Thursday, October 26

For Contrarians: Apollo Group

Fellow value investors and contrarians: Apollo Group is shouting for your attention!





Who is Apollo?

Apollo Group (ticker: APOL) is one of the largest for-profit companies in educational services, offering degree and career-enhancement programs for working adults. The company operates 100 campuses and 159 learning centers in the US; among them are the University of Phoenix, Institute for Professional Development, and College for Financial Planning.

Given a multi-year 20%+ earnings growth track record, the company has been a high-flyer, with share price zooming from $30 to $90+, and at one point commanding a P/E of 105x. Since mid-2004, the valuation has started to go back down to earth, stabilizing at $50 in 2006.

On October 18, Apollo announced its 4Q results (fiscal year in August). Earnings dropped the first time in many years. Investors got panic and dumped the stock. Now trading at $35.65.

Is it a good buy?

As contrarians we look for undervalued opportunities, that is, when most research reports stamp a big SELL on the stock and everyone is getting out and then ignoring it. If we believe the company is fundamentally strong and is only suffering from temporary hiccups, it would be a great buying opportunity.

Let's look at the fundamentals

According to an estimate by US Dept of Education, the US education industry is worth US$250 billion, with no major players dominating the market. As baby-boomers retire and have more time for education courses, the demand can only go up.

On a global scale, the most promising is, again, China and India: not only because of their size, but also because both cultures put heavy emphasis on education and learning. The increasing popularity of online/long-distance education is also very positive for companies planning to expand abroad.

We see that the education is quite an attractive sector. Now let's look at the PROs and CONs of Apollo Group:

PROs


  • Experienced in an attractive niche market: Apollo Group has 30+ years of experience in the niche of working adult education. The demand has kept increasing as the economy becomes more knowledge-based.
  • Strong financials: Even with the recent earnings drop, Apollo has a very respectable net profit margin of 18%, estimated earnings growth at 15%, and a return on equity of 63%.
  • Reasonable valuation: at 15x 2006 P/E, it is a good deal when compared to an industry average of 22x.

CONs

  • Sudden expense increase: it is natural to get worried about a rather sharp increase in expense, the main reason of the drop in earnings. One of the main items is bad debt expense: currently 4% of revenue is uncollectible. While not alarming, we would like to see the level going down to a normal 2%.
  • Uncertain if Ad spending is effective: The other major cost increase is advertising. We do not know if this is an ineffective attempt to curb a foreseeable, long-term decline in enrollment (bad spending), or a proactive approach to build reputation and further increase enrollment (good spending). We have to wait for at least a few months, look at the employment numbers, and see the results.
  • No dividend: if the stock price remains flat or negative, our loyalty will not be rewarded. However, no-dividend policy is quite typical for high-growth companies e.g. tech.

Conclusion

  • In my opinion, a break in a multi-year earnings growth is actually good news: at least management is not cooking the books.
  • At this point I cannot identify major problems such as fraud or significant litigation that would permanently damage the company. Given the strong fundamentals for both the company and the industry, I see the current price level a good entry point to this attractive market.

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