The Big Future of E-Learning: Beyond a Countercyclical Bump and a Student Loan Scare

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Paul Sagawa

203.901.1633

sagawa@sector-sovereign.com

May 3, 2010

The Big Future of E-Learning: Beyond a Countercyclical Bump and a Student Loan Scare

  • Education stocks have had a strong run YTD, as continued high unemployment is sparking accelerating enrollment at post-secondary institutions. Of late, the sector has been volatile, as fears of tighter thresholds on government sponsored student lending for occupational training ebb and flow. While the countercyclical nature of education spending and the threat to vocational programs are crucial near term factors, we believe secular trends favoring internet-based education at all levels may be an even bigger long-term factor driving outperformance in this sector.
  • Specifically, we expect that the spread of broadband connectivity, technology advances, favorable government policy and inherent cost advantages will drive share gain, and thus, unusual growth for the on-line, for-profit segment for years to come. We favor companies focused on e-learning, with a particular interest in 4-year and post-graduate degree granting programs, K-12 education, and e-learning software. Examples include Capella, Strayer, Apollo, DeVry, Bridgepoint, Grand Canyon Education, K12, Archipelago, Blackboard and SkillSoft.
  • The Dept. of Education will soon issue new guidelines on institutional eligibility for government sponsored Title IV lending, based on thresholds for the “gainful employment” of graduates and their projected ability to repay their loans. Companies disproportionately focused on 2-year occupational programs and those with a particularly high dependence on government sponsored Title IV lending will be the most vulnerable to any restrictions on lending. These companies include Corinthian Colleges, Lincoln Educational Services, Career Education Corporation and Universal Technical Institute.
  • The tuition for the average 4-year institution has risen more than 30% above inflation over the last 5 years. Against this, for-profit on-line programs have clear cost advantages, particularly given sharply rising enrollments, and have 46% lower tuition than private not-for-profit schools. Internet-based programs save students time and travel costs and do not require physical space or the labor that goes with it. Moreover, on-line programs are easily scalable, offer more flexibility for scheduling and can serve a geographically dispersed population, including foreign students that would require F-1 visas to attend traditional institutions. These factors are inherent in the 17% growth of on-line enrollment, far exceeding the 1.2% growth in the total student population.
  • On-line programs for K-12 education face a minefield of opposition led by teachers’ unions and textbook publishers. Nonetheless, a change-friendly Department of Education has improved prospects for on-line programs, which offer many cost and efficacy advantages over locally developed curricula. Budget crises at the state and local level may also create opportunities for internet-based programs.
  • The FCC’s goal of ubiquitous availability of 4Mbps+ broadband and explicit support for e-learning initiatives should be a further spur to on-line programs for both post-secondary and K-12 students. Currently, 5% of US households do not have access broadband. Moreover, a second goal, that at least 100 million US households should have access to networks with speeds of at least 50 Mbps by 2015 and 100 Mbps by 2020, if achieved, would dramatically enhance the quality of an e-learning experience and further boost potential enrollment.
  • While most IT companies have a stake in some way in the e-learning market, those providing e-learning specific applications and tools are the most levered to the trend toward on-line education. At the heart of the distance learning market is a battle between open source learning management systems (LMS) Moodle and Sakai vs. the proprietary market leader Blackboard, which despite share loss to the open source platforms is still growing its sales at better than 20% annually. Beyond the LMS market, are more specialized companies offering e-learning tools and content, such as Rosetta Stone, SkillSoft and Renaisance Learning.
  • In the post-secondary category, we prefer companies that are 1) predominately online vs. brick-and-mortar based, 2) focused on 4-year and post-graduate degree programs rather than 2-year vocational programs, 3) less dependent on Title IV students than average, 4) relatively high margin, as an indication of competitive cost structure, and 5) growing faster than average. The companies that fit these criteria are American Public Education, Capella, Strayer, DeVry, Grand Canyon and Bridgepoint. We also see K-12 online curriculum and LMS software as fundamentally attractive. K12 and Archipelago play in the first category, while Blackboard Inc. and Skillsoft play in the second.

