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Top Marks for Career Education

By Massimo Santicchia Higher learning, indeed. For-profit education concern Career Education saw its sales rise at a compound annual growth rate of more than 65% between 1996 and 2002. During the same period, earnings grew at a compounded annual rate of more than 100%, driven by significant and steady margin improvements.

And Career Ed (CECO) has beaten analysts' expectations in 21 of its 22 quarters as a publicly traded company, with an average earnings surprise (the degree to which reported earnings exceeds the consensus estimate of Wall Street analysts) of more than 20%. Career Ed is one of S&P's favorite stocks in the for-profit education market, and carries our highest investment recommendation of 5 STARS, or buy. Other industry players we follow include Corinthian Colleges (COCO) and Apollo Group (APOL).

Over the next three years to five years, we believe the company should be able to generate revenue growth in the 20-to-25% range and earnings growth of 30%-to-35%, driven by operating margin expansion. We have identified several factors that could fuel growth: growth within existing operations via a combination of enrollment growth, tuition increases, and a shift toward higher-priced programs; acquisitions of branded but undermanaged existing schools; openings of new start-up campuses; "transplants" of successful curriculum offerings to other Career Ed campuses; online education, and international expansion.

Despite its rapid growth, we expect Career Ed to generate increasing cash flows from operations and higher return on invested capital, as it reaps benefits from scale economies and operating leverage and grows its high-margin online business.

SCHOOL'S COOL. According to the U.S. Education Dept., postsecondary education is a $260 billion industry in the U.S., with about 15.3 million students obtaining some form of postsecondary education. This figure is projected to grow by 19%, to about 18.2 million students, by 2012. Federal funds available to support postsecondary education are estimated to exceed $54 billion during the 2001-'02 academic year. They have grown about 145%, from $22 billion, during the 1991-1992 academic period.

A number of trends are converging to contribute to growing demand for career-oriented education:

Higher required skill levels. The increasing technological skills required for entry-level jobs are spurring demand for specialized career-oriented training that may not be provided by traditional two-year and four-year colleges.

Increasing numbers of high school graduates. From the 1999-'00 school year through the 2011-'12 school year, the number of high school graduates (the largest pool of potential enrollees for outfits like Career Ed) is projected to increase by 11%, and grow to 3.1 million by the fall of 2011.

Demand for postsecondary education. The U.S. Education Dept. currently estimates that approximately 70% of high school graduates pursue some form of postsecondary education. The Labor Dept. projects the number of jobs requiring at least an associate's degree to grow by more than 14% between 1996 and 2006.

Growth of online education. The Education Dept. estimates that the number of degree-seeking students taking online courses will grow at a compound rate of 33% for the next several years, reaching approximately 2.2 million by 2004.

Rising demand for healthcare career education. According to the Labor Dept., 14% of all newly created jobs in U.S. are in the healthcare field.

Increasing awareness of the value of postsecondary education. According to a 2002 Census Bureau survey, on average, in 1999, an individual with an associate's degree earned approximately 23% more -- and an individual with a bachelor's degree earned approximately 52% more -- than an individual who had completed no more than a high school education.

Reduced funding for public education. Many educational institutions have had to cut back spending on general operations and refrain from increasing capacity. This may provide an opportunity for for-profit institutions to serve, at more competitive prices, the postsecondary education needs of individuals who would have otherwise attended public schools.

ENROLLMENT BOOSTERS. Career Ed offers educational programs principally in five career-related fields of study: visual communication and design technologies, business studies, information technology, culinary arts, and health education. Successful school programs are selectively duplicated at other schools within its system. In 2002, Career Ed successfully duplicated 15 programs, and an additional 50 program duplications are expected in 2003.

Career Ed seeks to increase school enrollment and profitability through intensive local, regional, and national direct-response marketing programs designed to maximize each school's market penetration. It also uses Internet-based advertising to attract potential students.

The company emphasizes the retention of students from initial enrollment to completion of their courses of study. Because, as at any postsecondary educational institution, a substantial portion of its students never finish their educational programs for personal, financial, or academic reasons, we believe substantial increases in revenue and profitability can be achieved through modest improvements in student retention rates. During 2002, the retention rate was approximately 73%.

Career Ed considers student placement a high priority, and 94.1% of its graduates who were available for employment for the academic year ended June 30, 2002, had found employment relating to their fields of study within six months of graduation.

We believe Career Ed can continue to achieve significant internal growth in enrollment, revenue and profitability at its existing 51 campuses. Over the last five years, revenue growth has been driven by a combination of same-school population growth, tuition increases, and a shift towards higher-priced programs.

