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Business prospects for the Education Industry remain challenging. The near-term outlook for most companies in this sector remains cloudy, largely due to the likelihood that total student starts and enrollments will continue to decline. New students during the third-quarter fell roughly 20%, on average, from the year-earlier period, which hurt revenues, margins, and profits at nearly every school.

Macroeconomic factors remain a primary concern. Although the Educational Services Industry is typically counter-cyclical, the ongoing sluggishness in the economy, after such a pronounced recession, has prevented many workers who lost their jobs from returning to school. Many individuals simply refuse to take on additional debt to go back to school, especially given weak job prospects.  

Although we believe the regulatory environment has stabilized somewhat from earlier in the year, we do not think that all major issues have been resolved. Although the $5,500 maximum Pell grant that most students can apply for will remain in place in 2012, future grants could be on the chopping block. Some members of Congress have sought to cut the Department of Education’s discretionary budget, which could reduce the amount of student loans available.

The schools most at risk from this scenario are Career Education (CECO) and Corinthian Colleges (COCO). The former is dealing with significant regulatory risk, as it recently disclosed that as many as 49 of its programs could be suspended if the company is unable to prove these courses were properly accredited. The stock has plummeted by roughly 50% since our October 28th report, but we still think there is too much risk to jump in at this point.

The latter educator has been doing what it can to remain in compliance with new regulatory guidelines. Nevertheless, management expects new student enrollment declines through most of 2012, which ought to drastically hurt profitability next year. The stock, at around $2.60 at the time of this writing, is down significantly from the beginning of the year, but still, carries significant risk.

On the other hand, DeVry (DV) and Apollo (APOL) stand to benefit the most from the possible reduction in Pell grants. These two educators have been some of the quickest to make operational changes in response to increased regulatory scrutiny. We, therefore, expect them to be the first to come out of the trough. 
Although student starts trends will likely remain negative over the next couple of quarters, we do look for them to turn positive by the second half of next year, thanks to easier comparisons and the advent of operational changes. We think earnings expectations have probably reached a low point, and this could provide an impetus for price improvement in the near term. However, the macro outlook, and particularly the employment picture, adds a significant amount of uncertainty to these stocks.

A bright spot for the industry is the fact that most companies are sitting on a considerable amount of cash. Many educators have been aggressively buying back stock, thanks to continued depressed valuations. This should help to support some positive movement in earnings. We also expect to see an increase in merger activity in the short term, which could prop up prices of target companies.

All told, we think there is some value in education stocks, but we remain cautious given challenging fundamentals, limited visibility, and the still soft economy. Risk-tolerant, value investors may find an appealing entry point given the depressed prices of many of the companies in the sector. However, these investors should expect ongoing volatility in the next couple of quarters, as declines in the new student population will likely continue, which should hurt sales and profitability.

Risk-averse investors should likely remain on the sideline pending more clarity regarding Pell grant funding issues. We also think that these investors should wait for a sustained improvement in fundamentals, including student starts, overall enrollments, and profitability, before making commitments. 

 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.