Sunday, March 30, 2008

A Second Look at Educational Services and Student Lending Problems

Disclosure: I do not own a position in ESI, CECO, DV, APOL, STRA

During the dot-com crash years I found myself moving from one company to the next as each company declared bankruptcy. All those lavish parties fueled by ridiculous expense accounts on virtual business plans are now but just a pleasant memory (it wasn’t fun at the time). What I do remember were several people who made the decision to go back to school to learn something new and fine tune their skills until employment activity picked up. Many MBA students put their studies on hold to pursue dot-com pipe dreams ended up heading back to finish up B-School.

Fast forward to 2008 and we are entering what looks like will be an extended period of economic weakness. I sat back one day and wondered if school would be a destination of choice for anyone losing their jobs this year. This led me to question whether for-profit colleges are naturally a recession proof type of business, dare I even say a business that experiences growth during economic weakness. Going to school is never a bad thing, especially when the employment market doesn’t look good.

This was a sector that had never crossed my mind before as an investment vehicle, so I started off searching for publicly traded educational service sector companies with market capitalization above $1 billion. I wanted to focus on the big players that had the capital and flexibility to scale their business the best way they saw fit. For-Profit colleges that meet these criteria are (symbol, market cap):

  • Apollo Group, Inc. (APOL, $6.91B)
  • DeVry, Inc. (DV, $2.85B)
  • Strayer Education, Inc. (STRA, $2.15B)
  • ITT Educational Services, Inc. (ESI, $1.83B)
  • Career Education Corporation (CECO, $1.09B)

The next step was to see how these companies faired during the dot com bubble explosion (March, 2000), through the 9/11 attacks, down to the market bottom around October of 2002. I also wanted to see how these companies faired one year after the market bottom.

During the dot-com meltdown, the S&P500 index trended down while this set of companies showed relative strength. The weakest of the bunch was DeVry, but that still would have been a good investment when compared to investing in a typical S&P500 index fund. The four other companies (ESI, APOL, STRA, CECO) did extremely well with explosive stock price appreciation, especially after they hit market bottom of October 2002. It was interesting to see this comparison, but it definitely wasn’t enough information to make any sound investment decision. What kept me digging further was the ISM Non-Manufacturing Report on Business readings published a few months ago.

The ISM Services Index and Educational Service Sector

The Institute of Supply Chain Management came out with horrid 44.6% reading for the ISM Services Index in January (please see my previous article about how to interpret this number). Although this showed contraction for the services sector as a whole, if you had dug into the details of this report you would have picked up the fact that Educational Services reported growth in the following 3 components of the index:

  • Business Activity
  • New Orders
  • Supplier Deliveries (quicker deliveries)

This all looked promising, until I picked up their latest February ISM Services Index readings. The report showed an overall reading of 49.3% indicating the second straight month of contraction in the US service sector [2]. Although much better than January’s reading, what brought down my enthusiasm was that Educational Services now showed contraction in the following areas:

  • Business Activity
  • New Orders
  • Employment

What happened? I was hoping to ride on the story of people heading back to school after getting layed off. As grim as that sounds, it may have been a good defensive play given the financial credit mess we are in right now. Oh yeah… the financial credit mess. Is that trickling over and affecting prospective students from borrowing money to go back to school?

What's different this time around?

There are several things different this time around for prospective students than in 2000-2002. First off gasoline prices were not as crazy, food costs were in control, and you could still borrow money to head back to school, and get 0% financing on that brand new GM SUV to get you to and from school in style. This time around, several private lenders are suspending loans to students for 2008 [3]. Some lenders are exiting the FFEL (Federal Family Education Loan) program all together, forcing some schools to switch to direct federal lending. This trickles all the way back down to the students who may have a harder time securing financing for their studies. 30 lenders have exited FFEL, while 7 lenders have suspended its private student lending programs [4]. In order to understand what is happening, let’s take a step back to see how things used to operate for students applying for loans, and what FFEL is.

