Higher Education Equals Higher Moats

It is not easy for a company to receive a wide moat rating from Morningstar. Currently, only 169 of the approximately 2,000 companies we cover are assigned this rating, and we think very hard before upgrading a company to wide moat. We recently upgraded  Capella  and are in the process of upgrading  Grand Canyon (LOPE), two for-profit education companies. The reasons behind these upgrades have to do with government-aided financing, low-cost business models, price-inelastic customers, and high demand for education.

We had recently seen an influx of new public entrants into this space with companies like Grand Canyon and Bridgepoint Education, a company that filed its initial S-1 in December. We wondered if the regulatory barriers to entry were less stringent than we had originally thought, potentially calling into question the wide-moat status of  Apollo ,  DeVry (DV), and  Strayer (STRA). After some discussion, we came to the conclusion that the barriers to entry are weaker than we had thought. However, due to other reasons, we believe these companies still have a wide moat. On top of that, we believe that Capella and Grand Canyon deserve wide moats as well.

Our new thesis that the barriers to entry are weaker than we originally thought stems from the ease of expanding an existing program. While accreditation is time consuming and difficult to achieve, making starting a school from scratch tough, there is another way to build a broad education platform. Anyone with a little bit of capital and an understanding of the immense profitability of education firms can purchase a small school that is already accredited. From there, the school can serve as a base to launch an online curriculum. Adding new campuses and getting accreditation expanded is much easier than starting fresh. So while we believe the barriers to enter as a new school are high, there's a potential shortcut in buying a small school and converting it to a for-profit, larger organization.

So if we no longer think the barriers to entry are very high, then why do we think these education companies deserve a wide moat rating? Despite a potential increase in competition, we believe education firms still have the ability to earn substantial economic profits (returns above their cost of capital) for many years to come.

For years, we have seen schools raise tuition costs at rates well above inflation. While it may appear that for-profit schools set their own prices, we believe that is not necessarily the case. It is traditional schools, such as public and private universities and colleges, that set the relevant market price for schooling. Government financial-aid limits are based on these prices and limits tend to increase over time as traditional schools raise tuition.

While traditional schools may set the market price of education, their costs are completely different from for-profit schools. Traditional schools are stuck with high cost structures that include sports stadiums, residence halls, cafeterias, campus police, and so on. However, the typical for-profit school does not have a lot of these costs and is thus able to provide a similar service at a lower cost.

Essentially, we now look at these wide-moat, for-profit education companies as low-cost providers that operate in a market where prices are set by the higher-cost competitors. Despite the fact that financial-aid increases do not come every year and are not necessarily a dollar-for-dollar match, we think financial aid limits will continue to rise as traditional schools hike tuition. Given the fact that the government wants to make education affordable, as long as the cost structure at traditional schools remains high, government aid limits should increase over time. This will help ensure that for-profit schools will be able to increase their prices as well.

Additionally, price increases are met with limited pushback from customers. Thanks to financial-aid and student loans, the out-of-pocket cost of education is pretty low, making students relatively insensitive to price increases. Our wide-moat education companies also see a significant amount of revenue coming from corporate tuition assistance, which also lowers a student's up-front cost. As long as students are able to finance or pass along a majority of their tuition costs, prices should not come under pressure.

Despite the weaker barriers to entry, increased competition should have a limited impact on the pricing power of these firms. There is little incentive for other for-profit schools to start a pricing war, as discounts may not bring the volume gains intended and any volume gains would be offset by lower prices. As discussed above, most students aren't very price sensitive. They choose a school based on location, recommendations from friends and family, the type of courses offered, or where they feel the most comfortable. Cutting a few thousand dollars off of tuition is not going to change students' minds, when they can just as easily finance the higher-cost schools they had their hearts set on.

Furthermore, the value proposition a degree offers is quite substantial, making a small change in price almost irrelevant. Take for instance an unskilled worker making $8 an hour at a retail store. Working 40 hours a week, that is roughly $17,000 a year in income. Compare that to an average initial salary of a new graduate from DeVry of more than $45,000. Even if a student paid $15,000 a year and took a full four years to earn a degree, the payback period is around two years. If a competitor chose to offer the same degree for 20% less ($12,000), the payback period changes to 1.71 years from 2.14. With such a small change in the value proposition, even a substantial discount, such as 20%, isn't likely to woo potential students away from their first choice.

Another element to consider is the demand for education. It would take many years and many more new entrants (or expanded players) to eat into the current demand for adult education. The U.S. Department of Education estimates that the total fall enrollment for degree-granting institutions will be just over 19.1 million students by 2011. This is a 1.6 million student increase from the 2005 level of 17.5 million students. That is roughly 267,000 new students a year. Most private universities and state colleges are not interested in absorbing all of this demand. Keeping up the prestigious perception of their degrees means traditional schools must cap their enrollment at some point and accept only students that meet certain enrollment criteria. This includes minimum standardized test scores and grade point averages. With more than 25% of the estimated growth coming from older students (25 years of age and older), a demographic not typically targeted by traditional schools, for-profit schools have plenty of opportunities.

It may seem odd to have numerous wide-moat companies in one industry. However, with a high demand for education, price inelastic customers, low-cost infrastructures, and government-aided pricing, we believe that a well-run for-profit education company can earn substantial economic profits for a long time to come.

One last thing investors should keep in mind is that not every education company has a wide moat in our opinion. Some have had various operational issues or accreditation problems. Others see limited corporate tuition assistance for their students and have a high exposure to private lending, which makes their programs less affordable since the private lending market has dried up. Because of these various issues, we have held back from giving all education companies wide moats and instead have held them to narrow moat ratings.