TWST: To set the stage for readers, please give us a snapshot of your coverage universe.

Mr. Dobell: I cover a variety of business services companies, including the education sector. The vast majority of the companies within education that I do follow are the for-profit higher education providers, so anything as small as National American (NAUH) up to the largest, Apollo Group (APOL)/University of Phoenix. I’ve been covering the group now at Blair for just over five years, but in totality it’s been 11 or 12 years since I first started in the business.

TWST: In terms of the education group, what's your overall sentiment on the space right now and why?

Mr. Dobell: It's still very challenging. There are pockets of light and a lot of evidence of continuing challenges for the companies. The interest level from the buy side remains pretty low, I think, because of the uncertainty around enrollments, around pricing, around the regulatory environment and around what the job market has done to the group in the past couple of years.

On a go-forward basis, I think the long-term opportunity is still pretty attractive, but it's going to take companies with the right combination of programs, pricing, technology and process, I think, to grow both on an enrollment and a revenue basis. And I think the ideas of qualitative metrics — such as graduation rates, default rates, student ROI — those will probably take on a little more importance in terms of how the stocks are valued or which ones are attractive for investors than they did in the previous five or 10 years.

TWST: You mentioned some of the main challenges these companies are facing today. Would you talk a bit more about them, perhaps starting with enrollment trends and how that impacts their revenues and competition among the companies?

Mr. Dobell: A lot of the schools have seen new enrollment and total enrollment declines in the past couple of years. Part of that was driven by the uncertainty around the regulatory environment, but in the last year or so, I think it's been driven more by just a general lack of interest among potential students. It doesn't matter if they're focused on a nonprofit or a for-profit, or in large part even what age group they're in. It’s been a lack of interest in going to school or going back to school because of the uncertainty around whether or not there's going to be a job for them after they finish their degree.

You've had a number of schools talk in recent quarters about applications and inquiries trending upward, and people going through the process of thinking about going to school and even applying; and then, when it comes down to it, they don't show up. So these show rates, as the schools call them, have still been quite poor, and we see that in both the ground and online schools.

I also think competition’s had a small impact on that. I think it's mostly focused in master's degrees, and more online than it is on ground, but the schools, I think, are challenged from a number of points of view beyond competition just to get people comfortable with the idea that there's going to be employment or a better employment situation once they finish their degree.

The regulatory framework has focused the schools, I think, into a narrower list of programs or a narrower student type, because of the focus from both the government as well as the accreditors on graduation rates, default rates, student churn, a bunch of metrics that we either took for granted for a number of years or that didn't seem too important in the grand scheme of things given the types of students that were in these schools. But with some regulatory changes, some accreditation changes, the schools have had to take a step back and look at what kinds of students they are attracting, look at their propensity to graduate, try to understand what programs are better suited for the students but also the job market. All those things, especially in the context of having a relatively easy 10 or 15 years of growing, have made the businesses a lot tougher to execute recently.

The competition, I think, has two directions. One is within the group. In general, the working adult schools are competing for a narrower pool of students that tend to have more credits to transfer. They tend to be a little older in some cases or have more work experience, so they have a better chance of completing the program. And then, you've got on the edges some competition from traditional schools who are trying to grow their revenue base without having to spend a whole lot of money to do so, and they tend to be focused more on graduate programs, because that's where the responsible, attractive, high-price-point students are for traditional schools.

I'd add to that, you've seen all the factors that I've mentioned — competition, tough job market, regulatory environment, internal changes or internal focus on different students — have in some cases redirected the institutions to focus less on the number of people starting as compared to the number of people continuing. The schools have always had a reputation for starting a lot of students, but not having great completion rates, and that's because a lot of students sign up, and after a course or two, they drop out. In most part, it's not the institutions’ fault, and in the vast majority of cases, those students are uneconomic for the school, meaning it costs more to enroll them through all the processes than the profits or even revenues, in some cases, that the schools get back. That's not good for anybody. Either the student leaves with some debt, or the taxpayer’s left holding the bag for a grant they got and then didn’t complete the program.

So as the schools have shifted from a number of these winds that are pushing them around, they've tended to focus as much as they can on getting the right students in, and making sure those students finish the program. Whatever it is — associate's, bachelor's, master's — finish the program, because everybody is in a better spot. The school has provided a good service. The student has a degree. Yes, they paid for it, but they've got a degree that they can use to get a better job. The taxpayer got a good outcome, because they supported a student who probably otherwise would not have gone to school and gotten a degree.

Everybody ends up in a better position, but the only way you get there is by reducing the number of students who come in with either ill intent — just scamming the financial aid system — or who come in thinking they know they want to go to school, but not understanding the burdens that it’s going to place on them and their families.