There are basically two different lenders that students could tap into for loans, directly from the government through the school (not every school participates in this financing avenue, only about 1000 of them) [3], or from private lenders such as Banc of America, and Citicorp who participate in a program known as FFEL (Federal Family Education Loan program). Private lenders used to have very favorable conditions to profit from student lending through government backed subsidies. These subsidies allowed lenders to offer earn healthy profits while also offering discounted rates to students. These subsidies however were cut late last year by approximately $20 billion (half of where it used to be) [5], crimping margins for the private lenders. The other advantage with participating FFEL, were that the loans were protected from default by the government. This put all the risk on the federal government, and almost no risk for the private lender. Private lenders need to come up with the cash to lend, either by digging through their deposits, or by going to the capital markets looking for investors to buy up this student debt. It was just another avenue for investors to park their cash.

Does this sound familiar? It should, as this is somewhat the similar model used by the banks, and investment houses to make money off the mortgage craze we saw over the past few years. Instead of mortgage borrowers, it is the student population. Students should be a safer bet against loan default compared to subprime mortgage borrowers. The intentions are different as one group is going back to further enhance their skill set and improve long term career prospects, while some within the mortgage group shouldn’t even have been taking out loans, or worse, they were speculators who rushed into the real-estate frenzy hoping to “flip” homes backed by interest-only mortgages or ARM’s.

All the investors who used to buy up student debt are having 2nd thoughts, even though they are backed by good natured students. One can surmise that when things are going really bad with mortgage backed investments, why take on more with student backed debt? As these investors stop bidding for these investments, the private lenders need to look elsewhere, or raise their payout to improve the risk/reward ratio for the investor. This means higher costs for the private lender to operate in the business, especially when FFEL loans have capped interest rates on what they could charge students. Margins are squeezed to the point where it doesn’t make sense to participate.

What are students’ options now?

Students can tap the federal government directly, but only if their schools are participating in their direct lending program. They can also go with private loans (no government involvement, higher costs). Private loan qualifications have become stricter, which affects loan applicants at the lower end of the credit range. This in turn may affect enrollment at institutions with a large percentage of revenues coming from this student base.

Which institutions are most exposed to this risk?

So why continue looking at these for-profit college stocks? Are all of them exposed to the private lending risk? Just look at the YTD (March.28.2008) performance for these stocks:

  • CECO , -47.84%
  • ESI, - 46.27%
  • APOL, -39.21%
  • DV, -21.01%
  • STRA, -11.31%

All of them will be affected in some way, but to what degree? Some of these stocks may have been punished too far and got caught up in the perception that they are highly exposed to the credit crisis. Credit Suisse currently estimates private loan exposure for ITT (ESI) and Career Education (CECO) to be at 29% and 18% respectively [8]. Right off the top we can eliminate these two from consideration.

Next we move on to the Apollo Group, which runs the University of Phoenix. They just reported 2nd quarter earnings on March.27th, and followed up with a 26% drop in their share price the next day. The drop off wasn’t because of their reliance on private student loan exposure, as only 4% of their revenues comes from private loans [8]. The company reported that they have added Banc of America as their 5th preferred lender, and that they were looking at contingency backups with respect to direct federal lending. Apollo was basically punished for a class action lawsuit in which the settlement range will be between $121 million and $216 million [9]. The other surprise came in the form of increased SG&A (excluding the litigation charge) of $584 million for the quarter, a 15% increase from the same period last year [9]. The quarterly results weren’t impressive, but I’ll be keeping Apollo on my watch list as some of the increased expenses in personnel maybe part of a longer term initiative to expand the business.

This finally leaves us with DeVry (DV) and Strayer (STRA). The management teams for these companies have been able to navigate the current credit mess quite well based on their earnings results. DeVry recently reported 2nd quarter earnings coming in 118% higher than the same period last year [10]. The company’s portion of revenues tied to private loans comes in at roughly 5% [12]. The company is in good position to mitigate this risk by having its own student lending program which accounts for 4 to 5% of total revenues [10]. Daniel Hamburger, the President and CEO came out on the latest earnings call to reinforce his position that DeVry students would have access to multiple sources of financing, and that the recent report of Sallie Mae discontinuing discount loan programs (loans for high risk credit students) would not affect new student enrollments since this only accounted for 1% of total DeVry revenues [12].

