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For-Profit Education Industry: An Analysis of: Apollo Group American Public Education Inc. Education Management Corporation ITT Technical Institute Strayer Education Inc. By: 1 Executive Summary American Public Education Inc. Ticker: APEI Analyst: Josh Ollek Current Price: $33.72 Target Price: $42 Recommendation: BUY Strengths Weaknesses Lowest cost provider in the industry. Highly exposed to cuts in Owns the military market - military spending. diversifying its revenue away from Size of military in decline - Title IV. will need to spend more on Reduces recruiting/ marketing/recruiting to marketing costs. grow. Exclusive Partnerships with WalMart and other large employers. Education Management Corporation Ticker: EDMC Analyst: Celene Menschel Current Price: $6.05 Target Price: $1.40 Recommendation: SELL Diverse educational offering - variety of degree offerings in a wide range of disciplines. Recognized brands. High-tuition model which has suffered throughout the recession. High withdrawal rate even compared to its peers. Decreasing margins as have to increase its spending on scholarships as well as regulatory compliance. ITT Technical Institute Ticker: ESI (ITT) Analyst: Lauren Meyer Current Price: $17.74 Target Price: $14.52 Recommendation: SELL High brand awareness: physical campuses in 39 states, and online programs reach students in 48 states. Breadth of degree programs. Profit margin is among highest in industry. Multiple campuses or programs are at risk of losing accreditation due to underperformance. ITT acts as a financier and thus is exposed to loan default and legal risk. Strayer Education Inc Ticker: STRA Analyst: Andrew Tindel Current Price: $48.00 Target Price: $9.00 Recommendation: HOLD Proven growth model through new campus expansion and acquisitions. Success in establishing corporate training partnerships (e.g. Starbucks) Historical pricing power. Revenue contraction due to enrollment softness and effective pricing decreases. Declining margins due to large fixed cost base. CEO retiring and dividend suspension in Q1 2013. Apollo Group Ticker: APOL Analyst: Nic Anderson Current Price: $17.23 Target Price: $25.21 Recommendation: BUY Largest enrollment in the industry: ~350,000 students Highest brand recognition Low cost per student Substantial restructuring; projected annual cost reduction of $350 million At risk of losing accreditation Rapidly declining revenues Margins under pressure Receives significant portion of funding from federal and state government programs 2 Overall Recommendation I. Best Pick: American Public Education Inc. We believe that American Public Education Inc. represents the best potential investment within our coverage group. APEI's current stock price is at a 20% discount to what we believe the intrinsic value is. APEI has a differentiated strategy that sets it apart from its peer group: the company has placed an emphasis on providing education to the military and other large employers in order to diversify its revenue base, and protect itself from regulatory changes. This strategy has also enabled them to reduce expenditures in marketing and recruiting and has allowed APEI to charge extremely low tuition rates while still maintaining high margins. Moreover, the company has done extremely well at managing its working capital, allowing it to fund all growth internally without ever having to take on debt. We believe that the company's recent acquisitions will enable them to continue diversifying their revenue sources and grow student enrollment outside of the military and Title IV funds. Lastly, as recently as two months ago the company's stock was trading at what we believe the intrinsic value is. The stock price decreased due to concerns that the \"sequester\" would reduce spending on military tuition assistance; however, Congress has since passed bills that would protect tuition assistance for military students. We believe that the market has yet to give APEI credit for this recent news and that in the near future APEI's stock price will return to its pre-sequester level of $43/share. II. Worst Pick: Education Management Corporation We believe that Education Management Corporation (\"EDMC\") represents the strongest sell within our coverage. Although EDMC has a diverse educational offering with recognized brands aligned with specific fields of study, the Company has some significant weaknesses that are not yet factored into its stock price. EDMC's stock price is significantly overvalued: on April 26th EMC closed at $6.05; the stock rose 26% over the prior five days after competitors ITT Educational Services and Capella Services reported earnings. EDMC will be slower to recover than the other stocks in the for-profit education sector because it operates a high tuition model. In the January 2013 earnings report, EDMC showed continued declines in new starts while other peers showed an increase in starts. EDMC's high tuition model will hinder its ability to attract new students until the economy fully recovers. EDMC also has very high withdrawal rates compared to other companies in this sector. This means the Company must continue to spend a substantial amount on marketing and recruiting. Furthermore, EDMC has indicated that additional compliance costs and investments in internal initiatives and infrastructure will continue to pressure margins. An additional risk for EDMC is that it is highly dependent on Title IV funding. As calculated by the 90/10 Rule, in fiscal 2012, the percentage of revenues derived from Title IV programs averaged approximately 79% compared to an average of 78% in fiscal 2011. If these numbers continue to increase, certain schools within the EDMC portfolio might lose their eligibility to participate in Title IV programs. Based upon our analysis we believe that EDMC is a sell at its current price of $6.05 and its intrinsic value is $1.40/share. 3 Industry Analysis I. Overview, Market Structure, and Key Players The for-profit education industry is broad, and includes consultants, test preparation (such as Kaplan), training companies, technology companies, and institutions that deliver content. Our analysis will focus purely on the post-secondary, for-profit education industry. This segment is comprised of online education, brick-and-mortar universities, and mixed offerings. Firms generate revenue through the delivery of educational courses, the content of which is generated and taught by professors of the university. For-profit schools have a cost advantage over traditional institutions because they do not provide any recreation facilities such as gyms, sporting areas, and other amenities. Instead, tuition goes directly to students' education, marketing and recruiting, and company profit. There are approximately 130 for profit education companies operating physically or online in the U.S. In the past 20 years, their enrollments have increased by 225%. As of 2011, for profit institutions \"enroll about 12% of all postsecondary students, about 2.4 million.