How Online Universities are Trumping Harvard

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The world of higher education has a strange dichotomy unfolding.

Once laughably feeble, online institutions such as the University of Phoenix, owned by the Apollo Group (APOL), and DeVry University, part of DeVry (DV), are undergoing an enrollment explosion and rapid expansion as renowned brick-and-mortar schools are slashing budgets, shrinking freshman class sizes and freezing development projects.

The reason for this shift is likely driven by the models on which these institutions are built.

The stock-market decline has pinched even the most gaudy of Ivy League coffers. Large university endowments, which are a major source of the schools' operating income, are concentrated in non-cash investments that have tumbled. Harvard, for example, lost $8 billion, or 22%, of its endowment's value in the four months since the fiscal year ended in June.

And the Cambridge, Mass.-based university, the oldest in the U.S., may have lost even more. The fund hasn't yet reported results of its recent private-equity commitments. With these vast pools of capital taking enormous losses, budgets have to be slashed to ensure expenses can be met.

This has resulted in an opportunity for online universities, which are not beholden to donors or endowment performance, to make gains on the old guard of higher education.

Publicly traded Apollo and DeVry have approached higher education in the same way any for-profit company approaches its products, and the market has approved. Apollo is up 3.95% this year, and DeVry has eked out a 2.2% gain, while the benchmark S&P 500 has almost halved over the same period.

Since Apollo and DeVry obtain funding from public markets and operating efficiencies instead of significant investment holdings, they have avoided the meltdown siphoning away working capital.

What's more, tuition payments have started to become shaky for major universities as family finances have hit the skids. Tuition at a private university can be as much as four times that of online programs. Even most public institutions are more expensive. More affordable online universities are becoming increasingly appealing due to relatively lower costs.

Long thought to be inferior to brick-and-mortar institutions because of a lack of exceptional faculty and students, online institutions such as DeVry University and the University of Phoenix may be able to poach renowned faculty members from prestigious universities by offering unmatched salaries. Where the best professors go, the best students are sure to follow.

There may soon be a tipping point where these institutions break into the mainstream and start seriously competing for the mainstream of potential college freshmen.

These trends can be seen in new undergraduate enrollment growth rates boasted by DeVry University. The college recorded a 14.4% increase in new enrollments in 2007-2008 from the previous school year. That led to third-quarter revenue growth of 21.3% from the same period a year earlier.

Beyond this, it should be noted that both Apollo and DeVry carry no long-term debt. This leaves plenty of room to expand financing with debt issuance to help fuel growth while preserving strong returns on equity. DeVry and Apollo have returns on equity of 64.92% and 18.25%, respectively.

Given debt-to-asset ratios, while neither school has tiny leverage levels when taking into account all liabilities, neither is operating close to the danger zone. With ratios of 0.55 and 0.43 for Apollo and DeVry, respectively, additional debt could probably be issued without much trouble. The extra capital could benefit the companies by providing a cheaper alternative to equity with which they can fund their expansion.

Both firms have been able to plow large amounts of cash back into the business through retained earnings. DeVry pays a meager dividend and Apollo pays nothing, opting to put the money back to work in the company. DeVry retained $69.1 million and $116.1 million in fiscal 2007 and 2008, respectively, while Apollo retained $437 million in 2007 and $499 million in 2008.

TheStreet.com Ratings has both Apollo and DeVry rated as "buys" because of their impressive price movements and the stability shown on their balance sheets. DeVry also has the distinction of being the highest-rated stock in TheStreet.com Ratings' universe, as of our most recent model run.

These companies have endured for years as the butt of jokes, but their performance isn't comical. Apollo and DeVry are poised to keep this outstanding performance going while silencing the laughter.

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