Investor Essentials Daily

This company coaches standardized test takers, while proving how rating agencies’ tests aren’t standardized

October 21, 2020

Standardized testing has become the cornerstone of many colleges’ application processes. Companies that help students navigate these tests have seen surging demand as the admissions process becomes more competitive each year.

Today’s company owns one of the top test preparation companies, as part of its many diversified holdings.

Below, we show how Uniform Accounting restates financials for a clear credit profile. We also provide the equity tearsheet showing Uniform Accounting-based Performance and Valuation analysis of the company.

Investor Essentials Daily:
Wednesday Credit Insights
Powered by Valens Research

Standardized testing has become the norm for school applications. The SAT, ACT, GRE, and GMAT are tests used across a variety of different levels of education.

The idea behind standardized tests is to create a level playing field when measuring all students’ performances. Everyone is taking the same exam, and can be evaluated against students all over the country or even the world.

This is in contrast to more personalized measures like the Grade Point Average (GPA), which can fluctuate heavily depending on the school, or admitting based on extracurriculars, which is a more subjective measure.

However standardized tests are anything but a level playing field. Behind the tests is a $30+ billion test preparation industry. Students with access to more resources and money can pay for private tutors or classes to teach them how to game the system and score better.

Those with access to fewer opportunities are forced to take the test with less preparation or a lower understanding of its implications.

The desire to get a leg up in the admissions process has helped create the booming test preparation industry. Large test preparation companies have virtual tutoring options, on-site classes, and a variety of different print options for studying.

Kaplan, Inc. is one of the largest in the industry. It provides educational services, including test preparation and student support services. Kaplan is owned by Graham Holdings Company (GHC), a diversified conglomerate that used to also own the newspaper company The Washington Post.

Graham owns everything, from Kaplan’s high-margin testing business to broadcasting and cable providers, and even health care companies. Graham has a diversified operation with a variety of high-performing business units.

Despite owning a diversified group of high-return businesses, Graham is rated as a high-yield credit by Moody’s. However, this perception of the company’s credit risk is not rooted in reality.

By looking at the firm’s Credit Cash Flow Prime (CCFP), we can see the safety of the firm’s credit.

Cash flows will be sufficient to meet all obligations until 2026, where the firm has a $400 million headwall. Even better for investors, Graham has a large expected cash balance that should build further in the future. It will be more than sufficient to service any additional obligations through 2026.

Moody’s rates the firm as a speculative Ba1 investment. This would imply the firm is at risk of defaulting on its obligations, despite its strong liquidity position.

Because of the firm’s strong liquidity, Valens rates the firm as a much safer investment-grade IG4 (Baa2) credit.

Ultimately, Graham is being treated as a credit risk by rating agencies because as-reported metrics don’t capture how profitable the business is and ratio analysis shows less of a coverage of cash flows over obligations, as they don’t take into account the company’s massive cash balance, among other issues.

However, when looking at Graham’s CCFP from a Uniform Accounting perspective, the firm’s minimal credit risk can be seen.

Graham should have sufficient cash flows to pay off all obligations through 2025 and still maintain a significant cash balance to service 2026 obligations. While the credit agencies have not seen the value of standardized metrics, Graham has been able to profit from its standardized testing offerings.

Widening of Bond Spreads Likely Given GHC’s Lackluster Recovery Rate

Bond markets are slightly understating credit risk, with a cash bond YTW of 3.681% relative to an Intrinsic YTW of 4.141% and an Intrinsic CDS of 387bps. Meanwhile, Moody’s is overstating GHC’s fundamental credit risk, with its speculative Ba1 rating two notches below Valens’ IG4 (Baa2) rating.

Fundamental analysis highlights that GHC’s cash flows should comfortably exceed operating obligations every year going forward. Additionally, the combination of the firm’s cash flows and substantial cash on hand should be sufficient to service all obligations including debt maturities through 2026.

This is important, as the firm’s lackluster recovery rate and moderate market capitalization may make it difficult for it to access credit markets to refinance at favorable rates.

Incentives Dictate Behavior™ analysis highlights mixed signals for credit holders. GHC’s compensation metrics should focus management on all three value drivers: asset efficiency, margins, and growth, which should lead to Uniform ROA expansion and increased cash flows available to service obligations.

In addition, management is not well-compensated in a change-in-control situation, indicating they may not be incentivized to seek a sale of the company or accept a buyout, which coupled with the family-controlled nature of the firm, reduces event risk.

However, most members of the management team are not material owners of GHC’s stock, suggesting they may not be well-aligned with shareholders for value creation, and that the Graham family may be incentivized to direct the company in a way that is focused on legacy building rather than value creation.

Operating sustainability and strong liquidity indicate ratings agencies are overstating fundamental credit risk, while a low recovery rate suggests bond markets are understating risk. As such, a ratings improvement and widening of bond spreads is likely going forward.

SUMMARY and Graham Holdings Company Tearsheet

As the Uniform Accounting tearsheet for Graham Holdings Company (GHC:USA) highlights, the company trades at an 8.8x Uniform P/E, which is below global corporate average valuation levels and its own historical average valuations.

Low P/Es require low EPS growth to sustain them. That said, in the case of Graham, the company has recently shown a 41% Uniform EPS decline.

Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Graham’s Wall Street analyst-driven forecast projects a 114% EPS growth in 2020, before inflecting to a 13% contraction in 2021.

Based on current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Graham’s $410 stock price. These are often referred to as market embedded expectations.

In order to justify current stock prices, the company would need to have Uniform earnings grow by 1% per year over the next three years. What Wall Street analysts expect for Graham’s earnings growth is above what the current stock market valuation requires in 2020, but below what the market requires in 2021.

Furthermore, the company’s earning power is around the corporate average, while cash flows and cash on hand are 2x higher than its total obligations—including debt maturities, capex maintenance, and dividends. Together, this signals low credit and dividend risk.

To conclude, Graham’s Uniform earnings growth is well above peer averages. However, the company is trading well below average peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research