\"1 However, students at for-profit institutions receive a disproportionate amount of federal scholarships - roughly 25% of all Federal Pell Grants and loans - and are responsible for 44% of all student loan defaults.2 These schools employ approximately 35,000 recruiters who proactively target potential students.3 The rise of this industry has raised concerns and criticism about the quality of education, their high percentage of scholarships and loans, their often-aggressive recruiting tactics, and the difficulty their graduates have in the job market. The major public companies in the for-profit education industry are listed below: Valuation Metrics Company Education Management Corporation (NasdaqGS:EDMC) DeVry, Inc. (NYSE:DV) Apollo Group Inc. (NasdaqGS:APOL) Grand Canyon Education, Inc. (NasdaqGS:LOPE) Strayer Education Inc. (NasdaqGS:STRA) American Public Education, Inc. (NasdaqGS:APEI) ITT Educational Services Inc. (NYSE:ESI) Capella Education Co. (NasdaqGS:CPLA) Bridgepoint Education, Inc. (NYSE:BPI) Corinthian Colleges Inc. (NasdaqGS:COCO) Median Market Enterprise Cap. Value $753.8 $1,739.1 $2,019.1 $1,156.8 $525.7 $600.3 $414.4 $446.1 $575.7 $173.4 $2,050.7 $1,467.2 $1,258.3 $1,152.5 $604.4 $485.4 $354.4 $318.3 $182.8 $176.9 EV / Operating Metrics Price / LTM EBITDA NTM EPS EBITDA Margin Net 1-year Growth Margin Revenue EBITDA 5.2x 4.4x 1.6x 8.5x 4.4x 6.1x 1.1x 4.7x 0.8x 1.3x 17.3x 11.2x 7.4x 14.8x 11.8x 13.0x 5.8x 14.1x 8.4x 8.4x 15.2% 16.7% 20.0% 26.6% 24.5% 25.5% 25.2% 16.1% 23.9% 8.1% (60.9%) 7.4% 8.9% 13.6% 11.7% 13.5% 9.0% 8.1% 13.2% (0.1%) (9.2%) (6.0%) (10.3%) 19.8% (10.4%) 20.4% (15.5%) (2.4%) 3.7% 2.3% (31.7%) (26.7%) (29.3%) 36.0% (31.5%) 10.9% (37.3%) (24.6%) (19.4%) (5.7%) 4.4x 11.5x 22.0% 8.9% (4.2%) (25.7%) Source: Capital IQ Note: Shading denotes companies covered in this project. 1 National Conference of State Legislatures Research. Published in 2012. http://www.ncsl.org/issuesresearch/educ/for-profit-colleges-and-universities.aspx 2 \"New Default Rate Data for Federal Student Loans: 44% of Defaulters Attended For-Profit Institutions.\" Pew Charitable Trusts. 15 December 2009. 3 Senate Committee on Health, Education, Labor, and Pensions, For Profit Education: The Failure to Safeguard the Federal Investment and Ensure Student Success. (July 30, 2012), 4 II. Industry Strengths Large addressable market. The for-profit education industry has revolutionized education and is indispensable to a large potential market in today's economy as it is typically lower-cost than traditional universities, helps close the income gap between college and non-college graduates, can increase employment opportunities for low-income students, and provides education at convenient times for working students. According to the U.S. Census, there are currently 206 million adults in the U.S. over age 25, and only 36% have a college degree, yielding a potential market for the for-profit post-secondary education industry of 132 million customers.4 Strong customer value proposition. According to the U.S. Department of Labor, in 2011 the unemployment rate for college graduates was half of that for those without college experience, and the median weekly earnings for college graduates was approximately 65% higher. A college degree has changed from a luxury to a necessity to be considered for many positions. According to research, jobs in the U.S. that require an Associate's or higher level degree are anticipated to grow by 28% while jobs requiring little or no college education are anticipated to decline by 3%.5 Product accessibility. Perhaps the greatest advantage of for-profit education is the innovation of making classes available at more convenient times for working students, including at night and online. Accessibility allows people who are working full time jobs to pursue a degree and obtain higher-paying jobs in the future, without sacrificing current earnings. III. Industry Risks Stringent and evolving accreditation / regulation. Post-secondary education is a heavily regulated industry in the U.S. Companies in the industry must satisfy three primary regulators: the federal government, state education regulatory bodies, and accreditation agencies. Through the federal government's Higher Education Act, companies are required to meet various standards to receive federal student financial aid, a very significant industry revenue source (see below). Additionally, companies must receive approval from state regulatory bodies in each of the states in which they operate, and companies must seek verification of education quality through an accreditation agency. Without approval, companies' operations and student financing would be limited, likely resulting in a severe decline in business and financial performance. Heavy reliance on continued Title IV government funding. A large portion of students attending for-profit post-secondary education institutions in the U.S. finance their tuition with federal government assistance (primarily loans and grants) offered through Title IV of the Higher Education Act. As such, companies in the industry derive a significant amount of revenue from Title IV programs, with most major companies relying on the federal government for the majority of their revenue. For funding, schools must meet two primary tests: (1) the \"90/10\" rule, which limits Title IV funds to 90% of revenue, and (2) the cohort default rule, which disqualifies any school whose 3-year cohort default rate exceeds 40% in any year or 30% in three consecutive years. Companies are vulnerable to any changes in the Title IV program, which has been under political pressure as part of the U.S. government's recent budget struggles. This program must be periodically reviewed and reinstated by legislatorsthe most recent version of the program is valid until September 2013 and various changes to the law have been proposed recently. With 4 \"Strayer Education Inc. Investor Presentation Q1 2013,\" Strayer press release, February 2013, on Strayer website, http://files.shareholder.com/downloads/STRA/2399283739x0x638701/36F92906 -6E21-4E21A073-B7BF93874923/STRA_Q1_2013_Investor_Presentation_-_FINAL.pdf, accessed April 2013. 5 Carnevale, Anthony P., Smith, Nicole, Strohl, Jeff. \"Help Wanted - Projections of Jobs and Education Requirements through 2018.\" Georgetown Public Policy Institute, June 15, 2010. 5 elevated scrutiny during the prolonged period of economic softness in the U.S., there is a risk of further changes to the Title IV program that could reduce enrollment and revenue for the industry. Waning public perception / value proposition. The U.S. has experienced chronic unemployment and underemployment resulting from the recent global financial crisis. Many post-secondary education institutions have been negatively impacted by these employment trends as college graduates have been unable to earn an acceptable return on their education investment. As such, according to the National Student Clearinghouse Research Center, college enrollments declined 1.8% in the fall of 20126. Continued poor employment prospects could negatively impact enrollment as potential students become increasingly skeptical of the value proposition. Risk of substitutes / pricing pressure. There is a recent trend in the education industry towards democratization of learning using technology to offer free courses over the internet. These courses - called massive open online courses (MOOCs) - involve existing universities making free course content available online7. While the future of MOOCs is unclear, the idea has been highly publicized and has developed interest from leading universities, such as Harvard and MIT, which recently announced an offering called edX. Historically, competition in the distancelearning segment has been among for-profit schools with comparable reputations. The entry of high-profile institutions into this space could alter the competitive landscape significantly. 6 Strayer Education Inc., December 31, 2012 Form 10-K (filed February 19, 2013), via EDGAR Online, accessed April 2013. 7 Lohr, Steve, \"Beware of the High Cost of 'Free' Online Courses,\" The New York Times, March 25, 2013, http://bits.blogs.nytimes.com/2013/03/25/beware-of-the-high-cost-of-free-online-courses/, accessed April 2013. 