Chairs

While I'm busying working out my analysis on Strayer (STRA, impressive quarterly report today by the way), I took up an entry position today on Herman Miller (MLHR) to start out my Q2 plays. This position is also part of my continued test of Joel Greenblatt's magic formula system. I scrummaged through a series of screens and decided to pick up Herman Miller purely on valuation and operating margin strength, as well as their strong brand and product offering. This may sound like a counterintuitive play given that current economic weakness will infect business capital spending, but I will explain my thoughts in more detail when I publish my formal analysis. Some other lessons learned this past month is the speed in which deep analysis can be done. The time it takes for an individual investor to analyze companies in detail took its toll as I missed the substantial gains DeVry (DV) and Strayer (STRA) have made over the past few weeks. I'd be curious to know if other individual investors out there have the same problem. I guess it all comes down to decision criteria when making a buy/sell. It's different for everyone.

Calling out Mark Mahaney of Citigroup

Not too long ago I had analyzed Amazon.com, and had decided to stay away from the stock eventhough I liked what they did from a customer's perspective.

Within the first week of January, Mark Manahey of Citigroup cited that for 2008, "Margin Expansion alone could drive double-digit EPS Growth". and that, "Mahaney says he sees 10% upside to the Street’s ‘08 EPS estimates for Amazon “driven by stronger than expected revenue growth and margin expansion.”

Let's roll forward to April, in a recent WSJ article, "Mark Mahaney said in a research note that first-quarter gross margins were mixed and that Amazon's forecast suggests that operating margins may not expand this year. "The margin outlook is disappointing," he wrote.

I wonder if he is still holding his $119/share price target. Maybe he will be vindicated sometime in the future and Amazon will hit $119/share someday. It makes me wonder what models he is using to come up with these numbers and what bits of information lead him to believe there woud be expanding margins this year for Amazon.com.

I'll take up Amazon, but not at these current levels.

Student Lending Problems (DeVry, "What's that???")

DeVry’s (DV) performance this past quarter was quite impressive. Compared to the same period one year ago:

• Revenue is up 18.4% to $291 million
• Operating Income up 70.9% to $50.6 million (17.3% operating income margin)
• Net Income up 67.2% to $38.3 million

These results come on top of some very impressive enrollment numbers:

• New undergraduate enrollment increased 12.1% to 12,410 students
• Total student enrollment increased 10.3% to 44,814 students
• Total number of online courses taken increased by 25% to 43,889

The company is following through on their investment plans to lay the foundation for their fastest growing business segments (Medical/Healthcare and Professional/Training):

• For the January 2008 term Ross University (medical/veterinary) is showing a 7% enrollment increase from a year ago.
• The company opened up Chamberlain College of Nursing opened up their two new locations in Illinois and Arizona. They are still planning to open up one Chamberlain facility per year going forward.
• Becker CPA review’s revenues surged 30.4% compared to the same quarter a year ago. A new office in Hong Kong was opened to meet the needs of Asia.

Daniel Hamburger (CEO), on the 3rd quarter conference call reiterated that the company's relationships with lenders still remains strong, and that FFEL and Private Lending would still be available to DeVry students. He did mention that there were some disruptions with Wachovia, but that the issues would be resolved within a few weeks. The other lenders that DeVry is working with are:

• Sallie Mae (DeVry is only 1 of 2 instutions Sallie Mae is continuing private lending programs with)
• Citibank
• Bank of America
• Wells Fargo
• Wachovia
• Chase

The company also spoke about a possible acquisition in the career college market, specifically around the healthcare segment. The company has strong cash flow, but the CFO did mention that they had a $250 million line of credit they could tap if they were to make an acquisition. Given this news, and the important summer months where students seek more student loans heading into the fall semester, I'm still waiting for an entry position under $50/share.

Keep an eye out for the next few months to see how the new government program to buy up student debt will play out.

DeVry's long term prospects

Disclosure: I do not own DeVry (DV).

From my last analysis on student lending, I had whittled down the group of for-profit educational stocks to two companies which I thought as possible investments given their minimal exposure to current private lending troubles. The two companies were DeVry (DV) and Strayer (STRA). I’m going to start off with DeVry today. Consider this part 3 of a made for Internet series on educational services.

What does DeVry do?

DeVry operates in the for-profit educational sector offering undergraduate and graduate degree programs across 86 locations in the United States and Canada. Revenues come primarily from 3 main segments: DeVry University, Medical & Healthcare, and Professional/Training.

