Serious Concerns About Grand Canyon Education's Future

Grand Canyon Education (LOPE) is a for-profit education services company that has been on a massive run over the last decade, delivering investors nearly 8 times their money. The bull run is nearing its end and there are a number of red flags that arise upon a thorough analysis of the company's recent filings with U.S. regulators.

The company underwent a major structural change last year when it separated from Grand Canyon University ("GCU"); the latter converted back to nonprofit status. Now, the company is a educational services company and provides many services to GCU in exchange for 60% of that institution's tuition and fees received from students. LOPE can also now pursue partnerships with other educational institutions to provide its services to them as well, theoretically freeing them up to massively grow revenue through these partnerships. Management has been discussing this partnership pipeline for several months now since the corporate structure change, but so far has not executed.

For those interested in the earlier history of GCU, this PBS Frontline episode is a good place to start. As the PBS story tells, the original entity, Grand Canyon College, was purchased by the original entity that was formed to create GCU as a shortcut to accreditation. This most recent conversion of GCU back to a nonprofit is another event in the long history of this institution. Additionally, for-profit educational institutions more broadly have had quite a checkered past.

For GCU this is the second attempt to shift to a nonprofit institution. A previous try was rebuffed by GCU's accreditor, the Higher Learning Commission. At the time, the HLC stated the service agreement gave the for-profit division too much control of the operations, criteria the HLC later revised, according to reporting from Inside Higher Ed.

GCU launched in 1949 as a nonprofit before it was purchased by private investors in 2004 and converted into a for-profit institution. According to the GCU website, since its purchase, the university grew from 1,000 residential students in 2009 to more than 19,000 this past fall, with another 60,000-plus online students filling out the ranks.

In sum, there is a large degree of optimism taking place in the market today regarding the newly revamped company's future prospects. Here, I contend that rather than "HUGE Long-Term Growth," Grand Canyon Education is overhyped and overvalued, and that current investors would do well to trim or exit their holdings as management needs to execute perfectly and outperform the aggressive vision they have outlined in order to justify the company's current public market valuation.

Current Market Valuation

LOPE's current market capitalization is just under $6 billion. On net income of ~$230m and sales of ~$767m, this represents trailing P/E of ~25 times, forward P/E of >20x, and a price to sales multiple of ~7.5. The company has been investing significantly into its technological capabilities around back-office infrastructure in education services, and currently trades at ~56x cash per share of ~$2.11. At nearly 40 times free cash flow, I consider LOPE common equity shares to be overvalued.

Recently, the company financed their overpriced $361.2 million acquisition of Orbis Education through a combination of operating cash on hand and debt:

During 2019, we financed our Acquisition of Orbis Education for $361.2 million, net of cash acquired, through an increase in our credit facility of $190.1 million and the use of $171.1 million of operating cash on hand. Our unrestricted cash and cash equivalents and investments were $102.7 million at March 31, 2019. As of March 31, 2019, we had $300,000 of restricted cash and cash equivalents, for pledged collateral for a newly acquired site lease.

Concurrent with the closing of the Acquisition, we entered into an amended and restated credit agreement dated January 22, 2019 and two related amendments dated January 31, 2019 and dated February 1, 2019, that together provided a credit facility of $325.0 million comprised of a term loan facility of $243.8 million and a revolving credit facility of $81.3 million, both with a five year maturity date. The term facility is subject to quarterly amortization of principal, commencing with the fiscal quarter ended June 30, 2019, in equal installments of 5% of the principal amount of the term facility per quarter. Both the term loan and revolver have monthly interest payments currently at 30 Day LIBOR plus an applicable margin of 2%. The proceeds of the term loan, together with $6.3 million drawn under the revolver and cash on hand, were used to pay the purchase price in the Acquisition. Concurrent with the entry into the amended and restated credit agreement and the completion of the Acquisition, we repaid our existing term loan of $59.9 million and our cash collateral of $61.7 million was released.

On July 1, 2018, in consideration for the transfer of assets under the Asset Purchase Agreement, we received a secured note from GCU in the initial principal amount of $870.1 million (the "Secured Note"). The Secured Note contains customary commercial credit terms, including affirmative and negative covenants applicable to GCU, and provides that the Secured Note bears interest at an annual rate of 6.0%, has a maturity date of June 30, 2025, and is secured by all of the assets of GCU. The Secured Note provides for GCU to make interest only payments during the term, with all principal and accrued and unpaid interest due at maturity and also provides that we will loan additional amounts to GCU to fund approved capital expenditures during the first three years of the term. Funding expectations for future capital expenditures for GCU are $70.0 million for the nine months remaining in the year ended December 31, 2019, and currently no funding is anticipated for the year ended December 31, 2020.

