May 16, 2006
Research Associate: Neha Poddar
Editor: Nelson Bishop, CFA
Sr.Editor: Ian Madsen, CFA : : 1-800-767-3771:x417
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Education Management Corporation / (EDMC-NSDQ) / $42.65Note: This report contains substantially new material. Subsequent reports will have changes highlighted.
Reason for Report: 3Q06 earnings update Previous Edition: March 23, 2006
Overview
Education Management Corporation (EDMC) provides private post-secondary education in North America. It delivers education to students through traditional classroom settings as well as online instructions. The company primarily offers academic programs through four educational institutions: The Art Institutes, ArgosyUniversity, SouthUniversity, and AmericanEducationCenters. The Art Institutes offer programs in the media arts, design, fashion, and culinary arts. In addition to the physical campuses, The Art Institute online offers a suite of bachelor’s, associate’s, and diploma degree programs in the creative fields. Argosy University offers doctoral and master’s programs in clinical psychology, counseling, and education. Argosy also offers doctoral, master’s, and bachelor’s degree programs in business administration; bachelor’s degrees in psychology; and associate degree programs in various health sciences fields. SouthUniversity offers undergraduate and graduate degree programs in business, legal studies, information technology, and health sciences fields. American Education Centers offers bachelor’s and associate’s degree programs in health sciences, business, information technology, legal studies, and design technologies. EMC was organized as a Pennsylvania corporation in 1962 and is headquartered in Pittsburgh, Pennsylvania. The website is
EDMC’s fiscal year ends June 30.
Analysts have identified the following factors for evaluating investment merits of EDMC.
Key Positive Arguments / Key Negative ArgumentsThe company maintains a strong legal and regulatory track record. / Student retention rates continue to be low compared to historical levels.
Student enrollment remains strong, with higher degree programs experiencing greater demand.
Demand for post-secondary education services should continue to rise in future.
The company has added over 100 programs yeartodate,and plans to add another 120 programs in FY06.
Revenue
Revenues in the third quarter ended March 31, 2006 increased 13.8% to $312.5 million, compared to $274.6 million in the same period a year ago. Revenue growth in the third quarter of fiscal 2006 resulted from an 8.8% increase in total student enrollment and an approximate 5% increase in tuition rates. Total enrollment in the quarter was 71,911 compared to 66,103students in the same period last year.
At the start of the current spring quarter (fourth quarter of fiscal 2006), total enrollment at EDMC's schools was 69,775 students, an 8.7% year-over-year increase. Same-school enrollment (schools owned for one year or more) increased 8.3% to 69,521 students. Campus-based enrollment includes students at Brown Mackie Colleges in Dallas and Fort Worth, Texas that discontinued accepting new enrollments in August 2005. There were a total of 22 students at these two schools during the current spring quarter compared to 383 in the prior-year period. At the start of the current spring quarter, excluding students at Brown Mackie Colleges in Dallas and Fort Worth, total enrollment and same-school enrollment at EDMC's schools increased 9.3% and 8.9%, respectively. Students taking 100% of their coursework online increased 55.6% to 4,796 students.
For 4Q06, the company projects revenue growth of approximately 13%.
One analyst (Stifel Nicolaus)forecasts 4Q06 revenue growth of 13% to about $288 million.
For FY06, analysts forecast revenue in a range of $1157.9M to $1170.0M, with an average of $1165.6M. For FY07, the range is $1285.2M to $1328.9M, with an average of $1307.3M.
Revenue (M)FY ends June / 2004A / 2005A / 1Q06A / 2Q06A / 3Q06A / 4Q06E / 2006E / 1Q07E / 2Q07E / 3Q07E / 4Q07E / 2007E
Total Revenue / $853.0 / $1,019.3 / $253.0 / $312.6 / $312.5 / $288.5 / $1,165.6↑ / $283.7 / $350.8 / $351.3 / $325.4 / $1,307.3↑
Digest High / $853.0 / $1,019.3 / $253.0 / $312.6 / $312.5 / $289.0 / $1,170.0 / $286.7 / $354.6 / $354.8 / $329.0 / $1,328.9
Digest Low / $853.0 / $1,019.3 / $253.0 / $312.6 / $312.5 / $288.1 / $1,157.9 / $280.6 / $347.0 / $347.7 / $321.8 / $1,285.2
YoY Growth / 19.5% / 18.4% / 13.3% / 13.8% / 13.0% / 14.4% / 12.1% / 12.2% / 12.4% / 12.8% / 12.2%
Sequential Growth / -0.9% / 23.6% / 0.0% / -7.7% / -1.7% / 23.7% / 0.1% / -7.4%
Margins
Third quarter operating income rose 16.5% to $64.6 million from $55.5 million in the same period a year ago. Consolidated operating margin improved 48 basis points to 20.7%. The improvement in consolidated operating margin was due, in part, to lower bad debt, salaries and rent expense as a percentage of revenue. On a proforma basis including the effect of stock compensation expense under SFAS 123operating income increased 23.3% to $68.4 million from $55.5 millionin 3Q05, resulting in consolidated operating margin improvement of approximately 168 basis points to 21.9% from 20.2%. Bad debt expense was 1.9% of revenue as compared to 2.6% of revenue in the prior-year period due to improved collections of accounts receivable, primarily due to alternative loan funding.