DeVry University offers a wide range of programs for anyone wanting to acquire a degree in such areas as computer engineering all the way to hospitality management. Their medical & healthcare education business comes in the form of Ross Medical University which offers medical and veterinary programs, and the Chamberlain College of Nursing which provides various nursing degree programs. Their professional training revenues come from running their Becker CPA and Stalla CFA review prep courses.

DeVry also runs a number of their programs online and competes directly with the likes of Apollo Group (APOL) which runs the University of Phoenix online program.

The majority of revenues come primarily from the DeVry University side of the business:

Although their medical/healthcare and professional/training revenues represent a smaller portion of overall revenues, these two segments are the fastest growing parts of their business with annualized growth rates over 22% over the past 2 years.

DeVry’s Strategic Moves

The company is in a midst of optimizing and turning around their business. Investors have reacted positively by bidding up the company’s share price by 84% over the past year. In 2007, they opened up a new 108,000 sqft facility to in Naperville, Illinois, and acquired Advanced Academics to focus on the online education segment. They are trying to match capacity to the current industry growth trends for online education which is growing at 20% annually according to the company.

The company is also assessing opportunities to expand their educational programs into emerging markets such as Latin America, China, and India. The company is currently operating with no long term debt which should provide them added flexibility for future investments.

They have optimized current operations by selling off real-estate assets, and last year trimmed their work force through a worker reduction program to keep their costs in check.

On their 2nd quarter earnings release it was mentioned that they would be increasing expenditures by about 5 to 7 million dollars per quarter to focus on expansion growth in their online business, Chamberlain nursing programs, and building out more capacity for Ross Medical School. Although expenses will have some impact to their bottom line in the next few quarters, the company is putting their investments in the right areas for future growth.

DeVry’s investment into these segments shouldn’t come as a surprise when you take a look at the operating income margins, with medical/healthcare and professional/training demonstrating double digit margins for 2007. Capital expenditures into programs like Becker CPA review and online programs are relatively light providing this line of business the ability to scale revenue growth but keep costs moderate.

Job Trends and DeVry’s medical and professional training segments

DeVry’s two strongest business segments (medical/healthcare and professional/training) are demonstrating success by the very fact of increasing demand for qualified professionals in the nursing accounting, and financial advisor professions.

According to the US Department of Labor, the employment of registered nurses through 2016 is expected to create 587,000 new jobs representing growth of 23%. Some employers in certain parts of the country are experiencing difficulty attracting registered nurses, while enrollments in registered nursing programs are increasing rapidly over the past few years. Applicants are reported to be turned away due to the shortage of nursing faculty [1]. DeVry’s move to open up another Chamberlain college of nursing facility in Ohio is a step in the right direction. The company also filed applications to open up Chamberlain facilities in Illinois and Arizona to add to their existing location in Missouri and Ohio. The company stated during the 2nd quarter earnings call that their goal was to open up one new Chamberlain facility per year. The aging baby boomer generation will only add to the demand for nurses going forward.

Within the accounting and financial industries, the US Department of Labor reports 226,000 new jobs in accounting, and 147,000 new jobs for financial analyst/advisors through 2016. This represents job growth rates of approximately 18% and 37% respectively. Demand for CPA and CFA designations will likely increase as these specializations help respective accountants and financial advisors advance their careers and compensation [2]. DeVry’s Becker CPA and Stalla CFA review programs have benefited from these trends showing over 20% top line revenue growth rates for the professional/training segments. The company has made efforts to align these programs with specific accounting firms and societies inside the US and internationally, in the hopes to increase the channel/demand for these review programs.

The storm in student lending

The sub-prime credit crisis has spilled over into the student lending industry putting student financial aid at risk. Student lending comes in various forms, with students seeking financing from generally 2 main sources:

• FFEL (Federal Family Education Program) / Title IV loans. These loans are backed by the government, but issued through financial institutions.
• Direct private lending from the financial institutions.

The main areas of concern for many for-profit schools surround the FFEL program and direct private lending. Many financial institutions have exited the FFEL program due to the sudden freeze in bids for student debt in the auction rate securities market. This in essence reduces the supply of financial aid at some schools. Some banks such as Bank of America have stopped private lending all together and are putting more efforts to switch to the FFEL program. Not all financial institutions can make this switch as 50 lenders have left the FFEL program [3]. So where does this leave DeVry? Apparently only 5% of their tuition revenue comes from private lending [4], so exposure to this channel of financing is light and should not materially impact the company. Looking at the FFEL program, the company should be in good hands as institutions will want to issue FFEL loans to schools with high graduation rates based on quality educational programs, of which DeVry has demonstrated. Just a few days ago the company reiterated their stance that the student lending problems should not affect their student’s ability to secure educational loans and has not affected their business to date [5].

