Michael Shearn - Strayer Education Write Up

8/12/2019 Michael Shearn - Strayer Education Write Up

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Strayer Education: An In-Depth AnalysisbyMichael ShearnonOctober 17, 2013

The following write-up is taken from the letter to partners of Time Value of Money, LP, datedOctober 17, 2013.

IntroductionThe main reason the fund has underperformed the S&P 500 over the last couple of years is

due to our more than 30 percent allocation in Strayer Education. We first purchased Strayer

for $125 per share toward the end of 2010 and it has since dropped in price to $41.52 per

share at the end of the quarter. Our average cost basis is $69.71 per share.

We believe that it is easier to be patient with an investment holding that declines in price

when one intimately understands the investment holding. From that perspective, we want to

give you our detailed investment thesis on Strayer so you can better understand why wecontinue to allocate a large percentage of the portfolio to this investment.

What is your investment thesis for Strayer and how has it changed over

the years?
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We first began buying Strayer when the for-profit education industry was suffering from

regulatory scrutiny and negative publicity about the value of obtaining a for-profit college

degree. At the time, Senator Tom Harkin (D-Iowa) who heads the Senate Committee on

Health, Education, Labor, and Pensions was investigating the for-profit education industry.

Many students were failing to graduate from for-profit colleges and accumulating debt whichthey could not pay back. In fact, more than half of the students who enrolled in those

colleges in 2008-9 left without a degree or diploma, and half of them lasted less than 4

months.

In addition, during the third quarter of 2010 the Department of Education (DOE) launched its

own investigation of for-profit colleges because they were concerned about the growing

percentage and amount of financial aid that was going to for-profit students. In 2001, only

12.2 percent of DOE program funds (loans and grants) went to for-profit students compared

to 25 percent of funds in 2010, even though for-profit students represented just 10 percent

of all the students the DOE funded over this same period of time. The total amount of Pell

grants (government grants of up to $5,975 to help the neediest students) given to for-profit

students also increased during this period from $1.1 billion in 2000-01 to $7.5 billion in

2009-10. Finally, this small group of for-profit students accounted for over 47 percent of

federal student loan defaults. This was because on average, 22 percent of for-profit

students defaulted on their loans compared to 9 percent of students attending non-profit

universities.

These investigations and the news that followed caused the stock prices of the majority of

the publicly traded for-profit education companies to drop by over 50 percent. At the time,

we believed that Strayer was the proverbial baby being thrown out with the bathwater

because Strayer did not engage in the same practices as its for-profit peers. Most notably,

they did not play the churn and burn game of enrolling as many students as possible

without regard to whether their education would result in better job prospects. For example,

at Bridgepoint Education, an online only for-profit college, enrollment grew from 968

students to 95,000 students from 2005 to 2012 after a private equity firm purchased the

college. By comparison, enrollment at Strayer grew from 27,305 to 49,323 during this same

period. Bridgepoint grew its enrollment rapidly by paying sales commissions to its recruiters,

which motivated them to make false promises to students. In some cases, recruiters told

potential students that they could easily double their salary by attending Bridgepoints online

program without any evidence that its graduates were achieving this outcome.Our confidence in Strayer was further bolstered during the recession, when new student

enrollment actually increased from 2008 to 2010, so we continued to buy the stock as it

declined in price, believing that the regulatory and publicity issues facing the industry would

not impact the fundamental value of Strayer.

Our original thesis about institutional quality was validated during the second quarter of

2013, as the DOE Review Program found nothing materially adverse and required no action


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from Strayer, unlike its for-profit peers who were saddled with various kinds of restrictions.

Even Senator Harkin singled out Strayer in a report, saying, Strayers performance,

measured by student withdrawal and default rates, is one of the best of any company

examined, and it appears that students are faring well at this degree based for-profit

college.Even though our original thesis was correct, we were completely wrong in thinking that

Strayers fundamentals would not deteriorate.

Beginning in 2011, Strayer began to encounter fundamental demand issues and reported

that new student enrollment had declined by over 20 percent. This 20 percent decline

continued for three straight quarters which caused earnings per share to drop from $9.70

per share at the end of 2010 to $5.76 per share at the end of 2012. During this period the

stock price declined from $150 per share to $61 per share. We continued to buy the stock

as it decreased in price because we believed that the decline in new student demand was a

short-term issue, mainly because we saw that enrollments in 2012 had stabilized and had

begun to grow. Then, in 2013, new student enrollment growth turned negative again,

declining 14 percent in the first quarter and 17 percent in the second quarter. This caused

the stock price to drop even further from over $61 per share to $40 per share. The mistake

we made is that we underestimated the length of time it would take for student enrollment to

fully recover.

Our current investment thesis is that Strayer is suffering from a cyclical low which will

reverse in the intermediate future as the high level of unemployment begins to decline,

uncertainty with legislative and regulatory proposals clears up, the economy begins to grow

and consumer confidence increases. At the end of quarter stock price of $41.52 per share,

we believe we are not paying for any upside potential which is why we continue to hold the

stock. Furthermore, we believe that as student enrollment stabilizes and begins to grow that

Strayer is potentially a multi-bagger investment because of its ability to easily double its free

cash flows with small changes in student enrollment growth.

What are the reasons behind the decline in demand in students for

Strayer?Historically, new student enrollment grew predictably at each campus Strayer opened. The

problem in the last two years is student enrollment has actually declined at mature

campuses and slowed at new campuses. We believe the main reason for this decline in

demand is the sustained level of high unemployment and the resulting decreased

confidence in job prospects.