TWST: What are your favorite names right now, and what do you like about them?

Mr. Dobell: There are a couple of ways that we've positioned people. I'll give you some broad perspectives, and then, narrow it down to the stocks within those perspectives. The online business is going to be more competitive than the ground business will be, and I say that because I believe that traditional schools and the advent of new learning technologies will have a bigger impact on the online business because of the opportunity for consumers to shop more schools. And, because traditional schools, as they push into the graduate programs in particular, are going to be able to utilize their brands as a way to get the attention of prospective students.

So online, we think, has a lot more competition. I think there's still a good secular growth story there, because online is much more convenient, and in some cases is better suited, for the adult learner than an on-ground program. But you're going to have a lot of pressures from competition and from the rules that have changed around how you deliver and what you have to track for the students.

The ground business, I think, is going to have fewer competitive threats from traditional education. Vocational programs don't tend to be on the list of things that a state school or a four-year university wants to do. You have a locational constraint, so if a student wants to get a degree but can't go online or shouldn't go online and can only travel 20 miles, they have a limited number of options in front of them to go to school.

If you look at some of the macroeconomic reports or participants, a lot of them say that the jobs that will be created in the U.S. in the next five or 10 years are going to be more vocational in nature than white collar in nature. So it's health care, it's IT, technology, a variety of things that, for a variety of reasons, are either in short supply or because of the changing nature of the global economy will come back to these shores versus being outsourced, like light manufacturing and what have you.

But the flip side of that is those students tend to be more challenging. They drop out at higher rates, they default at a higher rate, those kinds of things. So you maybe have an easier competitive matrix, but you've got a more challenging end market. A lot of those schools, the way that their accreditation is set up, they are responsible for placement rates of their graduates into the work force, and in a tough economy, those placement rates are very challenging.

So there are two ways to think about the market — online versus ground. Very different dynamics, I think, in both end markets. If you're going to be in the online business, I think you want to be in a stock that has a very low tuition price point, because there's more consumer price sensitivity, and having a low price point helps the school attract potential students more easily than a high price point school would. Again, like I said, students have the opportunity to shop online and price what they're looking for.

So within that construct, American Public (APEI) and Grand Canyon (LOPE) are the two that we've been bullish on. There have been issues across the group, these two stocks included, in the past couple of years, but I think the combination of low tuition price point, pretty good brands, management teams that are focused on not only the academic quality but the impact of what that quality can do for the financials, I think sets those two up pretty well.

On the ground side, it's a lot tougher. I think the end game for a school, like Education Management (EDMC), is going to be pretty good. In the near term, like all ground businesses, you've got a higher fixed cost, and therefore, a lot more margin pressure when enrollments decline. They are struggling, like a lot of the ground schools are, with profit declines that are much steeper than you see in the online business, because of the nature of the cost structure.

Also, the ground schools were more vulnerable, or more exposed, to some of the potential rules coming out of D.C., by virtue of the types of students that they were enrolling. Within the ground business, the near-term outlook for the four companies I think of being in that section — DeVry (DV), Education Management, ITT (ESI), Career Ed (CECO) — I think is still very, very cloudy. But I also think the long-term opportunity for ground-based vocational schools is quite good, because you don't have that new entrant risk or extra competition risk that you have in the online business.

I think we're more comfortable with Education Management than we are with most of them, given the program breadth, given the different types of vocational schools, the brand, especially the Art Institute, which we think is a great brand. And we think the management team has done a lot more behind the scenes to position themselves for growth, both in revenue and profitability, than the stock would tell you. But we also recognize that until you start to see new enrollments growing for that institution and others in the ground-based business, it's going to be tough for investors to come back to the stock.

TWST: So are valuations relatively inexpensive these days?

Mr. Dobell: Yes. There is always a caveat to that statement, because the stocks can look cheap, but if estimates get reduced, they don't look cheap anymore. But I think for the most part, given the idea that the trough in cash flow should probably be the next 12 months or the next 18 months, you almost have to take a viewpoint that these are like cyclical stocks — like a transportation stock, a trucking stock, a materials or a mining stock — where there is a cycle in the business. Right now, we're in the down part of the cycle, given the economy and given all the regulatory changes and all the execution challenges.

Even on numbers that you consider to be trough earnings numbers, probably calendar 2013 or maybe the middle of 2014, the stocks are pretty cheap. And by cheap, I mean three times to five times EBITDA or under 10 times earnings for a lot of these schools. With exceptions, like American Public and Grand Canyon, those are trading 13 times to 15 times earnings, so on a relative basis they look more expensive than companies who have more execution issues.

