For-Profit Education Stocks Worth Monitoring Even As Government Implements Reforms

Shares of Apollo Group (APOL), the leading for-profit education company (think University of Phoenix), fell a stunning 23% Thursday to $38 after the company withdrew its 2011 financial outlook in light of upcoming changes to their industry. With the unemployment rate at 9.6%, enrollment at for-profit schools has been surging in recent years as people try to boost their resumes by completing online college courses and earning an associate, bachelor, or graduate level degree. As a result, the private firms running schools such as University of Phoenix have been minting money.

The interesting part of the story is that for-profit colleges typically get more than 80% of their revenue from Title IV student loan programs subsidized by the U.S. government. With taxpayers footing the bill for all loan defaults, the colleges themselves have absolutely no direct financial exposure whatsoever if students rack up thousands in debt and cannot repay the loans. As loan defaults rise, the U.S. Department of Education is finally taking notice and is set to release new guidelines for Title IV funding. As you may imagine, if lending guidelines are tightened, new enrollment at these colleges could drop off considerably. The new rules, set to be issued in coming months, are likely to set maximum default rates for schools who want to accept Title IV loans, as well as gainful employment guidelines to help ensure that students will actually have the ability to repay these loans based on the jobs they secure with their new degrees (a communications degree online, for instance)

The market’s violent reaction to the sector on Thursday was triggered when Apollo Group withdrew its 2011 financial guidance in anticipation of these new rules. For the first time ever, for-profit schools are going to have to scale back growth plans and actually become more than simply fierce marketing machines. Maximizing enrollment at all costs is no longer going to work. In fact, Apollo is now requiring all new students to attend an orientation program which spells out in more detail exactly what kind of financial commitment these degrees require. The company says that about 20% of prospective students voluntarily withdraw from the program after attending the orientation. In addition, the company’s admissions staff will no longer be compensated based on enrollment rates, as the company seeks to increase the quality of their students, thereby reducing loan default rates and boosting retention rates.

While there is no doubt that enrollment growth rates will tumble at for-profit colleges, it is far too early to pin down exactly how their businesses will be impacted by these changes. I think it is worth it for investors to monitor the situation carefully, as some values may ultimately be worthy of investment consideration at some point in the future (the stocks are already down a lot from their highs). In the case of Apollo, the company’s enterprise value of about $4.2 billion compares with fiscal 2010 EBITDA of $1.4 billion and free cash flow of nearly $900 million. At 3 times trailing cash flow, these stocks are already in deep value territory.

It will be important to see if scaled down marketing and increased financial awareness for students serves to merely slow down enrollment growth or also seriously cuts revenue and earnings for these companies. Exactly how much revenue is reduced and expenses rise will determine if and when these stocks reach a point where the risk-reward is worth an investment. At current prices it appears that the market is pricing in cash flow declines of 33-50% over the next 1-2 years. While possible, we surely do not know that kind of hit is a given at this point in time. If it proves overly pessimistic, shares of Apollo could become quite attractive, as the schools remain strong cash flow generators.

Full Disclosure: No position in APOL at the time of writing, but positions may change at any time.

BP, Goldman Sachs, Google, and FinReg… What a Day!

Today is the kind of day that investment managers such as myself love; lots of resolutions on multiple issues that have been holding back certain companies, stocks, and industries. Let me tackle each one briefly.

BP: While it is nice to see the ruptured well capped without any oil spewing out, we have to keep things in perspective. This is a test, this is only a test. The well has been capped for only a couple of hours and leaks could still surface, not to mention the fact that the pressure could further damage the well. Hopefully the relief wells can be paired with this latest cap to finally put a stop to the oil leak, but it is too early to say and the rally in BP shares today (up 3 points) will easily vanish if any issues arise.

Goldman Sachs: News of a $550 million settlement with the SEC is great news for investors. Most were assuming a $1 billion fine to ensure they avoided a fraud charge but it came in at half that amount. Goldman reports earnings Tuesday and the numbers have been ratcheted down a lot due to a weak trading environment early in the second quarter. With the bar set so low, they could surprise on the upside, but the stock is getting a nice bump from the SEC deal, so any further move higher may take some time to develop. I still see GS as the premier firm in the space and earnings should climb back later in the year, which is why I will still be holding the stock for clients.

