This Industry Is in Serious Trouble

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If you’re an investor who owns stocks, you know that risk management is a key component of building a portfolio. As stockholders, we are residual claimants, meaning owners of a company aren’t entitled to anything. Whereas bonds are a contractual relationship, and bondholders are the first on the capital structure to receive payment, stockholders are often left holding the bag if a company goes bust.

Therefore, it’s critical to tread carefully among the minefield of the thousands of publicly traded stocks out there. Even companies that look cheap on the surface can be traps, and as equity investors we need to understand which industries are in structural decline. One such industry that I believe investors should avoid at all costs is the for-profit education industry.

Failing grades across the board

On June 26, the Dow Jones Industrial Average rose 150 points and the S&P climbed nearly 1 percent. Many of the for-profit education stocks, however, were deeply in the red—a disturbing signal during such an impressive, broad market rally.

For-profit education stocks such as Bridgepoint Education (NYSE: BPI) and Strayer Education (NASDAQ: STRA) dropped 0.5% and 3.3%, respectively. But this was nothing compared to the 10% drop in Apollo Group (NASDAQ: APOL) after the owner of the University of Phoenix reported its third-quarter earnings results.

Apollo said its third-quarter profit fell a whopping 40% from the prior year on a 16% drop in revenue year over year.

Moreover, the company’s current year outlook came in below Wall Street expectations. Apollo was expecting revenue to come in between $3.65 billion to $3.7 billion, falling short of analyst projections.

The big picture: an industry in decline

Apollo’s results are just one example of the bigger crisis affecting for-profit education, which is collapsing enrollments. Apollo’s University of Phoenix saw total enrollment fall 17%, and new student sign-ups fell a massive 25%.

This stunning drop in enrollments is being felt throughout the entire industry.

In May, Strayer released first-quarter results, which saw revenue and diluted earnings per share fall 8% and 24%, respectively. Furthermore, Strayer’s total enrollment dropped 9% and its new student enrollments decreased 14%.

Ditto for Bridgepoint: the company’s own first-quarter revenue declined 11% year-over-year, and diluted earnings per share collapsed 27% from the first quarter of 2012.

Again, enrollments were the main cause of the company’s deteriorating financial performance. Total student enrollment at Bridepoint’s academic institutions dropped 17% from the first quarter last year.

Cheap only on the surface

Proponents of investing in the for-profit education sector likely point to the cheap valuations on these stocks. It’s true that many of them trade for low multiples of trailing earnings and cash flow. For example, Strayer trades at 9 times trailing earnings. Apollo and Bridgepoint, meanwhile, change hands for just 5 times trailing EPS.

However, it’s important to remember that these valuations are just a snapshot in time. These stocks are only cheap when compared to trailing earnings, the key word being 'trailing.' Future earnings are likely to keep falling, which is why their stock prices have collapsed over the past few years.

This is where the term ‘value trap’ takes its meaning: stocks that seem cheap on the surface, but will look much more expensive once the earnings collapses are taken into account.

Many investors are willing to wait for distressed companies to turn their businesses around in exchange for buying in at low prices. However, shareholders aren’t being paid to wait for this. None of these stocks pays a dividend. Strayer was the last to do so, having suspended its $4.00 per share annual payout in 2012.

These companies will focus on cost-cutting to try to eke out profits going forward. For example, in the wake of its quarterly results, Apollo announced it is targeting $300 million in cost cuts in fiscal 2013.

However, cost-cutting can only go so far. Continuing drops in student enrollments will virtually ensure lower revenue and profits in future quarters.

Investors don’t need to gamble on stocks with such deteriorating fundamentals. There are plenty of highly-profitable stocks out there that reward their shareholders handsomely with rising earnings and dividends. Plainly stated, the for-profit industry is in a structural decline, and investors would be wise to send all for-profit education stocks to detention.

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Robert Ciura has no position in any stocks mentioned. The Motley Fool recommends Bridgepoint Education. The Motley Fool owns shares of Bridgepoint Education. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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