The Big Picture

For-profit education has jumped to the spotlight in recent months. First, in a time of high, rising unemployment, education may be the best countercyclical play in the market. Historically, displaced workers take advantage of their time to improve their future prospects, a phenomenon that is apparent in the strong surge in enrollments for all forms of higher education in the United States over the last two years. As such, most for-profit education stocks are up relative to the market YTD. Second, the Department of Education, under Secretary Arne Duncan and in particular, Deputy Under Secretary Robert Shireman, have set an activist agenda to reduce student loan defaults by requiring institutions to demonstrate that their programs leave the typical graduate with a debt load manageable within the income that they could be expected to earn or lose access to Title IV student lending. This has been highly controversial – the benchmarks proposed by the government have raised red flags with both companies and analysts, who assert that the department’s contention that only 6-8% of 2-year vocational programs would be affected understates the impact by nearly two-thirds. While the market awaits a final proposal of new rules for access to government sponsored student loans, expected before summer, stocks in the sector have been volatile, reacting to every possible indication of the Department’s intentions, no matter how vague.

These issues are important in the near term. Continued joblessness should continue to fuel rising enrollment, although an emphatic reversal in unemployment would certainly pull some students from school back into the workforce. Tough thresholds for average student debt loads relative to earnings could force many for-profit institutions to reduce tuition or even shut down programs. Increased clarity on both of these factors could be forthcoming and could be an inflection point, at least for the companies with the largest stake in the vocational segment.

However, we believe that there are important technology and secular trends also at work in the sector that make for-profit education attractive for the longer term, even in the face of a full blown economic recovery and a harsh scenario on Title IV lending. First, the echo of the baby boom and a growing population of foreigners studying in the US means that the total pool of students is as large as it has ever been and continues to grow. Second, for-profit educators are far ahead of their non-profit brethren in embracing online e-learning, a segment that is growing 14 times faster than post-secondary education as a whole and that has a dramatic cost advantage vs. the brick-and-mortar alternative. Increasing access to broadband internet connectivity, abetted by the FCC’s proposals in its National Broadband Plan, will make the experience of internet-based education better and available to a larger population, further fueling the e-learning phenomenon. Finally, budget crises at state and local government levels show no sign of resolution and portend reduced student subsidies and limits on enrollment at publicly funded colleges, an ongoing boon to shareholder-owned institutions.

We also believe that elementary and secondary school education is also at a crossroads. School budgets are under pressure, while at the same time, the Department of Education is leading a charge to force school accountability for student performance and as a shortage of qualified math and science teachers persists. A big part of the solution may be e-learning, with online resources supplementing or even replacing locally defined and delivered curricula. While the status quo – teachers unions, text book publishers, local politicians – have fought the incursion of these tools, their cost and efficacy benefits may be too obvious to ignore in the current situation, a significant opportunity for the companies offering these products.

Finally, the spread of online education requires technology. Learning management systems (LMS) are the base platforms for internet-based education programs, with modules for interactive content delivery, distribution of materials, interactions between students and between students and instructors, the distribution, collection and evaluation of course work, testing, grading, etc.. Blackboard Inc. leads this market after its acquisition of competitors WebCT and Angel, but open-source alternatives Moodle and Sakai have been taking share rapidly. For many other technology companies – e.g. Microsoft, IBM, Cisco, etc. – e-learning is a fast growing, but small piece of their business.

Education: The Ultimate Countercyclical

In times of high unemployment, displaced workers and those fearful of future job loss seek education, both to increase their working skills and to gain credentials that may be gateways to better employment. At the same time, the echo of the baby boom has yielded an unusually large number of 18 to 30 year-old adults in the United States, exacerbated by the steady growth in F-1 visas for foreign students. These factors are apparent in the accelerating student enrollments across all strata of American post-secondary institutions and the strong financial results being posted by publicly owned for-profit educators. On top of this, budget crises in nearly every statehouse threaten student subsidies and enrollment capacities for public 2-year and 4-year colleges, the lowest tuition option for most would-be students. This turmoil further increases the pool of students for the for-profit institution.

