Stay Away From For-Profit College Stocks

Few sectors have been surrounded by more controversy than for-profit colleges.  I'm sure you've heard of the cheating scandals, high student-loan default rates, and "boiler-room" tactics used by recruiters to entice students to enroll.  

For-profit college stocks have plunged in the wake of government investigations and recently released regulations aimed at curbing student-loan abuses.  Among the seven stocks in the for-profit education sector with market caps greater than $1 billion, prices have fallen an average of more than 40% from their all-time highs.  

But these sharp price declines have many asking whether it's time to jump back into these stocks based on depressed valuations.  The average p/e ratio for these seven stocks is 12.1 compared to 14.3 for the S&P 500 index.

Sentiment surrounding these stocks has taken on a skeptical tint as well.  Analysts have cooled toward these former growth stocks, with fewer than half now recommending them as a buy.  That makes the for-profit education sector one of the least-loved among analysts.  

Today these stocks still have attractive p/e ratios amid a negative sentiment backdrop.  For some value investors, this may be incorrectly interpreted as time to buy.

The problem with these supposed value plays is that if you focus only on p/e, these stocks may appear cheap. But a true value investment is more than just a low p/e.  You need predictable and consistent cash flow, a diversified revenue base, and – perhaps most of all – no controversy.  It's on those measures that the for-profits come up short.

Before I go on, I want to make it clear that I'm not here to bash higher education.   Even for-profit schools have a place in providing post secondary education. These institutions fill a valuable need for those looking to improve their professional skill sets.  

Part of the rising demand for these schools came from those with degrees who wanted to learn new skills to enhance their chances for landing another job.   Even those lucky enough to be employed knew that adding to their resumes gave them a better shot at just keeping their current job.  

These days, having a college degree isn't a guarantee of professional success.  In fact, a recent New York Times article pointed out that "a college degree is no longer the guarantor of a middle-class existence."  

But not having a college degree can mean  giving up the chance of nailing down a decent-paying job.  And with the job market tight (the unemployment rate may be headed lower, but no one is comfortable with 8.6 percent), a degree is almost a necessity.  Maybe that's partly why enrollment at for-profits soared 236 percent compared to less than 25 percent at public and private universities from 1998 to 2008.

Unfortunately, though, this new demand has resulted in unscrupulous methods aimed at swelling the enrollment ranks to increase revenue.   The problem is straightforward: these colleges derive most of their revenue (some estimate as high as 90%) from government-backed education loans that are relatively easy to obtain.  And that creates an environment ripe for abuse.

Government investigations have found that unqualified students have frequently been lured into these schools with promises of federal loans and good-paying jobs after graduation.   Some  recruiters were even paid based on how many students they enrolled, a violation of the federal law.  

Many students were poorly prepared and found jobs that paid far less than they were led to believe. That is, if they were lucky enough to find a job at all.  Many also left these schools burdened by staggering debt loads that they were unable to repay.   

The statistics are alarming.  According to the U.S. Department of Education, "students at for-profit institutions represent 12 percent of all higher education students, 26 percent of all student loans and 46 percent of all student loan dollars in default."  

Government scrutiny on the industry is intense, as Congress is wary of any loan program that ends up costing taxpayers in the end.  It's never a good thing when the Government Accountability Office puts out a report entitled, "For-Profit Colleges: Undercover Testing Finds Colleges Encouraged Fraud and Engaged in Deceptive and Questionable Marketing Practices."  

In August, the Justice Department filed a multibillion-dollar lawsuit against Education Management Corp. (NASDAQ:EDMC), the nation's second-largest for-profit college company (150,000 student enrolled in 105 schools), charging that it was not eligible for any of the $11 billion in state and federal aid it received from 2003 through June 2011.  The suit alleges the company had a "boiler-room style sales culture" in which recruiters used high-pressure sales tactics and inflated employment claims to enroll unqualified students.  

EDMC is not alone.  In 2009, Apollo Group, the largest for-profit college company and parent of the University of Phoenix, settled a whistle-blower lawsuit for $78 million.  That case involved paying recruiters for students, alleging tactics similar to those cited in the EDMC suit.

Despite the serious issues swirling around the for-profit education sector, the question for investors is whether these stocks make a good investment now based on low valuations and negative sentiment.  After all, the sector has staged an impressive comeback off its 2011 lows.

While a good deal of negative publicity is likely already priced into these stocks, the controversies and investigations surrounding these companies are far from over.  

In June, the government issued regulations that tied federal aid to "gainful employment" based on the size of student debt and the percentage of students paying back their loans.  Critics from both sides have attacked the rules (hardly a surprise there), which go into effect next year.  

The for-profit side claims the rules are cumbersome and punitive.  Furthermore, some claim that the rule-making unduly benefited short sellers and public universities that stood to gain from added pressure on the for-profit industry.

But others claim the rules were watered down under intense pressure from the for-profit lobby.   Changes in the initial rules allow colleges more ways and extra time to meet benchmarks, thereby reducing the number of programs penalized by the rules.  

The bottom line is that future regulation is far from settled.  Investigations aimed at illegal recruiting, grading practices and employment shortfalls will continue.  

And let's face it.  An overly indebted nation does not look kindly on an industry benefiting from a system that produces high default rates on government loans. Remember all those subprime loans that Fannie Mae and Freddie Mac absorbed? Taxpayers don't want or deserve to pick up the tab for the for-profit education industry's excesses.

Can the industry clean up its act?  Sure it can.  In fact, Robert Silberman, the chairman and CEO of Strayer Education Inc. (NASDAQ:STRA), says that the for-profits should share in the losses when a student defaults.  Furthermore, he welcomes a national eligibility test to screen out applicants who lack the necessary skills to attend college.  

But this is an industry facing far too many headwinds today.  Low valuations can always go lower, especially when high revenue growth and big profit margins change to substantial losses.  Negative sentiment can always get more negative.  And government investigations tend to breed more investigations and future lawsuits.  

Don't be tempted by low prices.  They're low for a reason, and I suggest even value investors avoid the sector until it cleans up its act.