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Equity Research

Capella Education Company


Takeaways From Investor Meetings; Tweaking Estimates Business Services: Professional
Services ¦ Educational Services

We recently hosted investor meetings with Capella’s management team, May 27, 2009
including new CEO Kevin Gilligan. Our initial impressions of Mr. Gilligan
are favorable; we believe he fits well into the Capella culture and clearly Stock Rating: Outperform
already has a pretty good grasp of the company, its mission and culture, Company Profile:Aggressive Growth
and the opportunities in the sector. It will likely take some time for Mr.
Symbol: CPLA (NASDAQ)
Gilligan to have as good of a handle on the minutiae of policy and Price: $53.90 (52-Wk.: $35-$67)
regulatory issues as the founder, but we fully expect him to be up to the Market Value (mil.): $876
task and eventually garner the same level of investor confidence that Fiscal Year End: December
Chairman Steve Shank has earned. Long-Term EPS Growth Rate: 20%
Dividend/Yield: None
We are reducing our second-quarter EPS estimate from $0.52 to $0.51,
due to minor modeling changes, mostly our misinterpretation of 2008A 2009E 2010E
management’s second-quarter guidance in the context of the full year; Estimates
our full year 2009 and 2010 estimates are unchanged at $2.26 (34% EPS FY $1.66 $2.26 $2.86
CY $2.26 $2.86
growth) and $2.86 (27% growth), respectively. At $53.90, the stock is
Sales (mil.) 272 327 392
trading at 24 times and 19 times our 2009 and 2010 EPS estimates. On Valuation
an enterprise value-to-EBITDA basis the stock trades at 15 times and FY P/E 32.5x 23.8x 18.8x
11 times our 2009 and 2010 estimates. Lastly, the free cash flow yield is CY P/E 23.8x 18.8x
5%-6%. We believe the Capella continues to do a solid job executing
against its long-term strategy, and we see no reason why it cannot meet
or exceed its target of 30%+ operating income growth from 2009-2011. Trading Data (Thomson Financial)
Shares Outstanding (mil.) 17
We remain buyers at current levels and would be more aggressive at or
Float (mil.) 14
below $50 (closer to 20 times NTM EPS) in the near-term, until Average Daily Volume 315,287
concerns around policy issues begin to dissipate. On Tuesday the DOE
disclosed that it would begin hosting negotiated rulemaking sessions in
September around some new items for the industry, creating some Financial Data (Thomson Financial)
noise that we would not expect to abate anytime soon. Long-Term Debt/Total Capital (MRQ) 0.0
Book Value Per Share (MRQ) 8.4
While there was little new information disclosed during our day with Enterprise Value (mil.) 755.0
EBITDA (TTM) 57.9
management, we would highlight a few items:
Enterprise Value/EBITDA (TTM) 13.0x
Capella is starting to see nice improvements in efficiency from its Return on Equity (TTM) 20.9
ERP implementation, which was completed last summer.
Management pointed to a 25% decrease in application processing Two-Year Price Performance Chart
times as one example.
One of the most common areas of investor questioning related to $70

$60
the fourth programmatic vertical, which we expect Capella to reveal $50

in the next few months. Management indicated they expect the $40

vertical to attract a similar student mix (graduate degree focus), that $30

there will be opportunities for specialized accreditations to $20

distinguish the program from its peers, and that the vertical has the $10

$0
opportunity to become at least as big as the company’s smallest 12/31/07 12/31/08

vertical today—education. For reference, we believe that education


Source: Thomson Financial, William Blair &
degree students represented 20%-25% of total Capella enrollments Company estimates
a couple of years ago.
Of students that have completed their first course, Capella
graduates 49% within 6 years

Brandon Dobell Christopher Shutler, CFA


312.364.8773 312.364.8197
bdobell@williamblair.com cshutler@williamblair.com

William Blair & Company, L.L.C. intends to seek or expects to receive compensation for investment banking services in the next 3 months from Capella Education
Company.
Please consult the last page of this report for all disclosures.
William Blair & Company, L.L.C.

Capella has experienced a roughly 200-basis-point improvement in its retention rate over the
last two years
Capella currently has $146 million parked in cash and short-term marketable securities ($8.50
per share or 16% of the current market cap) on its balance sheet that is earning next to
nothing given the interest rate environment. The company needs $50 million-$60 million of
cash on hand to comply with DOE financial responsibility ratios, leaving $86 million-$96 million
or so of dry powder. With $51 million remaining on the repurchase authorization, we expect
selective share repurchases but also expect the company to maintain a healthy portion of
cash on its books to make tuck-in acquisitions, although we didn’t get the sense that anything
would happen in the very near future; the new CEO’s historical experience, however, gives us
some reason to believe acquisitions may move up the priority list at some point down the road.
Consistent with past commentary, management indicated they have not seen any major shifts
in overall corporate reimbursement dollars. They highlighted Caterpillar as a company that
had 50 students enrolled at Capella, and when CAT cut off corporate tuition reimbursement
payments Capella offered these students the same level of support. The company lost only
three of the students. Further, management stated they have signed up five new corporate
alliance partners in recent quarters.

