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For-profit educational companies (FPECs) like Lincoln Educational Services (LINC) don’t have a great reputation. In many cases, that’s deserved.

During the financial crisis, FPECs took advantage of federal government funding to enroll hundreds of thousands of suddenly unemployed students and provide them with substandard education and limited job prospects. A Senate report last decade noted that, in 2009, FPECs spent $3.2 billion instructing students — and $4.2 billion recruiting them. More than half of those enrolled students left without a degree, often within four months, leaving those students, or more often taxpayers, footing the bill.

As a result, the Obama Administration passed the “gainful employment” rule in 2014 (rescinded by the Trump Administration in 2019, though the current White House may bring that rule back). The 2016 Corinthian Colleges fraud scandal further cemented the idea of the industry as predatory.

With the notable exception of Christian-focused Grand Canyon Education (LOPE), the sector’s reputation inside the market was not much better than its reputation outside of it:

source: YCharts. Chart from 1/1/2010 to 1/1/2018. Zovio formerly known as Bridgepoint Education (BPI)

Between the financial crisis and the pandemic, there was an easy explanation for the declining stock price (and earnings), one I heard often as an investor with both long and short investments in the sector. The sector’s dismal performance proved its inability to succeed when students weren’t treated as simply conduits for federal dollars.

But as is usually the case, the easy narrative wasn’t entirely correct. Government regulation was a factor, but more so for liberal arts-focused programs (like those offered by Apollo Education’s University of Phoenix) and far less so for vocational programs offered by Lincoln and rival Universal Technical Institute (UTI). Lincoln in fact would say in 2016 that the new gainful employment regulation affected programs that only served roughly 1.5% of its students.

Rather, a key problem for Lincoln and its peers was that the industry is structurally countercyclical. Whatever the ethics of the behavior of FPECs coming out of the financial crisis, that behavior only worked because there were millions of Americans looking to improve their prospects in a disastrous job market. As the economy entered its longest expansion ever, employment improved and the pool of potential applicants shrunk. Unsurprisingly, so too did revenues and profits across the industry. Lincoln itself was a bit slow in responding to the changes, not really moving to realign expenses until the second half of the decade.

Those changes, including cost-cutting and campus closures, have worked. Revenue has grown, student starts have turned positive, and profit margins have expanded dramatically. As a result, LINC has roughly tripled from late 2019 when it traded around $2.

That said, there still should be more upside ahead, even with the stock bouncing ~20% in recent sessions after selling off for most of May. Fundamentally LINC stock is exceptionally cheap. The countercyclical nature of the business provides some protection against macro issues (and suggests the 19% year-to-date decline is driven at least in part by market factors, rather than business concerns).

And Lincoln’s business is not one that investors need to hold their nose to own. Rather, it’s a business providing trained employees to key industries, and doing an apparently solid job of doing so. That adds potential secular drivers to the countercyclical protection. Add in sparkling fundamentals and LINC is just too cheap.

Introducing Lincoln Educational Services

Lincoln Educational Services has been around for some 75 years now; it was founded in New Jersey in 1946. (I remember TV ads for Lincoln Tech from my own childhood in that state.) The company now operates 22 schools in 14 states, mostly under that Lincoln Tech banner.

Lincoln’s programs generally have tuition rates of $20-$30K (with some exceptions), and last up to two years (with night students taking longer as classes are shorter). Those programs are offered in five categories:

• Skilled Trades (36% of average enrollment in 2021): electric, HVAC, welding, machining, etc.

• Automotive Technology (30%)

• Health Sciences (25%): nursing, dental and medical assistants, claims examiner

• Hospitality Services (7%): culinary, therapeutic massage, cosmetology & aesthetics

• Information Technology (2%)

LINC Stock Is Cheap

Fundamentally, LINC stock looks like a steal, even after the big rally over the past three years. The fully-diluted market cap sits at $201 million1. At the end of Q1, Lincoln had $65.6 million in cash — and no debt.

But even that cash figure somewhat understates the strength of the balance sheet. Working capital historically moves against Lincoln in the first quarter. In Q1 2022, Lincoln burned $15.4 million in cash despite a modest GAAP net profit.