6 Apollo Group, Inc. (Ticker: APOL) Recommendation: Buy I. Company Overview Apollo Group, Inc. is one of the world's largest providers of education. Founded in 1978, Apollo offers both online and on-campus programs at the undergraduate, master's, and doctoral levels through seven educational institutions. The largest, University of Phoenix (\"Phoenix\"), is the primary business, contributing 91% of Apollo's $4.3 billion of total revenue and over 100% of its $676 million of operating profits. In fiscal 2012, Phoenix had average enrollment of 356,900 students. By comparison, the largest US non-profit university, Arizona State University (coincidentally also in Phoenix, Arizona), has 72,000 students. II. Key Success Factors Like all educational institutions, Apollo is primarily concerned with enrollment, cost, and outside funding sources (primarily donations or state funding at non-profit institutions and Title IV federal funding at for-profit institutions). However, Apollo has developed a unique approach to each that has been extremely successful. Enrollment. Apollo's key competitive advantage in enrollment has been an aggressive, and at times controversial, marketing strategy. Apollo spends over $650 million a year on marketing and this number is increasing. The company has national brand recognition that rivals nearly any school in the country and has successfully applied cutting-edge internet marketing techniques to drive massive growth in enrollment. Recently, enrollment has declined significantly. By Q4 2012, total degreed enrollment at Phoenix had fallen 31% from its high in Q3 2010. Apollo's strategy for the future has four main components. First, the company believes it is critical to demonstrate an irrefutable link between education at Phoenix and enhance career opportunities, a link that has been called into question over the past few years as scrutiny of the industry increases. They are approaching this problem with several initiatives including connecting their educational programs directly with employers, providing enhanced recruiting services to assist students seeking jobs, and incorporating more direct career development into the curriculum. Second, the company seeks to enhance the academic quality of its offerings, an effort which includes a large investment to incorporate \"adaptive learning\" into the curricula. Third, the company intends to reduce attrition by enhancing student services and selecting for students who are more likely to succeed in the program. Some initiatives to this end include: 1) a free, mandatory three-week orientation program to allow inexperienced prospective students to get a better understanding of the demands of higher education before committing; 2) modified marketing content and channels to attract students who are more likely to succeed; 3) elimination of enrollment numbers as part of the performance evaluation of admissions employees. Lastly, Apollo plans to expand enrollment by acquiring and developing new institutions. Cost. Apollo's innovations on cost per student have also contributed to their growth. Apollo pioneered the online education model and has reaped the benefits of the tremendous economies of scale. The company also has a strict emphasis on teachingunlike many non-profit schools, no resources are directed towards research. As a result, Phoenix has a cost per student that is a fraction of most traditional schools and approximately a third of the median for-profit school. 7 Recently, Apollo has redoubled its emphasis on operating costs, launching several initiatives to improve the efficiency of the organization. This will be a critical factor in the performance of the firm going forward. The current restructuring plan is focused on two main areas: ground locations and employee headcount. The company is in the process of closing 115 of its previous 227 physical locations and campuses. To date the company has incurred $79.8 million of restructuring costs related to closing these locations and expects to incur $130 million of additional charges for lease exit and related costs. The restructuring plan also calls for the elimination of 1000 positions, in part related to the reduction in ground locations. The company has incurred $35 million of employee separation costs in this restructuring and expects to incur an additional $10 million. In total, the company expects the restructuring to reduce operating costs by $350 million per year. Federal Funding. Like most schools, Phoenix is dependent on federal Title IV funding for revenue. Phoenix has carefully managed their eligibility for this funding, but it is a delicate balancing act. To date, Apollo has managed this risk well and has found opportunities to enhance their funding eligibility by combining different government programs which do not count against their 90/10 limit. As the organization continues to become larger and more sophisticated it is likely that their ability to manage this risk will increase. III. Key Risks The biggest risk to Apollo relates to its continued eligibility for Title IV funding. In the constantly changing regulatory environment there is some uncertainty about how the requirements for this funding may change, and there are many ways that Apollo could run afoul of existing regulations as well. Change in Regulation. Changes in regulation, such as the proposed \"85/15\" rule replacing the \"90/10\" rule, could dramatically and immediately impact Phoenix' operations. Currently 84% of Phoenix' revenue comes from Title IV funding which would put them very close to violating the new rule if passed, and would put them in violation if the new rule were implemented in conjunction with another proposed rule which would require schools to include certain forms of military funding in the calculation. Other regulatory changes could require Phoenix to change its operations such that profitability declined. For example, new restrictions on marketing to and recruiting prospective students may cause the company's cost to acquire new students to increase significantly. Similarly, stricter requirements related to student outcomes (e.g. graduation rates) could also increase costs and/or reduce enrollment. Loss of Accreditation. If Phoenix were to lose its accreditation or its accreditor were to lose recognition from the Department of Education, the school would no longer be eligible for Title IV funding. This is not a hypothetical risk: UNIACC, another Apollo school, recently lost its accreditation and it has had a devastating impact on the operations of that school. Phoenix is currently under review by its accrediting body, the Higher Learning Commission (\"HLC\"), for failure to comply with certain guidelines; the review committee recommended the school be placed on probation. While we do not believe that this review will result in the HLC rejecting the university's accreditation, we do believe this has had a dramatic impact on the stock price. Apollo's stock slid approximately 25% in connection with this announcement. 