The typical student of a for-profit institution tends to be older and have a family to support. If

they are out of work, they need to be looking for work in order to support their families. The

decision to enroll in school is also not so much about money as it is about investing the


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necessary time to get an undergraduate degree which economic uncertainty makes even

more difficult.

What are the various scenarios for Strayers valuation, specifically in

2013?We believe it is important to think about various scenarios when valuing a business and that

valuation is dynamic rather than static. Although we are optimistic that student enrollment

will grow in the intermediate future, we are also aware that our investment thesis may not

work out and that a different scenario may unfold. It may take more time, for example, for

student enrollment to stabilize and begin to grow. Luckily, Strayers business model allows

us to look out 1 to 2 years ahead, as Strayers new s tudent enrollment in a given year has

always been a good leading indicator of total student enrollment in future years.

Strayers management team provides a financial model to help us understand how changes

in student enrollment impact the bottom line. In managements model for 2013, a 1 percentchange in revenue would have an approximately 50 basis point impact on the operating

margin, resulting in a $0.20 per share change in book earnings. Because we already know

the enrollment numbers for the first three quarters of 2013, we can use the model to predict

what earnings per share will look like using various scenarios in student enrollment for the

final two quarters of 2013. The assumptions we use are that revenue per student averages

$11,400 and at the end of the year Strayer has 10.8 million shares outstanding. The

earnings per share estimate for 2013 under these assumptions ranges from a low of $3.92

per share if student growth declines 20 percent in the fall quarter (compared to the same

quarter in the prior year) to a high of $5.48 per share if student growth increases 10 percentin the next quarter. Using a 10 times earnings multiple for the stock, this would imply that

the stock price would range from a low of $40 per share to $55 per share, compared to an

end of quarter price of $41 per share.

This wide range in earnings per share estimates for 2013 highlights Strayers tremendous

operating leverage. The reason for this is that Strayer has a high fixed cost structure

because it must offer a certain number of classes, regardless of student enrollment

numbers. In other words, it cannot eliminate certain classes that students require to

progress through their degree programs.

What is the catalyst for Strayer?The main catalyst for Strayer will be when the number of new students each semester

stabilizes and begins to grow. The timing of this is difficult to forecast, as is the rate of

growth. For example, in the last three quarters of 2012 new student enrollment grew, but

the new students were not growing as quickly as they shrunk the year before. Full recovery

will be further delayed by the declines in new students in the first two quarters of 2013. By


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the end of this month, when Strayer reports its enrollment growth for the fall term, we will

have a better picture of what earnings are likely to be in the intermediate future. If we

believe student growth is going to be pushed further out than our intermediate horizon, we

will have to think about reducing Strayers allocation in the portfolio.

Why do you believe that demand will return and earnings will improve

in the future?First, we strongly believe that student demand should improve with a decrease in the

unemployment rate. With broadest measures of unemployment currently at 20 to 25

percent, we believe potential students do not have the willingness to invest time and money

in a college degree.

Below is a chart of several unemployment rates including two Bureau of Labor Statistics

(BLS) rates. The lowest, the BLS U-3 unemployment rate, is the one most commonly

reported in news stories. The BLS U-6 rate is broader, and includes short-term discouragedand other marginally-attached workers, as well as those forced to work part-time because

they cannot find full-time employment. The highest rate, published by private publisher

ShadowStats, includes those who have not looked for work for a year or more.

By comparing the trends in these three rates to Strayers new student growth rate we found

many similarities. For example, in the periods where unemployment is relatively stable such


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as from 2001 to 2008, enrollment growth reliably followed the rate at which Strayer was

opening campuses. It was not until 2009, when there was a sharp spike in unemployment

that Strayer began to experience a slowdown in new student growth. As unemployment

begins to stabilize and improve we believe Strayers new student enrollment will begin to

grow.Second, Strayer encountered a similar period of low demand from 2004 to 2006 (we believe

this is similar to the period 2011 to 2013). Most for-profits, including Strayer, grew during the

recessionary period after 2001, looking countercyclical. Then, from 2004 to 2006, as the

economy began to stabilize and improve, new student enrollment growth slowed. By mid to

late 2007 new student enrollment growth began to accelerate once again, producing record

enrollments in the next few years.

Third, the decline in new student enrollments has been broad based for all universities,

colleges, and community colleges, whether they are non-profit or for-profit or even by

program (i.e., declines are not specific to one degree program such as criminal justice or

business). In fact, in 2012 for the first time since statistics have been kept by the National

Student Clearinghouse Research Center, there are fewer students enrolled in all colleges

and universities than the year before (a decline of 1.8 percent in the fall of 2012).

Fourth, we believe that Strayers cost structure is inflated due to its rapid new campus

expansion openings over the last 4 years, but will naturally decrease as these campuses

mature. Over the last 5 years Strayer opened 40 new campuses in markets in which Strayer

does not have an established reputation or academic recognition. To put this in perspective

Strayer currently has 100 campuses compared to 14 campuses in 2001 (majority of

campuses were in the Washington D.C. area). This means that approximately 46 percent of

its campuses have been opened in the last 5 years. As these campuses begin to mature,

they will positively contribute to free cash flows.

According to Strayers management, it takes 6 to 12 months to get a campus up and

running. Strayers new campuses typically have operating losses in the first 2 years, until

they reach 200 to 250 students, at which point the campus begins to break even.