GEOGRAPHY LESSONS. Career Ed has grown by acquiring new schools in the U.S., Canada, France, the U.K., and the United Arab Emirates and then applying its expertise in marketing and school management to increase enrollment, revenue, and profitability at those schools. We expect that this process will continue to be an important element of its growth strategy.

By acquiring new schools, Career Ed is able to realize economies of scale in terms of management information systems, accounting and audit functions, and employee benefits and insurance procurement, thus improving operating margins. We believe the recent acquisition of Whitman College represents an outstanding platform for Career Ed to penetrate the fast-growing market of health education.

Career Ed has opened four start-up branch campuses (two in 2002 and two in 2001) and expects to continue to establish branch locations of existing institutions. We believe that opening branch campuses enables it to capitalize on new markets or geographic locations that exhibit strong enrollment potential and the potential to establish a successful operation in one of its core curricula areas. Also, Career Ed has developed an expertise in migrating established programs and curricula from one campus to another. These "program transplants" should allow for leveraging of development, education, and marketing costs.

ONLINE ACADEMY. In February, 2001, Career Ed began enrolling students into full degree-granting online programs within American InterContinental University-Online. As of Apr. 30, 2003, AIU-Online had a total student enrollment of approximately 4,100, vs. just 300 a little more than a year earlier.

While we expect that its current campus-based school operations will continue to provide the large majority of its revenue in the near term, we believe that online education is Career Ed's greatest growth opportunity. We expect AIU to generate about $120 million in revenues in 2003. Career Ed's management projects $200 million to $300 million in revenues for 2005.

While in the short term the company's investment in its online programs is constraining overall profitability, we believe that in the long-term AIU will be one of the major drivers of increasing earnings power and higher return on capital. As the revenue from AIU increases as a percentage of total revenue, we believe Career Ed's operating margin will be more in line with that of industry leader Apollo. This in turn will, in our view, significantly boost Career Ed's return on capital.

We expect Career Ed to pursue international opportunities in private and for-profit postsecondary education and to continue its marketing efforts in selected countries to increase international student enrollments at its domestic schools. We believe the February, 2003, acquisition of the INSEEC Group, a postsecondary education company with nine campuses in France, provides Career Ed with a platform for additional expansion in Europe.

REVENUE RAMP-UP. S&P expects revenue and earnings growth at existing operations to be driven by new student enrollment, a projected 50 curriculum transplants in 2003, and new campus openings. We also see higher revenue per student due to online education growth, tuition increases, and optimization of acquired schools. We project revenue of $1.143 billion in 2003 and $1.48 billion in 2004.

Operating margins should widen slightly, on better operating leverage, increased offerings of advanced degrees, and growth of the online education division. After taxes projected at a rate of 40.5%, we see 2003 EPS at $1.07 and $1.39 for 2004. Our estimates do not include potential acquisitions. We project Standard & Poor's Core Earnings of 93 cents per share in 2003 and $1.22 in 2004, which are about 13% below our operating EPS estimates, due to option expensing.

In 2002, Career Ed generated free-cash flow of $47 million, and we project $64 million for 2003. Our 12-month target price, based on discounted cash flow analysis, is $58. The model assumes a compounded growth rate of free cash flows of 29% over the next five years, a gradual decline in the growth rate to 3% over the next 15 years, a 3% perpetual growth rate (in line with the 3% estimated long-term growth rate of GDP), a cost of capital of 8%, minimal long term debt, and an equity risk premium of 6%.

FEW NEGATIVES. The shares are trading at a well-above market multiple of 46 times our 2003 EPS estimate of $1.07. However, as we indicated above, we expect earnings growth to average 30%-35% over the next three to five years, driven by both student population growth and tuition increases. Also, in light of Career Ed's position in the for-profit postsecondary education market, and what we see as barriers to entry, annual revenue visibility above 60%, stable retention rates, increasing return on capital, and a consistent history of beating expectations, we believe such a premium is warranted.

In the long term, we believe that if Career Ed is successful in improving its operating margin through economies of scale and by growing the online business, its return on capital will increase and its shares' market multiples will consequently expand and trade more in line with industry leader Apollo.

Key risk factors, in our view, that could affect the company's operations and prevent Career Ed from achieving our target price include: failure to effectively execute growth initiatives; increasing competition that could raise prices paid for acquisitions; and declining placement rates that would be detrimental to new student population growth. Analyst Santicchia follows emerging growth stocks for Standard & Poor's

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