Google: The stock is down after revenue for the second quarter came in a bit higher than estimates but profits fell short on higher expenses. The company is back in acquisitive mode so free cash flow is on the decline. Without a new, clear growth engine (I am not convinced yet that Android app sales will fit the bill, but they are promising) I would not be willing to pay a premium for the stock. With 2011 earnings estimates around $31-$32, putting a 15 P/E on that gets you to $475 per share, right where the stock is trading after-hours. Color me neutral at these levels.

FinReg: Now that this bill has passed the Senate, we can finally stop hearing about it so much. The banks will see their margins on certain financial products squeezed temporarily (overdraft protection, for instance, is now opt-in, not automatic), but banks will always find ways to recoup the lost income in other ways (free checking accounts, for instance, may become less common in the future). The negative talk today was that the banks and investors are worried because the bill gives regulators a lot of power in forming new rules and this adds to uncertainty. This argument baffles me. Regulators already have the power to make new rules to deal with issues they discover in the marketplace. The bill gives regulators oversight over a few more areas of the financial services industry, but the idea that giving them the power to make rules is a new and overly aggressive idea is simply wrong. That has always been the role of regulators! Now we just need them to do their job, and frankly, that is the part that always seems to let the American people down. I have no reason to think anything will be different this time around.

Full Disclosure: Long shares of BP and GS at the time of writing, but positions may change at any time.

Despite Having No Chance of Passing, Bob Corker’s Homeowner Responsibility Amendment is a No-Brainer

When people ask me who was primarily responsible for the credit crisis, I give the typical “well, it was various groups acting together” answer but there is no doubt in my mind that the core of the problem was the emergence of poor home lending in this country. While I believe that both the bankers and the borrowers need to share in the blame for enabling millions of bad loans from being originated, it should be pretty clear to everyone (across the political spectrum) that if the United States had reasonable mortgage underwriting standards in place, the credit crisis would have been prevented. If I could rewind the clock to the early 2000’s and legislate underwriting standards that mandated income verification, the inclusion of a down payment, and forbade interest-only loans and mortgages where the borrower could pick from several payment amounts each month, I have no doubt the country would have looked a lot different over the past few years.

So imagine my surprise to learn that Bob Corker and four other senators have proposed an amendment to the current financial regulation debate (number 3955), which despite having obvious, reasonable, and necessary underwriting standards, has absolutely no chance of passing. The Homeowner Responsibility Amendment would, within five years, impose federal mortgage underwriting standards including a 5% down payment requirement, verification of income and employment history, private mortgage insurance for loans above 80% of the home’s value, and consideration of ability-to-repay metrics such as a borrower’s debt-to-income ratio.

Even more concerning than the fact that this amendment will be defeated handily is that one would have thought just by reading it that Republicans would be the side that had come out against it. Can’t you envision them claiming that this is over-regulation by the federal government and that it gets in the way of our capitalist, free market system? Instead, this amendment is being introduced by five Republican senators and is likely to get more Republican votes than Democrat votes. It may turn out that a majority of Republicans oppose the amendment for the reason stated above, but regardless I think it is a shame that after all our country has been through in recent years, our politicians cannot even agree that reasonable underwriting standards are needed in the mortgage industry.

If you cannot afford to buy a house, you should not be allowed to. You are not entitled to a home simply because you want one. And if you cannot put down a modest 5% down payment, verify your income, and demonstrate an ability to pay back a traditional 30-year fixed mortgage, then you should not be buying a home. And if the government wants to mandate that to avoid a future filled with billions in taxpayer bailouts and deep recessions, I don’t see why it shouldn’t, or why the American public should not be demanding such action.

Despite Recent Rise, Goldman Sachs Still Fetches Single Digit P/E

In recent weeks I have been accumulating shares of Goldman Sachs (GS) for my clients, more so now than any other time since I began managing money. In a market environment where over the course of a single year most stocks have gone from severely undervalued to fairly valued, it remains pretty easy to make the case that Goldman stock is undervalued, despite a $20 increase just recently.

Why is the stock still cheap? No doubt due to the negative press coming from both political and consumer circles. Somehow Goldman Sachs is being made out to be a bigger problem for our financial services economy than sub-prime mortgage lenders and insurance companies that chose to insure everything on the planet without ever setting aside any money to pay future claims. Goldman Sachs never gave out mortgages like candy on Halloween and although they did benefit from the AIG bailout (their claims were paid out 100 cents on the dollar after the government bailout) people should be mad at AIG and the government long before blaming Goldman Sachs for owning insurance policies.

