Education Stocks 101
No doubt, America will be spending more on schooling. But what does that mean for investors?

It's hard to discuss the education market without using language that sounds just a little academic. But central to any investment in the sector is the basic idea that knowledge -- as in people having the skills they need to get ahead -- has become a much more important part of our economy than it was years ago. "We're shifting from an industrial-based economy to a knowledge-based economy," says Scott L. Soffen, an analyst with Legg Mason Wood Walker. "People are going to need more education, and they need it more often."

Demand for advanced education will surge, predict analysts, fed by corporations' need for skilled workers, as well as employees' need to make more money. In 1980, workers with advanced degrees earned an average of 50% more than those with only high school degrees. Today, that gap is up to 111%, according to figures from Merrill Lynch. Real wages for a 30-year-old male with only a high school degree are less than two-thirds what they were in the 1970s. Yet only 21% of adults in the U.S. have a bachelor's or better, Merrill Lynch has found.

"There is not, in our view, a bigger problem in the U.S. today than the need to better educate our populace, and hence, we think the investment potential in this sector is tremendous," writes Michael T. Moe, Merrill Lynch's director of global growth research, in his Apr. 9 report on the education and training market titled, "The Book of Knowledge." The government, focused primarily on educating students from kindergarten through high school, is limited in what it can do, says Legg Mason's Soffen. "So the private sector is going to satisfy that demand."

THINK HEALTH CARE. Both Moe and Michael Milken compare today's for-profit education market to the health-care industry in the 1970s. At that time, critics questioned not only whether it was possible to make money in health care but whether it was ethical. Back then, this largely low-tech field lacked professional management and made up only 3% of U.S. capital markets. Today, health care is one of the top-performing sectors in the stock market and makes up 14% of U.S. capital markets. The comparison sheds some light on the opportunity in education, Moe writes.

As compelling as the broad-brush thesis is, investing in education gets much more complicated when it comes to picking actual stocks. The business is very fragmented, and although it has been consolidating, there are relatively few publicly traded companies. They mostly deal in specific niches of the education market, are small-cap names, and thus haven't performed well in a market focused almost exclusively on blue-chip and tech issues.

A range of widely differing niche companies fits into the broad sector. Moe divides the group into five segments. In early education, he favors Bright Horizon Family solutions (BFAM), which provides employee-sponsored day care. In the kindergarten through 12th-grade market, he recommends Sylvan Learning Systems (SLVN), which provides a range of educational services, including tutoring and testing. In post-secondary education, Moe believes Apollo Group (APOL) and DeVry (DV), both of which offer advanced degrees in for-profit schools, stand out. And, in corporate information technology, he recommends PROVANT (POVT), which provides IT training.

"TIERING" EFFECT. Most investor interest is currently focused on the post-secondary market, says Gerald Odening, an analyst with Hambrecht & Quist. "It has all the characteristics that investors want -- reasonably predictable revenues, strong demographics, free pricing, higher returns on equity."

But he says there has been what he calls a "tiering" effect, where the post-secondary schools offering the more elite degrees generally have the strongest fundamentals. He includes companies like Argosy (ARGY), Devry, Apollo, and Strayer (STRA) in that group. He believes they can continue to increase revenues at a 17% to 20% rate and earnings at a 25% to 30% rate annually.

Companies in the second tier, which offer associates and bachelors degrees, include Education Management (EDMC), Career Education (CECO), and Corinthian Colleges (COCO), he says. Although those companies also have solid growth prospects, says Odening, they may be a little more risky. "If investors are considering getting into the group for the first time, I'd suggest they look at the first-tier companies," he says.

A few companies have disappointed investors recently and sold off. Along with investors' general avoidance of small caps, "another factor has been concerns over regulatory, accounting, and management issues at some specific stocks," says Soffen. Apollo had some perceived regulatory problems, and ITT Educational Services (ESI) fell because of concerns about enrollment.

BROAD MIX. But some analysts believe those price dips have created opportunity. Soffen upgraded ITT Educational Services to a buy after it tumbled 40% following its first-quarter earnings release. Although the company met earnings estimates, enrollment in its core courses slipped because it was launching a new program. "ITT is positioning itself to be a leading provider of information technology education in the U.S.," says Soffen, who has a price targe of $32 a share. ITT closed on Apr. 29 at 24 1/2

Soffen's other pick is Sylvan Learning Systems, which he describes as a conglomerate of different education businesses and the broadest company in the sector. The mix of different education businesses, from after-school tutoring to English as a second language, makes the company less dependent on one business area, he notes. And the company is well managed and is increasing earnings at a rate of 30% a year. "Yet the stock is only trading at 20 times our 2000 earnings estimate, which makes its valuation very attractive." Soffen has a price target of $42. The stock closed on Apr. 29 at 25 3/8. "Investors need to do a lot of work to understand Sylvan," says Soffen.

The same is true for education stocks in general. The potential for long-term growth in the industry is easy to see, but at this early stage, picking the winners means rolling up your sleeves and doing some old-fashioned homework.

By Amey Stone in New York

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