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Follow the money ...

Don't know what made me look at the business section today -- but here's a great "follow the money" article ...

Do the Arithmetic and Go to Schools

By James K. Glassman

Sunday, December 7, 2003; Page F01

Back in 1995, I offered readers this prediction: "My candidate for the hottest industry in 2005 is education." We're nearly there, and I am nearly right. For-profit education remains a small industry, but it has grown impressively. Is it the "hottest"? According to the Value Line Investment Survey, which ranks 98 sectors using a formula that emphasizes momentum (a good synonym for heat), the hottest industry is home building, but education services rank second.

Value Line rates 13 education companies, and seven of them rank in Group 1 -- the inner circle to which only 100 stocks, out of 2,200 that the research firm analyzes, are admitted. Another two education companies rank in Group 2 (above average); none in the sector is below average.

In fact, only one industry out of 98 has more Group 1 stocks than education. That's special-lines retailing, whose 70 companies will have $215 billion in sales this year. By contrast, the 13 education companies have less than $7 billion in sales.

As I said, education is still a small business, which is reassuring if you missed the last eight years of fun. Education companies still have a long way to go.

Consider one of those Group 1 companies, ITT Educational Services (ESI), which provides associate's, bachelor's and master's degree programs in technical fields -- through 74 institutes in 28 states serving 33,000 students. When I wrote my education-sector piece on July 2, 1995, the stock was trading at $3.78 (after an adjustment for splits). Shares closed Friday at $46. That's an increase of 1,116 percent. The benchmark Standard & Poor's 500-stock index rose just 95 percent over that time.

But ITT Educational, which was spun off as a separate company from ITT Corp., the conglomerate whose parent is now Starwood Hotels (HOT), is still small by U.S. corporate standards. Its sales are about a half-billion dollars a year, roughly the same as American Italian Pasta Co. (PLB), and its market capitalization (or value according to its stock price) is $2.5 billion. That makes it a giant of the for-profit education business but only a mid-cap among all stocks.

There are two reasons education stocks have boomed while the rest of the market has stagnated. First, education spending always rises, year after year, so education stocks tend to be a safe haven in an economic downturn. Second, the business of education is growing as Americans become more dissatisfied with their kids' schools and, as workers, seek to upgrade their skills after high school or college to keep up with changing technology.

Some of the best business minds in the world are applying themselves to education, including Michael Milken, who has funded a string of start-ups, and Marjorie Scardino, chief executive of Pearson PLC (PSO), the diversified London-based information giant that owns the Financial Times. Pearson now derives about $3 billion -- a little more than half its total revenue -- from its education division, which publishes textbooks, develops curricula and administers tests.

Pearson stock has rallied by about half since March, but the company has had a rough three or four years. Right now, the best segment in education is not books or tests but postsecondary schools with a vocational bent. A degree of any sort is nearly always a pay-booster, and the companies that run these schools have a delightful competitive situation. They are up against public universities and community colleges that are not always well managed but, nevertheless, keep increasing their tuitions -- which in 2003, incredibly, were up an average of 14 percent.

ITT was not even the best of the bunch. The stock of Apollo Group (APOL), a larger for-profit chain of postsecondary campuses, most of them carrying the name University of Phoenix, has risen 460 percent. Apollo was launched in 1974 and went public in 1994. An investment of $10,000 in Apollo's initial public offering is today worth more than $936,000.

I first alerted readers to Apollo in my 1995 article, then wrote about it again in 1997 after a visit to the company's Phoenix headquarters left me somewhat giddy with the possibilities of using computer technology to teach students long-distance. "The only problem with Apollo," I wrote six years ago, "is that it isn't cheap." The stock was trading at a split-adjusted $7.37. It closed Nov. 28 at $69.36. Guess I was wrong. Anyway, I wasn't deterred by my own admonition and became a happy Apollo shareholder in 1999.

In September 2000, just as tech stocks were collapsing, Apollo had the courage to launch its University of Phoenix Online division as a separate stock, with the symbol UOPX. Apollo retained 87 percent ownership, so Apollo shareholders benefited from the success of the distance-learning subsidiary, whose enrollments have risen from 16,000 to 79,000 in two years. But purchasers of the pure online stock were bigger winners. Shares are up more than 1,000 percent.

