U.S. For-Profit Education Stocks:

A “Magic Formula” Approach

Oliver MihaljevicThe Manual of Ideaswww.manualofideas.com

Value Investing Seminar ItalyJuly 13, 2011

“Magic Formula”

—

A Brief Review

Selected Value-oriented Idea Generation Approaches (That We Like)

• “Magic Formula“• Advocated by Joel Greenblatt• “Good” and “cheap” stocks• Earnings-based

• Sum-of-the-parts• A staple approach of “activists”• Investment case often rests on

monetizing non-core and/or excess assets

• Earnings- and/or asset-based

• “Net-Nets” (and otherbalance sheet plays)

• Advocated by Ben Graham• (Current assets minus total

liabilities) > market value• Asset-based

• Other Approaches• Equity “stubs”• Turnarounds• Spinoffs• “Jockey” stocks

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Magic Formula: What Is It?

• Stock-screening methodology • Popularized by Joel Greenblatt in The Little Book That Beats

The Market (2005)

• Ranks companies based on two factors (equal-weight):• “Cheap”: Trailing EBIT / EV • “Good”: Trailing EBIT / Capital employed

Goal: Pay a low price for companies likely to reinvest capital at high rates of return.

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Magic Formula: Why We Like It?

• It works: • Performance vs. S&P 500 Index, 1999-2011*

• Advocated by Joel Greenblatt• Makes Sense• Simple• Will Continue to Work (institutional imperatives, emotional

bias)

* Data from 1999-2008 reflects the net performance of the Formula Investing Model Portfolio. 1999 data is from October 1, 1999 through December 31, 1999. Data since 2009 reflects the Formula Investing U.S. Value Direct Composite returns (net) of actual accounts. 2009 data is from May 1, 2009 through December 31, 2009. Data from January 1, 2009 through April 30, 2009 is not available. However, it appears the “magic formula” outperformed in that four-month period, as the Model Portfolio was up 46% while the S&P 500 Index was up 19% from January 1, 2009 through September 30, 2009. Year-to-date 2011 performance numbers are for the period from January 1, 2011 through May 31, 2011. Source: Formula Investing, www.formulainvesting.com

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(performance in %) '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 YTDMagic Formula 16 9 36 -21 52 28 22 13 15 -36 43 13 15S&P 500 Index 15 -9 -12 -22 29 11 5 16 6 -37 30 15 8

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Company(in alphabetical order) Ticker

Market Value

($ millions)

Most Recent

Filing DateAeropostale ARO 1,418 Apr-30

Amedisys AMED 805 Mar-31

Apollo Group APOL 6,400 May-31

H&R Block HRB 4,981 Apr-30

Capella Education CPLA 686 Mar-31

Career Education CECO 1,681 Mar-31

Comtech Telecommunications CMTL 741 Apr-30

Dell DELL 32,245 Apr-30

Deluxe DLX 1,295 Mar-31

Forest Laboratories FRX 11,493 Mar-31

GT Solar International SOLR 2,034 Mar-31

ITT Educational Services ESI 2,270 Mar-31

Impax Laboratories IPXL 1,423 Mar-31

InterDigital IDCC 2,125 Mar-31

Kulicke and Soffa Industries KLIC 819 Mar-31

Company(in alphabetical order) Ticker

Market Value

($ millions)

Most Recent

Filing DateLam Research LRCX 5,615 Mar-31

Lender Processing Services LPS 1,852 Mar-31

Microsoft MSFT 219,375 Mar-31

Oshkosh OSK 3,001 Mar-31

PDL BioPharma PDLI 824 Mar-31

Par Pharmaceutical PRX 1,207 Mar-31

Pow er-One PWER 850 Mar-31

SanDisk SNDK 10,200 Mar-31

TeleNav TNAV 736 Mar-31

Teradyne TER 2,812 Mar-31

Tessera Technologies TSRA 883 Mar-31

Unisys UIS 1,130 Mar-31

United Online UNTD 549 Mar-31

Veeco Instruments VECO 1,980 Mar-31

ViroPharma VPHM 1,472 Mar-31

Magic Formula: Recent Selections

* Source: www.magicformulainvesting.com

Top 30 companies with $500+ million of market value(based on July 1, 2011 share prices, sorted by company name)*

Magic Formula: Evaluating the Selections

Key questions:

• Are high returns on capital sustainable? “Moat”

Some issues to address: cyclicality, technological change, customer value proposition, fads, threats to key revenue source/business model (e.g. regulatory-driven)

• Does the business operate in a growing industry? High return reinvestment opportunities

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Evaluating the Selections: For-Profit Education

• Are high returns on capital sustainable?• Questionable due to regulatory risk: most companies derive

80%+ of revenue from Title IV* federal student financial aid (threat to key revenue source!).