Campuses then grow by 100 students or so each year until they reach full maturity of 1,000

students, typically by the tenth year, generating a 50 percent operating margin.

The length of time to profitability hinges on new student starts. From 2004 to 2010 Strayers

new campuses reached profitability within two years. From the period 2006 to 2008, new

campuses reached profitability in as little as two quarters. Beginning in 2011, newcampuses began to take longer than two years to break even, although this varies by

geography. The new Texas campuses, for example, are reaching profitability within two

years while those in the Midwest (Chicago, Kansas City, St. Louis) are not. New campus

student starts in 2012 and 2013 have been much lower, some as much as 20 to 30 percent

lower. As a result, Strayer is incurring excess expenditures as it takes longer for these new

campuses to break even.


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Fifth, there are many secular trends which should support future growth, albeit at lower

levels than the past. The National Center for Education Statistics (NCES), projects that

student enrollment will grow at a roughly 1.1 percent annual rate, compared to a 2.7 percent

annual rate in the previous 40 years (it is important to note that the NCES often understates

potential growth). There are various drivers for growth such as increasing employer-drivendemand for skilled professionals, increasing employee-driven demand as a result of

potential earnings premium, and increased acceptance of online degrees. The NCES also

projects that students aged 25-44 (typical age of a for-profit student) are expected to

increase 28.1 percent reaching 9.6 million in fall 2020 from 8.1 million in the fall 2009.

Finally, we note that as of 2010, only 30.4 percent of the U.S. population older than 25 has

a bachelors degree. Although this number will never reach 100 percent there is still large

implied long term demand.

Sixth, we believe the ability of students to afford a college education may affect revenues in

the future. Historically, Strayer has been able to increase its tuition 5 percent on an annual

basis. We do not believe that Strayer will be able to increase its tuition in the intermediate

future at similar rates, which will contribute to lower revenues per student. In fact, in 2013

Strayer froze the tuition for all current students through 2014 and has also offered new

scholarship programs which discount tuition as much as 40 percent. We dont believe that

these tuition discounts will persist for the next 10 years but do believe in the next 1 to 3 year

period they will persist; at least until the unemployment rate drops to more normalized

levels. One silver lining is that students applying to for-profit schools are more interested in

future career opportunities than cost.

There is hidden value in the recently acquired Jack Welch Management

InstituteRegardless of which scenario unfolds, we believe there is hidden value in the recently

acquired Jack Welch Management Institute which continues to have strong ties to former

CEO of General Electric Jack Welch. In addition to his involvement with the school, Welch

contributed about 30 percent to the purchase price, so he is also invested along with

Strayer. We believe the Jack Welch Executive MBA program serves as a great brand

builder for Strayers other programs since it increases the knowledge and awareness of

Strayer University in those organizations that typically hire undergraduates and graduate

students from Strayer.

Strayer is currently growing the Jack Welch Executive MBA program with a goal of enrolling

5,000 students in the next 5 years. A relatively new degree program, it had over 500

students this fall. If they are successful in meeting this goal, this program could be

potentially worth $100 million on a net present value basis, or about 20 percent of the end of

quarter market capitalization of Strayer. This is not counting any value from the Jack Welch


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Way Management Training business which is a non-degree corporate and management

training business, which should grow in size as corporate training budgets are increased.

The $100 million valuation was calculated as follows: 5,000 graduate students (70 percent

of the students in 2011 funded the education themselves) paying $36,000 (current tuition

from Strayers website) over a two year period translates to $90 million in revenue per year.At a two times revenue multiple five years from today, this means that the Jack Welch

program would be worth $180 million. If we then discount the $180 million using a 10

percent discount rate over a five year period this results in a $100 million net present value.

Understanding Strayer from the Customer PerspectiveOne of the most difficult and important things to do in investing is to view a business from

the customer perspective instead of ones own perspective. We believe most investors

misunderstand Strayer because they dont understand why a student would attend Strayer

when there are other universities with better reputations (such as those they attended). By

viewing the school through the perspective of its students, we can avoid making

assumptions about the reputation of the degree, and gain some insight into why students

choose this route.

What type of student attends Strayer University?Strayers students are typically working adults (average age is 35 and two-thirds are female)

who are returning to school to advance their careers. These working adults are usually

called non-traditional students, which means that they are generally older than average,

have dependents other than a spouse, and are independent of their parents. They may

have delayed college, and may be attending part-time or working full-time while enrolled.The reason they prefer Strayer to other universities is that these students want to be sitting

in a classroom with other 35 year olds like them.

Of the students enrolled in Strayer at the beginning of 2012s fall quarter, 66 percent were

age 31 or older and approximately 69 percent of students reporting were minorities (47

percent African American, 18 percent other ethnicities, 4 percent Hispanic) and 31 percent

were white. Most of Strayers students are part-time (86 percent), typically taking two

classes per semester. 3 percent are active duty military, 1 percent are international

students, and 7 percent of students are currently unemployed.

