LOPE - Grand Canyon Education: Still Looking Solid Despite Legal And Regulatory Threats

2023-10-13 04:18:50 ET

Summary

• Grand Canyon Education is facing government legal action and tightening regulatory rules in the for-profit higher education sector.
• The Biden administration's revival of the Gainful Employment rule poses a significant risk to the company's eligibility for federal student loans.
• An ongoing legal battle between flagship school Grand Canyon University and the Department of Education may also impact the company's future.

From resource extraction to commercial aviation, all manner of industries are vulnerable to government interference. Investors with exposure to such sectors must make their peace with regulatory risk-and be prepared to react when the rules change.

Few industries are as exposed to regulatory risk as the for-profit higher education sector. Even the highest quality players are not immune, as Grand Canyon Education (LOPE) will attest. Grand Canyon is staring into the teeth of government legal action and tightening regulatory rules, a less than ideal combination for a business that relies on government-issued student loans as a principal source of income.

Performance Review

Grand Canyon Education (hereafter referred to as GCE) is a shared services partner dedicated to serving colleges and universities. The company currently supports 27 university partners, of which Grand Canyon University (GCU), its flagship institution, is by far the most important. Through its Master Operating Agreement, GCE receives 60% of GCU's net revenue from tuition and other fees.

In August, GCE reported results for the second quarter . The company reported $211 million in revenue for the quarter, enough to beat the analyst consensus, albeit very narrowly. Revenue was up 5.4% from the same period last year, a result driven in large part by a 4% rise in GCU's total enrollment. Revenue per GCU student was also up, despite only limited tuition hikes. Indeed, GCU's net tuition rate has risen a mere 1% since 2018 even as average price of college tuition has soared .

GCE's bottom line performance also surpassed expectations, with non-GAAP diluted EPS of $1.01 handily beating the analyst consensus of $0.85. However, this beat was fueled principally by investment income, which contributed $0.09 to the EPS print.

GCE continued its stock buyback program during the second quarter, retiring 5% of its outstanding share count at the cost of $45 million. Despite the buybacks, GCE's cash balance grew to $233 million, up $38 million from the first quarter, while its balance sheet remained clear of debt.

Unsurprisingly, GCE's latest consensus-beating performance gave its stock a significant boost. However, even the fresh ebullience could not fully distract from a number of ominous clouds darkening the horizon.

Regulatory Changes Spark Concern

At the heart of the matter is the Biden administration's decision to revive the Gainful Employment ((GE)) rule, an Obama era policy targeting for-profit colleges and universities that was repealed in 2020. On May 17, the U.S. Department of Education unveiled the latest proposed iteration of the GE rule , which promises to "terminate access to Federal financial aid for career training programs that routinely leave graduates with unaffordable debt burdens or with earnings that are no higher than workers without any education beyond high school." As with the Obama era policy, the new GE rule would apply only to for-profit educational institutions.

Under the revised GE rule, students enrolled in for-profit higher education programs that meet either (or both) of the following criteria in two out of three consecutive years would lose their eligibility for federal student loans:

1. If the median student in the program graduates with an estimated annual loan payment equal to more than 8% of their annual earnings and more than 20% of their discretionary earnings.
2. If the median student in the program earns less than the average labor force participant aged 25 to 34 with only a high school diploma, in the same state as the institution.

Put simply, if a program leaves graduates with too much debt, too little income, or both, then other students in that program will lose their eligibility for federal student loans.

Proponents of this policy change argue that it will improve higher education and protect students, but this claim seems dubious for a couple of reasons. For one thing, there is evidence that a great many nonprofit institutions would also struggle if subjected to the GE rule. According to an analysis from 2020 of the previous GE rule, only about 60% of programs at private nonprofit schools and 70% of those at public schools passed muster.

Defensive Measures Face Legal Opposition

GCE has already taken steps to insulate itself from the GE rule. Back in 2018, the company made the bold decision to sell GCU to a nonprofit entity while retaining most of the asset's economic value through a Master Services Agreement. This move was supposed to protect GCU and GCE from the GE rule. However, the maneuver failed ultimately to deter the Department of Education, which continued to classify GCU as a for-profit institution. The argument over this classification precipitated a protracted legal battle that continues to this day.

This month saw the simmering dispute between GCU and the Department of Education boil over. On Oct. 5, GCU published a statement accusing federal agencies of "coordinating efforts with frivolous accusations in order to bring harm to [the] largest Christian university in the country." According to GCU, the issue has been taken up by a number of federal departments:

"Government officials associated with the U.S. Department of Education ((ED)), Federal Trade Commission ((FTC)) and under the authority of the Department of Veterans Affairs ((VA)) are coordinating efforts to unjustly target GCU in what appears to be retaliation for the university filing an ongoing lawsuit against ED regarding its nonprofit status…By intentionally mis-classifying GCU as a for-profit institution for purposes of federal student aid, ED is now able to target the university as part of a coordinated effort…to 'pursue the full range of sanctions' against for-profit institutions that they frequently decry as bad actors due to the disproportionate number of Americans who attended those schools and then defaulted on federal student loans."

Whether or not GCU's claims of mistreatment have merit, picking an extremely public fight with a federal government committed to cracking down on its business model is a risky move. I am not a lawyer, and thus am unable to offer legal advice. However, the fact that GCU is willing to fight the issue out in court suggests it has at least a case to make. The result of that fight will have significant repercussions for GCE.

If GCU fails to secure its nonprofit status, some of its programs could end up taking a hit from the GE rule. The Department of Education released the final text of the proposed GE rule on Sep. 27, but it is not set to go into effect until July 1, 2024. If the rule goes into effect next year as planned, programs at for-profit educational institutions that fall short would begin to lose their federal student loan eligibility starting in 2027. Even in this worst-case scenario, however, GCU will have some time to correct any errant programs that might run afoul of the reborn GE rule.

Assessment

Grand Canyon Education has developed an impressive, profitable business by carving out a defensible niche in the for-profit education space. However, the renewed government efforts to curtail the for-profit higher education sector is a potentially serious headwind on its own. The escalating fight between Grand Canyon University and the Department of Education only adds to the uncertainty.

Despite these headwinds, GCE's fundamentals continue to show strength. Strong forward-looking earnings guidance, combined with its $102 million authorized budget to continue stock buybacks, may be enough to maintain forward momentum through the end of the year.

Final Verdict

With a stock price effectively flat from five years ago despite improved financials and contracting share count, GCE looks quite attractive at its current price. While legal and regulatory threats persist, they seem unlikely to diminish GCE's ability to continue growing profitably over the long run.

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