Strayer on the other hand has only 3% of total revenues tied to private loans. Fourth quarter earnings rose 21% from the same period a year ago [7]. What I like about this company is their focus on academic quality as can be ascertained from their CEO (Robert Silberman) describing their expansion plans, “The single biggest challenge is expanding the University. Expanding an educational institution and maintaining a level of academic quality is not an easy thing to do.” [7]. Mr. Silberman came right out on the offensive during the 4th quarter earnings call to give assurances that all vendors participating in the FFEL program and those issuing private loans (including Sallie Mae) have reiterated their desire to increase loan volume with Strayer’s students [11].

Good management and focus on quality educational programs have helped DeVry and Strayer stay ahead of their competitors, and so far have kept them out of the FFEL and private lending troubles. Looking at some key performance measures tells the story of healthy operating businesses over the trailing 12 months:

Both companies are trading at high valuations, but investors maybe pricing them as such for their long term growth prospects and quality. DeVry and Strayer deserve a second look for a possible portfolio addition. Could we possibly see sustained stock price growth similar to the dot-com meltdown years? We’ll have to wait and see. After this first pass, I’ll be doing a deeper dive into both companies operations and financials for my next analysis. Stay tuned.

References
  1. 1.January 2008 Non-Manufacturing ISM Report on Business
  2. 2.February 2008 Non-Manufacturing ISM Report on Business
  3. 3.Colleges Turn Away From Private Lenders, Robert Tomsho, Wall Street Journal (March.25, 2008)
  4. 4.Lender Layoffs and Loan Program Suspensions, FinAid.org
  5. 5.Student-Loan Firms Leave the Program, Rappaort, Liz and Tomsho, Robert , Wall Street Journal (March.25, 2008)
  6. 6.The Downside of Diplomas, Wall Street Journal (Mar.6, 2008)
  7. 7.Strayer Sidesteps Rival’s Student Loan Woes, Alva, Marilyn., Investor’s Business Daily.
  8. 8.Apollo Group Inc., FQ2008 Earnings Call Transcript, SeekingAlpha.com.
  9. 9.Apollo Quarterly Report (10Q, March.27.2008)
  10. 10.DeVry Inc poised to weather credit crunch., Leonard, Kerry, Medill Reports Chicago (Mar.13, 2008).
  11. 11.Strayer Education, Inc., Q4 2007 Earnings Call Transcript. SeekingAlpha.com.
  12. 12.DeVry F2Q08 Earnings Call Transcript. SeekingAlpha.com.

Monday, March 17, 2008

Bear's Biff


I spent this weekend reading up on the Bear Stearns news. So much has been written up about them that I don't really have anything useful to offer. Except maybe for some lighter commentary for those who own XLF. I couldn't help but see a familiar character in the Ex-CEO of Bear Stearns and the guy who played "Biff" in "Back to the Future". Maybe it's just me. In any case, maybe the actor who played "Biff" can play James Cayne in a made for TV series about the mess we are experiencing now. For more serious thought, my take on XLF and the current environment can be found here. And for those who want to know about Bear Stearn's weighting in XLF. You can find it here.

Saturday, March 15, 2008

The COGS Black Box in Trimeris (TRMS)

Trimeris just came out with their 4th quarter and 2007 year end numbers. Plugging this into my cash flow analysis results in a new valuation range:

So what happened in the 4th quarter numbers to help push the low/high end valuation range from my original analysis? The company increased its cash position to $60.6 million through additional “collaboration income” from their partner Roche, and an increase in overall worldwide sales of Fuzeon. Net income doubled in the 4th quarter from the same period in 2006.

So far so good… not so fast. The company achieved these massive gains through one time events:

  • The company accelerated recognition of milestone payments from their partner Roche into 2007.
  • Reduction in workforce.
  • Changed the way cost of good sold were calculated.