Brandon Dobell 312.364.8773 2


Table 1: Income Statement

US$ in millions, unless otherwise stated 2006A 2007A 1Q08A 2Q08A 3Q08A 4Q08A 2008A 1Q09A 2Q09E 3Q09E 4Q09E 2009E 2010E
Revenue $179.9 $226.2 $65.3 $66.0 $65.2 $75.8 $272.3 $76.4 $79.2 $79.7 $91.2 $326.6 $392.2
Instructional Costs and Services 83.6 100.1 29.0 30.8 29.6 30.9 120.3 31.1 34.0 33.7 36.8 135.6 161.4
Selling & Promotional 56.6 69.8 21.4 19.6 20.8 20.9 82.7 24.8 23.5 25.2 24.8 98.3 116.5

Brandon Dobell 312.364.8773


G&A 21.8 26.4 7.7 7.0 6.2 7.5 28.4 8.3 8.8 8.9 9.0 35.0 38.3
Operating Income $17.8 $30.0 $7.1 $8.7 $8.6 $16.4 $40.8 $12.2 $13.0 $11.9 $20.7 $57.7 $76.0
Other Income/(Expense) 4.5 4.9 1.4 1.0 0.8 0.8 4.1 0.7 0.8 0.9 1.0 3.3 4.9
William Blair & Company, L.L.C.

Pretax Income $22.3 $34.9 $8.5 $9.7 $9.5 $17.2 $44.9 $12.9 $13.7 $12.7 $21.7 $61.0 $81.0
Provision for Income Taxes 8.9 12.1 3.0 3.3 3.2 6.0 15.6 4.5 4.9 4.6 7.8 21.9 29.2
Net Income, Continuing $13.4 $22.8 $5.5 $6.4 $6.2 $11.2 $29.2 $8.3 $8.8 $8.2 $13.9 $39.2 $51.8
Non-recurring Gain / (Loss) 0.0 0.0 0.0 0.0 (0.5) 0.0 (0.5) 0.0 0.0 0.0 0.0 0.0 0.0
Net Income, GAAP $13.4 $22.8 $5.5 $6.4 $5.8 $11.2 $28.8 $8.3 $8.8 $8.2 $13.9 $39.2 $51.8
Stock-based Compensation, After-tax (3.1) (2.6) (0.8) (1.0) (0.6) (0.7) (3.0) (0.3) (0.9) (0.7) (0.7) (2.6) (3.1)
Net Income, ex-SBC (incl. SBC in 2005) $16.5 $25.3 $6.2 $7.3 $6.8 $11.9 $32.3 $8.6 $9.7 $8.8 $14.5 $41.7 $54.9

Diluted EPS, Reported (SFAS 123-R) $1.06 $1.33 $0.31 $0.37 $0.34 $0.66 $1.66 $0.49 $0.51 $0.47 $0.79 $2.26 $2.86
Diluted EPS, Continuing (SFAS 123-R) $1.06 $1.33 $0.31 $0.37 $0.37 $0.66 $1.69 $0.49 $0.51 $0.47 $0.79 $2.26 $2.86

Diluted Shares 12.6 17.1 17.9 17.3 17.1 17.0 17.3 17.0 17.2 17.4 17.6 17.3 18.1

Margins (% of Revenue) - INCL SBC


Instructional Costs and Services 46.5% 44.3% 44.5% 46.7% 45.3% 40.8% 44.2% 40.7% 42.9% 42.3% 40.3% 41.5% 41.1%
Selling & Promotional 31.5% 30.8% 32.8% 29.6% 31.9% 27.6% 30.4% 32.5% 29.6% 31.6% 27.1% 30.1% 29.7%
G&A 12.1% 11.7% 11.8% 10.5% 9.5% 9.9% 10.4% 10.9% 11.1% 11.2% 9.9% 10.7% 9.8%
Reported EBIT incl stock comp expense 9.9% 13.2% 10.9% 13.1% 12.2% 21.6% 14.7% 15.9% 16.4% 14.9% 22.7% 17.7% 19.4%
Reported EBIT ex-stock comp expense 12.2% 14.7% 12.5% 15.2% 13.4% 23.0% 16.3% 16.5% 18.1% 16.1% 23.8% 18.8% 20.6%