8 Failure to Meet Title IV Requirements. An adverse change in the composition of its student body could cause Phoenix to violate the 90/10 rule or the cohort default rule, such as an increase in the proportion of students in associate degree programs, which have higher default rates. Other risks not directly related to Title IV funding: Competition. The industry has become increasingly competitive as for-profit schools have gotten larger, more have entered the market, and non-profits have begun to offer competing products. This latter factor may be the biggest challenge in the long term, as traditional schools with wellestablished reputations and brands begin to offer a greater variety of distance-learning programs. This not only impacts the quantity of students Phoenix will be able to attract, but also the quality; the most capable students are more likely to attend an online program at a school with a stronger academic reputation, leaving Phoenix with students that are less likely to graduate and more likely to default on their loans. Reputational Damage to the Industry or Phoenix. Critics of Phoenix and other for-profit institutions have accused the school of using deceptive marketing and recruiting practices, offering degrees with no career-enhancing value, and saddling students with debt burdens that are inappropriate for their earning potential. These allegations could negatively impact Phoenix' enrollment. Loss of state and local funding. The state of California recently modified its eligibility requirements for the California Grant Program. Schools must now achieve graduation rates of 30% and a three year federal student loan cohort default rate below 15.5% to be eligible for California Grant Program funding, making new Phoenix students ineligible. In 2012, Phoenix students received approximately $21 million in California Grant Program funding. Changes in eligibility requirements or budget availability in other states could result in a similar loss of funding for Phoenix students, and would likely also adversely impact the university's 90/10 ratio. IV. Accounting Policies Revenue Recognition. Apollo recognizes revenue pro-rata over the period of the course of study as services are delivered. Sales of physical books and materials are recorded when the student accepts delivery of the item. Allowance for Doubtful Accounts. The company reduces accounts receivable by an allowance for uncollectible amounts. In recent years the net write-offs have consistently exceeded the increased provision for uncollectable accounts receivable. As a result, the size of the allowance has been declining despite continued large write-offs. One explanation for this is that the company expects lower write-offs in the future. However, this may be a method of managing earnings during the recent downturn in the company's performance. The company estimates that a one percent change in the allowance for doubtful accounts would have resulted in a $2.9 million change in pre-tax income. A one percentage point change in bad debts as a percentage of revenue would have resulted in a $42.5 million change in pre-tax income. Restricted Cash. The company includes over $300 million of restricted cash on the balance sheet. It also includes changes in restricted cash on its cash flow statement as part of cash flow from operations. This cash consists primarily of funds from the Title IV financial aid program for unbilled educational services. The funds are held by the company as trustee on behalf of the student. Consequently, it appears this cash does not belong to the company and therefore may distort the assets and cash flow reported by the company. 9 Goodwill and Intangible Assets. In the most recent quarter the company reported $104 million of goodwill and $137 million of net intangible assets including $104 million of indefinite-lived intangibles. These indefinite-lived intangibles include trademarks as well as accreditations and other designations. Collectively, goodwill and intangibles account for approximately 10% of the assets on the balance sheet. The management has considerable discretion in the valuation of these assets. Management primarily uses qualitative factors to determine the timing and magnitude of any impairment in these assets. V. Financial Analysis The company's financial performance has suffered recently, primarily as a result of the trends that have impacted the entire industry. Revenue. Over the past ten quarters enrollment has been decliningmost recently at an annual rate of approximately 15%. To date this has not impacted revenue by the same amount due to selective price increases in tuition and other fees in the range of 3-5%. Revenue declined 9.7% in the most recent full year results and 13% in the most recent quarter. Expenses. Expenses have been declining, due to the decline in enrollment and the ongoing restructuring. The primary expense items causing the decline are Instructional and Student Advisory and Admissions Advisory which declined this quarter by 9.8% and 32.7% respectively. However these declines were offset by large expenditures on restructuring and marketing. Margins. Consistent with the company's overall poor performance, margins have declined dramatically over the past three years. NOPAT margins have slipped from 15.0% in 2009 to 10.1% in 2012. However, the company's ability to raise prices in some areas, combined with significant cost-cutting efforts, has helped stop the slide in margins. Adjusted for the restructuring charges and the large recent advertising campaign, the company's operating margins have been slightly increasing over the past four quarters. Leverage. During the six months ended February 28th, the company significantly reduced its leverage, paying down $629 million of debt and reducing total debt from $720 million to only $91 million. After this debt reduction, the company still has $850 million of cash reserves. VI. Forecasting and Valuation Revenue. We are forecasting a substantial decline in revenues over the next five years. For reasons described in the Key Risks section, we expect the current trend in enrollment to continue and therefore project a 15% decline in revenues in the next two years. In the future however, we expect enrollment to stabilize as the student body is pared down to the customers for whom the Phoenix offerings are the best fit. We project the rate of revenue decline to slow from 15% to 5% over the course of the next five years. After that point we assume that revenues will grow along with the economy (at 3%) as the industry stabilizes. 10 Table 1: Rolling Four-Quarter Average Enrollment Margins. We believe that the company's margins have already adjusted to the new market environment and do not expect any additional decrease in margins. The benefits of the restructuring and cost reduction that the company has undertaken will balance out any pressure on margins from the decline in demand and increased competition. We project that the company's NOPAT margins of 10% (the lowest to date) will persist for the foreseeable future. Net Working Capital. The company enjoys significantly negative operating net working capital as a result of requiring students to prepay for each course. With no change in the margins or the fundamental business model, we expect operating working capital to remain unchanged as a percentage of sales. Net Long-Term Assets. As the company shifts its mix of students towards a lower percentage of on-campus and higher percentage online, we expect both operating assets and operating liabilities to decline. As a result we expect a decline in net operating assets. Because we expect sales to decline as well, we assume that Net Long-Term Assets will remain the same as a percentage of sales. Net Debt. As noted in the Financial Analysis section, the company has paid down most of its debt recently, and we believe this indicates a shift towards a more conservative capital structure in order to weather the challenging period ahead. We expect the company to continue with little or no debt, leaving Net Debt significantly negative due to the company's strong cash position. Return on Equity. Using the Alternative DuPont Decomposition, we project a return on equity of 33%. The insights provided by the individual components are limited because of the nature of the Apollo balance sheet. The company has very low Net Operating Assets, primarily due to the extremely negative Operating Net Working Capital, and consequently a very high ROA. The company also has very high cash balances and very low debt and therefore negative Net Debt. As a result, the impact of financial leverage is fairly large and negative. 