2022 guidance for Adjusted EBITDA of $35-$40 million, even at the low end, suggests free cash flow ex-working capital of roughly $18 million. Even with some AR/AP headwinds, Lincoln should end the year with at least $90 million in cash; in a high-end scenario, the cash balance nears half of the fully-diluted market cap.

Lincoln also has a deal to sell its campus in Nashville, Tennessee for $34 million, a transaction that management said after Q1 would close in the third quarter. The company has to build another location, but that in turn should cost an estimated $15-$20 million. Add in that net gain plus ~$2M from the sale of another property in Connecticut and pro forma cash pretty easily clears half the market cap, and the enterprise value dips under $100 million.

So if it hits its guidance, on an enterprise basis (and adding back stock-based comp, estimated at ~$4.5M this year, to both figures), LINC is trading at ~3x 2022 EBITDA, and 7-8x normalized free cash flow.

Lincoln Financial Is Growing

Those are multiples befitting a company facing significant challenges, or posting declining financial performance. Neither is the case; in fact, Lincoln’s performance has been rather strong of late:

source: Lincoln 2022 annual meeting presentation

Profit guidance this year does suggest ~flat bottom-line growth, and ~100 bps of EBITDA margins compression. But both figures are explained by ~$2.5 million in incremental annual rent expense owing to a sale-leaseback transaction last year, along with modest investments in Q1 (including $850K to develop new short-term programs). Exclude those factors, and margins are stable while revenue is guided to rise 4-9% year-over-year.

Looking forward, there’s reason to believe growth will continue. Secular trends all show significant demand for Lincoln graduates. There are shortages of auto mechanics, electricians, welders, and nurses. Those programs account for well more than half of Lincoln students.

The country needs Lincoln graduates. (An article from last year, published elsewhere on Substack, made this point well.) Lincoln is planning to capitalize. Starting next year, the company plans to open a new campus each year. New programs are being added as well, and Lincoln has a longstanding strategy of “replicating” programs (ie, launching programs that succeed at one campus in other locations). Management has floated the idea of acquisitions as well.

After all, it’s not as if Lincoln is at peak revenue:

source: YCharts

Strategic changes (including campus closures) explain some of the decline before the recent rebound. Still, it’s not as if current revenue performance is anywhere near a long-term cyclical (or, in this case, countercyclical) top. Clearly, Lincoln has been able to drive organic revenue growth even in an exceptionally tight labor market. Inorganic growth opportunities should further drive top-line improvement.

There’s room for margin expansion as well. This is a model with reasonably solid incremental margins, as Lincoln’s own history shows. EBITDA margins neared 25% at the 2010 peak; they dipped below 2% at the 2017 trough. Here, too, company-specific factors play a role, but ~11% doesn’t appear to be a ceiling.

Minor tweaks may help on this front as well. Lincoln went from 100% hands-on instruction to, amid the pandemic, 100% online and back again. But the company plans to move to a more blended model: per the Q1 call, ~40% of students will be on a hybrid schedule by year-end, and ~100% by the end of 2023. That model allows for a reduced number of start dates and cleaner shifts for instructors, both of which should not only help costs but potentially improve retention (Lincoln is hoping to get its graduation rate to 70% from a current ~64%). Retention is a key boost to margin, as Lincoln already has spent up to get those customers in the door.

Fundamentally, there seems to be a pretty easy case for strong upside here. The cash balance currently limits fundamental upside (double EBITDA, and without multiple expansion the stock only gains 50%) but Lincoln plans to put some of that cash to work over time. Multiple expansion does seem possible, if only because ~3x EBITDA simply can’t hold if the business keeps growing.

Can Lincoln grow revenue to $500M over four years (~9% CAGR, again with some inorganic help), get EBITDA margins to 13%, and garner a 5x EBITDA multiple? The margin target might be somewhat aggressive, but that combination suggests the stock reaches $13 or so. With risks mitigated by the countercyclical nature and the cash balance, those kinds of rewards look incredibly tempting.

What Goes Wrong

But investors would be forgiven for believing those rewards are a little too tempting, and rightfully ask the always-important question: why does this opportunity exist?

