Education Management Barely Makes the Grade

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Education Management heads to market on Friday, and we have mixed opinions on the offering and the company. While we value it at $23 per share, above its range of $18-$20, we think there are some risks involved, particularly the company's high exposure to student lending and leverage that's outlandish for this space. Morningstar senior equity analyst Todd Young takes us through the hurdles facing Education Management in his investment thesis:

"After being taken private in June 2006, Education Management has seen impressive enrollment growth. While it is one of the largest companies in the profitable education industry, it also has some of the greatest risks.

"For-profit education is a very profitable industry. Traditional not-for-profit schools do not have enough space to meet all of the demand for educational services, and for-profit education companies have stepped in to fill this supply void. Tuition pricing is typically set by the higher-cost-structured traditional schools, and government aid limits are adjusted based on those rates. Healthy demand and government-set aid limits allow Education Management and other for-profit schools, which have a lower cost structure, to provide educational services at prices similar to traditional schools. Financial-aid and corporate tuition assistance help keep students' up-front out-of-pocket costs low, which in turn keeps customers price inelastic, allowing the industry to raise tuition at rates above inflation.

"With over 110,000 students, Education Management is one of the largest for-profit education companies. Long-term demand for education is strong, and by focusing on working adults and online education, Education Management is able to target an area of the market that is under-served by traditional colleges and universities. Demand for education has recently increased as the lack of available jobs has encouraged people to further their education. In fiscal 2009 the company added nearly 16,000 students to its average enrollment base, an increase of 17%. Strong growth is not the only thing Education Management has going for it. With the education industry being very scalable, as the company grows its top line, profitability increases should follow.

"Despite these positive attributes, Education Management does have its risks. Even after the company pays down debt with its IPO proceeds, it will still be highly levered. While education companies tend to produce impressive cash flows that can easily cover high levels of leverage, substantial leverage is rare in the education space. Not only are there regulatory constraints, but the companies have few hard assets.

"Education Management also has a relatively high exposure to private student loans. Management expects its exposure, which stands at 13% of revenue in fiscal 2009, to decrease to 6% in 2010. That could , however, put some of its schools above the regulation that requires no more than 90% of revenue to come from government financial aid sources. Also, with private student loan access drying up due to the tighter credit markets, the company has been providing increased internal lending to students. Internal lending puts the company on the hook for any unpaid loans and increases bad debt expense. Internal lending was only about 1% of revenue in 2009, but management expects it to increase from $19 million to $75 million in 2010.

While Education Management operates in a very strong industry and has plenty of upside potential, the risks associated with the company are higher than many of its competitors. Because of its high debt load, internal lending, and private student loan exposure, we have a high uncertainty rating on the company. We think there are other companies in the education sector that offer more attractive opportunities for interested investors."

Todd's fair value estimate of $23 per share is driven in part by a compound annual growth rate of 12%, which he expands on below:

"Our valuation assumes that the underwriters exercise their option to purchase 3 million additional shares. We forecast a compound annual growth rate of 12%, which is driven by enrollment growth and tuition increases. Due to its scalability, we expect operating margins to expand to 18% in 2014 from 16% in 2009. We expect increased bad debt expense to slow the company's margin expansion. If we assumed only 7% compound annual growth and average operating margins of only 15%, our fair value would drop to $11.50 per share."