Looking for Value in the For-Profit Education Industry

It's been a volatile run for stocks in the for-profit education sector. Anxieties -- and then hopes -- about proposed regulations from the federal government regarding for-profit programs moved sector stocks for several months before, on June 2, final regulations were passed by the Department of Education.

The market cheered the news, as the USEDU Index, Bloomberg's index of for-profit education stocks, rose 17% to an intraday high before settling with a 12% gain. Since the news, however, the sector has sold off, and as a whole is returning towards the levels reached before the final regulations were announced.

To be sure, there is still a fair amount of risk in these stocks, the most well-known of which include DeVry (DV), Apollo Group (APOL) -- which owns the University of Phoenix -- Bridgepoint Education (BPI), and Lincoln Education Services (LINC). While the final government regulations -- which imposed a series of tests on each program offered by a school, but also put off any program closures until 2015 -- have removed some regulatory risk, state attorneys general have kicked off a multi-state investigation into recruiting practices and advertising offers made by the schools. From the Arizona Republic:

Investigators are exchanging information, and industry observers suggest there is a good possibility that the inquiries will result in a global settlement, similar to the 1990s agreement with tobacco companies, that will seek fines and industry reforms.

And while the schools have been resilient in the face of economic headwinds -- many of the nation's unemployed have used their time to go back to school -- further struggles may begin to eat away at enrollment, as the average cost of a for-profit school now stands at well over $30,000 annually, nearly double the average at a state institution.

But the recent pullback in the sector does offer some interesting opportunities for the value investor. While a state-level investigation is by no means welcome news, its impact -- a short-term fine and modest changes in recruiting tactics -- are far less significant than some now-dead proposed federal regulations which would have significantly decreased the expected future revenues of the sector. In addition, the removal of federal regulatory risk should help to decrease volatility, potentially giving more power to hedging strategies. Herein we will look at some of the sector's best values, and some of the option trades available to hedge risk when invested in these companies.

DeVry: June 24 closing price $57.57

One of the two best-known brands in the sector (along with Apollo's University of Phoenix), DeVry has 94 locations under the DeVry, Ross University, and Chamberlain College of Nursing brands. DeVry offers very solid fundamentals; the company is debt-free, with $8.71/share in cash, and with trailing 12-month earnings of $4.59, offers an enterprise value-cash flow multiple of under 11. The company recently authorized a $100MM stock buyback -- its sixth such program.

DeVry does offer a small dividend (24 cents annually, for a 0.42% yield) and its strong brand and consistent performance have made it a relatively stable stock, with a beta of just 0.50. Yet there are still some good returns to be had with DV options. One interesting option for DV bulls is to use a Nov. 60 covered call (bid $3.90). This trade offers 6.8% downside protection, about 16.8% annualized. Maximum gain is 11.8% (29.1% annualized).

Lincoln Educational Services: June 24 closing price $16.09

The operator of Lincoln Technical Institute and other schools, LINC offers the best dividend yield in the sector, with its $1.00 annual dividend currently sporting a yield of 6.22%. (It should be noted that the payout ratio this year, based on company guidance, should be somewhere in the range of 55-67%, so the dividend's long-term viability can be questioned.)

LINC has been essentially range-bound since early November (trading between $14 and $16.50 a share), so there may be some issue as to whether the stock's recent rise will once again run into resistance at the top of that range. But Lincoln's earnings guidance for 2011 is in the range of $1.50-1.80 a share, offering a P/E ratio between 9 and 11.

Investors looking to get into LINC, but worried about the resistance in the high 16s, can sell cash-secured puts to play LINC stock. They will offer returns to the upside with the option to purchase the stock at a lower price should the stock stay range bound and return to support in the $14-15 area.

Sell Aug. 15 put (bid .65). Return is 4.5% on risk capital (19.4% annualized). Break-even is $14.35, an 11% drop from current price.

Sell Dec. 15 put (bid 1.65). Return is 12.4% on risk capital (25.6% annualized). Break-even is 13.35, a 17% decline from current price, owning LINC at a P/E below 10 even if the company misses the lowest end of its guidance range, with a 7.5% yield.

Strayer Education: June 24 closing price $123.29

Strayer Education runs 75 campuses through its Strayer University brand. STRA currently trades at a P/E of about 12.5, while also sporting a 3.24% dividend yield. The stock has bounced off support at about $115 multiple times, but now sits nearly 17% of its high reached in early June, after announcement of the DOE regulations. STRA currently has a short float of over 22%, meaning its recent consolidation in the low 120s may be a pivot point for the stock.

STRA options are well-traded, though with rather wide spreads, and offer several different plays. Given the spreads (a July 125 call, for instance, trades with a bid of 2.95 and an ask of 5.50), it's important to use limit orders with any STRA options, as settling for the bid willl cost you money.