11 Table 2: Alternative DuPont Decomposition NOPAT / Sales x Sales / Net Assets = Operating ROA 10.0% 50 500% Spread x Net Financial Leverage = Financial Leverage Gain 499% -0.93 -467% ROE 33% One question that arose during this analysis was whether to treat Restricted Cash and Cash Equivalents as an operating asset or as a financial asset. By default the BAV tool treats this cash as a financial asset and includes it in Net Debt. Our view is that this cash from federal funding held in trust by the company is an integral part of their normal business operations and thus should be treated as an operating asset. Furthermore, the offsetting short-term liability, Student Deposits, is treated as an operating liability; we believe that it makes more sense for both of these items to be included in Operating Net Working Capital, rather than just one of them. Making this adjustment does not change the ROE (the only difference is due to rounding) but it makes the components more reasonable and more useful for explaining the drivers of return. Table 3: Alternative DuPont Composition - Restricted Cash Adjustment NOPAT / Sales x Sales / Net Assets = Operating ROA Spread x Net Financial Leverage = Financial Leverage Gain ROE 10.0% 8 83% 83% -0.60 -50% 34% This illustrates that the operating assets generate a healthy return, but that the large amounts of unproductive cash on the balance sheet are a drag on the returns to the equity holders. This is not necessarily a negative thing; as mentioned above, the large cash position provides a margin of safety for the company as it navigates a very volatile period. A 34% projected ROE strongly supports our buy recommendation. VII. Recommendation Despite the gloomy projections for the company's future performance, APOL is a strong buy at its current price. In our base case described above, we estimate a share price of $25.21 using the abnormal earnings model. This represents a 46% premium to the current market price of $17.23. 12 This is despite a projected 44% decline in revenue over the next five years and assuming little to no benefit from the current restructuring. Our downside case uses even more conservative assumptions. We assume that revenues decline by 15% in each of the next five years, and then remain flat thereafter (0% perpetuity growth rate). Additionally, we assume that NOPAT margins decline by 50 basis points per year for five years and then remain flat. Even in this draconian downside scenario we estimate a share price of $18.51, a 7% premium to the current market price. While we believe the base case is by far the most likely outcome, there is significant upside potential as well. In our upside case we assume that revenue falls by less than expected: -10% for the first two years, then -5% for the next three years, after which we assume revenues grow with GDP (3%). Furthermore, we assume that Apollo will achieve meaningful benefits from their restructuring, giving them credit for 5% of their projected $350 million of cost savings initially, increasing to 25% over time. Under this scenario we estimate a share price of $37.31, a 117% premium to the current price. Our analysis begs the question: what is the market missing? We believe that the market is wrong in two respects. First, while we generally agree with analyst revenue estimates, we disagree about the extent of the margin compression that the company will experience. We believe that the company's restructuring efforts, along with the structural support to tuition prices, will allow the company to maintain its current margins, which have already declined by 5 percentage points in the past three years from 15% to 10%. Table 4: Sensitivity of Target Price to NOPAT Projection NOPAT Margin Estimated Value Per Share 5.0% $12.69 7.5% 10.0% 12.5% 15.0% $18.95 $25.21 $31.48 $37.74 Second, it appears that the market is pricing in a high probability of a major downside event related to the HLC probation recommendation, such as a loss of accreditation (and as a result a loss of Title IV funding). We believe the probability of such an event that is reflected in the price is much too highwe estimate the market may be pricing in a probability as high as 35%. We estimate this by assuming the current market price is a probability weighted average of the value assuming no major negative event and the value after a major negative event (essentially zero). Our view is that a major adverse event like this has a low single-digit probability. 13 Exhibits Exhibit 1a. Apollo Group, Inc. Consolidated Balance Sheet Current assets Cash and cash e quivalents Restricted cash and cash e quivalents Accounts receivable, net Prepaid taxes Deferred tax assets, current portion Other current assets Total current assets Property and e quipment, net Marketable securities Goodwill Intangible assets, net Deferred tax assets, l ess current portion Other assets Total assets Current liabilities Short-term borrowings and current portion of l ong-term debt Accounts payable Student deposits Deferred revenue Accrued and other current l iabilities Total current l iabilities Long-term debt Deferred tax l iabilities Other l ong-term l iabilities Total l iabilities Commitments and contingencies Shareholders' equity Preferred stock, no par value, 1,000 shares authorized; none i ssued Additional paid-in capital Apollo Group Class A treasury stock, at cost, 76,239 and 58,003 shares as of August 31, 2012 and 2011, respectively Retained e arnings Accumulated other comprehensive l oss Total Apollo shareholders e quity Noncontrolling (deficit) i nterests Total e quity Total l iabilities and shareholders e quity Common stock [Member] | Apollo Group Class A nonvoting common stock [Member] Shareholders' equity Apollo Group common stock Total e quity Common stock [Member] | Apollo Group Class B voting common stock [Member] Shareholders' equity Apollo Group common stock Total e quity Aug. 31, 2012 Aug. 31, 2011 $1,276,375,000 318,334,000 198,279,000 26,341,000 69,052,000 49,609,000 1,937,990,000 571,629,000 5,946,000 103,345,000 149,034,000 $1,571,664,000 379,407,000 215,567,000 35,629,000 124,137,000 44,382,000 2,370,786,000 553,027,000 5,946,000 133,297,000 121,117,000 77,628,000 22,750,000 2,868,322,000 70,949,000 14,584,000 3,269,706,000 638,588,000 74,872,000 362,143,000 254,555,000 324,881,000 1,655,039,000 81,323,000 15,881,000 191,756,000 1,943,999,000 419,318,000 69,551,000 424,045,000 293,436,000 448,937,000 1,655,287,000 179,691,000 26,400,000 164,339,000 2,025,717,000 93,770,000 68,724,000 -3,878,612,000 4,743,150,000 -3,125,175,000 4,320,472,000 -30,034,000 928,378,000 -4,055,000 924,323,000 -23,761,000 1,240,364,000 3,625,000 1,243,989,000 2,868,322,000 3,269,706,000 103,000 103,000 103,000 103,000 1,000 $1,000 1,000 $1,000 14 Consolidated Statements of Income 3 Months Ended 12 Months Ended In Thousands, except Per Share data, Aug. 31, 2012 31-May-12 Feb. 29, 2012 Nov. 30, 2011 Aug. 31, 2011 31-May-11 Feb. 28, 2011 Nov. 30, 2010 Aug. 31, 2012 Aug. 31, 2011 Aug. 31, 2010 unless otherwise specified Income Statement [Abstract] Net revenue $996,497 $1,122,258 $962,682 $1,171,900 $1,120,220 $1,227,898 $1,042,412 $1,320,519 $4,253,337 $4,711,049 $4,906,613 Instructional and student advisory 455,564 466,117 425,607 453,281 435,181 454,305 417,943 452,557 1,800,569 1,759,986 1,720,059 Marketing 180,322 158,583 158,973 165,564 170,660 160,846 156,957 165,936 663,442 654,399 622,848 Admissions advisory 85,852 95,290 101,405 101,388 99,428 99,923 102,283 113,752 383,935 415,386 466,358 General and administrative 92,322 88,085 83,994 79,899 98,473 87,857 84,344 84,874 344,300 355,548 301,116 Depreciation and amortization 44,741 45,042 41,854 46,167 41,529 41,023 38,809 36,325 177,804 157,686 142,337 Provision for uncollectible accounts receivable 38,733 35,430 30,996 41,583 39,631 39,217 45,540 56,909 146,742 181,297 282,628 Restructuring and other charges 9,408 7,577 16,148 5,562 19,067 0 0 3,846 38,695 22,913 0 Goodwill and other i ntangibles impairment 0 0 0 16,788 0 0 219,927 0 16,788 219,927 184,570 Litigation charge (credit), net 0 4,725 0 0 -16,454 