Investing with Conviction – Kian Ghazi

Kian Ghazi is with Hawkshaw Capital Management. He starts up by discussing previous picks in Wesco and Learning Tree and how they have played out.

Hawkshaw is a long/short U.S. equity investment partnership. There is a heavy emphasis on research investigation.

How do we invest with conviction?

Value investors identifying high quality one of a kind franchises that are financially strong. Then they kick the tires and uncover the land minds. Ask what could send the stock down 30% or more that would cause us not to want to buy substantially more stock.

Financially strong companies have rock solid balance sheets, positive free cash flows, and monetizeable assets.

Universal Technical Institute (UTI) is a technical school that trains mechanics, primarily auto mechanics. It trades around $15 right now.

What hit this stock? A perfect storm. The company increased capacity by 35% from 2005 to year-end 2006. Company-wide students starts turned negative shortly therafter (2Q06). This pressured margins. The strong labor market and student loan problems this year has really impacted the company.

Ghazi argues enrollment growth is poised to re-accelerate meaningfully through increased demand and improved operations. Analysts are not appreciating this. There is over concern about student loan market. He thinks normalized earnings power is about $2, which is twice the consensus.

There are some good trends. About 50% of qualified mechanics will retire over the next 7-10 years. UTI is twice the size of its nearest competitors. The value proposition here is compelling for the $25,000 investment. Ghazi estimates the return on this educational investment is 25% and if levered it is more like 50%. There are many OEM partners that reduces the capital outlays necessary for operating and equippling UTI campuses. The OEMS include BMW, Harley-Davidson, and many other auto manufacturers.

There exposure to the subprime market is very small. From 2003 to 2005 the company was hitting on all cylinders. Then management failed to adjust to changing employment market. The affordability of the program declined and the educational funding gap increased over time from $7,000 to over $12,000. This resulted in leads dropping by double digit rate. Those that show up after a contract went way down. In 2007, the federal government reduced the subsidies to student loan providers. UTI began funding the gap of subprime loans to students and this caused concern to the market.

As unemployment rate rise, enrollment rises. In 2006 and 2007, high school students could go into construction and make $30 an hours, so they were not finding it attractive to pay to become mechanics.

They have changed the SVP of marketing in January 2007 and the SVP of campus sales in September 2007. They also improved the marketing from infomercials to 30/60 second ads. They improved the company website and spend more time with prospective students to encourage them to enroll and stay in the program. Leads are already starting to grow in the most recent quarter (3Q2008). There was a 41% increase in leads. Modest contracts growth can lead to a high shows growth.

Under the presented scenario there is a potential value of $30 per share.

What could drive this stock down 30%? It could happen if students can’t secure financing, but it appears students still have access to prime loans. Regulatory issues could arrise if default rate spirals out of control and result in the school being cut off from federal student loans.

What you need to believe?

Contract growth: 5%
Show rate improvement: 3.5%
Starts growth: 12% for 2 years
Capacity utilization: 80%
Drop out rate: 30%
Incremental margins: ~50%
EBIT margins: 15%

With more relaxed assumptions, he could envision the stock being worth $45 per shares.

I must admit that I’m interested. My only concern is the amount of mechanics being trained by the military is probably high given the protracted war effort. The withdrawal of troops from Iraq could result in a surge of trained mechanics hitting the market.

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