On a historical basis, everything looks cheap, but it's a tough comparison to make, because the historical growth and the predictability of growth were much higher than they are right now with most of these stocks. So yes, I think they are undervalued, but at the same time, I recognize why the investors are not jumping into what look like cheap stocks, and it's because the last year or two have proven that even though they look cheap, it doesn't mean the numbers can't go down.

TWST: Has anything stood out for you from the recent quarterly earnings releases?

Mr. Dobell: I guess just the breadth of outcomes. Grand Canyon put up solid new enrollment growth, solid continuing population growth, and raised their guidance by a little bit. That was one end of the spectrum.

At the other end of the spectrum you had DeVry, for example, come out and preannounce a pretty big miss, and then, on the conference call last week talk about revenue enrollment and spending trends that caused a lot of analysts on the Street to push their numbers down. So you have some companies that are growing new enrollments, and then some companies, like DeVry, which, in its core business, starts were down 15%. So the breadth of outcomes is one thing that continues to surprise me. You haven't seen schools narrow in terms of performance.

The second thing is the reactions are still pretty volatile. Even though the interest in the buy side remains pretty low, the reactions on some of these stocks have been pretty volatile. Grand Canyon puts a good quarter up — stock's up 20%, actually 25% at one point. American Public, decent quarter, but on very, very low expectations — stock was up almost 20%. DeVry preannounced a pretty big miss, and we thought expectations were already pretty low — stock’s down 25%. The volatility has remained larger than I thought it would be.

From a fundamental perspective, the thing that sticks out for us is the interplay between population growth and revenue-per-student growth. You are seeing more scholarships and discounting from a number of schools, but you are seeing improving retention at some schools, and those were all factors that really can impact our revenue estimates on a forward basis. But it's still so volatile, and there's not much consistency across the companies, so that trying to say that one data point applies to a number of the stocks is still very difficult to near impossible.

TWST: Are there any other topics important to this industry you’d like to discuss?

Mr. Dobell: Two things that I think are worth mentioning. One, because there is so much regulation in this business, some people ask whether this is a group you want to own if the Republicans take the White House. That it’s an election trade, not only because of the election, but because of what happens in the two or three or four years following the election if the Republicans take the White House. And I would agree with that. I think there is a better chance that this sector just has fewer new headwinds — I don’t think the rules go backwards, but fewer new headwinds — out of the White House if it goes Republican.

But I would also say that, from my perspective, it’s almost more important looking at what the Senate does, because the majority of things that have come out of Congress — both in terms of actual proposed legislation but also just rhetoric and browbeating — have come from the Senate health, education, labor and pensions committee, which is chaired by Senator Harkin from Iowa. If the Senate goes Republican, then one of the biggest criticizers of this group will not have the same pulpit as he has had in the past three years. I think some good things have come out of what they've done, but a lot of it has been so focused on just the for-profits and not the issues in the larger education space that it's seemed to be a little bit ideological as opposed to rational. So the election trade, I think, is important. The election outcome is important.

At the same time, I think there is a lot of good stuff going on at a number of these institutions internally that has not started to show up in growth rates. It will at some point, and the combination of better quality plus growth should return valuations to much higher levels than they are right now. But if we see these schools start to turn their corner on the enrollments and start to turn the corner on profits and the stocks don't react, then I think you will see more activity in terms of consolidation or maybe some companies going private. But you've got to get more certainty on some of the fundamentals, and to a certain extent, more certainty on what the range of outcomes is out of Washington before companies start to take a look at targets or before companies start to think about going private. I think it will happen, but a little more certainty is going to be a big part of that equation.

TWST: Do you have any final words of advice to wrap up?

Mr. Dobell: I think the medium term, let's call the two- to five-year time frame, in this group looks pretty good. It's not great, but relative to what the stocks are trading for now and the sentiment around the stocks from investors, I think the investment opportunity is pretty good.

At the end of the day, these schools generate quality outcomes for their students, meaning the right program at the right price that gets a student the employment that they need or that they want. If those things are all lined up, then I think these businesses will be strong investment opportunities for several years.

If they can't get that equation right, then I think the companies that fall on the wrong side of that equation are going to be in big trouble. So the quality, the ROI back to the student, I think will be a primary determinant of what valuations look like on a go-forward basis, and the schools that do a good job there will be great investment opportunities.

TWST: Thank you. (MN)

Note: Opinions and recommendations are as of 08/13/12.

Brandon Dobell

Partner & Group Head, Global Services

William Blair & Company, L.L.C.

222 W. Adams St.

Chicago, IL 60606

(312) 236-1600

(800) 621-0687 — TOLL FREE

www.williamblair.com

e-mail: info@williamblair.com