2,048 1,574 881 4,725 -11,951 177,982 Total costs and e xpenses 906,942 900,849 858,977 910,232 887,515 885,219 1,067,377 915,080 3,577,000 3,755,191 3,897,898 Operating i ncome 89,555 221,409 103,705 261,668 232,705 342,679 -24,965 405,439 676,337 955,858 1,008,715 Interest i ncome 306 160 215 506 498 783 704 899 1,187 2,884 2,920 Interest e xpense -5,127 -2,830 -1,789 -1,999 -2,724 -2,383 -1,654 -2,170 -11,745 -8,931 -11,864 Other, net 520 -402 218 140 17 -1,864 313 -54 476 -1,588 -685 Income from continuing operations before i ncome taxes 85,254 218,337 102,349 260,315 230,496 339,215 -25,602 404,114 666,255 948,223 999,086 Provision for i ncome taxes -37,726 -87,059 -43,108 -115,179 -45,303 -129,284 -75,465 -169,084 -283,072 -419,136 -463,619 Income from continuing operations 47,528 131,278 59,241 145,136 185,193 209,931 -101,067 235,030 383,183 529,087 535,467 Income (loss) from discontinued operations, net of tax 26,641 3,104 1,930 2,148 -1,257 3,334 3,994 638 33,823 6,709 -13,886 Net i ncome 74,169 134,382 61,171 147,284 183,936 213,265 -97,073 235,668 417,006 535,796 521,581 Net l oss attributable to noncontrolling interests 1,279 -348 2,711 2,030 4,676 -825 33,035 -255 5,672 36,631 31,421 Net i ncome attributable to Apollo $75,448 $134,034 $63,882 $149,314 $188,612 $212,440 ($64,038) $235,413 $422,678 $572,427 $553,002 Earnings (loss) per share - Basic: Continuing operations attributable to Apollo (in dollars per share) $0.47 $1.11 $0.50 $1.13 $1.39 $1.50 ($0.48) $1.61 $3.24 $4.01 $3.73 Discontinued operations attributable to Apollo (in dollars per share) $0.20 $0.02 $0.01 $0.02 ($0.01) $0.02 $0.03 $0 $0.24 $0.04 ($0.09) Basic i ncome per share attributable to Apollo (in dollars per share) $0.67 $1.13 $0.51 $1.15 $1.38 $1.52 ($0.45) $1.61 $3.48 $4.05 $3.64 Earnings (loss) per share - Diluted: Continuing operations attributable to Apollo (in dollars per share) $0.46 $1.11 $0.49 $1.13 $1.38 $1.49 ($0.48) $1.60 $3.22 $4 $3.71 Discontinued operations attributable to Apollo (in dollars per share) $0.20 $0.02 $0.02 $0.01 ($0.01) $0.02 $0.03 $0.01 $0.23 $0.04 ($0.09) Diluted i ncome per share attributable to Apollo (in dollars per share) $0.66 $1.13 $0.51 $1.14 $1.37 $1.51 ($0.45) $1.61 $3.45 $4.04 $3.62 Basic weighted average shares outstanding (in shares) 112,815 118,134 125,298 130,318 136,594 139,856 142,354 146,352 121,607 141,269 151,955 Diluted weighted average shares outstanding (in shares) 113,539 118,793 126,467 130,874 137,295 140,343 142,354 146,663 122,357 141,750 152,906 Exhibit 1b. Apollo Group, Inc. Consolidated Statement of Income 15 Exhibit 1c. Apollo Group, Inc. Consolidated Statement of Cash Flows In Thousands, unless otherwise specified Cash flows provided by (used in) operating activities: Net i ncome Adjustments to reconcile net income to net cash provided by operating activities: Share-based compensation Excess tax benefits from share-based compensation Depreciation and amortization Amortization of l ease i ncentives Amortization of deferred gains on sale-leasebacks Impairment on discontinued operations Goodwill and other i ntangibles i mpairment Non-cash foreign currency (gain) l oss, net Gain on sale of discontinued operations Provision for uncollectible accounts receivable Litigation charge (credit), net Deferred i ncome taxes Changes in assets and liabilities, excluding the impact of acquisitions and business dispositions: Restricted cash and cash e quivalents Accounts receivable Prepaid taxes Other assets Accounts payable Student deposits Deferred revenue Accrued and other l iabilities Net cash provided by operating activities Cash flows provided by (used in) investing activities: Additions to property and e quipment Acquisitions, net of cash acquired Maturities of marketable securities Proceeds from sale-leaseback, net Proceeds from dispositions, net Collateralization of l etter of credit Other i nvesting activities Net cash (used i n) provided by i nvesting activities Cash flows provided by (used in) financing activities: Payments on borrowings Proceeds from borrowings Apollo Group Class A common stock purchased for treasury Issuance of Apollo Group Class A common stock Noncontrolling i nterest contributions Excess tax benefits from share-based compensation Net cash used i n financing activities Exchange rate e ffect on cash and cash e quivalents Net (decrease) i ncrease i n cash and cash e quivalents Cash and cash e quivalents, beginning of year Cash and cash e quivalents, e nd of year Aug. 31, 2012 Aug. 31, 2011 Aug. 31, 2010 $417,006 $535,796 $521,581 78,705 -1,150 178,234 -15,510 -2,798 0 16,788 -497 -26,678 146,742 4,725 21,850 70,040 -4,014 159,006 -18,822 -2,221 0 219,927 1,662 0 181,297 -11,951 55,823 64,305 -6,648 147,035 -13,358 -1,705 9,400 184,570 643 0 282,628 177,982 -125,399 61,073 -129,773 9,303 -11,568 12,525 -58,740 -39,154 -109,783 551,300 64,725 -121,120 -25,241 -9,900 -3,913 -70,120 -79,488 -44,364 897,122 -11,828 -265,996 10,421 2,183 21,624 3,445 32,887 -528 1,033,242 -115,187 -73,736 0 0 76,434 0 -1,694 -114,183 -162,573 0 10,000 169,018 21,251 126,615 0 164,311 -168,177 -5,497 5,000 0 0 -126,615 0 -295,289 -562,269 629,145 -811,913 11,949 0 1,150 -731,938 -468 -295,289 1,571,664 1,276,375 -437,925 410,051 -783,168 24,903 6,875 4,014 -775,250 712 286,895 1,284,769 1,571,664 -477,568 475,454 -446,398 19,671 2,460 6,648 -419,733 -1,697 316,523 968,246 1,284,769 16 Supplemental disclosure of cash flow and non-cash information Cash paid for i ncome taxes, net of refunds Cash paid for i nterest Capital l ease additions Restricted stock units vested and released Credits received for tenant i mprovements Debt i ncurred for acquired technology 246,824 9,794 44,145 36,182 27,009 $14,389 464,701 10,972 31,818 21,470 25,538 $0 514,532 7,837 2,372 19,868 17,372 $0 Exhibit 2. Pro-forma Financial Projections and Abnormal Earnings Valuation HISTORICAL 2011 2012 2016 2017 TERMINAL 2018 2019 -497.83 553.14 55.31 -448.04 497.83 49.78 -425.64 472.94 47.29 -438.41 487.12 48.71 -451.56 501.74 50.17 -874.80 0.00 936.26 61.46 -787.32 0.00 842.63 55.31 -708.59 0.00 758.37 49.78 -673.16 0.00 720.45 47.29 -693.35 0.00 742.07 48.71 -714.15 0.00 764.33 50.17 -15.00% 10.00% -18.00% 20.00% -10.00% 10.00% -18.00% 20.00% -10.00% 10.00% -18.00% 20.00% -5.00% 10.00% -18.00% 20.00% 3.00% 10.00% -18.00% 20.00% 3.00% 10.00% -18.00% 20.00% 2013 2014 -816.40 704.50 -111.90 -673.10 726.70 53.60 -553.14 614.60 61.46 -1,144.50 -1,352.10 0.00 0.00 1,356.10 1,240.40 211.60 -111.70 -874.80 0.00 928.40 53.60 -15.00% 10.00% -18.62% 20.10% FORECAST 2015 PRO FORMA - BEGINNING BALANCE SHEET Beginning Net Working Capital + Beginning Net Long Term Assets = Beginning Net Operating Assets Net Debt + Preferred Stock + Shareholder's Equity = Net Capital -852.80 1,064.40 211.60 Sales Growth NOPAT / Sales 12.23% Beg. Net Working Capital / Sales -18.10% Beg. Net Operating Long Term Assets / Sales 22.59% -9.72% 10.08% -19.19% 16.56% Net Debt / Book Value of Net Capital -540.88% 1210.47% -1632.09% -1423.36% -1423.36% -1423.36% -1423.36% -1423.36% -1423.36% Preferred Equity / Book Value of Net Capital 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Shareholders' Equity / Book Value of Net Capital 640.88% -1110.47% 1732.09% 1523.36% 1523.36% 1523.36% 1523.36% 1523.36% 1523.36% PRO FORMA - INCOME STATEMENT Sales NOPAT (Net Operating Profits After Tax) - Net Interest Expenses After Tax = Net Income - Preferred dividends = Net Income to Common 4,253.30 428.88 6.08 422.80 0.00 422.80 3,615.31 361.53 6.08 355.45 0.00 355.45 3,073.01 307.30 -4.99 312.29 0.00 312.29 2,765.71 276.57 -4.49 281.06 0.00 281.06 2,489.14 248.91 -4.04 252.95 0.00 252.95 2,364.68 236.47 -3.84 240.31 0.00 240.31 2,435.62 243.56 -3.95 247.51 0.00 247.51 2,508.69 250.87 -4.07 254.94 0.00 254.94 -0.09 -0.25 0.85% -10.00% -10.00% -5.00% 3.00% 3.00% RESIDUAL