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Online College Is Hot, But This New IPO in the Space Merits Barely Passing Grades

By Michael Brush
Exclusively for InvestorIdeas.com
December 29, 2006

A new year has arrived which means many of us are making vows to improve our lives. For lots of people that will mean taking college classes online – if the recent trends at Capella University are any guide.

Based in Minnesota, this recent initial public offering (IPO) -- where insiders have been scooping up shares -- offers doctoral, master’s and bachelor’s programs in areas like business and information technology.

Enrollment for the first nine months of this year was up a healthy 23% while revenue increased a robust 20%. Last year was just as spectacular. Enrollment and revenue were up 19% and 27%.

User-friendly format

It’s easy to see why students like the kind of online format that Capella Education (CPLA) offers. There are no formal class times – so the online classes can be squeezed in to the hectic schedules most of us have these days.

Instead, students visit online “course rooms” several times a week when they want. They have to respond to questions from the instructor and comments by other students.

Indeed, the company says growth in demand for its user-friendly format is “largely attributable to the flexibility and convenience that it offers to both working adults and traditional students.” In fact, most Capella University students are working adults earning degrees to advance their careers, often with their current employer.

Students pay $1,400 to $1,950 per course and a bachelor’s degree costs about $54,000. You can get a master’s degree for $17,000 to $28,000, and doctoral degree will set you back anywhere from $31,000 to $62,000. About 65% of the tuition bill is backed by federal financial aid programs.

The industry

With only $129.3 million in revenue for the first nine months of this year, Capella Education is just a small player with lots of room to grow. The Department of Education estimates that post-secondary, degree-granting institutions took in more than $260 billion in revenue in 2001.

The number of students in college should continue to grow because:

More people are graduating from high school
Employers need more skilled workers
People with more education tend to earn more

By one estimate, the number of students enrolled in online, degree-granting schools grew by 28% in 2005.

With these kinds of trends in place, it might be easy to see why several insiders -- including directors and the manager in charge of marketing -- bought over $400,000 worth of stock on the Capella Education IPO in late November.

Regular readers know we have had several successes with IPOs where insiders were buying. Insiders purchased shares for prices ranging from $20 to $25.15. The stock recently traded for $24.50.

Not surprisingly, analysts linked to the banks that helped do the IPO are rolling out buy ratings. They have price targets suggesting you could get 30% profits in a year.

Stifel Nicolaus analyst Jerry Herman, for example, expects Capella Education earnings to grow more than 20% a year for the next few years. He has a 12-month price target of $31 per share.

Barely passing grades

Despite all these positive signs, I’ll give this IPO a grade of C for the following reasons. You might make money with this stock because the insider buying is compelling, but I’d only put a small portion of my portfolio to work here.

The biggest problem is that this IPO looks more like an end game for top managers than a way to raise funds to actually improve the university. The IPO probably raised around $70 million for Capella Education. That’s a lot of loot which could improve the school by funding things like better infrastructure and more teachers. That would help both students and shareholders by raising the quality of the university.

But sadly, the IPO money won’t do any of that. Students and shareholders who buy now will benefit very little from the capital raise.

Instead, most of the money is being used to fund a special dividend payable in multi-million dollar dollops to top managers and directors. As pre-IPO shareholders, they are using the IPO as way to cash out -- just at a time when we as investors are being asked to believe in the company and its future.

Chief executive Stephen Shank, for example, is getting a rich $14.2 million, according to corporate documents. (He’s due to leave next year.) Two directors -- Jon Reynolds, Jr. and Tony Christianson – are getting around $11 million each. Two others, S. Joshua Lewis and Jody Miller, get $7.5 million and $6.8 million.

It’s never a good sign when most of the money in an IPO is being used chiefly to pay off early investors.

Now here’s the second reason why I’ll give Capella Education low grades. Not only will students see little benefit from the IPO funds, but they’re actually being asked to foot more and more of the corporate promotional costs – possibly to the detriment of their education.

Consider these numbers to see what I mean.

Back in 2004, promotional costs to attract more students were just under 30% of tuition revenue, while instructional costs were 50% of that revenue.

By this year, promotional costs had advanced to 33% of revenue while spending on instructors slipped to 47.5%.

That many not sound like a big change. But if you annualize revenue for the first nine months of this year, it means that Cappella University will spend $3.3 million less this year on teachers than it would have.

Since the going rate is fairly low for adjunct professors, the kind that Capella uses the most (85% of faculty), students gave up a lot of teaching power in exchange for the bigger promotional budget that drove the pre-IPO growth.

Given the fact that Capella has just 16,000 students, I’d guess they would feel the difference and get a better educational experience if their university had spent $3.3 million more on instructors this year.

“This increase was primarily attributable to an increase in investment in building brand awareness and market tests, an increase in the cost of online advertising and an increase in learner recruiting personnel,” says the company.

A skeptic might say it a different way: The school has been diverting more money from instruction to promotion during the past three years to help boost growth and dress up the company for an IPO that allowed insiders to cash out.

If that’s accurate, it’s not a very student-friendly -- or shareholder-friendly -- approach to things, and it would make me cautious about this stock.

Indeed there are other signs that Capella University has been stretching to meet growth targets:

At 33% of revenue, selling and promotional costs are much higher than the industry average of 23%.
There’s a hint that Capella University has been attracting, shall we say, a less committed student. Net cash from operations declined in the first nine months of year. The company cites several reasons but one is lower student payments for courses in the third quarter.

Capella University also faces other challenges like increased online education from old-school universities that have longstanding reputations. It also has a strategy of adding more students in its bachelor’s program where pricing is lower and competition is higher.

The bottom line: There’s little doubt that the robust growth in online post-secondary education will continue because it is so darn convenient. This recent IPO offers a way to play that trend. But giving the shareholder- and student-unfriendly debut as an IPO, I’d be careful about getting too much exposure to this company.

Disclaimer
At the time of publication, Michael Brush did not own or control shares in any of the companies listed in this column. Mr. Brush is an independent columnist for this web site.
For more on Insiders Corner disclosure, see the disclosure section in About Insiders Corner: http://www.investorideas.com/insiderscorner/. InvestorIdeas.com Disclaimer: www.InvestorIdeas.com/About/Disclaimer.asp. InvestorIdeas is not affiliated or compensated by the companies mentioned in this article.

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