We came away from recent meetings with Capella management convinced that demand trends remain strong, the company remains on track for total enrollment growth later this year, and the new Flexpath offering could materialize into a meaningful revenue and earnings opportunity as soon as 2015.
We continue to view Capella as one of the most innovative and differentiated companies within the postsecondary sector and believe its valuation will gradually increase toward the high end of the group in light of a significant enrollment and margin growth opportunity, an outstanding regulatory profile that allows for operational decisions to be made free of concern over policy implications, a management team that places long-term educational quality above short-term earnings gains, and a regulatory and investor perception of Capella as a “good actor” within the space. We reiterate our Outperform rating.
In line with commentary on the most recent earnings call on April 29, management expects midsingle-digit starts growth in the second quarter. This comes against a difficult 12.7% comp in second quarter 2013. We note that comps moderate in the back half with third quarter 2013 declines of 1.3% and fourth quarter 2013 declines of 6.8% (which represents a particularly easy bachelor’s comp with declines of 20% or more due to the rollout of a new orientation program).
We believe the popping of the “graduation bubble” (link to report) as well as dramatic retention rate improvement over the past few years support total enrollment growth in excess of starts growth for the next three to four years.
Total enrollment turning and retention gains support significant operating leverage in the coming years. Management indicated that incremental margins should be above 40% (versus 14.4% operating margin in 2013), but we believe “student-level” incremental margins (which are more applicable for the portion of incremental revenue driven by retention gains given that there are no onboarding costs for these students) are in excess of 70%. The chart at the end of this note details our estimates of fixed and semi-variable costs that should apply to the company’s retention-related margin gains in future years. We believe this inherent operating leverage is largely misunderstood by investors after four years of sector enrollment declines and decreasing retention as a result of the “graduation bubble.” We believe this supports 20% peak operating margins at Capella (lower than the prior peak of 22% due to structurally higher acquisition costs, but still an attractive tailwind to earnings growth relative to our 14.6% estimate for 2014).