Overall, especially in light of increasing leverage on its balance sheet, the market is significantly overvaluing LOPE common equity shares and investors who do not believe management can outperform the aggressive expectations they have set should exit their holdings.

Management Guidance and Vision

Management has been very precise around guidance, offering granularity into quarterly expectations for a variety of different performance metrics. LOPE's CEO projects GCU campus enrollment growing by nearly 50% over the coming years, and online enrollment growing at high single digit percentage rates. He also projects Orbis growing enrollment by ~35% through the end of the current decade - quite optimistic.

Moreover, LOPE's current revenue is still structurally concentrated with its one primary customer (Grand Canyon University). Through their acquisition of Orbis Education Services, they do now have less concentration in revenue, but fluctuations in the underlying performance of GCU or an inability to hit aggressive growth targets at GCU could materially impact fundamental earnings at GCE.

LOPE CEO Brian Mueller (who is, incidentally, also the President of GCU) and the rest of LOPE management have potentially been overpromising on the company's business development pipeline as well. Inking several new lucrative university partnerships over the rest of 2019 as Mueller and his management team have promised still remains to be seen, and in any event these partnerships are unlikely to be anywhere near as lucrative as the one with GCU.

Management has valued outcomes over process in the past, generating historical controversy on many fronts. LOPE's management team is politically well-connected in the state of Arizona, enabling them to achieve corporate objectives even in light of deteriorating fundamentals:

Between 2015 and 2016, an investigation by the nursing board into GCU's registered nursing program found rule violations pertaining to faculty and student evaluations, plus a drop in the rate of students passing the national nursing license exam.

GCU's passing rate for students taking the nursing exam for the first time had fallen below the 80-percent state standard for two years in a row, the Arizona Republic reported in April 2017. GCU agreed to a reprimand known as a decree of censure from the nursing board, the lowest level of discipline.

While the recent Orbis Education purchase should mask the underlying fundamental issues in LOPE's business, eventually stocks revert to fundamentals. The risk of regulatory scrutiny or increased scrutiny over the conflicts of interest in the current GCU-GCE relationship under a different, less favorable political regime continues to increase.

Interestingly, even amidst promising guidance from management and an extremely optimistic vision for corporate growth, insiders - including the company's CIO, COO, CFO, and CEO - have been exercising deeply in the money incentive call options and selling aggressively per SEC Form 4 filings over the last months. However, LOPE's management team still continues to be extremely well compensated by shareholders as per the company's latest proxy filing:

The management team at LOPE, by way of their professional backgrounds, is intimately familiar with the for-profit education world and is capitalizing on their experiences in this space to take advantage of investors who naively believe every element of their "education services" pivot. From a public markets perspective, LOPE management consistently has outperformed revenue and earnings expectations each quarter, creating even more fuel for the hype train:

Eventually, as it becomes clear that LOPE massively overpaid for the Orbis acquisition and as fundamentals continue to deteriorate at the underlying business level, this consistent out-performance of guidance will become increasingly difficult to achieve. Shorting LOPE offers an interesting risk/reward in the event of a broader macroeconomic downturn as enrollment rates are likely to plummet in students' need for short-term cash inflows, making management's optimistic vision even more difficult to achieve.

Accounting Concerns

There are significant accounting concerns at Grand Canyon Education, in particular around the company's recent acquisition. Unfortunately, due to LOPE's recent Orbis acquisition, the latest quarterly results are not easily comparable to historical results.

Still, LOPE immediately jumps out as a massive outlier on a historically valuable indicator of potential earnings manipulation - the Beneish M-Score. Essentially, M-Scores greater than the ~-2.0 threshold are problematic indicators that a company's management team may be manipulating earnings to mask underlying trends in business fundamentals. LOPE's M-Score is a whopping 74 on this, primarily driven by the model's components of Asset Quality Index ("AQI") and Days Sales Receivables Index ("DSRI"). It is important to note that this is not apples-to-apples in light of the Orbis acquisition skewing comparison across periods, but when the balance sheet is analyzed in depth there are still major concerns which jump out - leaving the M-Score as a valuable indicator of potential concern nonetheless.

Digging into these red flags, analysis of LOPE's balance sheet from the company's latest SEC filing reveals some troubling trends.

First, on the AQI front: The company's noncurrent assets jumped by over 40% from the prior period, primarily driven by net amortizable intangible assets and goodwill both attributable the LOPE's expensive ~$361 million acquisition of Orbis Education in January of this year. Specifically, the company reports $208.6 million of net amortizable intangible assets on the latest balance sheet, up from $0 in the prior period. Reading the footnotes in the latest filing, this is amortized down from a $210 million figure valuing Orbis's existing university partner relationships with a 25-year estimated average useful life. Without greater granularity into this valuation's inputs, it is difficult to evaluate, but let's assume management is being fair on this figure.

