Education Management Corp.

A Company to Consider Buying. Education Management Corporation (EDMC) provides private post-secondary education in North America. EDMC delivers education to students through traditional classroom settings as well as through online instruction. Its educational institutions offer a broad range of academic programs concentrated in the following areas: media arts, education, design, information technology, fashion, Law and legal studies, culinary arts, business, psychology and behavioral sciences, and health sciences. It offers academic programs through four educational systems: The Art Institutes; Argosy University; American Education Centers; and South University.

EDMC acquired AEC and South University during fiscal 2004. As of June 30, 2004, EDMC had 67 primary campus locations in 24 states and two Canadian provinces. Its program offerings culminate with the award of degrees ranging from associate’s to doctoral degrees. It also offer non-degreed programs, some of which result in the issuance of diplomas upon successful completion. Prior to fiscal 2004, The Art Institutes and Argosy University were managed as separate operating segments. During the first quarter of fiscal 2004 we shifted from an educational system approach to a centralized corporate structure utilizing divisions which have been aggregated into one operating segment. EDMC currently has three distinct operating divisions organized by geographic location within North America: the Eastern Division; Central Division; and Western Division.

Looking at the Stock Selection Guide

Quality. Look at Part 1 of the SSG. EDMC has had consistent growth in revenues and earnings over the past seven years. Value Line rates its earnings predictability 100 (out of 100) and its financial strength a “B+”. Section 2 of the SSG shows pretax profit on sales as 13.8% (5-year average) and trending up slightly. ROE is up over the last three years but slightly below the 5-yr average.

One caution is that EDMC has not done as well as its industry competitors over the past five years on return on equity (18.0 vs. 21.9) or net profit margin (8.3 vs. 12.7). Also, it would be better if Value Line financial strength were a B++ or higher. Overall, EDMC is a quality company.

Growth. Value Line projects EPS growth at 21.5 (based on revenue growth of 21.5. Reuters projects EPS growth of 20% (based on 7 analysts). Morningstar also projects 20% growth (based on 11 analysts).

Projected EPS in Five Years. The SSG uses EPS growth RATE of 19%. Resulting in a 5-yr EPS of $2.58. Here is the formula for 5-yr EPS using the trailing twelve months (TTM) EPS of $1.08 and projected growth rate of 19%: [2.58 * (1.19)^5]. Using the “preferred procedures on the SSG (assuming 19% revenue growth, 15% pretax profit margin (Value Line 17.6%), 40% tax rate and 78M shares outstanding, projected 5-yr EPS is 2.47.

Average High and Low PE. The SSG uses an average high PE of 28.5. This PE is 1.5 times the 19% projected growth rate (1.5 * 19 = 28.5). The current PE is 27.3. Relative value of 106.2 and projected relative value is 89.1. Since EDMC is fairly priced relative to its historic PE, gains form PE expansion are unlikely.

Projected 5-year Return (Annualized). Using the data from above, total return for EDMC is 20.1% and projected average return (PAR) is 15.7%. The upside-downside ratio is 4.4.

Bank of America

Bank of America (BAC) is the stock to study in the November 2004 edition of Better Investing magazine. Here is the presentation (470 kb) on BAC given to the NAIC DC Chapter on November 9, 2004. Related files include a SSG and PERT (480 kb) and a presentation (480 kb) presented by Bank of America investor relations personnel at the NAIC Better Investing National Conference this week.

Report for October 2004

At the end of October, the Moose Pond Investors portfolio had the following weighted averages: projected total return of 21.4%, projected average return (PAR) of 16.1%, upside / downside ratio of 4.6 to 1 and a relative value of 92.2. These are all very good averages. The portfolio has 8% of its assets in cash, part of which we will deploy this month.

Defense and offense alerts.*  Several of our stocks have fallen short of the sales growth targets for the trailing twelve months. (See defense report above.) These stocks include Fannie Mae, Affiliated Computer Services and Harley-Davidson. One other stock in the portfolio to watch closely is UTStarcom.

* A defense alert means that a stock’s current sales or earnings growth has fallen below the growth rates that were projected for that stock. We look at changes in growth rates for the both current quarter and the trailing twelve months. In both cases, we compare current sales and earnings with the corresponding period on year earlier. An offense alert means that a stock’s projected average return has fallen below our desired return for that stock.

Evaluating Management

“Objective tests of managerial ability are few and rather unscientific. … The most convincing proof of capable management lies in a superior comparative record over a period of time….” – Graham and Dodd, Security Analysis

The attached file (933 kb) contains a presentation on Evaluating Company Managment given to the NAIC DC Chapter on October 30, 2004.

Section 2 of the NAIC stock selection guide (SSG) helps to evaluate how management is performing. It shows the key measures of management quality, pre-tax profits margins and return on equity for the past ten years. It also shows the trends for each of these (up, down or constant). The data in Section 2, when compared to the industry peers for a company, provides a good indicator if management effectiveness.

Pretax Profit Margin. Pre-tax profit margin represents how much of each sales dollar a company keeps before taxes. The SSG focuses on pre-tax profit margin rather than net profit margin because tax rates change from time to time. It is easier to compare pre-tax profit margins over a long period of time.

Look for consistency in pretax earnings, e.g., a consistent (flat) or upward trend that is above average for the industry. Be skeptical of above pre-tax profit margins that make a big jump. Consistent pre-tax profit margins might mean that a company has reached peak efficiency or it might mean that management has stopped improving efficiency. Do some additional research. See how the company’s pretax profit margins compare to its competitors.

Pre-tax profit margins can provide an early warning indicator of trouble. A decline in pre-tax profit margins often shows up in the income statement before earnings growth starts to decline. Both NAIC Investor Toolkit and Stock Analyst contain graphs that plot quarterly pre-tax profit margins and trailing twelve month pre-tax profit margins.