Where do the students come from (by type)?Students come from a variety of places. Below is a breakdown of sources of students:

25 percent come from corporate and government institutional relationships

20 percent of new students come from community college partners

20-25 percent are media generated/pay per lead otherwise known as non-affiliated students


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20 to 25 percent are referred by current and previous Strayer students (source is student

surveys)

Although there is overlap with the categories above, we also have the following data on

students:

10 percent are military which includes active duty, veterans, GI Bill and Yellow Ribbonprograms

10 percent are online only

Lets examine the three sources that account for the largest percentage of students in more

depth:

Corporate and government institution (25 percent of students)

Students from national accounts (corporate and institutional) represent about 25 percent of

the student body. These are students that come from corporations or government

institutions that have an established relationship with Strayer, such as Starbucks, United

States Postal Service, American Express, and FedEx. These employers typically reimburse15 to 20 percent of the tuition. This is the most valuable student for Strayer because

corporate sponsored students tend to graduate at a higher rate due to the affirmation from

their place of employment. We believe as the economy recovers and labor markets tighten,

employee sponsored tuition reimbursement programs will increase, potentially boosting

enrollment growth rates.

Community college partners (20 percent of students)

Strayer has articulation agreements with more than 200 community colleges, including nine

statewide compacts covering 1,000 colleges and campuses throughout the United States

whereby credits transfer from the community college to Strayer. Strayers students who

enroll after getting their community college associates degree tend to graduate at a higher

rate. As a result of this, Strayers management does not view community colleges as

competition and even allows local community colleges to utilize Strayers campuses during

the day free of charge (Strayers campuses are mostly used at night).

Non-affiliated students (20 to 25 percent of students)

Non-affiliated students tend to come from media generated leads, or those who heard an

advertising message from Strayer and enrolled. These are the students with the largest

current drop in demand. The non-affiliated student has the lowest graduation rate,

averaging 15 percent, because most of these students need developmental courses (extra

coursework just to be ready for college credit courses). They also typically have zero to

limited transfer credits or college experience.

It is important to point out that Strayer does not have a lot of exposure to student leads

purchased from third party lead generation firms, which we estimate to represent 10-15

percent of Strayers non-affiliated student base. This lowers the risk for Strayer because

higher exposure to third-party leads results in less control of student flow. For example,


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Apollo Group (University of Phoenix) has little control over the type and volume of students

because more than 60 percent of its enrollment is from third party lead generation firms.

Where do the students come from (by geography)?Strayer students are mainly from the eastern U.S. (source: NCES College Navigator, Fall

2011 data):

Virginia 22 percent

Georgia 13 percent

North Carolina 9.7 percent

Maryland 9.0 percent

Global Online 8.7 percent

Florida 7.3 percent

Pennsylvania 5.9 percent

South Carolina 5.0 percent Tennessee 4.9 percent

D.C. 3.9 percent

Ohio 2.2 percent

Alabama 2.2 percent

Texas 1.7 percent

What is the experience like for the average student at Strayer?The overriding goal of Strayer is workforce preparation. Strayer offers coursework that

graduates can apply immediately in their professional fields. Strayer offers a practical set ofacademic majors with 70 percent of students majoring in business or accounting, 15

percent majoring in information systems programs, and 7 percent majoring in criminal

justice. Strayer uses a combination of classroom learning and online learning which allows it

to reach more students and also allows students to choose the learning mode that is most

effective for them. Having the option of taking a class online gives many students more

flexibility. In any given quarter (11 weeks long), 55 percent of campus-based students will

be taking their courses online but this number can change as students decide to go back

and forth between the on-ground campus and online modality. In 2012, roughly 30 percent

of students in a given semester took all of their courses online (this is true for the last 5years, even though 90 percent live near a campus). In 2012, about 20 percent of students

took all of their courses in a physical classroom. Classes at physical locations typically meet

once a week (4.5 hours one night a week) for ten weeks then have one week for exams.

That leaves the remaining 50 percent of students who take a combination of both online and

physical classroom courses.


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We believe the physical campuses give Strayer a competitive advantage over online only

schools, because we do not believe that online education will fully replace classroom-based

learning. In an online modality there is limited peer to peer and faculty interactions which

are key ingredients in education.

What percentage of students graduate?On average, students at Strayer take about 6 years to receive their bachelors degree.

Because it is such a huge undertaking, many students drop out of Strayer. Management

recently reported Strayers graduation rates during a second quarter 2013 conference call.

Graduate students, who represent 30 percent of students, have the highest graduation rates

which range from mid-60 percent to 70 percent. Undergraduate students, which represent

65 percent to 70 percent of students, have lower graduation rates which range from 15

percent to 55 percent, depending on the number of transfer credits they bring in. For

example, if a student comes in with a year or more of college credit (which represents

approximately 40 percent of new students), their graduation rate within 6 years is in the 50

to 55 percent range. As a student brings in fewer transfer credits this begins to drop, falling

to 15 percent for students who have no transfer credit whatsoever. On a fully blended basis

for both masters and bachelors students the graduation rate is 40 percent which compares

favorably to the average at for-profit schools of 32 percent. For means of comparison the

average graduation rate at public not-for-profit schools, such as UT Austin, is 56 percent

and at private not-for-profit schools, such as Harvard, it is 65 percent (source: National

Center for Education Statistics).

How does Strayers tuition compare to other universities?To attend Strayer, or any other university for that matter, requires a big financial

commitment. If you think about it, college tuition is probably the second or third largest

purchase people make in their lives, with home mortgages being the largest. As a result,

cost is a big factor for a student when considering attending a for-profit institution. Recently,

affordability has become a larger issue as potential students consider whether they can pay

loans back or benefit financially from the education they receive. In essence, college price

tags cant outrun the gain students expect from increased salaries after graduation. In fact,

one of the big risks to Strayer in the future is rising interest rates, which would increase the

cost of attending Strayer, and might affect enrollment. For example, a 1 percent increase in

rates will lead to a 5 percent increase in monthly loan payments on a 10-year loan and a 9

percent increase on a 20-year loan.

