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Education Management

Today we'll take a fresh look at the stock, not just because it's up (although that's certainly reason enough), but also because it turned up recently on another one of our screens. This one looks for companies whose share prices look cheap relative to their free cash flow.

Free cash flow performs double-duty as a financial metric. Like earnings, it's a measure of income. But it's also a measure of financial strength. Simply put, free cash flow is the money a company has left over each quarter after paying its bills and spending on new plants and equipment. When calculating their earnings, companies spread the cost of plants and equipment, known as capital expenditures, over the projected useful life of the items. These quarterly charges are known as depreciation. Companies do this so as not to produce herky-jerky earnings movements fat profits in quarters when they don't have to buy new machines, and skimpy ones in quarters when they do. So earnings are useful for financial modeling and valuation work. But they don't actually measure money going into and out of the till.

Free cash flow, on the other hand, does away with depreciation charges and instead subtracts all capital expenditures in the quarters the money is paid. Notice we say "paid" rather than incurred. That's another useful thing about free cash flow. Net earnings measures the income a company accrues, not necessarily the cash it receives, and reflects the charges it incurs rather than money it pays. Again, free cash flow is simply a measure of cash coming in minus cash going out. So it shows the real dollars a company has left to spend on things like dividends, share repurchases, debt retirement and other shareholder goodies.

Spotlight Stock
Education Management Corp. A provider of proprietary postsecondary education in the U.S. Offers programs in the creative and applied arts through Art Institutes Division and programs in psychology, counseling, education, business, law and the health sciences through Argosy.
Monday's Close	$33.38
Market Value	$2.5 billion
Trailing 12-Month Sales	$980 million
2005 P/E	25
Proj. Long-Term EPS Growth Rate	20%
Additional Data: | | | |

It's a useful measure. In December 2004 we wrote about free-cash-flow screen survivor Intrawest, a Vancouver-based ski-resort operator ("It's All Downhill. It had produced substantial free cash flow by "partnering with deep-pocketed financers like J.P. Morgan and Manulife to fund its real-estate development efforts in exchange for a split of the profits." That had allowed the company to pay down its debt/Ebitda (the latter stands for earnings before interest, taxes, depreciation and amortization) ratio to 3.2 from 5.4 in a year. Investors who bought the stock at the time of our story are up 25%, vs. the S&P 500 index's 3% increase.

For stock screening purposes, there's a right way and a wrong way to use free cash flow. Don't use it to look for young growers, as these companies often spend more than they make in their early years of expansion. Do use it, however, to look for value stocks mature companies producing heaps of extra cash relative to their share prices. In other words, look for companies with low price/free-cash-flow ratios.

Use our stock screener and price/free-cash-flow recipe anytime to run our search for yourself. Recently it produced a list of 10 companies, including Education Management.

Pittsburgh-based Education Management runs 70 postsecondary schools in 24 states. The Art Institutes produces web-site designers, fashion marketers, chefs and more. Argosy University offers associate through doctoral degree programs in fields like education, psychology and business. Brown Mackie College offers a full menu of degree programs with particular breadth in its health choices. Same for South University. And there's a law school: Western State University.

To call these schools for-profit is an understatement. Bachelor's programs at Argosy, for example, cost students about $400 per credit hour; graduate courses cost $800 per credit hour. Operating margin for the company stands at 16%, roughly double the average for education and training companies.

Education Management is scheduled to release fourth-quarter results on Thursday. Its third-quarter results, released May 4, benefited from the unlikely combination of sales that surpassed expectations by $1 million and operating expenses that fell short of forecasts by $5 million. Sales increased 17% year-over-year to $274.6 million. Earnings ballooned 35% to $34.2 million. Per-share earnings of 45 cents topped estimates by four cents. Total enrollment during the quarter grew 12.3% to 64,139, while same-school enrollment improved by 11.8%. Online-only enrollment (read: high-margin enrollment) climbed 85.7% to 3,082.

"EDMC's vast offering of programs and degrees provides the foundation necessary for sustainable long-term growth trends," wrote Jefferies analyst Richard Close in a research note on the day after the earnings release. Nearly 60% of the student body, he pointed out, are seeking degrees, vs. about 48% for the Art Institutes two years ago. "The length of stay is approximately three years and continues to inch up as more and more students gravitate toward higher-level programs," wrote Close. (Close doesn't own shares of Education Management; Jefferies doesn't have an investment-banking relationship with the company.)

Also inching up is free cash flow, which totaled $148 million in the third quarter, a year-over-year increase of 27%. The company is spending some of that money on expansion. It opened a Brown Mackie campus in Denver in July. But it's expanding on the cheap by co-locating schools. The Brown Mackie campus will share space with an existing Art Institutes location.

Shares of Education Management trade at 14 times trailing free cash flow the lowest P/FCF ratio of the 27 education companies in our database. Education's price/earnings ratio of 25 is greater than the group's 20. But Education is projected to boost its earnings by 20% annually over the next five years, faster than peers' 14.5%. That gives it a price/earnings-to-growth, or PEG, ratio of 1.25, lower than the group's 1.38 and the S&P 500's PEG of 1.55 further evidence that the stock is attractively priced.