A recent bill is being considered by the government to allow the federal government to step into place and buy up student debt and inject liquidity into the FFEL program. The government would pretty much step in place for what were once investors, who have now backed off making bids on securities backed by the FFEL loans [6].

As of 2007, DeVry reported more than 80% of their students use government sponsored financial aid. The company will be able to mitigate some of this risk with their very own financing program, EDUCARD. EDUCARD only steps in after all other financing options have been exhausted, requiring students to pay within 12 to 24 months. Accounts Receivables totaled $52.9 million from EDUCARD. Investors should focus on this balance going forward to see if DeVry students increase their reliance on this program, as the company will need to put more due diligence on collections.

DeVry reports 3rd quarter earnings tonight and you can be sure many questions will be asked surrounding these developments. Particularly surrounding DeVry’s lender relationships, and the speed at which these lenders can work with the government to spin up the new program. There is already some debate surrounding this new government proposal since it really isn’t doing anything to increase yields for these lenders, thus making no sense for lenders to participate if they aren’t making any money, or losing money on every loan they issue [6].

What is DeVry’s business worth?

Given the company’s successful growth in the medical/healthcare and professional/training segments, and the furor surrounding the student lending industry, this provides a baseline on which a low/high end valuation can be formed.

In order to conduct the cash flow analysis for the next 10 years, I set the discount rate at %11.75 to determine the value of all future cash flows for DeVry. I feel that this rate is justified given some of the risks surrounding the lending industry in the near term, even in light of DeVry’s assertions that they will not be materially affected.

For the best case scenario, I set revenue growth rates at 20% for the next 5 years, trailing off to 5% for each year thereafter. This assumes DeVry optimizes it operations through continued real-estate sales and targeted capital expenditures and investments to realize continued growth in their medical/healthcare and professional/training segments. This results in a high end valuation of $61/share.

For the low end valuation, I set revenue growth to 10% for the next 5 years, trailing off to 5% for each year thereafter. This is a slightly more conservative assumption, but still represents healthy growth over the next 5 years given the job trends in the medical and financial service industries. This results in a valuation of $44/share.

Free cash flow for the next 10 years assuming the conservative side trends nicely upwards:

I will be waiting for tonight’s earnings call to see where DeVry stands with respect to handling student loans in this market and get some gauge towards their medical/healthcare and professional/training segment growth. Consideration will be given on entering a position near the midpoint of this valuation range if it trades below $50/share.

DeVry looks to be one of the few for-profit educational stocks that will be able to weather the student lending problems, and its strategic moves over the past year have helped grow their business. Government action to inject liquidity is definitely promising, but still has some risks as the program is not off the ground yet. Long term prospects look promising going forward... just waiting for a good entry point.

References

1. US Department of Labor, Bureau of Labor Statistics (Registered Nurses)
2. US Department of Labor, Bureau of Labor Statistics (Accounting/Auditors and Financial Analysts/Advisors).
3. Bank of America to Direct Student Loans to Federal Program, Wall Street Journal, Apr.18th.2008.
4. DeVry earnings call transcript 2Q08, SeekingAlpha.com. Jan.24th.2008
5. DeVry provides update on Student Lender Relationships, April.21st.2008.
6. White House Backs Student-Loan Plan, Wall Street Journal. April.24th.2008.

Earnings time

Some things to keep an eye out for tonight and tomorrow evening when NutriSystem (NTRI) and DeVry (DV) report.

NutriSystem: Focus in on guidance going into the next quarter, as they pre-announced top line revenues above their previous guidance a few weeks ago. It should give some indication as to whether they will be following a under promising, and over delivering strategy for the next little while. It will be interesting to note what the new CEO Joseph Redling will talk about with respect to stabilizing top line revenues given current economic weakness, and whether they can stabilize operating margins given their recent marketing and advertising push. Hopefully there will be some news of forward progress regarding their international expansion plans. Basically, is there enough strength in their actions to convince customers (new and reactivated ones) to pay out $300/month for their food program.