INCOME VALUATION Cost of Common Equity 11.24% 11.24% Net Income to Common 355.45 312.29 - Charge for Common Equity (Beg Book V alue of Equity x Cost of Common 104.35 Equity)105.24 = Residual Operating Income 251.10 207.05 Present V alue of Residual Operating Income 225.73 167.32 Present V alue of Terminal Abnormal Earnings 11.24% 281.06 94.71 186.35 135.37 11.24% 252.95 85.24 167.71 109.53 11.24% 240.31 80.98 159.33 93.54 11.24% 247.51 83.41 164.11 11.24% 254.94 85.91 169.03 Book V alue of Common Equity Growth Rate 4,711.00 575.95 3.45 572.50 0.00 572.50 Beg. Book V alue of Equity + PV of Residual Operating Income (forecasted years 1-5) + PV of Residual Operating Income (terminal value, beginning year 6) = Estimated Value of Equity = Number of Shares Outstanding (MM) Estimated Value Per Share 1,991.58 928.40 731.49 1,169.21 2,829.10 112.20 25.21 17 Sources Apollo Group, Inc., February 28, 2013 10-Q, via SEC.gov, accessed April 2013. Apollo Group, Inc., August 31, 2012 10-K, via SEC.gov, accessed April 2013. Apollo Group, Inc., August 31, 2011 10-K, via SEC.gov, accessed April 2013. Apollo Group, Inc., August 31, 2010 10-K, via SEC.gov, accessed April 2013. Apollo Group, Inc., August 31, 2009 10-K, via SEC.gov, accessed April 2013. Apollo Group, Inc., August 31, 2008 10-K, via SEC.gov, accessed April 2013. Fain, Paul. \"Phoenix Reloads.\" Inside Higher Ed, October 26, 2012. http://www.insidehighered.comews/2012/10/26/university-phoenix-down-not-out, accessed April 2013. Kelderman, Eric. \"U. of Phoenix Expects to Be Placed on Probation by Its Accreditor.\" The Chronicle of Higher Education, February 25, 2013. http://chronicle.com/article/U-of-PhoenixExpects/137565/, accessed April 2013. Pinsen, David. \"More Reasons To Be Cautious About For-Profit Colleges.\" Seeking Alpha, March 26, 2013. http://seekingalpha.com/article/1302231-more-reasons-to-be-cautious-about-forprofit-colleges, accessed April 2013. S. PRT. 112-37 Volume 1 - For Profit Higher Education: The Failure To Safeguard the Federal Investment and Ensure Student Success. Prepared by the Committee on Health, Education, Labor, and Pensions, United States Senate. http://www.help.senate.gov/imo/media/for_profit_report/Contents.pdf, accessed April 2013. Silber, Jeffrey. \"First Thoughts: FY2013 EPS Well Above Consensus; FY2013 Guidance in Line.\" BMO Capital Markets, March 25, 2013, via ThomsonONE, accessed April 2013. Source: CollegeMeasures.org, partnership of American Institutes for Research and Matrix Knowledge Group, accessed April 2013. Tarkan, Michael. \"Size Matters: Initiating at Sell as Growth Remains Distant.\" Compass Point Research and Trading, LLC, April 5, 2013, via ThomsonONE, accessed April 2013. 18 American Public Education, Inc. (Ticker: APEI) Recommendation: Buy I. Company Overview8 American Public Education is a for-profit, online, post-secondary university with an emphasis on educating the military and public service communities. APEI consists of two universities, American Military University (AMU), and American Public University (APU). Together, these two universities form the American Public University System (APUS). APUS is regionally accredited, with 87 degree programs and 69 certificate programs. As of December 2012, it served approximately 127,000 students across the U.S. and internationally. Since it's founding in 1991 APEI has put a strong emphasis on the military student. Originally the military made up nearly all of APEI's revenue, however, over time the company has been able to diversify away from this segment, which now makes up only 38% of revenue.9 Exhibit 1 shows APEI's sources of revenue over time. APEI derives the majority of its revenue from federal funding through either Title IV funds, or the Department of Defense (DoD) Tuition Assistance (TA) program. They have, however, more recently formed exclusive partnerships with large corporations such as Wal-Mart. It is expected that in the future a larger portion of their revenue will come from these large corporate partnerships.10 The company also looks to expand internationally. In the past year they purchased a 20% stake in New Horizons, the worlds largest IT training company. In the future, they expect to leverage this platform to roll out additional certificate programs to working adults internationally.11 II. Key Success Factors Low-cost tuition. APEI seeks to have the lowest tuition in the industry. They have not increased tuition rates since 2001, which currently stand at $250 per credit hour. The low cost strategy serves two purposes: (1) it helps to ensure access to federal funding, and (2) it enables APEI to compete with other online universities, community colleges, and in-state colleges. APEI has set it's tuition rate such that the DoD TA program will cover 100% of the costs of an undergraduate degree and 75% of the costs of a graduate degree12. This has enabled APEI to capture a large share of the military student market, which as will be explained below, has been a competitive advantage for APEI. Moreover, access to federal funding, through both the DoD TA program and Title IV funds, is highly regulated. These programs are frequently scrutinized by politicians and industry regulators who seek to ensure that public funding is spent wisely. By 8 This section is largely derived from the company's 2012 10-K filing. American Public Education Inc., December 31, 2012 Form 10-K (filed February 28, 2013), via Capital IQ, accessed April 2013. 9 American Public Education Inc., February 28, 2013 Form 8-K (filed February 28, 2013), via Capital IQ, accessed April 2013. 10 Source: Presentation by American Public Education Inc. at Credit Suisse Global Services Conference (27 March 2013), OneSource Information Services, Inc., accessed April 2013. 11 Source: Presentation by American Public Education Inc. at Credit Suisse Global Services Conference (27 March 2013), OneSource Information Services, Inc., accessed April 2013. 12 American Public Education Inc., December 31, 2012 Form 10-K (filed February 28, 2013), via Capital IQ, accessed April 2013. 19 maintaining low tuition costs and high student outcomes, APEI remains in favor with its regulators and helps to ensure it continues to receive these sources of funding. Additionally, APEI's affordability provides it with a strong competitive advantage over local community colleges, state colleges, and other online universities. As depicted in Exhibit 2, APEI's tuition rates are nearly 20% below those of any other local university.13 Focus on the military student market. The low cost strategy is enabled by another one of the company's strategies - building a strong relationship with the military. This relationship provides APEI with a reliable revenue stream through the DoD TA program as well as the Montgomery and Post 9/11 GI Bills. Moreover, since the military ties pay increases and promotions to learning objectives, military students are more likely to graduate and to refer others. The benefit to APEI is that the military's larger referral base enables a low customer acquisition cost, and hence higher margins. Furthermore, because military students have higher graduation rates, their lifetime customer value is higher as they will continue to take additional classes with little to no advertising or recruiting costs incurred by APEI. 50% of APEI's graduates return for a second degree, and 40% of its students are referred to them.14 This is apparent in APEI's financial statements as it has the highest gross margin of all of its competitors, and one of the highest EBITDA margins (see Exhibit 3 for a comparison of operational performance). Lastly, revenue in the form of DoD TA payments as well as the GI Bill, help to diversify APEI's revenue away from Title IV funding and keep it in compliance with the 90/10 rule. The 90/10 rule states that