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Education stocks have been hit especially hard in recent months, thanks primarily to increased regulatory scrutiny. Many companies in the for-profit education sector have been criticized in Congress for allegedly providing students with poor educations while saddling them with excessive debt. New regulations are intended to improve the Education Department’s ability to monitor schools. However, costs associated with implementing these new rules could hurt margins and profits for many operators.

A report by Education Trust, an education advocacy group, indicated that the median debt level for bachelor’s degree recipients at for-profit colleges is more than $31,000, compared with roughly $8,000 at public institutions and $17,000 at private non-profit colleges. In addition, only 22% of first-time, full-time students seeking bachelors degrees graduate from for profit-colleges within six years, compared to 55% at public colleges and 65% at private universities. The loan repayment rate is only 36% at for-profits, compared to 54% at public universities and 56% at private schools. Hence, the need for some type of reform and regulation is clearly evident in lawmakers’ eyes.

As a result of this situation, the U.S. Education Department is seeking to restrict funding of for-profit schools whose graduates have poor records of repaying their student loans. Some of these institutions get up to 90% of their revenues from federal grants and loans, so any restriction of the flow of tax-payer money to these schools could significantly hurt business. The U.S. Education Department will also be able to monitor compensation for recruiters, and allow it to take action against schools that engage in deceptive advertising and marketing practices. These regulations will take effect in July of next year.

However, the Department delayed releasing one of its more controversial proposals regarding gainful employment. This rule would eliminate federal aid to programs that create high student debt and have low loan repayment rates. We expect a decision on this regulation sometime next year.

Given this backdrop, the stock prices of most for-profits have plunged since the beginning of the year. Of the nine companies that we cover in the Educational Services industry, the stock prices of six have fallen, year-to-date. The best performing stock thus far has been New Oriental Education (EDU), a Chinese educator not affected by American regulations, while the worst performer has been Corinthian College, which is down a whopping 68%.

In an attempt to reduce its risk of exceeding federal cohort default rates, Corinthian is becoming more selective when accepting less-than-creditworthy applicants. This will no doubt hurt enrollment growth and profits, but management does not have much of an option. Apollo (APOL) is another school that intends to clamp down on its recruiting practices. It expects a 40% year-over-year decline in enrollments in the quarter ending November 30, 2010. We think this more cautious tone will be followed by other schools in the industry, particularly ones that have high default rates.

We also believe there are some opportunities in the for-profit education space. From a valuation perspective, most companies in the industry are relatively cheap, thanks to huge declines in their stock prices over the past few months. Risk-tolerant investors, who can deal with a significant amount of uncertainty regarding which regulations will actually pass, should look for companies with low default rates, high repayment rates, low tuition, and high job placement rates. They should also seek companies with strong balance sheets, solid cash flow generation, and healthy enrollment growth rates.

Renaissance Learning (RLRN) is one of the companies that we think fits the bill, thanks to improving growth prospects and strong cash flow growth. The company posted better-than-expected earnings during the September quarter, despite a challenging funding environment. We think that a likely continuation of high unemployment over the next year or two should also help support the industry as a whole, as more and more people consider higher education to improve their career opportunities.

On the other hand, we think risk-averse investors should remain on the sidelines until the regulatory landscape becomes clearer. As we mentioned, there is still a large amount of uncertainty right now, and we look for additional stock price volatility over the next few months, as the industry continues to face a barrage of negative news stories. 

As always, we recommend that investors review individual reports before making any commitments.

 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.