Margin / 2004A / 2005A / 1Q06A / 2Q06A / 3Q06A / 4Q06E / 2006E / 1Q07E / 2Q07E / 3Q07E / 4Q07E / 2007EGross Margin / 36.0% / 37.2% / 32.2% / 45.3% / 42.9% / 35.8% / 39.5% / 32.9% / 46.8% / 44.5% / 37.7% / 41.2%
Operating Margin / 15.6% / 16.5% / 8.2% / 24.9% / 20.7% / 10.0% / 17.0% / 9.6% / 26.5% / 23.4% / 12.6% / 18.2%
Pre Tax Margin / 15.3% / 16.6% / 8.4% / 25.4% / 21.4% / 10.1% / 17.0% / 9.3% / 26.4% / 23.4% / 12.5% / 18.7%
Net Margin / 9.0% / 10.0% / 5.5% / 15.2% / 12.9% / 6.1% / 10.3% / 5.6% / 15.9% / 14.1% / 7.5% / 11.1%
One analyst (Stifel Nicolaus) forecasts FY06 marketing spending (included in G&A) to be slightly above the historical range of 15%-17%. Another analyst (Piper Jaffray) forecasts a 200bps y/y decline in pro forma 4Q06 operating margin, driven primarily by an increase in online and marketing and admissions spending.
Earnings per Share
In 3Q06, net income grew 17.9% to $40.4 million, or $0.52per diluted share, compared to $34.2 million, or $0.45 per diluted share, in 3Q05. On a pro forma basis including the effect of stock compensation expense under SFAS 123, net income was $30.4 million or $0.40 per diluted share, an increase of 32.8% year over year.
The Company anticipates fourth quarter diluted earnings per share of $0.20, which reflects an estimated impact of $0.04 due to expenses associated with the proposed acquisition by Providence and Goldman and $0.03 due to equity compensation expense under SFAS 123.
The average of consensus EPS estimates for FY06 by 10 analysts in the Zacks survey with published forecasts is $1.56. Individual analyst forecasts range from $1.53 to $1.61. For FY07, analysts’ EPS forecasts range from a low of $1.78 to a high of $1.94, with a Digest average of $1.85.
EPSFY ends June / 2004A / 2005A / 1Q06A / 2Q06A / 3Q06A / 4Q06E / 2006E / 1Q07E / 2Q07E / 3Q07E / 4Q07E / 2007E
Zacks Consensus / $0.23 / $1.53 / $0.22 / $1.82
Digest High / $1.03 / $1.13 / $0.18 / $0.62 / $0.52 / $0.26 / $1.61 / $0.23 / $0.73 / $0.65 / $0.36 / $1.94
Digest Low / $1.03 / $1.13 / $0.18 / $0.62 / $0.52 / $0.20 / $1.53 / $0.20 / $0.72 / $0.58 / $0.34 / $1.78
Digest Average / $1.03 / $1.13 / $0.18 / $0.62 / $0.52 / $0.23 / $1.56 ↑ / $0.22 / $0.73 / $0.62 / $0.35 / $1.85↑
YoY Growth / 9.7% / 260.0% / 34.8% / 30.0% / 8.6% / 37.6% / 19.4% / 16.9% / 18.3% / 53.5% / 19.0%
Sequential Growth / -14.3% / 244.4% / -16.1% / -56.2% / -5.7% / 237.2% / -15.2% / -43.1%
Management Guidance / $0.20
One analyst (Harris Nesbitt) has reduced FY06 EPS from $1.55 to $1.53 based on additional advertising and marketing costs, and thevolume of advertisements associated with the private-equity acquisition. Further, the analyst has maintained FY07 EPS of $1.78 based on slightly higher enrollment and revenue growth forecasts, offset by lower margins based on the expected additional marketing and infrastructure costs. Another analyst (Stifel Nicolaus) forecasts FY06 EPS estimate of $1.53, which includes $0.09 in transaction costs. Yet another analyst (Lehman) has raised FY07 EPS from $1.80 to $1.91 based on strong 3Q06 enrollment results, particularly 7.0% campus-based student growth.
Target Price/Valuation
Of the ten analysts covering the stock, five analysts have a neutral rating. None of the analysts gave a positive or negative rating. One analyst (Barrington) did not provide any rating. Four analysts (Zacks Investment Research, B.of America, Jefferies, and Suntr. RH.) have not come up with their reports.
The analysts providing the valuation have pegged the price target at $43, which happens to be the buyout price quoted by Providence Equity Partners and Goldman Sachs Capital Partners. The deal is expected to close during the summer of 2006. The average target price is $43.00 (↑from $42.94 published in the previous report).
Rating DistributionPositive / 0%
Neutral / 100%
Negative / 0%
Max. / $43.00
Min. / $43.00
Avg. Target Price / $43.00↑
No. of Analysts with Target Price/Total / 4/10
Capital Structure/Solvency/Cash Flow/Governance/Other
On May 17, 2006 EducationManagement Corporation announced that ArgosyUniversity is adding campuses in Santa Monica and San Bernardino, Calif. Argosy San Bernardino will open on June 29 and offer EdDs, master's degrees and BAs, in psychology and education.
