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Stock Pick of the Week: Buy Apollo Group Inc cl A (APOL)- Very Attractive Rating

After offering several technology companies for “stock pick of the week,” we are switching to education stocks this week. Enter the Apollo Group, aka University of Phoenix, (ticker APOL), a leading provider of private, online education. APOL is our stock pick of the week and one of January’s Most Attrac­tive Stocks. APOL boasts a 39% ROIC, a level rivaled by Strayer Education (STRA) at 37% and dwarfed by ITT Educational Services Management Group (ESI) at 112%. Though not as high as the previous companies, other, smaller players in the sector also enjoy strong (2nd Quintile) ROICs: Career Education Corp at 11% and Corinthian Colleges Inc (COCO). The only other sector with so many high ROIC companies is the tech sector.

Technology and education companies have more in common than best-in-market returns on invested capital (ROIC). The underlying strategy behind both business models is to monetize intellectual capital. The tech sector leverages intellectual capital (i.e. intelligence and innovation) to build products that offer better service/output at lower costs that the products they make obsolete. The education business sells intellectual capital directly to those who want to acquire it. Both of these businesses are highly profitable because their customers are willing to pay premium prices because of the benefits they expect to receive. For example, buyers of iPods are willing to pay an exorbitant price for the package of plastic and metal that make up an iPod because that package of plastic and metal can do quite amazing things compares to other packaging of plastic and metal. The same concept applies to online education: consumers are willing to pay much more for media that provides certifiable education than they pay for a NetFlix movie (NFLX). Technology and education companies also enjoy a, relatively,  low cost of goods sold because a single, good idea/concept is leveraged across multiple products (i.e. iPods) or students. One good concept or idea can be resold again and again with little incremental cost to the seller.

As most of our readers know, a high ROIC alone will not get a stock on our Most Attractive Stocks list. The valuation of the stock must be very cheap as well. And APOL fits the bill nicely with a price-to-economic book value ratio of 0.4, which means the current stock price ($42.31) implies the company’s profits will decline by 60% and remain at that level permanently. I repeat: the market price is predicting that not only with the company’s profits never grow again, they will decline permanently by 60%. Market expectations are set­ting the future-profit-growth bar quite low for this stock.

As shown in our free report on APOL, the company’s return on invested capital (ROIC) (39%) is in the top quin­tile of all the com­pa­nies we cover and its eco­nomic earn­ings are higher than reported accounting earnings. During its last fiscal year, APOL’s economic earnings rose $136mm to $707mm while accounting earnings fell $45mm to $553mm. APOL is one of only 71 companies of the 3000+ we cover that whose economic earnings are higher than its accounting earnings. It is quite rare for a company to have higher economic earnings than GAAP earnings given that the accounting rules enable companies to overstate their GAAP profits so easily.

At the same time, the stock’s val­u­a­tion implies that APOL’s prof­its will decline by 60% and never grow again. Given that most investors are not aware that the company’s operating profits are as strong as they are, the market is probably not giving APOL appropriate credit for its profitability.

In summary, APOL gets our “very attractive” stock rating because its economic earnings are strong and growing while its valuation implies economic earnings will decline permanently by 60%.

APOL fits the risk/reward pro­file of a great stock to buy.

HIDDEN GEMS:

  1. Our dis­counted cash flow analy­sis shows that APOL’s cur­rent val­u­a­tion (stock price of $42.31) implies that the company’s prof­its will decline by 40% and never grow again.
  2. Eco­nomic earn­ings are higher than reported accounting earnings.
  3. Excess cash of $1,201mm or about 20% of its market cap

For details on what causes the dif­fer­ence between eco­nomic ver­sus account­ing prof­its, see Appen­dix 3 on page 10 of our report on APOL. See Appen­dix 4 to learn how APOL increased net operating profit after tax (NOPAT) on strong revenue growth even though its NOPAT mar­gin fell from 17.1% to 16.8%. APOL’s ROIC (detailed in Appendix 7) still rose from 37.7% to 39.3% because, as detailed in Appendix 5,r educed its invested cap­i­tal while revenue grew and raised its invested cap­i­tal turns from 2.21x to 2.34x.

Note: Stock pick of the week is updated every Tuesday.

3 Comments

  1. Brian Leung says:

    You take a very interesting approach to your DCF analysis, in particular projecting a growth/decline that justifies the current valuation. That’s what Munger would call “invert, invert invert”.

    I did a similar calculation to yours using a DCF calculator that I’ve built. Check it out at:
    http://stockzoa.com/dcf/APOL/MTImLTEwJjAmMCY

    I’ve run DCF calculations of APOL in the past and it’s always been pretty compelling. More so in 2007 and i really regret missing that boat. I’m going to take a more careful look. Thanks for your analysis!

  2. Brian:
    Thank you for your comment.
    I love your site. Excellent simplification of the DCF process and a great tool for investors. It is very important that more investors understand the expectations for future cash flows that are embedded in stock prices.
    My approach to valuation is better-known as “Expectations Investing” – we start with the stock price and work backwards to figure out the discounted future cash flow stream that generates that stock price. We aim to be as complete and transparent as possible about valuation.
    Here are links to the DCF page and WACC page of our model for APOL. There are many other pages in the model, notably a Forecast page where one can enter custom assumptions for revenue growth, pre-tax profit margins, cash tax rates, working capital needs and fixed asset needs. Note we have similar models for all 3000 stocks we cover.

    http://ncblog.cloudapp.net/wp-content/uploads/2011/01/Screen-shot-2011-01-26-at-9.40.35-AM.png – DCF page from our Company Valuation Model
    http://ncblog.cloudapp.net/wp-content/uploads/2011/01/Screen-shot-2011-01-26-at-9.42.07-AM.png – WACC page from our Company Valuation Model

    The main difference in your results and mine is caused, I think, by your WACC assumption at 12%. We are at about half that. We are probably on the low end. But the results to not vary much when you bump up the WACC by 250 basis points or so.

  3. great blog If you are the type to update your blog regulary, then you have gained one daily reader in me today. keep up the super work.

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