Here's a new homework submitted by Charlie, a computer engineer and recent college graduate. His choice of business is Apollo Group (APOL). Make sure to read the entire post, because he also asks for advice about a business his parents may want to purchase.
Phil,
Thank you so much for your help. Your philosophies have made all the difference in my ability to objectively evaluate a company.
I would like to submit this "homework" to you i have done on Apollo Group (APOL). I would also greatly appreciate your feedback and possibly your objective opinion on a business deal I'm currently working on.
Apollo Group:
Meaning: Apollo group is an industry leader in the online education arena. As the cost of higher education rises, coupled with increased "blue-collar" competition from overseas, Apollo Group is in a position to educate the entire world (most notably China) in the years to come at a lower cost than a traditional university.
In the face of competition, Apollo Groups profits may decline, but as an industry leader, Apollo Group could be in a position to acquire competition. As such, the need for educated workers will most likely not fade in the next ten years.
Management: Apollo Group is currently lacking a CEO. The tenured senior management is still on board, with the COO (15 years in) taking control until a suitable replacement is found. If this company has a con, the leadership is a bit shaky. It is comforting to know everyone isn't leaving though!!
Moat: Apollo Group has the money, the size, profits, flexibility, and offerings to fit almost any budget. They have enormous "sales" offices all over Phoenix to acquire students. Apollo Group's historical financial performance as seen from the Trend Analysis on InvestTools shows GREEN GREEN GREEN!! Not a single number under 10%.
Morningstar seems to agree with me on the Wide Moat Issue as well. Comforting to know.
MOS: I ran a valuation Analysis for Apollo Group and the sticker price vs. current market price is right in line with what we're looking for.
- Historical Growth Rate = 62.12%
- 5 -year Analyst Mean = 20.09%
- Growth Figure I Used = 17%
- Historical PE = 56.50
- My PE = 30
- 2 X Earnings = 34
- Discount Rate = 15%
- STICKER PRICE = 90.91
- Current Price = 51.98
- MOS % = 43%
Almost there!!
Also, institutional interest in this stock has fallen tremendously recently, with current BigChart scores in the single digits. No where to go but up I guess.
That's my take on Apollo Group. Seems like a good buy opportunity may come knocking real soon!!
Also, Phil, my parents are considering purchasing a business. It's a retail "Smoke Shop" that deals in tobacco and other gifts. The business has been operating for six years. Average net profits range from $8000/month to $30000/month. Inventory levels float at $60,000 with turnover between 2-6 weeks. The owner is a friend of the family and has been very forthcoming with us. He needs to leave for personal family issues overseas and has offered us the business for 150,000 pursuant to a two year lease option. We'll owe him $3000/month for two years (72k) + 150,000. All other profits flow to my family. My father seems to think this is too much money to pay for a business. I think it's a good deal. If you could, please let me know what you think about this. An educated second opinion would be very helpful.
Thank you so much for your time Phil, I'm eagerly awaiting March 21st!
Charlie
Here's my response to Charlie:
Apollo Group is definitely on sale, Charlie. And your numbers are definitely conservative in my opinion. I think they can grow at 20%.
And you are using a PE of 30 when the Rule #1 PE is 34 (or in my case it would be 40), both of which are lower than their historical PEs. So I'd say for any Rule #1 investor who likes the Meaning (and I do) and the Moat (and I do) and the MOS (and I do)... all we have left is to find out what the heck happened with the CEO???
Man did he just up and quit or did he get fired? What's up with that? This guy was the heart of that business and something really dire must have happened and current management ain't talkin'. I listened in to their analyst meeting in January -- I think it's still on the website -- and when asked what happened they just referred everyone to their SEC filing -- which I read and which said zippo. Kind of ticked me off and I took Apollo off my buy list. I just didn't like the Management "M" to be so messed up.
Still, it is a tempting price, isn't it? But without a great CEO how do we know what's going to happen? That puts Apollo into (at best) my Risky Biz portfolio with Google and Taser. But I can only put so much toward Risky Biz's. 10% of the portfolio is a good guideline.
