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Market Mis-Grading Apollo's Prospects

Erik Kobayashi-Solomon

Erik Kobayashi-Solomon: Hi, I am Erik Kobayashi-Solomon, co-editor of Morningstar's OptionInvestor. And today it's my great pleasure to welcome senior equity analyst Todd Young to talk about Apollo.

Todd, thanks for coming.

Todd Young: Thanks for having me. I appreciate it.

Kobayashi-Solomon: So, in the option portfolios we've got a position in Apollo. I just wrote another QuickShot article about Apollo. So, this is a bullish position. I know you're very bullish on the stock. I just want to talk a little bit about that company.

Young: Sure, absolutely.

Kobayashi-Solomon: So, the way I understand Apollo--kind of Apollo's business model, they are accredited; they have accreditation. So they're able to charge a lot of money for their classes. But because they don't have buildings, they don't have to spend a lot on brick-and-mortar. So, basically it's all about profit margin.

Young: Sure.

Kobayashi-Solomon: If I got that right?

Young: Yeah. So there is two forms of accreditation. There is regional accreditation and national accreditation. And…

Kobayashi-Solomon: It's the regional, that's the better, right?

Young: The regional is better, which would sound a little counterintuitive. But the regional is the same accrediting bodies that--there are six of them--that accredit your Harvards, your University of Chicagos, your University of Virginias, your large state schools and things like that. So, Apollo has that same accreditation as those schools have.

Kobayashi-Solomon: So, in other words, Apollo has got the same--kind of the same credentials as a Yale or something?

Young: Yes, the same--and obviously, it doesn't have the same brand reputation as one of those schools--but it has the same accreditation as those. And their typical tuition is--a good rule of thumb is for-profit schools that have this regional accreditation charge probably above what an in-state tuition would be at a state school, but below what a private school would be charging or maybe an out-of-state tuition depending--obviously depending on the state.

So, they are able to charge these rates because financial aid limits are typically going to be set based on the cost at traditional schools. I consider traditional schools as your private and your public institutions, private--you know like Ivy Leagues and things like that.

So, they don't charge as much per se, or sometimes more, sometimes less, but they are able to charge those rates because financial aid is based on those schools' tuition costs. But they don't have the same cost structure as those programs. They don't have the dorms. They don't have sport stadiums. They're also not offering classes in history and musical studies. They're focusing on…

Kobayashi-Solomon: It's really kind of very professional focus.

Young: Yes, career focus. These schools are looking to put people into degrees where they think they can get them a job afterwards.

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Kobayashi-Solomon: So, I know they've got a wide moat. Is that the source of their moat there?

Young: Sure. That's why--because they have such a low cost infrastructure, but are able to charge costs in line with the higher-cost-structured traditional schools, the returns on investment are extremely high. And then the student pushback on tuition is very low because they're able to get financial aid from the government to pay for school.

Kobayashi-Solomon: Mainly government sponsored grants and stuff like that.

Young: Government sponsored grants, and loans; we call them Title IV loans. You could think of them as Stafford loans and things like that.

Kobayashi-Solomon: I see. Okay. So, that's pretty clear to me. They're charging this much and they only have to pay out this much. And so that looks like a really good business. I think, they throw off a ton of cash, right?

Young: Absolutely.

Kobayashi-Solomon: So, they're trading right now at a real discount to your fair value estimate. What is the market not seeing? Is this – are they worried about revenues, are they worried about profits decreasing, is it regulatory environment? What's going on?

Young: So, there's two things. There's one thing affecting the whole industry, which is some regulation that's going on. I'll get to that in a minute. And then second, Apollo itself has an informal SEC investigation into its revenue recognition practices.

Now, we're not too worried about that for a couple reasons; one, their revenue recognition is pretty conservative, in our view. Take for instance, let's say a program cost you $1,000, and it was 10 weeks long. Two weeks into that program they've only recognized $200 in revenue, even though they've collected $1,000 upfront from the loan money. So, it's relatively – it's an industry standard practice, seems relatively conservative to us, and then the fact that you look at some of the metrics in the cash flow and income statement, it's not like they are artificially making up revenue like you saw with other companies in the past.

Kobayashi-Solomon: So, the SEC thing probably, I mean, if there is impact, it'll be minimal.

Young: If there is impact, there will probably be an accounting impact and not a cash impact to the company. So, it doesn't really bother us. It's more of a kind of a timing of the revenue issue.

Kobayashi-Solomon: I see. Now what about the regulatory side, how does the Obama administration conceive of these for-profit education companies? Is this a thorn in their side?

Young: Yeah. So it depends on how you – who you listen to. The Obama administration has made some goals to have the United States workforce the most educated workforce in the world sometime in the next decade or so, and to actually meet those standards because…

Kobayashi-Solomon: You need schools, right?

Young: Yes. And when was the last time your typical state university added 50,000 or 100,000 students to it? They relatively grown maybe 1% or 2%, because they want to keep their elite status. They want to have high SAT score entrants requirements and high GPAs, but there is a lot of the population that doesn't have those--a stellar high school GPA or maybe they've been out of school for 10 years, and taking the SAT is something they don't really want to do or wouldn't even score well on it if they did, but that doesn't mean that they don't need an education as well.

Kobayashi-Solomon: So these for-profit companies, they're really kind of fitting--let's say, in a sense, fitting into the Obama administration strategy?

Young: Correct. Correct. And, you know, the Department of Education, if you listen to Secretary of Education Arne Duncan. He has made some comments that, you know, there is definitely a place for for-profit education to reach these goals. And then on the other hand, the Undersecretary, Rob Shireman, who just announced he is going to be leaving his post in July. He has made some kind of negative comments towards the industry. So, there is definitely, you know, some negative overtones that are out there for the industry, but overall to meet the administration's goals, for-profit has to play into the account somewhere in that equation.

Kobayashi-Solomon: I see. Now, there is one other thing that I was thinking about, we talked about earlier that seemed really interesting to me, and that is kind of the degree to which these for-profit education companies are cyclical or non-cyclical. It seems like, a lot of times when jobs are scarce, people will prefer to stay in school or go to school, beef up their degree credentials. Can you talk a little bit about the cyclical aspect?

Young: So the industry is often thought of as countercyclical. I think it kind of depends on where your degrees are. I think of it kind of more broadly as more acyclical. But, as you walk up the degree level, you walk down the counter-cyclicality. So, a Ph.D. is going to be completely acyclical, you know someone who wants to become a doctor isn't going to say, 'Oh, the economy is bad, I'm be going back to school.' But, someone who wants to go be a nurses' aide and take an 18-month program to get out of their $8 an hour job and get into something that maybe pays health insurance and things like that--that person when they lose their jobs is going to go, 'Hey, I'm going to go back and get my associate's degree, and become, you know, a dental hygienist or a nurses' aide.' And that is going to be…

Kobayashi-Solomon: So, that is going to be countercyclical.

Young: That's going to be really countercyclical. So, the trade-based schools tend to be a little bit more countercyclical. Apollo was kind of in between. It offers advanced degrees, master's and things like that, but it does have a good portion of associate degree programs, but those are mostly less technical, more like business or IT services based. So, I would put Apollo in the kind of more acyclical category, although there is a decent portion of their revenue stream that could be more countercyclical.

Kobayashi-Solomon: Well, Todd, thanks a lot for coming in and talking about Apollo with me.

Young: Absolutely. I appreciate you having me. Thank you.

Kobayashi-Solomon: And thank you for joining us. Please stop by the Morningstar OptionInvestor website, where we have many more great option ideas based on Morningstar's fundamental research.