Return on Equity (ROE). ROE is a measure of how well a company has used reinvested earnings to generate additional earnings. ROE is a key financial factor in defining the growth potential of the company from internal sources.

ROE can be used to calculate the the “implied” or “sustainable growth rate” of a company. This is the potential earnings growth rate a company can maintain without borrowing. The calculation is simple, Return on Equity x Earnings Retention Rate. It usually better to a an average ROE (such as the 5-year average). The Earnings Retention Rate is how much the retains after taxes (1 – tax rate).

Barrons — Drug Industry

In an article this week, Barrons notes that the big drug stocks trade today for just 12 to 14 times projected 2004 profits. The last time the drug stocks saw valuations like these was in 1993-94 when Wall Street feared President Clinton’s health-care proposals would lead to industry price controls.

Pfizer and Merck are two of the stocks mentioned in the article. The consensus earnings projection for PFE over the next 12 months is $2.33. Using Friday’s closing price of $28.50, the forward PE is (28.50/2.33) or 12.2. PFE’s historical 10-year average PE is 32.6.

The consensus earnings projection for MRK over the next 12 months is $2.77. Using Friday’s closing price of $30.50, the forward PE is (30.50/2.77) or 11.0. MRK’s historical 10-year average PE is 22.6.

Return on Equity Screen

There seems to be a correlation between stocks that have a good return on equity (ROE) year after year and quality growth stocks.

Here is a screen using AAII SI Pro with the following parameters:
   – ROE for each of the last seven years > 15%
   – Current PE < 5-year average PE    - (PE / EPS growth) < 1.5    - 5-year (diluted) EPS growth > 10%
   – Projected long term EPS growth > 10%
   – positive EPS growth for each of last 4 quarters

Using data from October 8, the screen yielded 22 stocks.

17 of the 22 stocks have an U/D ratio > 3.0, total return > 15%, and a relative value < 110. In an equally weighted portfolio, all of these stocks together would have a total return of 20.1%, a PAR of 15.1%, an U/D ratio of 4.7, and a relative value of 89.1. The attached PDF file contains a PERT chart (sorted by total return) and a trend report (sorted by PAR) with the stocks passing the screen. The PERT chart uses First Call data for projected EPS and 5-year growth.

NAIC

The National Association of Investors Corporation (NAIC) teaches individuals how to become successful strategic long-term investors. NAIC investors use fundamental analysis to study common stocks and mutual funds. Information about NAIC and its investor resources can be found at http://www.better-investing.org. Volunters throughout the United States work with local chapters to teach individuals and clubs how to invest.

Unfortunately, NAIC has found itself at the center of a controversy and the subject of an investigation by the Finance Committee of the U.S. Senate. The core allegation is that the officers have abused the tax exempt of NAIC to enrich themselves at the expense of the members and the volunteers of the organization. A CNBC investigative report frames the issues. It remains to be seen whether the organization will remain viable as the controversy unfolds.

Report for September 2004

At the end of September, the Moose Pond Investors portfolio had the following weighted averages: projected total return of 21.0%, projected average return (PAR) of 16.1%, upside / downside ratio of 4.6 to 1 and a relative value of 92.2. These are all very good averages. The portfolio is nearly fully invested in stocks with 5.2% of assets in cash.

In September, we purchased additional shares of Intel and Pfizer. The big price movers in our portfolio this month were Fannie Mae (-14.8%) and Capital One Financial (+9.1%) and Lowes (+9.4%). (But remember, it’s not price movement but stocks fundamentals that matter in the long term!)

Defense and offense alerts.*  Several of our stocks have fallen short of the sales growth targets for the trailing twelve months. These stocks include Capital One Financial (3.0% vs. 14%), Harley Davidson (7.1% vs. 12%), and Affiliated Computer Services (8.4% vs. 14%). Also, Brown & Brown is below our target projected average return (12.3% vs. 15%). Other stocks in the portfolio to watch closely are UTStarcom and Fannie Mae.

* A defense alert means that a stock’s current sales or earnings growth has fallen below the growth rates that were projected for that stock. We look at changes in growth rates for the both current quarter and the trailing twelve months. In both cases, we compare current sales and earnings with the corresponding period on year earlier. An offense alert means that a stock’s projected average return has fallen below our desired return for that stock.

Intel Corporation

From Value Line (07-16-2004): Intel shares have fallen quite sharply in trading today following uninspiring news related to the chip behemoth’s second-quarter results. Although sales just north of $8 billion and share net of $0.27 were both roughly in line with expectations, the company’s outlook for the remainder of this year is not quite so favorable. More precisely, management now expects the gross margin to be 60% plus or minus a couple of percentage points, compared with prior guidance of 62%. This primarily reflects increased revenue of lower-margined products such as flash memory chips, chipsets, and motherboards. What’s more, a slight reduction in average selling prices of microprocessors and a slower-than-anticipated reduction in manufacturing costs per unit will also likely hinder profits. As a result of the recent news, we have lowered our 2004 share-net target, from $1.25 to $1.20. Intel shares remain ranked 3 (Average) for Timeliness.
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Brown and Brown

From the August IAS: Brown & Brown’s second quarter results indicate continued execution of its growth strategy. Total earnings and revenue each increased 15%, including 5% internal revenue growth with the balance coming from acquisitions. EPS expanded 12%. The company also raised $200 million in the debt market at fixed coupon rates of 5.7-6%, which management refers to as “dry powder” for future acquisitions. Going forward, the company is expecting lower internal growth, as the improving economy will fail to compensate for nationwide price declines in the commercial property insurance industry. With internal growth slowing, Brown’s success becomes more dependent on its proven ability to acquire and integrate good companies. BRO (44.75) is a buy up to 39.
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