At Strayer the total cost for a bachelors degree in Business Administration is $72,400, a

masters degree in Business Administration is $28,820 and an associates business degree

is $36,500. The best way to put this cost in perspective is to compare it to other for-profit

colleges, community colleges and non-profit colleges on a per credit hour basis. For


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example, Strayers part-time undergraduate tuition rates for 2012 averaged $394 per credit

hour (if you include discounts it is $367 for 2012). In the for-profit industry (which represents

30 colleges) Strayers tuition stands in the middle of the pack. The lowest cost per credit

hour in the for-profit industry is at American Public Education (APEI) which primarily serves

military students and charges $225 per credit hour. The highest is the University of Phoenixwhich charges $585 per credit hour.

Tuition rates per credit hour at community colleges (such as El Paso Community College)

are typically $154 which are the lowest because most of the costs are subsidized by the

government. At public non-profit schools (such as UT Austin) the tuition ranges from $200

to $250 per credit hour. The highest tuition rates tend to be at private non-profit schools

(such as Princeton) which can charge in excess of $1,500 per credit hour.

How does Strayer meet our investment criteria?We continue to believe Strayer is a compound machine rather than an opportunistic

investment. The reason for this is that Strayer has high organic growth opportunities with

the potential to grow both the number of students at its existing campuses and a long

runway to open new campuses in new geographic locations. The average number of

students at existing campuses is 508 as of the end of 2012, compared to 1,000 for a mature

campus. We believe as Strayer gains more brand recognition and its referral network

grows, the number of students at existing campuses will continue to increase.

Strayer also has the ability to double the size of its campus footprint as it currently has

campuses in only 24 states. It is interesting to note that out of the top 50 MSAs

(Metropolitan Statistical Area) Strayer currently operates in 30 of them, leaving 20 of the top

50 MSAs in which it can expand, including such cities as Boston, San Francisco, Phoenix,Detroit, Seattle, and Minneapolis.

Strayer has historically generated a high return on invested capital (calculated using net

operating profit after tax divided by average invested capital) which has exceeded 40

percent for the last 4 years (2012: 42.4 percent; 2011: 68.5 percent; 2010: 62 percent;

2009: 45.6 percent).

Another necessary ingredient for a compound machine is a management team with strong

capital allocation skills. We believe Strayers Executive Chairman Robert Silberman has

historically shown strong capital allocation skills, such as buying back stock at opportunistic

prices, growing in a disciplined manner, and making a home-run acquisition. Lets reviewthese capital allocation decisions in more depth.

Strayers management team historically has only repurchased stock when it believes the

stock price is undervalued. For example, in 2011 it repurchased 1.58 million shares for

$202.7 million (average stock price of $128.15 per share) because at the time the dividend

yield on the stock exceeded 4 percent and Strayer was able to borrow funds at 3.1 percent

to help finance these repurchases, thus profiting from this spread. From 2003 to 2012,


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Strayers management team repurchased 5.2 million shares for a total of $683 million

(average price $131.25). Interestingly, this total exceeds Strayers end of quarter stock

market valuation by 1.6 times. Even though managements historical stock repurchases

dont look opportunistic today, we believe when the cycle turns they will have added a lot of

value. For example, had management not made these share repurchases then earnings pershare would be lower by 20 percent today. We are concerned, though, that management

did not repurchase any stock during the second quarter of 2013, even though Strayer had

the available cash balance and had previously been buying back 5 percent of shares

outstanding each quarter.

Another concern is that Executive Chairman Robert Silberman has a strong track record of

being a good capital allocator but he has not been buying stock with his personal money.

Since 2004, Silberman has received cash proceeds from option sales of Strayer stock of

$77 million (after 35 percent tax this would net $50 million). In other words, he has plenty of

capital to buy the stock.

Strayers management team follows a disciplined growth strategy in which it sets its new

campus growth rate on the availability of its human talent (the number of people it has to

staff a new campus with) so that it can ensure a high level of academic quality. Strayer also

grows in geographically contiguous markets (e.g., first opening campuses in Louisiana and

then Texas) so that it always has the ability to access talent in markets that are close by. As

of 2013, Strayers management team said they will not be adding any new campuses until

they believe they have the ability to predict growth in enrollment.

The only acquisition made under the current managements tenure is the Jack Welch

Institute, which Strayer paid $9.1 million for in December 27, 2011. This acquisition appears

to be a home-run as Strayer has successfully increased the number of students from fewer

than 35 when it acquired the Institute to more than 536 students as of October 2013. As we

previously mentioned, we believe this acquisition has the potential to be worth over $100

million on a net present value basis.

The product is good for the customerOne of the key questions we ask when evaluating a business is whether the product or

service is good for the customer. A college education is still the greatest enabler of social

mobility in the United States and continues to be on a relative basis the single most

important predictor of economic success. According to the Bureau of Labor Statistics thenumber of jobs requiring postsecondary education increased from one-third of the overall

labor market in the 1970s to two-thirds today. Consider the significant impact that the most

recent recession had on job prospects for those without undergraduate degrees. According

to the Bureau of Labor Statistics, unemployment rates in 2012 for those without a college

degree were four times higher than for those individuals with a degree.


