ITT Educational Services, Inc. (ESI)

There is fairly significant risk for ITT and the other for-profit education stocks, but there is incredible upside if current regulatory risks subside. If near-term regulatory risks are overcome, I think this stock could be trading around $150 in a year, and I think that may be a conservative estimate. Here's what I like:

*Excellent historical and forecasted earnings growth.* ITT has shown stellar EPS growth over the past five years, and that growth is projected to continue in 2010 and 2011. For 2004, ITT had earnings per share of $1.61. Since then, earnings have shot up at a 34.30% CAGR, resulting in 2008 earnings of $5.17 per share. In 2009, EPS growth accelerated as more people returned to school due to high unemployment. Earnings were $7.91 per share – a 53% increase from 2008. On January 21, 2010, management announced an initial 2010 earnings forecast of $10.00-$10.50 per share. This range was well above consensus analyst estimates of $9.48 per share. Based on management guidance and conservative estimates, I am estimating 2010 EPS of $10.07. Due to the current state of the economy and my conservative assumptions, I believe there is considerable upside to my guidance.

*Position in an expanding industry.* Over the past few years, an increasing number of Americans have recognized the value of postsecondary education, causing a substantial increase in enrollment at career colleges like ITT. Between 2003 and 2007, annual enrollment increased 21% in two year or fewer programs, 24% in two to four year programs, and 25% in four year or longer programs. These trends are expected to continue in the future as more workers seek postsecondary education. By 2018, workers with associate degrees – ITT’s most popular offering - are expected to increase 19%. In addition, workers with other postsecondary degrees are expected to grow 17-18%. The need for postsecondary schooling is punctuated by low growth rates in workers without some form of higher education: employment requiring only some form of on the job training is expected to grow only 8%.

*Strong growth should persist as unemployment rates remain high over the coming year.* Historically, ITT’s revenue growth rate has been strongest during periods of increasing unemployment. When performing a regression analysis between these two factors between 2000-2010 (2009 and 2010 projected), I found a 91% positive correlation between ITT’s annual revenue growth and unemployment. According to the Conference Board, the unemployment rate is forecasted to increase to 10.5% in the first quarter of 2010 and remain at that level until dropping to 10.4% in the fourth quarter. With unemployment remaining high in the US economy, revenue growth should remain very growth for ITT over the next year.

Catalysts:

*Gainful Employment dropped from NegReg.* The Department of Education is currently in the middle of a rulemaking session (“NegReg”) to prepare proposed Title IX regulation. A major issue is whether to tie federal student loan eligibility to expected compensation after graduating. Uncertainty over how this potential legislation could affect the company’s access to federal funding has been a major concern over recent months. If the gainful employment section is dropped off the proposed legislation, it would ease significant investor fears.

*Slower than expected economic recovery.* If the US economic recovery is slower than expected and unemployment continues to grow, historical trends suggest that ITT would benefit from unemployed workers seeking to increase their education levels and become more attractive to potential employers.


Risks:

*Potential legislation.* As mentioned in the “Catalysts” section, the Department of Education is considering whether to link federal student loan eligibility to the expectation of certain income levels after gradution. If the DoE passes such legislation, it could affect for-profit college students’ ability to obtain federal loans. Such legislation could force for-profit educators to lower tuition rates to ensure access to Title IX funds. If such legislation were passed, it would limit future revenue growth potential at for-profit educators. The NegReg committee debating the issue is scheduled to meet from January 25-27, 2010. Once the session is complete, any possible negative impact on ITT and the for-profit education industry should be known.

*The US economy recovers at a faster than expected pace.* A faster than expected jobs recovery would reduce the number of people pursuing higher education.

*ITT’s student loans.* If there are increased defaults on ITT’s loans to its students, it would increase bad debt expense, thus reducing earnings and margins.

Valuation:

ITT Educational is currently trading well-below historical averages for most valuation metrics. Moreover, the valuation multiples are extremely attractive when compared to its for-profit education peers. Currently, ITT’s 10.52x NTM P/E is well-below the peer group average of 13.88x, a 32% discount versus the peer group. The company’s low share price is largely a result of proposed regulation on access to student loans. There is certainly a risk for ITT as a result of this potential regulation. However, I believe much of this risk is priced into the stock, and that ITT’s current valuation and future growth potential offers compelling reason to buy.

Using DCF analysis and relative valuation, I valued ITT and determined a 1-year price target based on the following assumptions:

1-Year Target Price: $152 (~40% Upside)

Gainful Employment is not included in new DoE rules or regulation is watered down and has minimal effect on ITT. However, the DoE maintains a tough stance and potential near-term risks remain. Enrollment grows at a 10.75% CAGR between now and 2014, but gross margins begin declining in 2011. This valuation implies a 14.5x multiple of FY2009 EPS of $7.91, which is a 24% discount to the 5-year historical average LTM P/E of 25.7x. This discount is assessed based on the current regulatory risks ITT is facing. DCF analysis was based on a WACC of 10% and a 3% terminal growth rate.