The investment case for Goldman stock, however, does not really involve a political or moral viewpoint (many of us will disagree on those points anyway). The real issue from an investor standpoint is that Goldman is the best of breed investment bank in the world ( this was one of the key takeaways from the credit crisis, in my view anyway), has seen many of its competitors go out of business or dramatically scale back operations, and yet at around $170 per share the stock still trades for less than 10 times estimated 2010 earnings.

Why do I think such a valuation is too meager? Well, all we have to do is rewind the clock back to before the credit crisis and recall what the investment banking landscape looked like. Back when the Big 5 investment banks were still in existence (Goldman, Morgan, Merrill, Bear, and Lehman) there was often a valuation discrepancy. It is actually very interesting to revisit how these stocks used to be valued by the market. Ever since it finally went public back in 1999, Goldman typically fetched a premium to the group (they have always been seen as the cream of the crop). Morgan Stanley and Merrill Lynch were very diversified and strong global franchises, and therefore were close runners up while Bear Stearns and Lehman Brothers were generally seen as less attractive, mainly due to an over-reliance on fixed income businesses for their revenues. They typically traded at a discount to Morgan and Merrill (about 10 times earnings versus 12 times) while Goldman often commanded a premium (15 times earnings or more).

This is interesting, of course, because the credit crisis essentially proved that the market was very accurate in its evaluation of the five large investment banking institutions. Bear and Lehman collapsed thanks to their heavy concentration in fixed income (many of those bonds and securities were backed by mortgages). Merrill Lynch and Morgan Stanley were on the brink but managed to find partners to help them back (Bank of America bought Merrill and Morgan got a large investment from overseas). Goldman, meanwhile, came through the credit crisis relatively unscathed (and would have been okay even if they had only gotten 80 or 90 cents on the dollar for their AIG contracts). For the most part, the market got it right.

Fast forward to today. We know that Lehman and Bear were the worst of breed and that Goldman is still tops. And yet Goldman Sachs stock today trades at a lower valuation than Bear Stearns and Lehman did pre-crisis. How does that make any sense? Has the credit crisis not proved that Goldman traded at a premium for good reason?

Going forward, I believe the valuation range we will see for investment banks will continue to be 10 to 15 times earnings. Maybe the lower end of the range is more likely near term as investors worry about political and consumer backlash. Maybe Morgan Stanley fetches a 10 P/E instead of 12 times, but Goldman should still command a premium to reflect their investment banking franchise. Granted, maybe that premium is only 12 times earnings.

Still, from my perch buying Goldman stock at less than 10 times earnings is a tremendously attractive risk-reward opportunity. The only way such an investment comes back to bite anyone is if either, one,  the P/E drops significantly below 10, or two, Goldman’s earnings have peaked and will trend lower in coming years. Frankly, I see both of those possibilities as extremely remote, especially longer term. Instead, I think Goldman Sachs should be able to earn around $20 per share and after the policy fallout has passed longer term, the P/E ratio should rise to 12 or higher. In that scenario, Goldman shares would fetch $240 each, or about 40% above current levels.

Full Disclosure: Clients of Peridot Capital were long shares of Goldman Sachs at the time of writing, but positions may change at any time

Glass-Steagal Act Should Not Be Core of Financial Regulatory Reform

There has been a lot of talk lately about the repeal of Glass-Steagal in the 1990’s and the potential that such a move contributed greatly to the financial crisis. Glass-Steagal, originally passed in 1933, had many parts to it but it is most widely known to have disallowed commercial banks that gathered customer deposits and gave out loans from also being investment banks that would underwrite securities and trade for their own account.

The logic of Glass-Steagal makes sense; banks should not use depositor or government capital to fund internal hedge funds. Should the enormous risks the trading desks take turn sour, it puts customers’ deposits in jeopardy and reduces the amount of lending the firm can do. Not to mention the fact that cheap government funding is given to banks to boost lending and the economy, not to generate trading profits for the firm’s partners.

Despite the soundness of the law, those who maintain that the repeal of Glass-Steagal was a leading contributor to the financial crisis are off base. Why? Because most of the casualties of the financial crisis were not banks at the time. Off the top of my head I can name AIG, Fannie Mae, Freddie Mac, Lehman Brothers, Bear Stearns, and Merrill Lynch.