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The primary purpose of a for-profit college is to give students the support and tools they

need to learn and secure a degree that is valued in the job marketplace. In other words,

colleges should be providing students with relevant, practical skill sets that employers are

willing to pay a higher salary to attract. The best way to measure if a for-profit college is

succeeding in this effort is to examine the income a student generates before they earn afor-profit college degree and the earnings they make after they graduate. The average

student at Strayer comes in with an annual salary in the high $20,000 to low $30,000 range.

Strayer graduates have salaries ranging from $50,000 to $60,000 (higher salary is typically

a masters degree holder and keep in mind that 60 percent of students drop out so these

figures are for graduates only). The median debt for a Strayer student to acquire this degree

is $22,000 (lower than full tuition because many students transfer in with college credit). We

believe it is important to point out that on the Department of Education website the median

debt for a Strayer student to acquire a degree is shown as $31,000 versus $22,000. The

main reason for the difference is that the DOEs data includes living expenses which they

believe should be included in order to represent the true cost of an education.

The management team is customer orientedCustomers are the lifeblood of a business so it is critical that a management team has a

customers best interests in mind. Strayer is a student -focused university where the

management team is focused on the quality of education first rather than on maximizing the

short-term profitability of the business. Strayers management team clearly understands that

the value of Strayer is directly correlated with the quality of education it gives its students.

As Executive Chairman of Strayer Robert Silberman says, If you are going to have a

successful business, first you have to have a successful university.The way the management team ensures that it places the interest of its students

(customers) first is as follows:

First, the management team operates the university through a unique bifurcated

management structure. This serves Strayers dual mission of maintaining success as an

academic institution while also being an effective steward of shareholders capital. What this

means is that there are two leaders that run the university, a campus dean and a campus

director. The campus dean is responsible for all academic elements such as hiring the

faculty, scheduling the classes, and coordinating the delivery of the various academic

support services like advising and tutoring. Missing from this job description is responsibilityfor the profit and loss statement. Instead, this responsibility falls on the campus director who

is in charge of managing the enrollment process such as the financial aid application

process, corporate reimbursement process, and facility management. The main advantage

of this dual leadership structure is that it allows the campus dean to make decisions that are

in the best interests of students, without having to worry if the decision is profitable to the

university.


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Second, Strayer has an independent board of trustees that oversees the academic quality

of Strayers classes and makes sure that Strayer upholds high standards. The independent

trustees have staggered terms and serve a longer term than other trustees affiliated with

Strayer. Only independent trustees can make nominations for replacement to the main

board of trustees. Current independent trustees include the founding Chief Executive Officerof the Community College of the District of Columbia, the former President of Central Penn

College, and the former Vice Chancellor for Academic Affairs at State University of New

York.

Third, Strayers management recently raised the standards for developmental students

(those who have not yet passed English and math exams) by restricting their enrollment in

online classes. Additionally, if students fail these tests more than once, they are disenrolled

from the university. What is noteworthy about this action is that it will hurt enrollment growth

in the near future at a time when enrollment growth is already suffering. Therefore,

management has demonstrated that it is avoiding the temptation to lower standards as a

way of increasing new student numbers. Strayer is supplementing this stricter admissions

standard by requiring that faculty who teach developmental classes to spend the vast

majority of their class time working in small groups instead of lecturing. Strayer is also

offering free unlimited advising and tutoring to help students pass these developmental

courses.

Fourth, admissions officers have never been compensated on the number of students they

bring in and therefore are not salespeople as compared to other for-profit competitors. In

fact, this practice has caused most of the problems in the for-profit education industry. This

incentive structure created a boiler-room atmosphere where hitting an enrollment quota was

a recruiters highest priority. This practice was eventually banned by the Department of

Education in mid-2011. Strayer employs fewer recruiters which it calls academic advisors

compared to other for-profit colleges. Strayer has one recruiter for every 154 students,

whereas the industry average is one recruiter for every 53 students.

Fifth, Strayers marketing strategy (the way it spends its advertising dollars) is geared

towards allowing a potential student to self select into Strayer instead of actively convincing

students to enroll.

Sixth, Strayer employs more student service representatives per student than any other for-

profit college, which has played a significant role in the success of its students. Student

services staff assist with tutoring and library resources, career services and the like. In2010, each student services staffer was responsible for 125 students. Contrast this to for-

profit competitors who typically employ 1 student services staffer for every 200 students. In

fact, Strayer employs more career counselors per student than any of its for-profit

competitors. These staffers help students with resume writing, career exploration, and

employer networking. In 2010, each career counselor at Strayer was responsible for 368

students whereas at for-profit competitor Apollo Group (University of Phoenix) there are no


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career services employees. Bridgepoint has only 1 career services employee. The closest

competitor is DeVry which has one career counselor for every 557 students.

Seventh, there are some recent technological innovations that Strayer is beginning to

implement which should help it with its student retention and satisfaction rate. Strayers

management is now better able to predict which students need help, which students will fail,and which students are doing well in classes by the 8th day of the academic term. This will

allow Strayer to step in early and help students graduate.

Eighth, Strayers management is committed to creating a hassle-free experience for its

students outside of the classroom. Their goal is to be easy to do business with. The thinking

behind this is that the students have already committed an enormous amount of time to the

academic program, so Strayer makes the other elements, such as enrolling for classes or

financial aid, easy to manage.

Strayers management team has good relationships with employees

A business cannot execute its strategies if its employees have not bought into the culture of

the business. We believe the top management team at Strayer has created a strong culture.