institutions receiving Title IV funds must derive at least 10% of their revenue from non-Title IV funding sources. DoD tuition assistance, and the GI Bill do not count as Title IV funding for the purposes of this rule.15 Develop exclusive partnerships with large employers. APEI learned early on that a partnership with the military helped it to reduce costs and enhance student performance. They then applied this same model to civilian employers such as Wal-Mart. APEI currently has an exclusive partnership with Wal-Mart - the largest employer in the United States. Wal-Mart uses APEI to help train its employees in reverse logistics, logistics management, and several other fields.16 APEI also has developed relationships with BAE systems, Sun-Maid, and other larger corporations.17 Like the relationship with the military, these partnerships provide APEI with low customer acquisition costs, and a high lifetime customer value. Moreover, the relationships with corporations help APEI to further diversify away from federal funding. III. Key Risks 90/10 rule revised. Recently, legislation has been proposed which would revise the 90/10 rule to include military funding as part of Title IV funding, and increase the proportion of non-Title IV 13 American Public Education Inc., March 11, 2013 Form 8-K (filed March 11, 2013), via Capital IQ, accessed April 2013. 14 Source: Presentation by American Public Education Inc. at Credit Suisse Global Services Conference (27 March 2013), OneSource Information Services, Inc., accessed April 2013. 15 American Public Education Inc., December 31, 2012 Form 10-K (filed February 28, 2013), via Capital IQ, accessed April 2013 16 Source: Presentation by American Public Education Inc. at Credit Suisse Global Services Conference (27 March 2013), OneSource Information Services, Inc., accessed April 2013. 17 American Public Education Inc., March 11, 2013 Form 8-K (filed March 11, 2013), via Capital IQ, accessed April 2013. 20 revenue to 15%. If military funding were included in the calculation of Title IV revenues, APEI would derive 87% of its revenue from Title IV funds, which would put it in violation of the proposed 85/15 rule.18 DOD Tuition Assistance declines. On March 11th 2013, the \"sequester\" went into effect, cutting nearly $85billion from the Department of Defense. As a result, the DoD froze the tuition assistance program. It would continue to pay for currently enrolled students, but no new students could receive benefits under the program.19 Since APEI derives 38% of its revenue from this program, the sequester could have a material impact on APEI's performance. However, on March 20th, the Senate passed an amendment, which would reinstate funding for the tuition assistance program.20 Going forward, there is the possibility that federal spending cuts could reduce the available funding for tuition assistance programs. However, I believe this is unlikely given that the military relies heavily on this program to assist with recruitment. Furthermore, many military students can also rely on the GI Bill to cover the costs of their education. Growth will require diversifying away from the core military market. The company's student growth rate has declined every year since 2007, with a year over year growth rate of 15% in 2012.21 As the military begins downsizing, APEI will need to focus on recruiting new students outside of the military in order to sustain high growth. This will entail additional marketing expenses, and could result in lower student performance and thus lower customer lifetime value. In its most recent 10-K, APEI admits that this is beginning to happen. The trend can also be seen in the company's financial statements as SG&A expense as a percent of revenue has increased from a low of 31% in 2009 to 39% in 2012. IV. Accounting Policies Revenue Recognition. APEI records all revenue as deferred revenue at the start of its courses, which are either eight or sixteen weeks in duration. Revenue is then recognized on a pro-rata basis as the courses are taught. At any point in time, revenue may not directly correlate to the number of courses enrolled in for the year, because revenue is deferred while courses are in progress. Revenue associated with fees, and books, is recognized immediately22. Accounts receivable and provision for doubtful accounts. At the time of course registration the company records deferred revenue and an account receivable for the amount of the tuition for that course. The student can remit payment himself, or elect to have the payment provided by other funding sources (tuition assistance, title IV, employer, etc.). Accounts receivable is reduced once the student remits payment. Also, based on the funding source and management's expectations, a provision for doubtful accounts is created to account for the likelihood that some accounts receivable will not be paid.23 18 American Public Education Inc., December 31, 2012 Form 10-K (filed February 28, 2013), via Capital IQ, accessed April 2013 19 American Public Education Inc., March 11, 2013 Form 8-K (filed March 11, 2013), via Capital IQ, accessed April 2013. 20 \"Senate backs money for military tuition assistance program hit by sequester,\" March 21, 2013, Fox News, http://www.foxnews.com/politics/2013/03/21/senate-backs-money-for-military-tuition-assistanceprogram-hit-by-sequester/, accessed April 15, 2013 21 Data obtained from APEI 8-K filings 2007 to present, via Capital IQ, accessed April 2013. 22 American Public Education Inc., December 31, 2012 Form 10-K (filed February 28, 2013), via Capital IQ, accessed April 2013 23 Ibid. 21 V. Financial Analysis APEI strategy results in high gross margins, but continued growth may imply a decline. Displayed in Figure 1 below, is APEI's key operating statistics as a percent of sales for the years 2007 thru 2012. Figure 1- APEI Key Operating Statistics 2007 - 2012 !"#$%&'("(%)"*+,-.%/00%12)3 !"#$% &!"#$% &'(%)&(*&!"#$% &+,(%%&-,(*.) &!+/0 &=>$,").?@&A?B(C$ &-,$DE"F&A?B(C$ &E"F&GF>$?%$ %9":%;'* 4557 45634 455 4558 472 455 45-5 42839 455 45-91537 455 45-4 :4:3; 455 Note that APEI's marketing and recruiting expenses show up under SG&A, while its cost of sales generally consists of teaching expenses. Figure 1 shows that APEI has become more operationally efficient as the cost of sales has steadily decreased with growing revenues. This is likely the result of economies of scale, which are achieved by leveraging APEIs technology platform to teach the same courses to a larger number of students without a proportional increase in teaching expenses. However, in order to grow, APEI has in the most recent years, spent more money on marketing and recruiting (SG&A as percent of sales has increased from 31% in 2009 to 39% in 2012). The result is a slight decline in net income margin. To generate further growth, APEI will need to continue to spend on marketing at recruiting, and its net income margin may trend downward as a result. Strong working capital management. APEI has consistently benefited from strong working capital management, enabling the company to fund growth internally. Figure 2 - APEI Working Capital Management !"#$%$"&'$%()*$*"+,-+. !"#$%8"#"9&' ;(=?-+.%@"7?7??@ F>DC DF@ BC@ =C =CD>AE@ ?D@ =E>BF ADB@ ?B@ =D>F= A=?>=F@ BA@ CG =EB>=?@ AF@ =?A =GC>GF@ BEG HBE>GB@ H?>G@ ABC@ H?>GF HCBD>F?@ A=?>=FG=@ =EB>GA H==B@ =GC>GF@ H?>GF H=E=>AF@ O-PQNR SLP,OR SSPMQR ,QPSQR S-PN,R ,-PSKR APEI has extremely high operating leverage as evidence by the line item Sales/Net Assets in Figure 3. Because APEI operates a purely online university, it can leverage its technology platform to reach more students without a proportional increase in assets. Additionally, Figure 3 shows us that APEI is decreasing its return on equity by not taking advantage of financial leverage - APEI currently has no debt. While t