As such, education stocks have been strong performers in a strong market, up 12.77% on average YTD. Given that strong performance, industry analysts are skittish. A handful of recent downgrades on the basis of valuation have trickled out for companies in the sector, although the growth in enrollments shows no sign of a deceleration that could signal the end to the countercyclical upturn.

Watching the “Gainful Employment” Tea Leaves

At the same time, the Department of Education has signaled intention to tighten institutional access to “Title IV” government sponsored student financial aid by setting explicit rules for satisfying the requirement that vocational educational programs lead to the “gainful employment” of graduates vaguely stated in the Higher Education Act of 1965 which initiated the program. Previously, the ambiguity around the language around gainful employment had led to relatively easy accreditation under Title IV. Noting scattered reports of students left with untenable financial burdens from payments on loans for occupational training that failed to provide sufficiently improved earnings, the Department has focused on establishing firm criteria for program eligibility. In January, the Department issued a proposed litmus test that the average student debt load in any program should be able to be repaid within 10 years based on payments of no more than 8% of the average student earnings after completing the program. Programs failing to meet those criteria would be forced to reduce tuition or lose eligibility for government loan programs.

The Department of Education has estimated that just 6-8% of for-profit vocational programs currently qualified for Title IV would be forced to change by the new rules, while the Career College Association, a trade group of for-profit institutions, estimates that nearly 20% of occupational education programs serving nearly a third of vocational students at these institutions would be affected. Recently, analysts covering the sector have added fuel to the fire with speculation that the final rules may include exclusions for programs that demonstrate 50% completion and 70% job placement, a change that would reduce the number of programs at risk. Meanwhile, any public comments by government officials assumed to be privy to the debate over these rule changes are parsed under a microscope for clues, driving day to day volatility in for-profit post-secondary education stocks.

The governments more rosy picture of the likely impact of rule changes is perhaps indicative of the Department’s desired outcome. We believe that a policy that eliminated funding for a third of students taking vocational training courses would be as unacceptable to this administration as it would be to the for-profit educational industry. Rather, the government would like to weed out “bad” programs that are prone to drive students to take on excessive debt, and would likely tweak any rule changes to achieve something close to the target scenario. We note that the assumptions governing future student earnings used to determine the debt service threshold are open for debate. Moreover, programs that fail the 8% of income test would be given the opportunity to adjust to the new criteria by reducing tuition and attracting more students with ability to pay without government loans. That said, for-profit education investors will remain skittish until the controversial rules are issues.

Risks for Some, Rewards for Others

In an environment of booming enrollment, threats on the Title IV funding eligibility of some for-profit vocational programs is serious risk for the institutions with programs likely to fall below the threshold, but a potential boon to those with less exposure. On one hand, companies with significant revenues from vocational programs in notoriously low-paid areas such as culinary arts, fashion and art will likely show a greater impact from the new gainful employment requirements. On the other hand, baccalaureate and graduate level programs are not targeted by the Department of Education rule changes, leaving companies with a focus on these degrees far less vulnerable.

We also note that companies with low costs of instruction and correspondingly low tuition will find it far easier to meet the new criteria. Here, on-line programs have an obvious advantage over brick-and-mortar campuses. Moreover, the bottom-line focus of for-profit programs is a likely advantage relative to the cost structure of not-for-profit institutions, and in particular, private colleges without benefit of state subsidies, a phenomenon evident in the significantly lower tuitions at for-profit programs.

These factors suggest that companies disproportionately focused on 2-year associate level and non-degree granting programs, that receive a relatively high level of Title IV funds today, that are skewed to campus-based programs vs. on-line and that suffer from relatively weak margins will be most at risk. Companies with this profile include Corinthian Colleges, Career Education Corporation, and Lincoln Educational. Conversely, for-profit educators with a greater proportion of 4-year bachelor’s degree and post-graduate programs, that have lower dependence on Title IV, that are primarily internet-based and that enjoy premium margins may actually benefit from the changing regulatory environment. Companies with this profile include American Public Education, Strayer, and Capella.

