Summary
- Strategic Education missed Q4 earnings but didn't contain any surprises.
- Enrollments have returned to growth, so the market is looking for margin and operating income expansion going forward.
- The valuation is somewhat demanding, and investors should remain cautious at these levels.
Strategic Education (STRA) reported Q3 and Q4 earnings since my last review of the company. Q3 reported a minor net enrollment loss when aggregating all segments, but management guided investors that they would be returning to enrollment growth and the stock rallied. This latest Q4 report validated that trend as STRA eked out enrollment growth for the first time in a while. That's important because of the company's operating leverage where if enrollments trend higher, management can have more confidence in tuition rates and any incremental improvements essentially fall to the bottom line.
Following the Q4 report, however, the stock reacted negatively. At face value, we can see that STRA missed on both the top and bottom lines . The top line wasn't really much of a miss though coming in about $1.8 million beneath analyst expectations. When comparing Q4 versus Q3, USHE stabilized more, ETS revenue growth slowed slightly, and ANZ slowed even more. On balance, that's positive but not exciting, in my view.
Within the core operating business, instructional and support costs delevered approximately 169bps and general and administrative costs delevered 218bps relative to revenue. Those expense lines increased by 2 and 6%, respectively, which is decent with 2022 inflation clocking at 6.3% for the US and 7.8% for Australia. Operating income was only down 0.8%, which was consistent with the decline in net revenue, but was mitigated by negative restructuring costs. Overall that's decent expense control, but within the context of declining revenue, not a positive outcome for investors either. I believe the more significant reason for the stock price decline was that the valuation simply moved too far ahead of itself.
In my previous article, I reiterated that the company's fundamentals were improving and that the bear thesis was losing steam, which has been confirmed by the last two reports. However, investors should be cautious, given the demanding valuation. Presently, STRA is valued around 22x TTM free cash flow, but it's more nuanced than that.
Free cash flow has been bouncing between $90-130 million over the last two years. Changes in working capital have had some positive and negative effects, but swings are largely neutral at this point. Compared to an enterprise value of $2.1 billion, the multiple ranges as high as 23x to 16x at best. So overall, the stock is clearly pricing in some growth with the implied margin and operating income expansion that would go along with that. In other words, we can probably attribute part of the Q4 sell-off to the earnings miss, but it's likely more so due to the demanding valuation.
I think investors should also consider the recent uptick in stock-based compensation [SBC]. In FY21, total SBC was about $18.15 million and $21.8 million in FY22, or ~20% growth year-over-year. Although revenue and core earnings stabilized in Q4, which in itself is a good achievement, investors should be aware that a 20% increase in SBC is dilutive to shareholders.
In previous years, STRA's SBC was fair, but now there's some creep with the increase from the average of $12 million to $22 million today. Putting this into context, that $22 million expense is about 15% of TTM EBITDA and 17%-24% of TTM free cash flow. If we actually factor in SBC into the free cash flow calculation, then the EV/FCF multiple increases to a range of 19x-30x, which is somewhat expensive for a company that has yet to produce tangible earnings growth.
On the capital allocation front, STRA did a pretty good job in 2022. They repurchased about $25 million worth of stock in the first half of the year, when the share price was depressed, and very heavily in Q2. And then another $11 million in Q3, and rounded out Q4 with $3 million. Following management's buyback patterns, clearly there's less interest in retiring shares at these lofty levels.
Looking Forward
Overall, STRA appears to be executing by returning to enrollment growth, growing its corporate accounts, managing tuition rates to incentivize new enrollments, and controlling costs. Fundamentally, I think management will continue executing on its strategy to drive the top line and that the core business still has positive momentum. However, the industry is intensively competitive, which is a prevailing headwind to revenue and margins, in my view.
Going forward, STRA will need to post more enrollment momentum and actually demonstrate an inflection to earnings growth. Without that, it's hard to see significant incremental upside in the stock price.
So despite the shift to enrollment growth, I can understand the negative stock price reaction following Q4 earnings. It primary comes down to the valuation. I think for those who believe in the story of enrollment momentum, which still exists, the stock is priced about right today. However, I think any fundamental hiccups, i.e. negative momentum materializing in USHE, ETS, and/or ANZ, would easily send shares lower.
While I think STRA is executing, the valuation seems too expensive. I remain on the sidelines and would only accumulate shares at lower levels. How do you think STRA will perform? Let me know in the comments section below. As always, thank you for reading.
For further details see:
Strategic Education: The Stock Got Ahead Of Itself