• Growing industry? • Yes, but regulatory changes could impede growth (“gainful

employment” rule; regulations related to recruitment, marketing and other business practices).

For-profit education stocks are easy to dismiss…

8* Title IV of the Higher Education Act of 1965 covers the administration of federal aid to students.

Evaluating the Selections: Other Companies

• Amedisys: 80+% of revenue from Medicare – regulatory threats

• Comtech: losing ~50% of revenue as U.S. Army contracts expire

• Deluxe: paper check provider – rise of payment cards, e-banking

• Forest Labs: branded pharma – 2012 patent expiry, “Obamacare”

• SanDisk: tech obsolescence, pricing pressure in data storage

• Microsoft: software model under attack from “cloud” computing

• Dell: desktop PCs, laptops under attack from netbooks, tablets

• H&R Block: paper filings in decline, share gains by Intuit, Internet

…other companies are also easy to dismiss.

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(Unlikely) Winners from Past Magic Formula Screens

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• McGraw-Hill (MHP; $13 billion market value)• Shares traded at $24 when featured in the September 2009 “Magic

Formula” issue of The Manual of Ideas; Einhorn’s Greenlight shorted MHP due to regulatory risks at Standard & Poor’s; recent price: $42.

• Metropolitan Health Networks (MDF; $190 million market value)• Shares traded at ~$2.20 when featured in the September 2009 “Magic

Formula” issue of The Manual of Ideas; Metropolitan’s revenue is dependent on Medicare Advantage funding; recent price: ~$4.50.

• Travelzoo (TZOO; $1.3 billion market value)• Shares traded at $5 when featured in the November 2008 “Magic

Formula” issue of The Manual of Ideas; the online travel-related company faced declining demand due to economic weakness; recent price: $70.

All three would have been easy to dismiss.

Magic Formula: Conclusions

• It works.

• For-profit education stocks score highly…

• …but are easy to dismiss as investments.

• Other Magic Formula stocks are also “easily dismissed.”

• Past “winners” would have also been easy to dismiss.

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U.S. For-Profit Education Stocks

—

“Value Traps” or

Typical “Magic Formula” Candidates?

Dismissed by the Market, But not by the “Magic Formula”

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Example: Corinthian Colleges (COCO): May 2009 – July 2011(selected events and share price reaction)

U.S. For-Profit Education: Recent Valuation

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1 Trailing twelve months refers to the twelve months ended March 31, 2011, except for Apollo (ended February 28, 2011).2 Based on P/E ratios implied by the average of analyst EPS estimates as of July 8, 2011. All EPS estimates are for calendar 2012, except for Apollo (FY ended August 2012), Corinthian (FY ended June 2012), and DeVry (FY ended June 2012).3 Trailing EBIT excludes impairment of goodwill/intangibles (and, at Apollo only, estimated litigation losses).

EV-to-trailing EBIT of less than 5x for selected companies implies an undemanding valuation even if

“normalized” EBIT is 50% lower than trailing EBIT

Market Enterprise EV / EV / MV / MV / EV / TTM1

Price Value Value TTM1 TTM1 TTM1 2012E 2 Student FCFCompany Ticker 7/8/2011 ($mn) ($mn) Revenue EBIT Net Income Net Income ($) YieldApollo3 APOL $48.88 $6,921 $6,086 1.2x 4.4x 17.7x 15.0x $15,000 13%Bridgepoint BPI 27.25 1,440 1,075 1.4x 4.3x 9.5x 10.6x 12,200 13%Capella CPLA 44.40 698 513 1.2x 5.5x 11.4x 13.7x 12,900 8%Career Ed.3 CECO 22.72 1,763 1,365 0.6x 4.0x 9.6x 10.2x 11,500 8%Corinthian3 COCO 4.52 382 546 0.3x 3.1x -4.7x 18.8x 5,300 -19%DeVry DV 62.59 4,306 3,712 1.7x 7.7x 13.2x 13.1x 28,600 6%Grand Cany on LOPE 14.46 649 644 1.6x 8.8x 14.7x 11.8x 15,100 -1%ITT ESI 88.77 2,492 2,301 1.4x 3.8x 6.7x 11.4x 27,400 22%Lincoln LINC 19.43 439 439 0.7x 3.8x 6.6x 13.0x 16,400 16%Stray er STRA 137.48 1,683 1,692 2.6x 7.9x 12.8x 15.9x 29,400 7%

Average: 1.3x 5.3x 9.8x 13.3x $17,380 7%Median: 1.3x 4.4x 10.5x 13.1x $15,050 8%

U.S. For-Profit Education: The ”Bear” Case*

“Classic Value Trap” (Jim Chanos, Kynikos):• Stocks look cheap• Structural issues

• Business funded by government largesse in the form of student loans (risk resides with taxpayer and student)

• Questionable educational outcomes

• Business fundamentals in decline• Title IV federal student loan funding well “drying up”• New regulations holding companies accountable in relation

to “gainful employment” and other performance/integrity criteria

• Declining new student enrollment• Revenue pressure, negative earnings leverage, w/c issues

15* Based on the presentation from James Chanos, Kynikos Associates, at VALUEx Vail (June 16, 2011).