Growth (Y/Y)
Revenue 20.5% 25.8% 23.5% 22.5% 17.5% 18.4% 20.4% 17.1% 20.0% 22.1% 20.4% 19.9% 20.1%
Instructional Costs and Services 17.4% 19.7% 23.4% 25.4% 19.4% 13.4% 20.2% 7.1% 10.2% 14.0% 18.9% 12.6% 19.1%
Selling & Promotional 24.2% 23.2% 16.8% 16.2% 18.5% 23.0% 18.6% 16.1% 20.0% 21.0% 18.2% 18.8% 18.6%
G&A 24.4% 21.2% 29.2% 6.9% (9.6%) 7.0% 7.7% 7.8% 26.3% 43.4% 19.9% 23.3% 9.3%
Operating Income 20.0% 67.9% 42.2% 45.3% 36.6% 29.4% 36.2% 71.4% 49.6% 37.3% 26.2% 41.4% 31.8%
Other Expense/(Income) 93.9% 9.6% 27.3% (11.0%) (33.0%) (42.1%) (17.2%) (50.6%) (22.0%) 5.6% 19.5% (17.7%) 47.8%
Pretax Income 29.9% 56.2% 39.6% 36.3% 25.1% 22.2% 28.7% 51.4% 42.2% 34.5% 25.9% 36.1% 32.7%
Provision for Income Taxes 28.5% 35.5% 34.0% 43.3% 28.8% 21.1% 29.4% 50.6% 49.4% 41.6% 29.0% 40.1% 33.3%
Net Income, Continuing 30.8% 69.9% 42.8% 32.9% 23.2% 22.8% 28.4% 51.9% 38.4% 30.7% 24.2% 33.9% 32.3%
Diluted EPS, Continuing 35.8% 25.2% 33.3% 32.2% 27.1% 29.7% 27.0% 59.5% 38.9% 28.0% 19.7% 33.7% 26.5%

Tax Rate 39.9% 34.6% 35.4% 34.3% 34.2% 35.1% 34.8% 35.2% 36.0% 36.0% 36.0% 35.8% 36.0%

Source: Company data, William Blair & Company, L.L.C. estimates

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Table 2: Education Services Comparables

Price Market Short P/E Ratio EV/EBITDA Ratio FCF Yield


$ in millions except per-share data Rating FYE 5/26/09 Cap EV Interest NTM FY1 FY2 NTM FY1 FY2 FY1 FY2

Brandon Dobell 312.364.8773


POSTSECONDARY EDUCATION

Covered (William Blair Ests)


William Blair & Company, L.L.C.

American Public Education (APEI) O Dec. $36.26 $685 $632 7% 27x 29x 20x 13x 14x 10x 3% 5%
Apollo Group (APOL) O Aug. 61.12 9,948 9,062 6% 14x 15x 13x 7x 8x 7x 7% 9%
Bridgepoint Education (BPI) O Dec. 12.46 729 650 1% 13x 15x 10x 6x 7x 5x 11% 12%
Capella Education (CPLA) O Dec. 53.90 919 773 17% 23x 24x 19x 11x 15x 11x 5% 6%
(1)
Career Education (CECO) O Dec. 20.86 1,876 1,369 11% 15x 15x 12x 6x 6x 4x 7% 12%
DeVry (DV) O June 45.16 3,281 3,119 2% 15x 19x 15x 9x 11x 9x -3% 6%
Grand Canyon Education (LOPE) Restricted Dec. 14.42 655 620 8%
ITT Educational Services (ESI) O Dec. 100.76 3,940 3,725 10% 15x 15x 13x 8x 8x 7x 6% 6%
Strayer (STRA) O Dec. 188.11 2,634 2,550 22% 24x 25x 21x 13x 19x 14x 3% 5%

(2)
Uncovered (Consensus Ests)
Corinthian Colleges (COCO) June $16.90 $1,508 $1,417 15% 16x 22x 15x 6x 8x 6x 6% 7%
Lincoln Education (LINC) Dec. 20.01 545 589 8% 15x 15x 13x 6x 7x 6x 8% 9%
Universal Technical Institute (UTI) Sept. 14.87 351 263 10% 30x 52x 24x 8x 9x 6x NA NA

Average (all) $2,256 $2,064 10% 19x 22x 16x 9x 10x 8x 5% 8%


APEI, CPLA, and STRA only $1,413 $1,318 15% 25x 26x 20x 12x 16x 12x 4% 5%

OTHER EDUCATION SERVICES

Covered (William Blair Ests)