Or look at Corinthian Colleges (COCO), a company that did not hold its IPO until 1999. Since then, the stock has gone from $1.13 to $63.03. And no wonder. Corinthian, which runs 82 colleges and 15 corporate training centers -- in such fields as criminal justice, health care and diesel repair -- has boosted its annual revenue in just four years from $133 million to $517 million and its profit from $7 million to $66 million. Earnings in the fiscal year that will end June 30, 2004, are projected to rise 38 percent, and Value Line expects annual increases averaging more than 30 percent through 2008. A report last month by analyst Michael Jaffe of S&P gave Corinthian the research firm's top rating, five stars (Apollo is just below that, at four stars).

On the other hand, as with any fledgling industry, there were huge losers as well as huge winners. One of those was Education Alternatives Inc., a firm that specialized in managing public schools under contracts with local education authorities. In my column eight years ago, I quoted an education-stock analyst saying that the company "could double this year." It didn't. EAI stumbled badly, changed its name to the Tesseract Group Inc., then crashed and burned.

Similarly, Edison Schools, founded with great fanfare in 1992 by former magazine publisher Christopher Whittle, intended to start a chain of low-cost private academies. When he couldn't make the numbers work, Whittle turned instead to managing public schools, took Edison public, lost gouts of money, then took it private in a deal consummated last month. Most investors were big losers. A share of stock bought at the IPO in 1999 for $18 ended up worth just $1.76.

While education remains small as a business, it is gigantic as a government endeavor, accounting for about $800 billion in spending last year. Profit-making ventures are working around the edges -- in software, publishing, curriculum development and in running postsecondary schools and institutions to upgrade the skills of people already in the workforce.

The holy grail remains kindergarten-through-12th-grade education. Smaller companies are springing up and finding that progress isn't easy, partly because the public education establishment doesn't give up power lightly and partly because new schools have yet to prove they can deliver -- except, of course, in the upper reaches of prepdom, a tiny, elite market that is largely nonprofit.

Sylvan Learning Systems (SLVN), based in Baltimore, has changed its focus and is concentrating on online higher education and on for-profit universities abroad. The company has acquired universities in Chile, Mexico, France and Spain and a hotel-management school in Switzerland. The stock, which had taken a big dive, losing two-thirds of its value from early 1999 to mid-2000, has been rallying. It has doubled this year, and the company is expected to make its first profit in four years.

Another revival story is Washington-based Strayer Education (STRA), with 23 campuses and 20,000 students (about one-third of them online) in business and information-technology programs. Strayer stock has doubled this year and more than quadrupled since early 2001. Like most profitable education stocks, it is trading at a rich price-to-earnings ratio -- in this case, 53 -- but earnings, according to Value Line, are expected to grow 24 percent next year and about 20 percent annually through 2008.

Investors looking at education stocks have two choices: bet on the companies that have already accelerated, in the hope that their markets will continue to grow, or look for the laggards, which appear to have sound businesses but have generated little enthusiasm lately.

In the first category, ThinkEquity, the San Francisco investment firm headed by Michael T. Moe, who as a Merrill Lynch analyst was one of the first to recognize the bright future of education stocks, is a fan of Education Management Corp. (EDMC). It provides postsecondary education to 59,000 mainly through Art Institutes, which focuses on careers in design, fashion and food. Shares have roughly doubled since January, but the P/E ratio, based on estimates for next year's profits is 29 -- not outrageous for a company that has been boosting earnings at more than 20 percent annually.

In the second category, look at DeVry Inc. (DV) of Oakbrook, Ill., which was being widely praised by analysts when I wrote about it in 1995. DeVry was badly hurt by the tech collapse since so many of its courses targeted jobs in that sector. Its stock produced better returns than the market as a whole over the past five years, but it trailed competitors like Apollo badly. Now things are looking up. Value Line projects earnings will rise at an annual rate of 14 percent through 2008, and shares trade at a decent valuation.

Another relatively unloved education stock is Renaissance Learning (RLRN), which provides educational software to three in five public schools in North America. The stock trades at less than half its 2001 high despite its Beautiful Line of rising earnings and cash flow, stretching back to its 1997 IPO. Renaissance, notes Value Line analyst Justin Hellman, "has decent turnaround potential" but is "still too risky for most investors."

The best approach to education-stock investing is to own a diversified portfolio. I am not aware of any mutual funds that package the sector, so you'll have to do it yourself. Buy a half-dozen, in different segments and with different prospects. Still, you won't get complete diversification because you won't be targeting younger students, the biggest market. I dearly wish there were a strong K-12 company out there, opening profitable charter schools or developing the chain that was Whittle's dream. Unfortunately, that will have to wait until education stocks get even hotter.

Of the stocks mentioned in this article, James K. Glassman owns Apollo Group. His e-mail address is jglassman@aei.org.

© 2003 The Washington Post Company