DeVry: This stock all comes down to the effects the student lending problems will have on their business. During the last earnings call, they had mentioned there were no concerns as only 5% of their revenues streams come from private lenders, and only 1% attributed to borrowers with poor credit. This provides some security for investors with respect to private lending exposure, but no news was given about FFEL/Title 4 loan impact. These types of loans are guaranteed and backed by the federal government, but many lenders have left this business due to the sudden freeze in the auction rate securities market. Basically there are limited bids to buy up student debt, thus reducing the availability of FFEL loans to students. With the recent news surrounding government legislation that would allow the federal government to buy up student debt, I am hoping there is some discussion about DeVry’s action plans regarding the speed at which this can be implemented if this bill were to pass. With the fall school season approaching, the speed at which the government and for-profit education companies act will be somewhat critical to ensure there are no disruptions to student enrollments. There should also be some discussion about how DeVry’s EDUCARD program (DeVry’s student financing program) is helping deflect some of the loan availability concerns and to what depth this program has to issue more loans to DeVry students, and the receivables collection success or erosion surrounding the program. (A detailed report on DeVry will be out shortly).

Throwing in the towel on Trimeris

Trimeris reported first quarter sales of its only drug Fuzeon declining 34% compared to the same period a year ago. In previous quarters, sales outside North America managed to offset the losses domestically. That is not the case anymore as sales outside of North America also suffered a precipitous drop of 26%.

The company might able to work out another favorable agreement with their partner Roche in which they will receive some credit for COGS miscalculations as they have done in the past, and they might finish the Phase 1 trials on their next generation fusion inhibitor (TRI-1144) and sell the comapany, but I am not waiting around for that.

I sold the position yesterday, it's time to move on.

NutriSystem moves higher

NutriSystem issued preliminary first quarter results today with revenues coming in at $216 million compared to the original range the company projected of $200 to $210 million. A management change is also in the works as Joseph Redling, an ex-AOL executive, will take over as CEO. The stock surged up today 24%.

Mr.Redling will be looking to beef up their online strategy to make it more core to the business. The hopes are to add a community feel to this channel, something I had referred to as the social aspect of their business in my original analysis. You can read more details about this guidance from Businessweek's post today.

A good move today, but more details to analyze when they issue first quarter results and hold the earnings call Apr.23rd.

$9,946.19 (Q1 2008 Performance Update)

The first quarter has come and gone putting the Ten Grand Chicago portfolio through its paces. The equities market went on a roller coaster ride with the Bear Stearns fiasco, credit markets tightening up, and the Fed stepping in to inject some liquidity into the markets. The portfolio suffered a drop of 0.54% year to date which is not too bad when compared to the S&P 500 index which fell 8.6%. In real dollar terms the portfolio is running at a value of $9,946.19. A few things about portfolio performance:

• Beating the S&P 500 index is nothing to brag about. Especially only after one quarter. The fact is I am currently losing. Some money managers like to advertise that they can beat the index, and that is something to brag about if you can do it consistently year after year. However, my take on beating indexes, is that if your portfolio is down, the fact of the matter is you are down.
• Secondly, it’s easy to sit on the sidelines with a majority cash position and say you are beating the S&P500 index. We’ll see how things go after 2008 is over when all of my money is in play.

Now that I’ve got that out of the way let’s jump straight into what happened with respect to the stocks covered this past quarter.

Southern Copper Corporation (PCU, 16.69%) The market has pushed commodities to record levels, but as of late everything from gold, wheat, and oil has come off their highs. Copper on the other hand is currently come off $3.60’s and pushing $3.90’s at the moment. Since entering the position, the stock has been the strongest performer of the bunch with a 16.69% rise. This is purely a supply and demand situation, and in order to meet demand the company just stated that they would be increasing their investment ($1.3B) in their Peruvian copper project [1]. As long as China, India, and other emerging markets continue to buy copper, copper prices should remain relatively high for the coming year. It will be interesting to see what China’s first quarter GDP numbers are at on April.14th. This should give some indication to the degree of infection the US economic malaise is having world wide.

Intevac, Inc. (IVAC, 13.90%) The company has done well to tack on orders for its 200 Lean magnetic disk sputtering systems of late [2], which has helped push the stock’s price up from its lows in mid January. More analysis about this company’s image and magnetic disk manufacturing business will be out shortly.

