Bridgepoint Education (BPI) - Posted Sum Zero 9/2/2010 - price 13.44

Warren Buffet once said “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well."

It is fair to say that education stocks are unpopular right now. I myself have shorted two for profit colleges in the past year. There is a lot not to like with the industry - including a tendency to spend more on marketing than instruction, low graduation rates, a perception (perhaps well deserved) of poor quality. In addition, the Department of Education (DOE) has targeted high growth for profit schools with proposed regulations that could restrict or eliminate access to Title IV loans which are the lifeblood of for-profit providers. A proposed set of rules which is generally referred to as “Gainful Employment” impacts schools whose graduates are not repaying loans (repayment rate below 45%) and/or saddle their students with loans far greater than their earning power (debt burden> 8% of income) the schools will either be restricted from the loans if they fail both criteria, and forced to provide warnings to incoming students if they fail one of the criteria. The loss of Title IV loans for most for profit colleges would be devastating as many providers derive between 80%-90% of their revenue from these loans.

The proposed regulations will be effective at stopping schools that saddle students with the most debt and provide the poorest job prospects to graduates. The popular press including 60 minutes and Frontline have highlighted abuses and Steve Eisman has a short thesis on the space.

(http://myinvestingnotebook.blogspot.com/search?q=Eisman)

The gist of the short thesis is that many providers will have to significantly reduce tuition so as to not violate the debt burden stipulations. These tuition cuts will directly impact profitability. Schools will also have to be more selective in the students that they recruit, because their survival is partially tied to loan repayment. Greater selectivity could lead to slower growth or enrollment declines – creating a triple storm of lower profitability per student, fewer students, and a lower multiple for an enterprise with declining earnings and prospects. It is a solid thesis and may very well play out in the earnings/operations eventually.

There are a couple of macro points to be made before diving into the specifics of Bridgepoint Education. The first is that the regulations are not yet approved (target date of November 1, 2010). The second is that even if the regulations are approved, the penalties do not go into effect until 2012-2013. This gives the industry more than a year to lobby for regulatory reform which has already begun:

(http://online.wsj.com/article/SB10001424052748703418004575455773289209384.html?mod=wsjcrmain).

As an industry, the companies spend billions on marketing, diverting 5%-10% of the marketing budgets to lobbying could take teeth out of the bill. There are also arguments against the regulations including the philosophical one – why should the tests and penalties only apply to for profits? For example, of the 96 Historically Black Colleges – all non profit – only 1 would pass the 45% of students repaying debt threshold of 45%. If the industry can broaden the scope of the regulations, they will be closer to softening them. There is also the argument that schools with lower repayment rates are more driven by student demographics than anything else and ultimately you will be limiting choice and quality for those most in need.
(http://www.magicdiligence.com/articles/gainful-employment-hurts-low-income).
In my opinion, the pessimism driven by the proposed “Gainful Employment” regulations has created an interesting risk reward proposition in Bridgepoint Education. Bridgepoint has been a remarkable growth story. In 2004 a management team and Warburg Pincus bought an accredited university with the premise that if they stressed affordability (low tuition), ease of enrollment (ability to transfer more credits than competitors – and start any week you want), they could fill a void in the market between more expensive for profits and slower less aggressive facility based non profits. They rebranded the school, Ashford University, and have been able to grow enrollment from under 1,000 to over 60,000 in less than 6 years. They have also grown revenue from under $10M to almost $700M per year. Clearly their product positioning and marketing have been effective.

Bridgepoint has been able to have hyper growth while maintaining profitability since 2007. The company has several attractive features:

Operating Leverage: With 99% of student receiving services on-line, the business has significant operating leverage. For example in the first half of 2010 the company grew revenue by 56% and Net Income by over 300% (excluding one-time items).
Not Currently Impacted By Regulations: As indicated in the press release for the last quarter “While several complexities remain with respect to the Department of Education’s proposed gainful employment rules, our initial analysis indicates that all programs at Ashford University would satisfy both the 8% debt-to-income ratio and the 45% repayment threshold, reaffirming our confidence that our academic institutions are well positioned to meet the proposed new requirements.”
1st Stock Buy Back – The company has announced a $60M buyback to be executed in the next year. At current prices, this is roughly 8% of the outstanding equity and less than what the company will generate in the back half of the year. In addition, the company has $60M in unrestricted cash and $80M in receivables – so additional buybacks are plausible and provide some downside protection.
Warburg Pincus Ownership – Some analysts claim there is a Warburg overhang because eventually Warburg will eventually have to sell its 60%+ stake. However, in this period of turmoil I rather have Warburg with two board seats and a large ownership stake making capital allocation decisions and growth decisions than an unchecked CEO feeding at the shareholder trough. Warburg has a long time-horizon and incentives that are aligned with equity investors.
Conservative Guidance – Modeling Bridgepoint is not overly complex, the largest imputs are enrollment, sales and marketing, and G&A. Management has guided to earnings in the back half of the year being down 18% despite guiding to revenue being up 15% for a business with operating leverage. In addition, despite announcing a buyback for what amounts to almost 8% of the company their guidance assumes a flat share count. There are three ways to win here – on the revenue side, cost side, or share count side – my belief is that at least one of these comes in.
Growing Industry – The for profit education sector has had hyper growth for the last 10 years.
Cheap Valuation – Bridgepoint is currently trading at less than 6X this years earnings (ex cash) which is based on conservative guidance and less than five times next year for a company in a growing industry with operating leverage, a management team with a history of impressive execution, in the midst of a buyback.
Better Positioned than Peers: The passage and implementation of the gainful employment regulations in their current form would likely not be a positive for Bridgepoint – but given their “affordable” positioning and low student debt level relative to peers the company should not have to lower pricing to comply.

Risks The biggest risk is clearly not multiple compression. In the long term, this business has no “moats” – it’s positioning as affordable and easy to transfer into with courses starting weekly is clearly replicable. In addition, the gainful employment regulations could be the first step in an increasingly negative regulatory environment. I think the most significant risk in the next 1-2 years is that fraud is revealed during the “high growth” phase. There is an outstanding OIG investigation that has not been positioned as terminal – but of all the risks – I think the greatest is the OIG or a whistle blower uncover something that restricts Title IV loans and causes repayment of prior loans. Of slightly less concern is that the quality of the students has deteriorated over time and even though according to the USDOE calculations existing graduates are repayment rates are over 45% as more students from the “hyper growth” phase graduate – IF they are of lower quality – it would drag BPI below the 45% threshold.