Out of these 3 events, the one that is most concerning is how cost of goods sold was calculated with their partner Roche all the way back to 2003, and how it is different now. There must have been some serious negotiations with Roche because the resulting change allowed Trimeris to receive a credit of $5.5 million from Roche because of previous “over charges” in the way they calculated cost of goods sold (COGS). What poses an increased risk for current shareholders is that Trimeris and Roche are still in discussions about how to calculate COGS for 2007 and 2008. No forward guidance was given as to what the outcome of this will be. It is hard to comprehend the amount of time it is taking to figure out how to calculate COGS. You have X amount of inputs to create a dose of Fuzeon. What do those inputs cost? The fact that Trimeris did not have accurate visibility into Roche’s accounting method for COGS for several years, makes it all the much harder for investors to have trust in Trimeris’ controls. This can make it rather difficult to sell Trimeris to a prospective buyer. Will the new buyer continue their relationship with Roche for Fuzeon marketing and distribution, or will they disband?

If you strip away these one time events (well, there may be another COGS recalculation surprise in the works) the focus turns to the sales of Fuzeon. Sales in the US and Canada decreased due to what the CEO, Martin Mattingly described on the conference call as pressures from competing drugs by Pfizer and Merck. The company mentioned that they the US and Canadian Fuzeon sales decline leveled off going into the end of the year. With the one time events out of the way, more focus will be put on 2008 1st quarter sales to see if Fuzeon sales are leveling off within North America or continue its slide.

During the earnings call, a Piper Jaffray analyst posed an interesting question about Fuzeon’s inventory going into the end of the year. The company responded that they believe inventories rose due to the holiday season, and that they were able to work off this $8 million worth of inventory in the first part of 2008. I absolutely do not think that the holidays had anything to do with it, as Fuzeon requires two injections a day. HIV patients don’t suddenly stop using just because it is the holidays. This may have been more of a smoke screen to deflect some news surrounding competing drugs eating into Trimeris’ market share.

The company called to attention the development of the next version of Fuzeon (TRI-1144). The company started their first human clinical dose the very same morning of the earnings call. This highlights the urgency for Trimeris to get out any positive news. TRI-1144 apparently showed some positive signs during animal testing in which dosing could possibly be reduced to once a week and come in a form of a self-injectable pre-filled pen. However, this is way too early to tell if TRI-1144 will materialize.

Investors shouldn’t be too happy with the black box that Trimeris has put up surrounding how COGS will be calculated. The only good thing surrounding Trimeris at this point are the continued sales growth of Fuzeon overseas, the substantial cash position they have ($60.6 million), and no long term debt. Next quarter’s results will paint a clearer picture on Fuzeon’s market share within North America. Hopefully the COGS mess will be out of the way.

Saturday, March 8, 2008

Growth Inhibitors in Trimeris (TRMS)

Disclosure: I own a position in TRMS

I’ve been working in the technology field for several years designing and laying down systems to push bits and bytes around over the web. Anyone that works in this industry knows that in order to stay competitive, one must dedicate themselves to continuous research and development. So when a company such as Trimeris whose sole foundation is based upon research and development of new drugs suddenly decides to eliminate its research and development staff, it does not paint a pretty picture for the future.

So how did I end up with Trimeris in the Ten Grand portfolio? It was not the smartest of decisions on my part, but in documenting my decision criteria and analysis, I hope some of you will learn from my mistakes.

What does Trimeris do?

Trimeris was in the research and development of a new type of drug called “Fusion Inhibitors”. The main source of their revenues comes from their Fuzeon drug. Fusion Inhibitors block viral infusion. According to the company,

“FUZEON is a 36-amino acid synthetic peptide that binds to a key region of an HIV surface protein called gp41. FUZEON blocks HIV viral fusion by interfering with certain structural rearrangements within gp41 that are required for HIV to fuse to and enter a host cell.” [3]

The surface looked great:

I decided in January to purchase Trimeris based on the following criteria [2]:
  • P/E Ratio of 7.9 (For a biotechnology company this was relatively low. For comparison, Amgen runs with a P/E ratio of 15.67 and Genentech with 30.65)
  • Return on Assets of 29.9% (Earning 29.9 cents for every dollar of assets)
  • Cash and Cash Equivalents of approximately $57 million as of the period ending Sept.30th.2007
  • No long term debt.
  • They developed a drug to help HIV patients. They were doing something to help humans, always a good thing.