The right answer here on Apollo is to find out what happened and what they are going to do about it... and then, if we're comfortable, buy in on the arrows. The almost right answer is to learn all we can and buy in on the arrows anyway! The trouble is, as long as no one knows what went wrong, the big guys aren't likely to do a lot of buying and if they aren't buying, it ain't going up much over any green signals. So watch the volume, watch the news. If this turns around it's going to FLY!!!!
Now -- about the Tobacco Shop deal. I don't know what you're Dad's smoking but it isn't tobacco. Based on those numbers, the TTM EPS is probably around $150,000. I took out $50,000 to pay a manager since most small business owners forget to call that part of the expenses since they are paying themselves. (Note: If there is only one owner, the earnings per share are the same as the net earnings because there is only one share of stock.)
Small businesses often can't grow much, so they don't sell for as big a multiple of earnings as more rapidly growing businesses. Also, small private businesses are much more difficult to sell than shares in a public business. That lack of liquidity -- the inability to get out when we want -- also reduces the value to an investor. Still, it is common for small private businesses to sell for the value of the inventory less debts plus a year of revenue. Or if they can grow with inflation another valuation tool is to just ballpark the value at about 3-5 times one year's earnings.
I don't know what one year of revenues is for this shop, but based on the net earnings it's probably in the ballpark of $500,000 since the net is hardly ever more than about one third of the gross in a small biz. So just for fun, let's say this shop is growing with inflation and would normally be for sale in an open market with a seller who had time to find the right buyer. In that case it could easily have a price of 3 times $150,000 plus $60,000 for the inventory. That's about $500,000. And if we did it the other way we get a similar value.
And here's why it could be worth $500,000 to a reasonable buyer. If I buy the biz for $500,000 but I net $150,000 a year, I've got my investment back in 3 years (because the inventory is worth what I paid still). From then on, I get the whole $150,000 every year and it's probably going up with inflation. My ten year annual rate of return is about 30%. (You can double check me but I think I did this right: Minus $500,000 in year one and then $150,000 a year plus 4% coming in for the next 9 years.) Obviously 30% is an insanely high rate of return. Double our minimum. And that's not even the deal your Dad is getting.
The deal he's getting is off the chart. His rate of return is so good it's hard to calculate. I decided I'd treat it like I put up $72,000 and then the business paid off the second payment out of cash flow. The end result is something close to a 100% per year rate of return. YEAH BABY!!!!
So let's do a Rule #1 analysis on this puppy.
Great MOS for starters. Hopefully your Dad likes tobacco and can see himself owning this thing. So we'll say the Meaning is good.
Management is Dad and he probably has his own best interest at heart so that M is good.
That leaves the Moat, doesn't it? So you better do some homework to make sure that the family friend isn't bailing out of a bad situation moat-wise. Is the Barnes & Noble of tobacco businesses about to move in next door and blow the Smoke Shop away? Can The SS hang in there against low price competition? Is The SS brand awesome in the town and does it have the loyalty of its customers (Or are the customers loyal to the friend who is leaving? A common concern when a dentist sells his biz). Does The SS produce a secret formula that you can't get anywhere else (and is it legal?). Is this the only place in town where you can buy real smokes? So think about the Moat. What is it and is it dependent on the management or does it stand on its own? Remember that moat is all about the durability of a business and our ability to predict its future.
So here's the big moat question: What the heck is a two year lease doing in this deal? If that means what I think it does, that means the lease on The SS space goes away in two years and Dad has to move. Is that a problem? Is location key? Will it wreck the biz? Is the landlord just dying to get you out of there and open up his own lucrative smoke shop?
Losing a lease is one of the BIG killers of small businesses. Make sure you have long term options to renew that lease if the location is at all key to the Moat or you think the landlord is going to compete the moment he can. And make that part of the deal in writing. You need ten years. And anything short of five years and the rate of return on this deal goes straight south.So to sum up: Dad is crazy or knows nothing about the value of a business or both. He should jump all over this if he can get these other details worked out. If that moat thing isn't a problem this is a Rule #1 business deal, my friend.
Now go sell your Dad on working for you so you can go play.
Phil