None of those firms were commercial banks but they lost the most money. Those losses came from poor mortgage underwriting, poor insurance underwriting, and extreme leverage ratios of up to 40-to-1. More effective government regulation surely could have helped prevent such monumental downfalls (minimum underwriting standards and leverage limits to name a couple), but a combination business model of commercial and investment banking was not the culprit by any stretch of the imagination.

Now there were commercial banks that failed or nearly did during the recent crisis. Wachovia and Citigroup are the two big ones. But again, Glass-Steagal would not have prevented this. Citigroup was hampered by its leverage and significant holdings in mortgage backed securities, CDOs, and SIVs. Wachovia failed after it acquired a California-based mortgage lender that pioneered interest-only, pick-a-payment, and option ARM mortgage products. Such poor, undocumented, mortgage underwriting doomed them from the start, not investment banking (Wachovia did little, if any).

I am all for better regulation of the financial services sector, but many of the ideas floating around do not really address the core issues the industry faces. Not only that, existing regulators and laws easily allow for better regulation, without further changes, even though modern products such as credit default swaps and futures contracts clearly need to be regulated going forward.

Executive Compensation Restrictions Work In Everyone’s Favor

The core difference between the Bush and Obama administrations in terms of how they doled out government bailout funds was what, if any, terms came with getting the money. Former Treasury Secretary Paulson gave out the first half of TARP funds with no strings attached. Secretary Geithner, conversely, wanted to make sure the government funding came with restrictions, including how much executives of bailed out firms could earn while they still owed the taxpayer billions of dollars. Skeptics argued that this was a way for Washington to gain control of the private sector, but in reality it really was just a way to maximize the odds that the government got repaid.

The Obama administration’s auto task force required that GM CEO Rick Wagoner resign because they knew that under his leadership we would never get our money back, not because they wanted firm control over GM. In fact, the CEO they handpicked, Fritz Henderson, just resigned after the GM board (not the government) insisted he move faster in making necessary changes, something GM-lifer Henderson was unwilling to do.

Executive compensation restrictions have served as another way to increase the chances that TARP funds are repaid. The restrictions made it more difficult for Bank of America to find candidates to be the banking giant’s new CEO. As a result, BofA raised $19 billion in new capital last week in order to be in a position to immediately repay its $45 billion in TARP loans. I do not know anyone who expected the entire $45 billion to be repaid this quickly, and therefore it appears the pay restrictions did exactly what they were intended to do; give TARP recipients incentive to repay the money as fast as they could.

This is just one of the many reasons I think Treasury Secretary Geithner has done a very solid job so far. There will always be critics who blame everything they don’t like on certain people, but a lot of these decisions are proving to have worked.

Data Shows Trend Clearly Pointing To Job Gains Soon

There will be no way to argue that the job market is healthy until we see sustainable job growth but this morning’s monthly non-farm payroll data (preliminary figures for November show net payroll declines of only 11,000 workers, the best monthly performance since December 2007) continues to show that the trend in layoffs is moving in the right direction.

The Obama administration will continue to get heat as long as net layoffs are still being recorded (and they will be in trouble if the jobs picture does not improve by the mid-term elections next year) but if we look at the monthly job figures so far this year, it is hard not to be optimistic about the trend:


From this chart it looks like those predicting net job gains by year-end or early 2010 at the latest may in fact be proved correct, which would be great news for the U.S. economy and stock market alike.

Corporate Tax Breaks For Hiring Workers Won’t Work

There is chatter today that Congress is considering new tax breaks for corporations that hire unemployed workers. On the face of it this might seem like a good idea; incentivize companies to start hiring again. The only problem is that this is yet another example of a tax cut that won’t work. Proponents of tax cuts seem to think they can solve any problem in a capitalist economy, but that argument defies logic much of the time.

I have long argued that cutting the capital gains tax from 20% to 15% (as the Republican-led Congress did under President Bush) did nothing to boost demand for stock market related investments. The argument seemed to be that lower tax rates on profits would encourage more capital being allocated to the market, but that conclusion falsely assumed that the chief reason investors buy stocks is to save money on taxes.

In reality, we buy stocks if we think we can make a profit from doing so. Nobody was avoiding the stock market because of a 20% tax rate of capital gains (which, if anything, would encourage investing since it was lower than the income tax rate). They were avoiding the market because they didn’t think they could make good money in it. Cutting the tax rate on stock gains from 20% to 15% doesn’t make investing any more attractive to people because a 20% tax rate wasn’t what was holding them back to begin with.

