No Child Left Behind a key topic of Wall Street Transcript Education Services Issue
Ohanian Comment: Here's the good news from Wall Street:
This Wall Street Transcript 50-page feature costs $175, $425 for a year’s subscription to the ‘education sector.’ Even your intrepid news gatherer, who subscribes to everything, can't do this one. Note that it is targted at serious investors. Children as market shares.
67 WALL STREET, New York--The Wall Street Transcript has just published its EDUCATION SERVICES issue, a report offering a timely review of the sector to serious investors and industry executives. This 50-page feature contains an expert roundtable forum of leading industry analysts, an interview with 2 experienced research analysts, and industry commentary through in-depth interviews with top management from 6 firms. The full issue is available by calling (212) 952-7433 or via The Wall Street Transcript Online.
The issue discusses the latest trends and developments in different aspects of the education industry, including K-12, post-secondary, training services and online learning. Topics include: Post-secondary market, K-12 government funding, Reauthorization of the Higher Education Act, Enrollment shrinkage, No Child Left Behind, Raising credit standards, Headlines, investigations and lawsuits, Regional and national accreditation, Repeal of the 50% rule, Online education, IPO outlook, Increased competition and escalating marketing costs, Market share battles, Shortage of skilled workers, Rising student acquisition cost, M&A activity, Declining multiples of the group, Stock recommendations, Stocks to avoid.
Companies include: Career Education (CECO); ITT, Educational Services (ESI); Corinthian Colleges (COCO); Laureate Education (LAUR); Apollo Group (APOL); DeVry, (DV); Universal Technical Institute (UTI); University of Phoenix Online; ProQuest (PQE); Education Management (EDMC), Educate Inc. (EEEE), Education Management Corporation (EDMC), Healthstream Inc. (HSTM), Learning Care Group Inc (LCGI), Learning Tree International Inc. (LTRE), Nobel Learning Communities Inc. (NLCI), School Specialty (SCHS), Bright Horizons Family Solutions. Analysts Include: Richard Close, Jefferies & Company; Kirsten Edwards, ThinkEquity Partners LLC; Jeffrey M. Silber, Harris Nesbitt Corp, Robert Craig & Jerry Herman, Legg Mason Wood Walker.
In the following brief excerpt from the 50 page report, Robert Craig & Jerry Herman discuss the impact of the No Child Left Behind on industry participants.
TWST: Let's start out with the K-12 space and work up. What's going on in that space at this point?
Mr. Craig: Let me give you an overview here. First, most important, state fiscal health continues to improve. According to the National Conference of State Legislatures, budget gaps are still only present in three states in fiscal 2005, down from 31 states in 2003; state income tax receipts are greater than forecast in 29 states and less than forecast in only two states and the aggregate budget gaps that states have had to close since fiscal 2001 is in the range of $235-$240 billion. So things are improving from a macro point of view.
Second, mandates under No Child Left Behind are starting to kick in and federal funds are flowing. We continue to see estimates of over 10,000 failing schools, and that encompasses an awful lot of kids. These kids and their families have choices in terms of supplemental education services like tutoring or school alternatives if their school continues to fail.
Third, certain areas like testing in assessment, teacher development and supplemental education services are attractive, and each has significant growth potential. Fourth, we have seen and we think we'll continue to see consolidation in this sector. As an illustration, Bain Capital recently announced it was augmenting its stable of education assets through the pending acquisition of School Specialty (SCHS).
Lastly, valuations in that sector have partially, if not largely, discounted a recovery already. The average forward 12-month p/e ratio is about 25 times, and that's slightly greater than the five-year average. Overall, we think that the K-12 business is starting to improve, and we are actively looking for ways to capitalize on it and invest in that segment. The only current Buy recommendation that we have in that segment is a company called Educate (EEEE), which is essentially half of the former Sylvan organization. They are the leader in tutoring, which is one of the businesses that we do like in K-12.
TWST: Just going back on a couple of the points, No Child Left Behind seems to still be a controversial issue. Is it finally beginning to settle out and are people accommodating to it?
Mr. Herman: It does remain a controversial issue and we think it will continue to be such. Whenever you're dealing with a subject that sparks such passion like education you can expect such. However, from a funding perspective it's important to note that the predominance or about 93% of K-12 funding still comes from state and local budgets, and that's why the comments in regard to those budgets improving is so important.