New Oriental Education (EDU) MP May $55.04 $2,107 $1,820 7% 25x 35x 25x 19x 28x 19x 4% 5%
Rosetta Stone (RST) O Dec. 23.70 502 438 0% 25x 24x 20x 11x 11x 9x 5% 5%
SkillSoft (SKIL) (3) O Jan. 7.97 816 901 2% 13x 13x NA 9x 9x NA 10% NA

Uncovered (Consensus Ests) (2)


K12, Inc. (LRN) Dec. $7.86 $227 $204 NA 13x 19x 12x 3x 5x 3x -9% 6%

Notes:
(1) CECO EPS estimates are ex-one-time items and ex-transitional schools.
(2) Sources: Thomson, company filings
(3) SKIL data reflects continuing EPS (fully taxed) and continuing EBITDA, both including stock-based compensation expense.

4
William Blair & Company, L.L.C.

Chris Shutler or members of his immediate family own shares of Capella Education Company.

William Blair & Company, L.L.C. and its affiliates beneficially own or control (either directly or through its managed
accounts) 1% or more of the equity securities of Capella Education Company as of the end of the month ending
not more than 40 days from the date herein.

William Blair & Company, L.L.C. is a market maker in the security of Capella Education Company and may have a
long or short position.

Additional information is available upon request.

Capella Education Co. (CPLA)


Current Rating: Outperform
May 25, 2007 - May 26, 2009 Previous Close: $53.90
$75
$70
$65
$60
$55
$50
$45

$40
$35 7/26/07 - I-O

12/31/07 12/31/08
Source: William Blair & Company,
Legend:
L.L.C.
I =and
Initiation,
FactSet D = Dropped, R = Restricted, NR = Not Rated @ = Analyst Change

Current Rating Distribution (as of 04/30/09)


Coverage Universe Percent Inv. Banking Relationships* Percent

Outperform (Buy) 57 Outperform (Buy) 3


Market Perform (Hold) 42 Market Perform (Hold) 1
Underperform (Sell) 1 Underperform (Sell) 1

*Percentage of companies in each rating category that are investment banking clients, defined as companies for
which William Blair has received compensation for investment banking services within the past 12 months.

Brandon Dobell attests that 1) all of the views expressed in this research report accurately reflect his/her personal
views about any and all of the securities and companies covered by this report, and 2) no part of his/her compensation
was, is, or will be related, directly or indirectly, to the specific recommendations or views expressed by him/her in this
report.

Stock Rating: William Blair & Company, L.L.C. uses a three-point system to rate stocks. Individual ratings reflect
the expected performance of the stock relative to the broader market over the next 12 months. The assessment
of expected performance is a function of near-term company fundamentals, industry outlook, confidence in
earnings estimates, valuation, and other factors. Outperform (O) – stock expected to outperform the broader
market over the next 12 months; Market Perform (M) – stock expected to perform approximately in line with the
broader market over the next 12 months; Underperform (U) – stock expected to underperform the broader market
over the next 12 months; Not Rated (NR) – the stock is currently not rated.

Company Profile: The William Blair research philosophy is focused on quality growth companies. Growth
companies by their nature tend to be more volatile than the overall stock market. Company profile is a
fundamental assessment, over a longer-term horizon, of the business risk of the company relative to the broader
William Blair universe. Factors assessed include: 1) durability and strength of franchise (management strength
and track record, market leadership, distinctive capabilities); 2) financial profile (earnings growth rate/consistency,
cash flow generation, return on investment, balance sheet, accounting); 3) other factors such as sector or industry
conditions, economic environment, confidence in long-term growth prospects, etc. Established Growth (E) –
Fundamental risk is lower relative to the broader William Blair universe; Core Growth (C) – Fundamental risk is

Brandon Dobell 312.364.8773 5


William Blair & Company, L.L.C.

approximately in line with the broader William Blair universe; Aggressive Growth (A) – Fundamental risk is higher
relative to the broader William Blair universe.

The ratings and company profile assessments reflect the opinion of the individual analyst and are subject to
change at any time.

The compensation of the research analyst is based on a variety of factors, including performance of his or her
stock recommendations; contributions to all of the firm’s departments, including asset management, corporate
finance, institutional sales, and retail brokerage; firm profitability; and competitive factors.

THIS IS NOT IN ANY SENSE A SOLICITATION OR OFFER OF THE PURCHASE OR SALE OF SECURITIES.
THE FACTUAL STATEMENTS HEREIN HAVE BEEN TAKEN FROM SOURCES WE BELIEVE TO BE
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OR COMPLETENESS OR OTHERWISE. OPINIONS EXPRESSED ARE OUR OWN UNLESS OTHERWISE
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2009, William Blair & Company, L.L.C.

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all disclosures.

Brandon Dobell 312.364.8773 6