Credit Bulletin: Higher Education
Identifying Credit Quality in a Changing Landscape
- Strong pricing power enjoyed by the higher education sector for decades appears to be diminishing.
- Students and families are more selective with their education dollars after the recession.
- Certain schools will fare better than others in maintaining credit strength in this new operating environment.
- Broad geographic appeal, diverse course offerings and a strong value proposition are key to attracting students.
- Analyzing student demand is now a critical component of credit analysis, while revenue diversity, financial performance, and endowment strength remain key credit attributes.
Across the country, families are reevaluating how much they are willing to pay and borrow for their child’s college degree. Student debt levels are highlighted by media accounts of recent graduates shouldering six figure debt burdens while working low wage, low skill positions. As parents and students become more price and outcome conscious, higher education institutions may no longer have the luxury to automatically increase tuition and other costs. However, these challenges do not fall evenly across the sector as some institutions are better positioned to maintain pricing power and a solid credit profile. The potential divergence in credit quality across the sector creates an opportunity to use in-depth credit analysis to determine those institutions best equipped to manage through a changing environment. As Exhibit 1 below shows, aside from the strongest AAA names, spreads have varied in recent years, making security selection an important aspect of investing in this sector.
Costs Soar for Decades
It is important to put into context the degree to which universities have historically enjoyed pricing power in terms of their ability to increase tuition. According to the Bureau of Labor Statistics, between 1984 and 2013, college tuition and costs increased at an average annual pace of 6.9%. This far outpaced the 2.9% increase in the Consumer Price Index over the same period. Over the last decade, the increases were funded in part by a massive increase in student loan debt. The Federal Reserve shows the size of the student loan market increased to $1.08 trillion by the end of 2013 from $241 billion in 2003. According to the Institute for College Access & Success, 68% of 2012 graduates from non-profit schools had student loans with an average balance of $27,850. The survey noted that graduates with student loans at the top 20 high-debt private colleges had loan burdens ranging from $41,500 to $49,450.
Purchasing Power Erodes
A substantial drop in household net worth during the recession, a slowdown in high school graduate growth, and the previously mentioned student loan concerns have appeared to cause some schools to max out on what they can charge for tuition and still meet matriculation targets. This new operating environment can clearly be seen in the recent data from across the higher education space. Moody’s published a report entitled “Weakened Tuition Revenue Plagues US Higher Education,” which shows that fiscal year 2014 net tuition revenue is actually projected to decline 28% for public and 19% for private schools. For those schools that are able to raise tuition, the increase will fall short of inflation for 44% of public and 42% of private schools.
While the net tuition numbers already paint the picture of a decline in pricing power, looking further into tuition discount levels paints an even starker picture. Tuition discounts show the amount of institutional financial aid offered to students as a percentage of gross tuition. The freshmen discount rate in particular may best reflect the current competitive environment amongst colleges for high school graduates. The National Association of College and University Business Officers reported that tuition discounts for freshmen students at private institutions have risen for six straight years and now stand at a substantial 45% of sticker price. Simply put, while many schools may keep tuition’s sticker price constant, they are being forced to offer more aid to compete with other schools. However, it remains important to put discount metrics into an individual school’s context and consider things such as merit aid, need blind aid, as well as endowment strength.
Competition for Students on the Expenditure Side
Looking into the cost structure at colleges and universities may indicate another way in which competition for students influences operating results. Ronald G. Ehrenberg the Director of the Cornell Higher Education Research Institute, studied the cost drivers for colleges between 1987 and 2008 in his report “American Higher Education in Transition.” During this period, spending on student services outpaced inflation by 2.16% annually. This is more than double the growth rate for instructional spending, which outpaced inflation by a more modest 1.07%. Student service spending includes “activities whose primary purpose is to contribute to students’ emotional and physical well-being and to their development outside of the classroom.” Many of these student service expenditures are designed to attract potential students and to retain those already enrolled. While schools enjoyed pricing power, the competition for students took place more on the expenditure side. Any industry with the sort of pricing power shown in higher education since the 1980s would face little pressure to bring down their cost structure. Costs can simply be passed on to consumers, since their demand is relatively inelastic. As revenue growth slows in higher education, many institutions are struggling to bring expenditures in line with this new environment. Moody’s notes that between 60% and 70% of public and private schools reported expense growth that exceeded revenue growth in the fiscal year ending 2012.
Certain Trends Provide Support
Despite all of the noise, the increased earnings potential from a college degree is substantial. In addition, unemployment rates for those with a bachelor’s degree are consistently below national levels. Positively, according to the Western Interstate Commission for Higher Education, the number of high school graduates in 2014 will reverse recent declines. However, growth from 2014-2024 will be just 0.8% annually, compared to 1.9% between 1997 and 2010.
The impact of the various revenue pressures will be far from uniform. Those schools that combine high tuition, limited course offerings and a small geographic appeal face stronger headwinds. Many schools offer a strong value proposition, a wide course offering and maintain immense geographic appeal. Such schools will see solid demand going forward, even from a more selective consumer. This shift away from industry wide pricing power offers increased opportunity for investors to benefit from in depth credit analysis to separate the strong from the weak. Samson seeks to invest in universities that will meet the challenges of a shifting demand environment and have a history of strong financial performance.
Bryan Laing, CFA
Credit Research Associate
March 24, 2014
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