It’s difficult to say, exactly. The sector’s reputation might play a role. The market’s appetite for small-cap stocks at the moment is not exactly voracious. The decline in LINC from the beginning of May probably wasn’t solely market-driven: the stock dropped almost 20% in three sessions coming out of the Q1 earnings report.

The report itself does look a bit soft, with Adjusted EBITDA down sharply year-over-year and starts, at least per one analyst on the call, below expectations. But Lincoln also guided for double-digit growth in starts in Q2 while pointing out timing issues (due to the aforementioned change in program start dates), and full-year guidance was re-affirmed. A more bullish market no doubt would have been a more forgiving market, and so the double-digit decline in LINC stock for the month seems like an overreaction.

Fears of government intrusion in the space might play a role. Reports suggest the Biden Administration is looking at resurrecting gainful employment. But, again, Lincoln itself said the rule had little impact on its enrollment at the time; it’s difficult to see why that would change now.

Certainly, Democrats — notably Sen. Elizabeth Warren (D-MA) — have long been exceptionally critical of the industry. But the Biden Administration just revamped the 90/10 rule in a way that led a for-profit industry lobbyist to say, “Although we might not like everything in this language, we can live with it.” FPECs simply are not the target they were a decade ago.

The political environment could create competition; progressives like Warren long have called for free college, and other Democrats have made less aggressive calls simply for free community college. But Lincoln’s programs seem better than public options; indeed, that competition has existed for decades (including in 2010-2012). Meanwhile, partnerships with Ford (F) and Republic Services (RSG), among many others, both prove that fact and give graduates an ‘in’ with major employers.

So what’s the key risk here? The biggest appears to be that Lincoln in retrospect turns out to simply have been a pandemic winner. The market has absolutely punished those names this year, and there is a case where that label applies to Lincoln. As highlighted by the chart shown above, Lincoln’s EBITDA margins went from 4.9% in 2019 to 11.4% in 2021. The shift to online instruction helped that expansion to some degree.

CARES Act funding no doubt boosted demand. The pandemic gave potential students (even if they were working students) far more time to go to school; there wasn’t that much else to do. Ostensibly, when normalcy returns, the boost to enrollment and retention (Lincoln noted that retention dipped slightly last year when the online-only model ended) will fade, and Lincoln will wind up right back where it started. Skeptical investors might argue LINC will do the same (and it started 2020 modestly below $3).

There’s no doubt some truth to this argument. But even if the pandemic helped Lincoln’s results, normalcy is returning and starts still are growing. If enrollment growth was purely a result of the pandemic, that tailwind should have faded by now. And, that aside, the external environment is historically negative. Again, this is a countercyclical business: the tightest labor environment in potentially decades is a headwind, not a tailwind.

That changes at some point, and possibly soon if the common predictions of a Fed-driven recession prove correct. And whenever it changes, the incentive to move into welding or nursing or other Lincoln fields is going to be exceptionally high; the shortages in those fields are not abating. LINC seems cheap enough to wait for that secular trend to play out, because it indeed seems like it almost has to play out.

Returning to our downside risk, what happens if that risk does play out? It doesn’t seem like LINC gets crushed. EBITDA margins of 6% (against 2018-2019 levels below 4% adding back current stock-based comp; this does appear to be a better-run business, and as noted there is room for expansion) at $250 million in revenue (below 2018-2019 levels) still suggest a pro forma EV/EBITDA multiple of ~9x. Cut the multiple to 6x (it should expand as the pandemic boost fades, at least theoretically) and LINC is back down to $5 or so.

This simply looks like a stock that should be trading around $8 right now — at least. $8 provides a reasonable midpoint between downside and discounted upside, while still assigning ~5.5x EBITDA/~12x FCF multiples to a business that seems like it should be able to grow over the mid- to long-term. LINC is at $6 in part because of a nervous market, in part because it’s still a disliked sector, and perhaps in part because investors don’t completely understand the countercyclical and secular drivers.

At some point, that seems likely to change. Before then, LINC looks like a buy.

As of this writing, Vince Martin has no positions in any securities mentioned. He may initiate a long position in LINC this week.

Tickers mentioned; LINC

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