It Gets Better the Longer You Look

While investors ponder the education cycle and peruse the tea leaves for direction on Title IV funding, we think the long-term prospects for on-line education at all levels are compelling. Certainly the trend is impressive. Online course enrollments have grown at a 19% clip over six years, well beyond the 1.5% growth of the total higher education student population, with more than 25% of post-secondary students now taking at least one course online. A Babson/Sloan Consortium survey of educators found that the percentage responding that the learning outcomes from online courses were the same or better than face-to-face programs has increased steadily from 57% in 2003 to 68% in 2009, attesting to the improving quality of the online experience and the increasing acceptance of internet-based education.

For many students, online courses offer clear advantages. Internet courses save commuting time and cost, and can be accessed from nearly anywhere internet connectivity is available. They have convenient means for communicating with classmates and instructors, and keep coursework intrinsically organized. Modern LMS systems can enhance the interactive nature of the classroom, enabling both text and oral discussion. Non-interactive sessions can be easily time-shifted to meet student schedules. And of course, tuition fees tend to be lower.

Institutions can offer online classes for less than traditional face-to-face programs because the costs are significantly lower. Obviously, there is no need for a physical classroom nor any other parts of a traditional brick-and-mortar campus, thus saving the substantial associated capital and labor costs. Online programs are also more scalable, leveraging faculty more broadly as well. This is reflected in lower tuitions and in higher margins at for-profit institutions with disproportionate focus on internet-based instruction.

The Spiraling Cost of Education

Adjusted for inflation, the tuition and fees for both public and private non-profit 4-year institutions are more than 2 and a half times the level that they were 30 years ago. The pace of increase has accelerated – public college charges are up more than 6% for the 2009-2010 academic year, despite slight deflation, as state governments struggle with the costs of subsidizing higher education in the face of serious budget challenges. Tuition fees at for-profit programs are more than 20% lower than those for out-of-state students at public colleges and more than 35% lower than the cost of the average private non-profit college. Subsidized prices for in-state students at public institutions are half the level of for-profit alternatives, but likely to continue rising in the current environment.

More of the same will likely be forecoming. State budget appropriations for higher education fell 5.7% in 2008-2009, and will likely have fallen at an even faster rate for 2009-2010, once the figures have been tallied. Inflation adjusted endowment assets dropped 4% on a per student basis in 2008, the first drop since 2003. While market recovery will likely have significantly aided these endowments, the current climate is very difficult for charitable giving and may get much worse with proposed changes in the tax code. Moreover, many state sponsored schools have chosen to cap enrollment in a further effort to conserve tax dollars. While not-for-profit institutions do not publish financials for comparison, it seems reasonable to assume that profit-focused educators would do a better job of controlling costs than either public or private colleges. With continued growth of the student population, it would seem that the for-profit segment is collectively well positioned to capitalize.

In addition, campus living adds significant costs for students – the college board survey estimates that the average commuter saves more than $2,100 per year vs. a campus resident at a private not-for-profit college and about $1,000 vs. a subsidized state college student. Furthermore, online students save transportation costs – about $1,400 per year for typical commuter students. These savings are equivalent to a quarter of the typical for-profit program tuition.

The National Broadband Plan

The FCC recently published its “National Broadband Plan” stating its goal to make broadband services delivering at least 4 Mbps of real downstream bandwidth available and affordable for every US household by 2020. Along the way, it also aims to assure 80% of households have access to 50 Mbps service by 2015 and 100 Mbps by 2020. The plan offers concrete proposals to make this happen, including opening 300-500 MHz of new spectrum to wireless broadband competition and offering cross-subsidies to enable poorer households to afford access.

This broadband manifest destiny is intended to, and will be, a serious boon to e-learning. More households will have access to and be able to afford broadband connections, and thus, online education programs. Faster speeds will improve the quality of the experience – technologies now deployed for high-end tele-presence applications will inevitably find their way into the home at far lower costs – making the e-education value proposition even more compelling to would-be students. Widespread mobile broadband will increase convenience for time-pressed and peripatetic students. Educators will be even more facile with the tools of e-learning and develop programs that take advantage of the rich interaction possible. We believe that in the end, the perceived value of an online education will increase and graduates of online institutions will find greater appreciation for their degrees in the job market.