ING 6 month CD @ 3.65% This was one of my more conservative moves to park cash until the 3rd/4th quarter of this year when I will be looking for more stocks to invest in. Looking back it was a good move as interest rates have dropped further. ING is currently offering 6-month CD’s at 2.75%

XLF Financials ETF (XLF, -4.12%) I thought it was a good time to get into the US financials this past quarter due to all the bad financial news taking down XLF. All the action of late by the Fed, and Henry Paulson’s announcements about a new “regulatory” plan and some of Wall Street’s push back is pretty much the free capital market system at work. Although any corrections will take time, the system allows for this back and forth, and iterative corrections to happen. XLF should prove a good move over the long term.

Trimeris, Inc (TRMS, -6.99%) The company continues to try and maximize its cash flow through the sales of Fuzeon. 1st quarter results will show where this is heading. I wasn’t happy with their recent announcements that they are still working with their partner Roche in determining how to value COGS. There could be another adjustment coming down the pipe to this line item on next quarter’s income statement. Any adjustment may be in Trimeris’ favor, but the lack of visibility is of concern. The stock is currently trading above my top end of my valuation of $6.69/share.

NutriSytem, Inc. (NTRI, -36.28%)* This was the most damaging performance to the portfolio to date yielding a drop of 36.28%. That hurts and I definitely did not think the worst case scenario would play out this hard. In my original analysis, I had assumed that in the worst case, the company would drop top line revenues by 5% this year. This results in a lower end valuation of around $19/share. Unfortunately the company guided down full 2008 revenues to a range of [$690million - $710million] [3]. If we assume the worst case scenario of $690 million, and customers ditching their $300/month meal plans, that registers a drop of just over 11% in top line revenues for 2008. Plugging this back into my original cash flow analysis and adjusting 2009 top line revenues dropping 6%, this yields a valuation of $20.37/share. The stock currently looks undervalued, but I’ll be waiting for 1st quarter results to see if there is an opportunity to add to my position.

Closed Positions

DST Systems, Inc. (DST, 0.27%) I got out of DST after doing a deeper dive into their business. My conservative estimates when valuing this comapny's business ($15.47/share) was way off my entry point of $73.60/share. My analysis showed a long term pattern of shrinking free cash flow based on increaing top line revenues. That was enough for me to exit. A reader had questioned my valuation and eluded to it being way too conservative. After doubling back on the company's balance sheet I remain firm on my decision. The comapny has a number long term investments, some of them parked into real estate. That may come in handy for valuing the company's book value, but my whole approach surrounds valuing a given comapny's operations and cash flow.

Q2 Plays I’m slowly building out my playbook for the 2nd quarter and will have more coverage in the coming weeks. Up next will be DeVry (DV), and Strayer (STRA).

*Corrections:

The valuation for NTRI based on a worst case scenario is $18.83/share. This assumes a 11% drop in top line revenues in 2008, followed by a 6% drop in 2009. The original posting had the valuation listed at $20.37/share

References:

1. Southern Copper to invest more in Peru. Cespedes, Teresa. April.1.2008. Reuters.

2. Intevac, Inc. Receives Orders for Five 200 Lean ® Systems. February 20.2008. Business Wire.

3. Wednesday’s Winners and Losers: NutriSystem. February.20.2008. TheStreet.com.

Suggested Blogs and Reads

Listed below are some other sites that I highly recommend.

Wikinvest.com: Mike Sha and Parker Conrad, two Harvard grads started this site not too long ago, and has since attracted a number of contributors from the investment community to author content for this site. It is somewhat a different take from SeekingAlpha.com, beefed up with various tools like WikiChart and WikiData (you'll have to check it out for yourself to see how great these things are). What I like about this site is that it pushes for democratization of investor information and education and tries to hone the information down to facts through self-governance. Whether you want to learn about 3G networks, or auction rate securities, they have a massive "Concepts" section that I use to start some of my top down analysis for certain investment opportunities or sectors to avoid.

SeekingAlpha.com: A number of investors from professionals, to independents post numerous articles, and opinions about economics, stocks, and industries. This site goes good over a cup of Dunkin' Doughnuts coffee in the morning if you are a business news buff. This is a good destination for long/short opinions with some contributors posting some real good research.

Inca Cola News: Otto Rock recently started this blog covering Latin American markets. Everything from the marcro economic picture, to specific stock plays from mining to energy. He has a lot of valuable insight and depth into everything surrounding this region.

Humble Student of the Markets: Cam Hui runs this site out of one of my favorite cities (Vancouver). He has been working in the investment industry for several years, and provides good insight into various capital market stories and trends. His recent article on building a synthetic gold stock is pretty interesting as I had never heard of such a technique before.