Write covered July 125 call (bid 2.95). Downside protection is 2.39%. Maximum gain 3.78%. Yes, the returns are small, but this is just a 21-day option (tracking to the Monday following expiration), providing a small amount of protection and the opportunity to re-write a call if this option is not exercised. (Bear in mind this option provides an annualized return over 40%, and, as mentioned, a limit order may provide a better price.) Earnings are scheduled for July 25, allowing us to either take a quick trading profit of nearly 4% or re-write a call ahead of earnings for further downside protection. Again, use a limit order with such a large spread (2.95/5.50).

Sell Jan. 115 put (bid 10.90). Return on risk capital is 10.4% (17.9% annualized). Break-even is $105.10, a 14.8% decline. (There will be $2 in dividends paid over this time period as well, which are factored into our premium.). Downside is owning STRA at $105.1, below long-term support, near 10x earnings with a yield near 4%.

Bridgepoint Education: June 24 closing price $23.69

Bridgepoint Education is a primarily online institution (according to its most recent 10-K, 98.9% of students are enrolled online). BPI has had a strong run over the last 10 weeks, jumping nearly 50% since bouncing off support around $16 in mid-April. With a look at the fundamentals, it's not hard to understand why. Bridgepoint has $5.68 in cash per share, leaving an enterprise value of $18.01 as of Friday's close. With 2011 and 2012 earnings expected to be over $2.50/share, according to Reuters Finance figures, its enterprise value/earnings ratio is a little higher than 7. Cash flow numbers are equally strong; operating cash flow for 2009 and 2010 combined were $270 million, 28% of its current enterprise value of about $965 million.

BPI looks to be a particularly strong candidate for a hedged play. Its options offer solid returns, while its 50% run-up into the sector-wide sluggishness of late may suggest some prudent caution when entering a long position.

Sell cash-secured July 22.5 put (bid 0.75). Return is 3.45% (59.8% annualized). Break-even is 21.75 (8% decline). Another short-term trade of interest. Bullish on BPI? Why not take 3+% to the upside for three weeks, with the downside being owning it an 8% discount to its current price?

Sell cash-secured Aug. 20 put (bid 0.95). Return on risk capital is 4.98% (32.3% annualized). Break-even is 19.05 (19.6% cushion on an eight-week trade).

Sell Nov. 25 covered call (bid 2.70). Downside protection is 11.3%. Maximum gain is 17% in just under five months (41.7% annualized). This is an interesting way to leave a strong upside while also providing double-digit protection to the downside.

Capella Education (CPLA): June 24 closing price $42.72

Capella is an online-only college and, like Bridgepoint, offers strong characteristics of a value stock. With $11 in cash per share, it has an enterprise value-earnings ratio about 8, with EV-cash flow figures about the same. While the fundamentals look strong, the charts do not; CPLA has been on a steady downtrend, interrupted only briefly by the June announcement codifying the new federal regulations.

Considering the headwinds on the chart, we may want to wait to establish our position in CPLA, rather than trying to catch a falling knife. (Although, in CPLA's defense, at this point the knife is no longer falling, but sliding.) In order to gain some protection against a continued slide, CPLA is a good candidate for a December 45 covered call (bid 3.70). This option gives us 8.6% downside protection in a little under six months (over 17% annualized), with a maximum gain of $5.98, or 15.3%.

Career Education Corp. (CECO): June 24 closing price $19.84

Career Education Corp. is a brick and mortar education company, with colleges not just in the US but France, Italy, and Monaco. Its schools include American InterContinental University and Le Cordon Bleu culinary schools. With over $5/share in cash, CECO is another value darling. With ttm earnings of 2.3, and projected FY11 earnings of 2.23, CECO should earn almost one-third of its enterprise value in 2010 and 2011. Its historical cash flow has been very solid for a company with an enterprise value of about $1.14 billion: $613 million combined from 2007-10.

CECO offers some interesting trades as well:

Sell July 20 put (bid 0.85). Maximum return is 4.44% on risk capital in three weeks. Needs a less than one percent rise to meet maximum; make 3.47% if stock stays flat. Break-even is $19.15, a 3.5% drop. Downside is owning CECO at $19.15.

Sell July 18 put (bid 0.20). Return is 1.12% in three weeks (over 18% annually). Small gain but requires a 10% drop in three weeks (without an earnings report) to lose . Downside is owning CECO at 17.80, over 10% discount to current price. (Beware of commission here, of course, with the trade only generating $20 per contract. There is a good amount of open interest in CECO options, so you should be able to trade multiple contracts.)

Sell covered Oct. 20 call (bid 2.15). Option returns 10.8% in under four months (33% annualized). Break-even is $17.69. Maximum gain is 11.6%

There are certainly risks in this sector -- political, economic, and competitive. But it does seem like the worst may be behind the sector, particularly on the regulatory front, and using some hedged bull strategies can offer exposure to some solid stocks with protection to the downside.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BPI, CECO, LINC over the next 72 hours.