The company achieved 94% sales growth from 2005 to 2006, and reported higher revenue growth of 51% in the first 3 quarters of 2007 compared to the same period in 2006. This was a good initial screen which prompted my purchase of TRMS stock. Looking back, I should have dug further into the company’s operations. Thanks to PDTBiotech (a fellow reader) for calling on me to dig further and highlighting some risks.

What happened to the stock price?

You have to go back to March.15th 2007, when the company issued its full year results for 2006. The company had decided to make a strategic shift into focusing on the profitability of Fuzeon, in addition to reducing its staff by 25% [4]. More recently, the company announced that it would no longer staff any research and development personnel going forward [1]. This pretty much nailed home the fact that the company would put its entire efforts into maximizing cash flow on their only product Fuzeon. There would be no new drugs coming down the pipe.

There are two other distractions that are of concern:

  1. Back in November Novartis filed a lawsuit against Trimeris for patent infringement based on its Fuzeon drug [6].
  2. Two new HIV drugs from Pfizer and Merck entered the mix in 2007 presenting competitive pressures for Fuzeon.

Sales of Fuzeon have increased overall in 2007 due to the strong growth outside of the US and Canada. If it weren’t for the growth in international sales, overall sales for 2007 would have been lower.

Trimeris’ Future: How much would you buy the company for?:

After highlighting all the challenges facing Trimeris, what does the company have going for it? It still continues to post good sales growth of Fuzeon outside of the US and Canada, and continues to wring profits from its only drug Fuzeon with operating margins around 45% for the first 9 months of 2007. Two board seats were given to HealthCor Management and is the company’s largest shareholder. HealthCor’s goal is to extract value through the sale of Trimeris [5]. Given the risks and the outlook for Fuzeon, if you had the capital to buy Trimeris, what would you pay for it?

I tried to answer this question by valuing the company’s future cash flows. This it not easy with companies that have long developmental pipelines, but Trimeris essentially shut that down by eliminating its entire R&D staff. The successful sale of this company rides on the success of Fuzeon against competitors in the future. Listed below are some of the assumptions I made for the cash flow analysis:

  • Future revenues of Fuzeon would not go longer than 6 years. With companies like Pfizer and Merck having deep R&D benches, it is only a matter of time before Fuzeon is no longer viable in the market place. Trimeris’ situation now becomes a race in how fast it can sell itself to realize its current value against the backdrop of forward competitive pressures.
  • Estimated cost of capital for Fuzeon was set at 27.67%. This was used as the discount rate to determine the present value of the company’s future estimated cash flows.
  • Revenue growth for 2008 was set to 7%, and then trailing off to 5% the remaining 5 years.

This results in a present value of $103.8 million dollars, with a value of approximately $4.79/share. Now let’s take a more optimistic scenario and set Fuzeon to continue sales for the next 10 years. This results in a present value of $5.98/share assuming 5% year over year growth.

Another focus for 2008 will also be to bring its next generation fusion inhibitor (TRI-1144) to Phase 1 clinical trials. If they can get through to this point, they might be able to push a higher premium through a sale, and let the new company take over to finish up Phase 2 and 3 trials. This is nothing to get too excited about, but does provide some sense of direction for the company.

There are some tough challenges ahead, but I will be holding on to my position in Trimeris to see if HealthCor can push a sale through commanding a premium above the top end of my estimate. After going through the analysis I realized that successful biotech investing requires a different set of skills. I will put in a plug for a book my brothers recently got me as a gift called “Master Traders”. There is a good chapter in there titled, “The Keys to Biotech Investing” written by David Miller who has covered the industry for several years. If you want to invest in biotech, I suggest you read this chapter first. David Miller highlights the drug development process and what to pay attention to during the drug development pipeline. If I had read this a few months earlier I probably would have moved down my stock screen list and picked up another company. But now that I am in Trimeris, I’m going to sit tight and see what comes out of the March.13th full year earnings call.

References:

1. Trimeris Announced 2008 Strategic Plan.

2. Trimeris 3rd Quarter Results

3. 2006 Trimeris Annual Report

4. Trimeris Reports Financial Results for the Fourth Quarter and Year End 2006

5. Trimeris gives two board seats to HealthCor

6. Now What Trimeris Needs

Wikinvest Wire