First, management only promotes employees from within, which ensures that employees

have a strong belief in Strayers core values. Second, Strayer operates a flat organization

(i.e., no bureaucracy) with only 2 layers of regional managers for 100 campuses. For

example, a campus director reports to one Regional Vice President and then to the CEO.

Finally, Strayer has extremely low employee turnover for academic and administrative staff.

The senior management team has a long tenure at the business and is relatively young

Managements long tenure at a business often helps limit the risk that a management team

will fail in executing its strategies. The bullets below show the age and tenure that eachsenior manager has at Strayer:

Executive Chairman Robert Silberman (age 55) since 2001

CEO Karl McDonnell (age 46) since 2006

President of Strayer University Dr. Michael Plater (age 56) since March 2010

Chief Financial Officer Mark Brown (age 53) since 2001

Chief Administrative Officer Kelly Bozarth (age 44) since 2008

Provost Randi Reich Cosentino (age 39) since 2001

Other ways Strayer meets our criteria The bench strength of employees needed to open new campuses is improving and this will

allow Strayer to open campuses at a faster rate in the future when the economy improves.

Over the last three years Strayers management team has eliminated many discretionary

expenses.


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As of 2013 there are not any underperforming campuses or any markets where there are

too many campuses.

Free cash flows continue to be strong. In the first six months of 2013 free cash flows were

$41.4 million which represents a 10 percent free cash flow yield at the end of quarter stock

price.

Historically, Strayer has generated significant amounts of free cash flow. The evidence for

this is the taxes it has paid to the IRS in recent years. In 2010, Strayer wrote a check for

$85 million which implies $214 million in taxable income using a 39.5 percent tax rate. In

2011, Strayer paid $65 million which implies $163 million in taxable income. In 2012, they

paid $44 million which implies $110 million in taxable income.

Conservative balance sheet. As of the end of 2012 there is a $125 million term loan facility

that has a fixed interest rate of 3.1 percent. This loan matures December 31, 2016 and the

covenants are that the leverage ratios not exceed 2.0:1.0 with a coverage ratio of not lessthan 1.75:1.00, which Strayer meets even if free cash flows were to drop by 80 percent from

2012 levels.

Strayer has limited competitionA few Wall Street analysts have been reporting that the recent decline in student demand at

for-profit universities is due to increased competition from non-profit universities, such as

Arizona State University or Duke University, which have both started new online programs.

They suggest that enrollments in these online programs have been growing rapidly by

taking students away from for-profit universities. We do not agree with this assessment for

the following reasons:

First, the rapid growth in the online programs at non-profit universities such as Arizona

State has been from existing students who are already enrolled at the university. These

existing students are basically choosing to take some of their courses online.

Second, when a student leaves a university for another university they must transfer their

transcript. As a result, Strayer knows where its students are going when they leave the

university. The management team recently reported that Strayer students have not been

transferring to non-profit competitors.

Third, many non-profit universities have attempted to target for-profit students in the past,

with limited success. Universities such as Drexel and the University of Massachusettsrecently failed in offering online programs for working adult students. The fact is that

working adult students (average age 30 and above) and traditional college students

(average age of 18 to 25) are very different and have different needs. One of the reasons

that for-profit education came about was because most non-profit universities

could not serve the needs of working adults. Non-profit universities have a difficult time

tailoring their academic curriculum to the needs of corporations in the area. Another


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challenge that traditional universities face is tenured faculty (often in charge of hiring other

faculty) who are typically reluctant to fully utilize adjunct or contract faculty at the university.

Fourth, there is substantial evidence that Strayer can succeed even in markets saturated

with traditional universities that have successful night and extension programs. In Maryland,

Strayer successfully competes with the University of Maryland which has one of the mostsuccessful working-adult focused extension programs.

Fifth, many analysts believe that in the future Strayer will face more competition from

MOOCs (Massive Open Online Courses). We believe that the notion of not going to school

and instead completing a MOOC is akin to telling somebody to just read a textbook.

MOOCs cannot replace the student support, study groups that are needed to ensure

successful academic outcomes. Further evidence is that the completion rates on these

courses are extremely low, often averaging less than 1 percent. MOOCs in general also

cannot replace the accredited credential, making the effect of a MOOC on employability

low. In other words, employers are not likely to give a job promotion to an employee who

has completed a series of MOOCs.

Regulatory environmentOver the last 2 years, there have been a lot of regulatory issues that have contributed to

Strayerslow stock price and have also distracted the senior management team from

focusing on the core business. These regulatory issues include the reauthorization of the

law governing federal student grants and loans, new rulemaking proposals from the

Department of Education (DOE), and a recent White House proposal to promote a college

rating system. Educational spending has become a big issue because according to the

Consumer Finance Protection Bureau, the cumulative student loan debt (from both federaland private sources) has crossed the $1 trillion threshold making it the largest component of

debt in the U.S., surpassing auto loans at $730 billion and credit cards at $693 billion. The

for-profit industry has been singled out because according to the U.S. Department of

Education data, 96 percent of for-profit students take out student loans compared to 13

percent of students at community colleges, 48 percent at 4-year public schools, and 57

percent at 4-year private non-profit colleges.

We want to give you a better understanding of what regulatory issues Strayer is facing and

more importantly the impact they have on Strayers business.

Loan fundingSome investors are concerned that the for-profit industry may face government cuts to

funding for student loans, otherwise known as Title IV loans. The reality is that the

government (through the Department of Education) is not cutting access to loans but

instead is attempting to raise the bar for outcomes at schools where federal loan dollars are

going.