The more troubling figure to me is the new goodwill figure of $151.2 million, up from $2.9 million in the prior period. The net increase of $148.3 million is primarily composed of the difference between the $361 million purchase price of Orbis and the acquired net assets (mostly comprised of the university partner relationships described above, but see below for the full purchase price allocation).

It is not clear to me why LOPE paid a 68% control premium for the $217.7 million at which they valued the net assets of Orbis. This seems high to me from an M&A perspective in this industry at this time, and I imagine the goodwill recorded on LOPE's latest balance sheet will provide to be largely worthless over time. Such an irresponsible capital allocation decision does not bode well for LOPE's future in the absence of perfect execution of an aggressive growth strategy.

Next, on the DSRI front: the latest company balance sheet puts net accounts receivable at $74.7 million, up from $46.8 million in the prior period. As a percentage of recorded net revenue, this represented a jump from ~17% to ~38%, which created the red flag in this component of the M-Score. Orbis likely has far less attractive of a receivables profile than pre-acquisition GCE, which is another unattractive element of this acquisition. Investors should more closely examine the pro forma revenue and net income disclosures provided in the linked filing above as well: at best, the acquired company represents a source of great potential growth for GCE but is not immediately accretive to shareholders due to its unprofitability and relatively less attractive receivables profile. At worst, LOPE management massively overpaid for Orbis in order to continue providing fuel for the growth engine, continue hyping the stock so their own elevated levels of personal compensation and option exercises+stock sales can continue, at the expense of long-term shareholder value.

Finally, the below is the quarterly GAAP-to-non-GAAP reconciliation provided by the company from LOPE's latest earnings release earlier this month.

The GAAP figures should be assigned more credibility by investors given the uncomfortably high price LOPE paid for the transaction referenced in the adjustment lines. Additionally, $0.06 of the non-GAAP earnings increase is attributable to a one-time tax benefit negotiated with the state of Arizona.

Interestingly, Jack A. Henry, a member of LOPE's Board of Directors, has significant accounting experience as he managed the Phoenix office of large accounting firm Arthur Andersen until his retirement amidst some controversy in 2000. In that controversy, an organization called BFA was implicated in some accounting fraud and blamed Henry's firm for failing to identify fraudulent activities at the firm. Ultimately, Henry's firm paid $217 million in a malpractice settlement related to this case. Henry's status as an influential member of the Phoenix business community has likely helped LOPE achieve its objectives on the political front, but his involvement on LOPE's board is not necessarily comforting from an accounting integrity standpoint.

Risks to the Short Thesis

One potential risk to the short thesis here is that LOPE could increase the amount of debt on its balance sheet to finance growth over the medium term. Given the agreement with GCU and pickup of more consistent cash flows after the Orbis acquisition, management could increase the company's debt burden amid the predictable annual cash flows and avoid equity financing to provide additional cash runway for growth. This in turn would delay some recognition of likely outcomes which would be favorable to the short thesis, but arguably increased leverage would only exacerbate the magnitude of potential negative outcomes in the longer term.

Additionally on the risk front, LOPE's board may also choose to support the share price in public markets through expansion of the existing share buyback program in place. At the end of the latest quarter, there was just under $80 million remaining in the company's already authorized buyback program. This is one lever the board has to maintain a high stock price in the event upcoming quarters disappoint investors or that management does not perform up to their guidance.

The other major risks to the short thesis involve management following through on attractive partnership deals with new universities. On their latest earnings call, CEO Brian Mueller teased four potential partnerships to be announced by the end of the calendar year with universities in the Midwest and Northeast. While no further details were given, announcements of major university partnerships could potentially send equity shares higher in the short term. However, I believe this is fully priced into the rich valuation of the stock and it may be a "sell the news" outcome as the partnership deals need to be significantly beneficial to LOPE in order to justify even higher share prices from current levels as much of this growth is fully discounted by investors today.

Conclusion: Short LOPE Equity Shares

There is significant downside to LOPE equity shares from current ~$118/share levels.

Shareholders may expect to be diluted further in the event the company continues to raise equity financing through secondary offerings and continues to offer generous stock-based compensation by issuing significant equity packages for new hires as the company scales.

LOPE may also need to restate prior period earnings or take significant writedowns of overvalued assets if this short thesis proves itself out. Avoid investing in LOPE at all costs.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in LOPE over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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