The ”Bear” Case: In Print

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“Enrollment Drop Hammers

For-Profit Education Sector”

- Forbes, 10 Jan 2011

“For-Profit Education: Classic Value Trap”- James Chanos, 16 Jun 2011

“U.S. senator lashes out at for-profit education”- Reuters, Aug 4, 2010

“For-Profit Colleges Mislead Students, Report Finds”- NYT, 3 Aug 2010

“For-Profit Colleges Under

Growing Scrutiny.”

- WSJ, 27 May 2011

“For-Profit Schools Under Fire, Stocks Down Nearly 30 Percent for the Year”- CNBC, 17 Dec 2010

Before We Declare the Business Model Dead (and the Stocks Zeroes), Consider…

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# of Gainful % of Programs % of ProgramsEmployment That Fail That Lose

School Category Programs At Least Once Eligibility by FY15Public 37,218 3% 1%Non-Profit 5,072 5% 1%For-Prof it 13,155 18% 5%Total 55,445 8% 2%

Only 5% of for-profit programs are to lose eligibility by 2015!

Impact of the "gainful employment" rule enacted on June 2, 2011 (as estimated by the U.S. Department of Education)

“The Department believes that institutions will strengthen their educational programs to meet these higher standards, and relatively few programs will fail.”- Federal Register / Vol. 76, No. 113 / Monday, June 13, 2011 / Rules and Regulations / 34390

“Gainful Employment” Rule: Not a Red Card for the For-Profit Industry!

• Programs must pass at least one of the three metrics to remain eligible for federal student aid funding:• Repayment rate: At least 35% of loans (dollar-based) are being repaid (a $1

decline in the loan balance per year suffices!).

• Debt�to�total earnings ratio: The annual loan payment may not exceed 12% of typical graduates’ total earnings.

• Debt�to�discretionary income ratio: The annual loan payment may not exceed 30% of typical graduates’ discretionary income.

• To lose eligibility, programs must fail measures in 3 out of 4 years.

• Final rule “watered down” from initial proposals• First programs become ineligible in 2015 (not 2012).• No enrollment growth restrictions.• Debt payment timelines extended up to 20 years (not 10 years)• Emphasis on giving schools the “opportunity to improve” 18

Lenient Regulation? Sounds Familiar…

Selected regulated industries that are alive and kicking after left for dead by some:

•Rating agencies

•Sell-side equity research and banking in general

•Gulf of Mexico oil drillers

•Health insurers

•For-profit education companies?

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Structural Issues: The Other Side of the Coin

• 88 million U.S. adults are without a college degree (67% of population above age 25).1

• 33 million U.S. adults above age 25 have some college experience, but no degree.1

• Current estimates show a shortfall of 13-16 million graduates to meet goals of the Obama Administration.2

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1 Source: U.S. Department of Commerce, Census Bureau, Current Population Survey (CPS), March 2009.2 Source: National Center for Higher Education Management Systems.

Private sector is needed to achieve U.S. educational goals.

For-Profit Education: Here to Stay

• Sizeable: 10%+ of total U.S. postsecondary students attend for-profit colleges (up from ~3% in 2000). There are ~4 million students in for-profit education programs.

• Needed to achieve U.S. educational goals: Current estimates show a shortfall of 13-16 million graduates to meet Obama’s goals by 2020.

• Benefits from political expedience: Politicians are unlikely to throw millions of students on the street by cutting for-profit funding; for-profit education has an effective lobby and many (voting) students and teachers (90,000+ parties submitted comments on the proposed Dept. of Education rules; 75% opposed the rules).

• Tough to attack: Many for-profit students are minorities or people who otherwise would not get an education. Outcomes are difficult to assess. As public schools may not be doing better, crucifying for-profits may expose bigger waste in the system.

• Not the first government-funded sector with questionable outcomes/practices: See healthcare, defense contracting, recent bailouts etc. 21

The Economy Factor

• Educational outcomes difficult to judge in the weak economy of 2009/10. Like in many other industries, bad practices were exposed during weak economic times. But that does not mean the entire industry is a fraud. Job placements and student loan repayment rates have cyclical elements.

• Student loan repayments are likely to improve as the economy gets better and unemployment reduces over time.

• Recent economic weakness may explain regulators’multi-year approach when testing programs’ performance and eligibility for future funding. This gives companies time to adapt and improve.