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We do not believe that the government will ever cut student loans because we believe that

Title IV lending may actually be a profit center, or at least does not operate at a large loss

for the U.S. government. The overall default rate on Title IV loans is around 14 to 16

percent on average, which means 85 percent of loans get repaid. Meanwhile, the U.S.

government earns interest on these loans and can borrow at extremely low rates. Also, theDepartment of Education and Congress are intensely interested in producing more U.S.

college graduates, not fewer. In fact, the Secretary of Education recently stated in August

2013 that the North Star guiding the DOE was to lead the world in college graduation.

Gainful employment standardsOne of the best ways to understand if a for-profit college degree is helping its graduates

gain meaningful changes in salary is to look at the gainful employment data. This measures

the earnings of graduates of for-profit universities and compares those earnings to the debt

level the graduates incurred to finance their education.

Proposed in 2010 and released in 2011, the DOE attempted to establish three new rules to

determine whether a for-profit university could access Title IV funding based on gainful

employment standards:

35 percent of former students must be in satisfactory repayment status three to four years

after entering repayment, meaning their loan balances declined by at least $1.00 over the

course of the year.

Loan payments each year should not exceed 30 percent of discretionary income in the third

or fourth year after graduation.

Loan payments each year should not exceed 12 percent of annual earnings in the third or

fourth year after graduation.

The first rule was tossed out by a federal court in 2012, but the DOE has subsequently

announced a new round of negotiated rule-making, with new draft standards to consider.

We believe Strayer will be able to comply with the old standards as well as the new

proposed rules which are less aggressive in some ways than those proposed in 2010.

Default ratesCongress, the Department of Education and the White House are also targeting colleges

with high loan default rates. To measure default rates, regulators take a group of students in

one year and simply follow the same students, noting the percentage in default after a

certain time period. Regulators are currently transitioning from calculating the number of

defaults over a two-year period to a more representative three-year period. Colleges

currently can lose funding if their two-year default rates exceed 25 percent for 3 consecutive

years or if they exceed 40 percent in one year.

The three-year default rate of all 30 for-profit colleges examined by Senator Harkin

increased each fiscal year between 2005 and 2008 from 17.1 percent to 22.6 percent.


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Although Strayers 3-year default rate has gradually increased over the last 4 years,

growing from 9.4 percent for students entering repayment in 2005 to 12.8 percent for

students entering repayment in 2008, overall, Strayers default rate is far below the 22.3

percent average 3-year default rate for the for-profit education sector and closely tracks the

default rate for all schools (includes non-profit universities).

Pell Grant fundingPell Grants (government grants of up to $5,645 to help the neediest students) are the single

largest source of federal grant aid supporting postsecondary education students. The

program provided over $35.7 billion to approximately 9.7 million undergraduate students in

2011, with grants to students attending for-profit schools making up 22 percent of

distributions in the 2011-2012 school year. For-profit providers receive a relatively greater

amount of Pell Grant dollars, because they generally cater to a lower-income student when

compared to non-profit peers. Strayer generated 17 percent of its revenues from Pell Grants

in 2012, up from 7 percent in 2007, so a cut in Pell Grants could negatively impact Strayer.

Interestingly, when Executive Chairman of Strayer Robert Silberman was asked about the

risk of the government cutting Pell Grants he said in a first quarter 2011 conference call,

We are not concerned about Pell Grants as a source driving students towards Strayer

University. We find that the more the students have invested in their own education the

more likely it is that the student is going to be successful. Were not concerned about that

being lowered. As a matter of fact, were frankly mildly in favor of that.

Post 9/11 GI bill and Department of Defense tuition assistance

For-profit universities receive the largest share of military educational benefits. Thesebenefits are always at risk of being cut. As of 2012, 37 percent of post-9/11 GI bill benefits

and 50 percent of Department of Defense tuition assistance benefits went to for-profits. In

fact, Strayer is one of the top 10 recipients of post-9/11 GI bill funds because 10 percent of

its students are affiliated with the military (includes active duty, veterans, GI Bill and Yellow

Ribbon Programs). Revenue received from the Department of Defense and Veterans Affairs

education programs accounted for 7.1 percent of Strayers revenue in 2010 (latest data

available).

Prohibiting federal funds from being used for marketingSenator Harkins committee recommends prohibiting institutions from funding marketing,

advertising, and recruiting activities with federal financial aid dollars. Strayer currently

allocates 17.5 percent of its 2012 revenue to marketing, advertising and recruiting activities

and generates close to 25 percent of its revenue from non-federal financial aid dollars, so

even if this proposal were to pass, Strayer would be able to meet this regulatory standard.

The Harkin committee found that for-profits on average spent 22.7 percent of revenues on


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marketing alone. Strayers total sales and marketing costs are lower than its other for-profit

peers because Strayer has a higher exposure to corporate alliance students and community

college students.

Raising threshold of non-federal revenues from 10 percent to 15 percentSenator Harkins committee also recommends requiring that for-profit colleges receive at

least 15 percent of revenues from sources other than federal funds. In 2011, Strayer

reported 76 percent of revenue from Title IV financial aid programs. We believe Strayer will

be able to comply with this rule because 25 percent of Strayers students receive tuition

help from their employers or associations, which is a great source of non-federal financial

aid revenue.

Michael Shearn - Strayer Education Write Up

Documents