called $150m of long term debt is a revolving credit facility that allows them to repurchase their shares. The first agreement filed in 2006 matures in 2009 and as of the latest 10-k filing, the agreement has been amended and restated in 2007 to borrow up to $160m under two revolving credit facilities: one in the maximum principal amount of $50m and the other $110m. They now mature in July 2010. As of Dec 31, 2008, the borrowings totalled $150m, secured, and interest are at 0.59% per annum. Approximately $158m of ESI's investments and cash equivalent serve as collateral. Even with the additional debt, it still managed to outperform the industry return on capital average by 30 percentage points. It just goes to show how good this company's business model is.
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Growth
In terms of earning per share or cash flow per share, the company has never ever stopped growing. While most companies experience dips in earnings during the recession in the early part of this century, or in the recent credit crisis, this company has never reported a dip in its earnings before for the past 10 years. Earnings per share grew at a compounded rate of 26.8% from 1999 to 2008 (.48, .57, .72, .94, 1.27, 1.94, 2.34, 2.72, 3.17, 5.17), while cash flow per share compounded 17.7% annually in the same period.
Because earnings visibility of this company is clear, it is easier to forecast its earnings in the next few years. 1Q' 09 has seen it hit $1.59 per share, a 47% jump, and it should not be hard for them to hit $7 a share this fiscal year. At the price of $92 that I bought, that is almost a 8% return on investment on a company which has a stellar business model that churns out outsized growth and profits each year.
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Valuation
ESI has always had a higher PE than its peers in the industry because of its outperforming profitability and margins. Yet because there is a lingering doubt about the credit risk they are taking in partnering with private student loan providers , their price has taken a beating over the last year (with respect to other listed for profit educators) due to the market's psychological fear of any company that has any exposure to loans of any kind. In fact, their current trailing PE (17.8) is lower than the industry average at 20, even though their prospects are better.
This company impresses me because it has grown tremendously with very little debt. I suggest stocking up on ESI should it fall below $92, a 10% discount to the industry average PE valuation. In fact, if this recent market rally proves to be a fluke, ESI may fall even lower in the short term like it did in 2008. And when that time comes, I will be stocking ESI up like there's no tomorrow.