The situation with any corporate tax break for hiring unemployed workers is essentially the same. Companies don’t hire workers based on tax rates, they hire them based on whether they need them in order to produce the amount of goods and services demanded by their customers. No competent CEO is going to hire a worker he or she doesn’t need simply to get a tax break. That would be like making a charitable donation simply to get the tax deduction (you wind up foolishly spending a dollar in order to save 30 cents).

Don’t get me wrong, I am all in favor of incentives (unfortunately, our country all too often needs to rely on them to get people to do productive things they otherwise wouldn’t), but we have to match up the incentive with the desired behavior. If we don’t, it’s just wasted time, money, and effort.

Income Tax Rates Must Rise To Offset Higher Deficits? Not So Fast.

Per one’s request, my latest quarterly letter to Peridot Capital clients included a section on the current macro-economic outlook for the United States. The question they wanted me to address had to do with possible hyperinflation resulting from ever-increasing budget deficits at the federal level. As with any question like that I try to completely ignore everything I have heard and instead rely on what the numbers tell me to form an opinion. Numbers don’t lie, people do.

The latest set of numbers I have looked at are very interesting and so I thought they were worth sharing. The consensus viewpoint today is that higher budget deficits will ultimately lead to higher income taxes on Americans, which is likely to hurt the economy over the intermediate to longer term. Interestingly, historical data does not necessarily support his hypothesis. Let me explain.

Despite current political debates, which are more often than not rooted in falsehoods, the United States actually saw its level of federal debt peak in 1945, after World War II. Back then the federal debt to GDP ratio (the popular measure that computes total debt relative to the size of the economy that must support it) reached more than 120%. Even after a huge increase over the last decade, currently the ratio is around 80%. As a result, our federal debt could rise 50% from here and it would only match the prior 1945 peak.

Given all of that the first question I wanted to answer was “how high did income tax levels go after World War II to repay all of the debt we built up paying for the war?” After all, the debt-to-GDP ratio collapsed from 120% all the way down to below 40% before President Reagan spent all that money in the early 1980’s. Surely tax rates went up to repay that debt, right?

The reality is that the top marginal income tax rate went down considerably over that 35 year period and even if Congress maintains the top rate at 39.6% (up from 35% under President Bush) the rate will still be near historic lows since the income tax was first instituted nearly 100 years ago.

Below is the actual data in graphical form. All I did was plot the top marginal income tax bracket along with the federal debt-to-GDP ratio. This makes it easy to see what was happening with tax rates as debt levels were both rising and falling over the last 70 years.


As you can see from the data, tax rates did not go up even as debt was paid off dramatically. As a result, it appears to be a flawed assumption that increased federal borrowing automatically means we will have to pay higher taxes in the future. Political junkies won’t like what this data shows, but again, numbers don’t lie.

Chrysler, Ford Riding Government Incentives to First Sales Gains in 2 Years

It is hard to argue with the success of the “Cash for Clunkers” automobile incentive program so far. With $1 billion already blown through, Congress is working on a $2 billion extension, despite most Republicans being against the program (probably because it was a Democratic idea, not because it is not working).

So far the average consumer is trading in their clunker for a new car that gets 9 miles per gallon more than the vehicle it replaced. The sales spike during the last week of July has led both Chrysler and Ford to report July sales gains, the first increase in 2 years for the domestic automobile industry. General Motors reported a 19% decline in sales, but still saw an enormous benefit from the program.

It remains to be seen if car sales will be sustained at higher levels, but the glass looks half full at this point. New car inventories are near all-time lows so inventory rebuilding in coming months should boost GDP pretty significantly, perhaps leading to a positive GDP print for the third quarter.

The car companies are not the only beneficiaries, however. “Cash for Clunkers” helps consumers and the country as a whole too. Higher fuel efficiency should not be understated. Consumers will save money by spending less to fill up their gas tanks, freeing up money for other things. In addition, less pollution from the new vehicles not only is safer for Americans but the environment in general as well.

Despite skepticism from many, this program does this show that smart government spending can stimulate the economy. In this case it does so in more ways than one, making the investment well worth the several billion dollars spent.

Full Disclosure: No positions in Ford or GM at the time of writing, but positions may change at any time