On March 6, 2006 Education Management Corporation announced the execution of a definitive agreement to be acquired by Providence Equity Partners and Goldman Sachs Capital Partners in a transaction valued at approximately $3.4 billion. EDMC's Board of Directors unanimously approved the transaction, and recommended its approval by the company's shareholders. Under the terms of the merger agreement, the private investors will acquire all of EDMC's outstanding shares of common stock for $43.00 per share in cash, representing a premium of 16.3% to the price of EDMC shares as of March 3, 2006, and a 26.4% premium to EDMC's average closing price of $34.02 during the previous 30 trading days. The transaction is expected to complete during the summer of 2006, subject to the receipt of shareholders’ approval and regulatory approvals, including the U.S. Department of Education, accrediting agencies, and state licensing boards. The Company will hold a special meeting of its shareholders on Thursday, May 25, 2006, to vote on the proposed acquisition.
On Dec. 12, Education Management Corporation announced that The Art Institute of Dallas has been placed on probation by the Commission on Colleges of the Southern Association of Colleges and Schools. While EDMCis yet to receive formal notification from the Commission, it understands that the action relates solely to The Art Institute of Dallas's failure to satisfactorily document identified expected outcome and assessments of its programs and services as required by the Commission's institutional effectiveness comprehensive standard.
The company has rolled out over 100 programs in FY05 (new programs and transplants of existing programs) and plans another 120 in FY06. New programs include a bachelor degree in fashion retail management, a bachelor degree in criminal justice, a doctorate program in community college executive leadership, and a simulation and virtual environment program that will be introduced into the AI system this year.
As ofMarch 31, 2006, the company had cash and cash equivalents of $394.0 million as compared to $177.1 million as ofMarch 31, 2005 due to higher cash flow from operations, improved collections and lower capital expenditures. Cash flow from operations for the three-month period ended March 31, 2006 was $189.0 million compared to $176.0 million a year ago. Higher cash flow compared to the same period in the prior year was primarily due to the growth in net income and positive working capital changes. Capital expenditures were $48.9 million, or 5.6% of revenue in the first nine months of fiscal 2006, compared to $53.5 million, or 7.0% of revenue, in the comparable period last year.
Long-Term Growth
Long-term earnings growth rate for EDMC is 20%. Analysts believe the company has put itself in a position to achieve strong growth over the next few years by leveraging acquisitions, through its wide range of programs, and a co-location strategythat involves resource sharing. Expansion ofEDMC’s facilities and online offerings should provide further prospects. Particularly, EDMC’s expansion into higher growth regional markets (Miami, Florida; and Los Angeles, OrangeCounty, and San Diego, California) should boost overall enrollment growth.
Individual Analyst Opinions
POSITIVE RATINGS
None
NEUTRAL RATINGS
Harris Nesbitt -Neutral ($43 - target price): 05/03/06 –The analyst maintains a Neutral rating and believes the stock to continue to trade in a tight range close to the value of $43. However, the analyst believes the deal may be delayed beyond thesummer of 2006, as it will likely incur intense scrutiny. The analyst believes that EDMC appears to be doing a better job than most in the current decelerating-growth environment. In addition, the long-awaited approval of Argosy Online is finalized, with classes expected to begin in late FY06/early FY07.
Stifel Nicolaus – Hold (No target price): 05/02/06 – The analyst has downgraded the shares form Buy to Hold based on the proximity to the target price and rising probability of the deal closing successfully for the company to be taken private.
Lehman – 2-Equal weight ($43 - target price): 05/03/06 – The analyst maintains an Equal weight rating with a target price of $43 due to pending LBO and limited upside to thetakeout price of $43 from the current market price.
Piper Jaffray – Market Perform ($43 - target price): 05/02/06 – The analyst maintains a Market Perform rating with a price objective of $43. The analyst expects improvement in student rate in the art institutes based on the increase in the number of assistant director of admission personnel, and restoration of the application fee, thereby improving the quality of the applicant pool and conversion rates. However, the analyst remains concerned about the ability to successfully open and acquire new campusesas well as EDMC being highly dependent on government-sponsored student financial aid.
UnionBankSwitz. – Neutral 1 ($43 - target price): 05/02/06 – The analyst has set a target price of $43 and has maintained a Neutral 1 rating. The analyst remains cautious on EDMC due to enrollment growth, regulatory concerns and its ability to attract and retain students along with key employees and faculty.
NEGATIVE RATINGS
None
Not Rated
Barrington:05/02/06 – The analyst has suspended the rating based on the expectation of a successful close to the proposed acquisition (subject to share holder meeting to be held on May 25th). Further, the analyst believes that private ownership will certainly allow EDMC to further respond to the changing needs of its students and allow the company to accelerate investment in certain areas of growth.
CEASED COVERAGE
R W. Baird: 03/13/06 – The analyst ceased coverage of Education Management Corporation (EDMC) given its planned take-private sale to Goldman Sachs and Providence Equity Partners.
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