Elementary, My Dear Watson

Much of the attention has been on for-profit post-secondary educators, but the current environment offers opportunities for companies focused on K through 12 as well. The current Department of Education, under Secretary Arne Duncan, has shown itself to be firmly behind charter schools and school accountability for student performance. In the context of budget crises and property tax revolts, school districts are being forced to consider more creative options than the union-approved “hire more teachers”.

Enter online curriculum companies. Traditionally, the frameworks of school curriculum are set out by state regulators, but mechanics of daily learning are determined at the local and often, classroom level. This process is effective where caliber of teaching talent is high, less so where that is not the case. K-12 curriculum companies, like K12 and Archipelago, develop curriculum modules centrally and expertly, offering the benefits of online learning, well defined lesson plans, integrated supplementary material and well calibrated tools for evaluating student progress. They are also cost effective, if the alternative to the school district is to “hire more teachers”. Currently, the growing market for these companies is home-school families and charter schools, but the Holy Grail is acceptance into the public school classroom.

Tools of the Trade

The spread of e-learning in K12, post-secondary and corporate training environments is an important phenomenon being pursued by nearly every major technology company – Microsoft, Google, IBM, Cisco, Oracle, Apple, et al.. That being the case, there are still specific niche areas being addressed by pure play companies. Chief amongst these are Learning Management Systems, software platforms used by schools and institutions to deliver their content online. A modern LMS multi-casts classes, enabling oral and text interaction with the instructor and amongst classmates. It distributes course material, facilitates classwork, administers exams, and manages student evaluation. It provides a virtual campus, where students can chat, conference and email with fellow students and instructors. It handles scheduling, record keeping and billing as well. Every post-secondary program uses an LMS – some purchased commercially, some available as open-source software and some developed internally – as do some leading edge K-12 schools.

The leading player in LMS is Blackboard Inc., which bought up commercial software rivals WebCT and Angel to consolidate its leadership. It is also the leader in the for-profit segment, with Capella, STrayer and Grand Canyon all customers. The fastest growing platforms in a rapidly growing market are the open-source alternatives, Moodle and Sakai Partnership. Skillsoft is a relatively new face in LMS, but has leveraged its leadership in corporate training platforms to win several high profile accounts, including Cornell University and the University of Iowa. Still other educators have chosen to develop their own proprietary LMS platforms, most notably Apollo’s University of Phoenix, now the largest university by student population in the US.

Given the momentum behind online post-secondary programs, we believe that the market growth for LMS platforms will remain explosive. Moreover, the huge potential market for K-12 schools has barely been scratched. While open-source solutions are an attractive option for institutions with strong internal IT support capabilities, we believe most will still opt for commercial packages and the support and ongoing development that comes with them. It would also seem that these commercial LMS providers could one day be attractive candidates for the technology giants that hover over the e-learning market.

In Summary

We believe that the bright future of for-profit education will be brightest for companies that fit specific criteria. First, we prefer companies with a primary focus on online education, rather than physical classroom instruction. Second, we prefer companies that are predominately 4-year bachelor degree and post-graduate degree granting institutions, as vocational programs face greater pressure from competition and from Title IV restrictions. Third, we prefer institutions that are somewhat less dependent on Title IV support than average. Fourth, we prefer companies that have sustained higher than average margins, indicative of strong cost management and focus on higher profitability program areas. Finally, we prefer companies that have shown sustained double digit growth. Against these criteria, American Public Education, Capella, Strayer, DeVry, Grand Canyon and Bridgepoint stand out.

We also believe that there are bright opportunities in K to 12 education, in particular, providing curriculum and teaching support online. Here K12 and Archipelago are representative companies. We also favor companies providing the technology needed to further e-learning. Much of the benefit will accrue to the very large market leaders, for whom e-learning is a modest part of their business. However, the LMS software market, central to the delivery of education services online, contains several pure play companies, such as Blackboard Inc. and Skillsoft.

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