NCLB is a big opportunity because it layers in an expanded source of funding. A key piece of NCLB is Title I, which are federally funded programs in high poverty schools that target children with low achievement. The dollars devoted to Title I now approach $12.5 billion and are up about 35% since NCLB was signed into law. The dollar flow is significant, and perhaps more important, it now appears that the decision makers - principals and superintendents - have an improving understanding of requirements under the law and how to access funding. From an investment perspective, we are more intrigued with the K-12 sector than we've been in many years. Our recent upgrade of Educate, Inc., is an illustration of that renewed interest.
TWST: What is the appeal of Educate? Why have you raised that one to a buy?
Mr. Craig: They are essentially one half of the former Sylvan organization; the K-12 assets were separated from the postsecondary assets in 2003. The reasons we like Educate are several. First, we like the tutoring business. It's a very large market, around $4 billion in total expenditures. It's extremely fragmented, and it is growing at an estimated 10%-15% per year. Educate is the largest factor in that business by at least a factor of four and has by far the highest brand awareness.
Second, they're also a beneficiary of No Child Left Behind. They have instituted an NCLB-related supplemental education service offering of their own, and in a little over two years, that business has grown from roughly a standing start to a $35 to $40 million business. It should continue to grow rapidly. Coupling that with other newer initiatives, the overall revenue and EPS growth rates should remain strong. The company just announced the rollout of live online tutoring throughout their entire network.
Also, they recently acquired Hooked on Phonics, another well-recognized consumer brand, which they intend to capitalize on by essentially creating a distribution channel for a more affordable and less intensive tutoring service offering. All of these initiatives should help this company maintain an EPS growth rate of 20% plus, and looking at our estimates, $0.60 for this year and $0.72 for next year, the valuation is reasonably relative to those growth prospects
Mr. Herman: If you look at the way the company distributes its tutoring services, it covers both the retail and institutional tutoring sectors. It delivers to the retail customer through some 1,000 Sylvan Learning Centers, offering programs that cost $2,500 to $4,000. That's a fairly large ticket item and, as you might expect, there is some economic sensitivity to that business. Consistent with an improving economy, we are seeing improving trends in those retail centers.
They also have institutional distribution, selling and delivering to schools and districts. Bob referenced the benefits of the No Child Left Behind funding improvement as well as the state budgets. The institutional tutoring business of Educate is benefiting. From a company-specific point of view, that's all leading to accelerated growth. A key metric for the company is same territory growth, which last quarter was the best we've seen in well over a year.
Finally, it's worth making one other point on valuation. Because of a tax benefit that shelters the first $0.40 or so in EPS, there's another $0.15 in incremental cash flow on top of the estimated EPS. So cash EPS estimates are about $0.75 for this year and $0.87 for next year.
TWST: If you were looking beyond Educate, what else is out there that, longer term, might provide some traction in this space?
Mr. Craig: We haven't, by the way, touched upon the pre-primary or childcare area and there's really an outstanding company that we cover in that space - Bright Horizons Family Solutions (BFAM). They focus on corporate sponsored childcare, which is a $2 billion plus market and one that's growing faster than the overall childcare pie. Their competitive position is, again, second to none and it is a very well-managed company with very good growth prospects. We believe, however, that its valuation already reflects its healthy growth prospects at least over the next 12 months, which is the time frame on which our rating system is based. It's a very good company and a very good business.
TWST: As you look at the space today, where should investors focus?
Mr. Craig: Our modus operandi during this period of legal and regulatory uncertainty, which is by nature very difficult to handicap and predict the ultimate outcome of, is to focus on companies that couple a generally more attractive regulatory risk profile with a reasonable valuation relative to their growth prospects. Because of that, we have gravitated toward two names in particular, one of them being Education Management (EDMC) and the other being Laureate Education (LAUR). We like them for very different reasons. In Education Management's case, it's a business model that is transitioning to one of less capital intensity, possibly greater growth, and higher returns on invested capital through the utilization of shared facilities in locations. Also, the company's emphasis on quality and steady-eddy growth has resulted in a lower legal regulatory risk profile, and valuation is reasonable relative to the prospects for a continuation of 20% EPS growth.
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