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From “Bear” Case to “Base” CasePotential "base" case for selected companies that screen highly on TTM EBIT/EV:

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1 1Q11 new student starts: CECO (-14% y-y); COCO (-22% y-y); LINC (-39% y-y). The industry figure is estimated based on new student starts of the three featured companies, in addition to Apollo, Bridgepoint, Capella, DeVry, Grand Canyon, ITT, and Strayer. 2 EBIT margins (TTM/5-year average): CECO (16%/10%); COCO (9%/7%); LINC (18%/12%). Trailing EBIT margins at CECO and COCO exclude the impairment of goodwill/intangibles. The defense industry EBIT margin of ~10% is based on the five-year average operating margins for Northrop Grumman, Raytheon, Lockheed Martin, General Dynamics and Boeing for 2006-10.

Assumes revenue at 20% below the TTM revenue level (industry new student starts declined an estimated ~20% y-y, on average, in 1Q11)1

In-line or below the average ~10% EBIT margin of the U.S. defense industry —another government-funded sector2

Estimated intrinsic values are modestly higher than recent market values

Career Education

(CECO)

Corinthian Colleges(COCO)

Lincoln Educational

(LINC)TTM rev enue (tw elv e months to 3/2011) $2.1 billion $1.9 billion $0.6 billionDiscount factor 20% 20% 20%Estimated normalized rev enue $1.7 billion $1.5 billion $0.5 billionEstimated normalized EBIT margin 10% 5% 10%Estimated normalized EBIT $170 million $80 million $50 millionFair v alue multiple 10x 10x 10xEstimated enterprise v alue $1,700 million $800 million $500 millionPlus/(Minus): Net cash/(debt) 400 million -160 million 0 million

$2,100 million $640 million $500 million$27 per share $8 per share $22 per share

Implied upside to recent stock price 19% 68% 14%Implied EV-to-TTM revenue 0.8x 0.4x 0.8xIndustry avg est. EV-to-TTM revenue 1.3x 1.3x 1.3x(Discount)/premium to industry average -39% -68% -39%

Estimated fair value of the equity

Potential “Bull” Case?

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Potential “bull" case for selected companies that screen highly on TTM EBIT/EV:

Assumes revenue at 10% below the revenue level of the trailing twelve months

In-line or modestly above the average ~10% EBIT margin of the U.S. defense industry — another government-funded sector

Estimated intrinsic values are significantly higher than recent market values

Career Education

(CECO)

Corinthian Colleges(COCO)

Lincoln Educational

(LINC)TTM rev enue (tw elv e months to 3/2011) $2.1 billion $1.9 billion $0.6 billionDiscount factor 10% 10% 10%Estimated normalized rev enue $1.9 billion $1.7 billion $0.6 billionEstimated normalized EBIT margin 15% 10% 15%Estimated normalized EBIT $290 million $170 million $90 millionFair v alue multiple 10x 10x 10xEstimated enterprise v alue $2,900 million $1,700 million $900 millionPlus/(Minus): Net cash/(debt) 400 million -160 million 0 million

$3,300 million $1,540 million $900 million$43 per share $18 per share $40 per share

Implied upside to recent stock price 87% 303% 105%Implied EV-to-TTM revenue 1.4x 0.9x 1.4xIndustry avg est. EV-to-TTM revenue 1.3x 1.3x 1.3x(Discount)/premium to industry average 4% -32% 10%

Estimated fair value of the equity

Recent market valuations leave significant upside potential for selected stocks.

Some Last Thoughts and Facts

• Bridgepoint’s new student starts grew 13% y-y in the March quarter.

• Most for-profit education companies have strong balance sheets and are buying back shares.

• Valuations are diverging (Corinthian’s EV-to-trailing adjusted EBIT is ~3x versus Strayer and DeVry at ~8x). Potential for M&A?

• Internet-focused companies have inherently scalable, high-margin models, which may not change drastically with increased regulation.

• Intriguing non-U.S. opportunities (e.g. Apollo/Carlyle JV in the U.K.).

• Increasing entry barriers due to regulatory scrutiny?

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For-Profit Education: Conclusions

• Typical “Magic Formula” Candidates

• “Bear Case” May Have Run Its Course

• Current Risk-Reward Appears Attractive for Specific Candidates (or for a “Basket” Approach)

• “Magic Formula” Beats Shorting!

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Resources and Contact Information• Magic Formula

• Joel Greenblatt: “The Little Book That Beats The Market”• www.magicformulainvesting.com• www.formulainvesting.com

• U.S. For-Profit Education• Bear case: Jim Chanos at Ira Sohn (May 2009) and VALUEx Vail (June

2011); Steve Eisman at Ira Sohn (May 2010)

• Bull case: Case Study—University of Phoenix, Nexus Research & Policy Center (August 2010)

• The Manual of Ideas• www.manualofideas.com• oliver@manualofideas.com

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