“Over the past 15-months, THQI’s stock has declined in excess of 80% in large part due to poor execution by the company in its efforts to target “core gamers” and decreased receptivity among young consumers for traditional video games from established brands such as Nickelodeon and Pixar. The stock currently reflects substantial concerns about THQI’s ability to remain economically viable. Consensus estimates for FY10 (March FYE) have been revised down sharply and the street has no confidence in management. We think the stage has been set for a sharp recovery in THQI shares in the next 3-6 months…”

Even though April 2009 seems like another lifetime, many of the dynamics surrounding THQI shares remain the same: the company has generated significant operating losses, investors remain doubtful the company can consistently deliver high quality titles targeted towards core gamers, and concerns about THQI’s liquidity position are paramount.  It should be noted that less than 3-months following our initial report on THQI, the stock more than doubled following better than expected sell through for the first iteration of the UFC Undisputed franchise.  Just as we did in April 2009, we think the near term appreciation potential for THQI from current levels is SIGNIFICANT.  At long last, we think THQI has completed what at times seemed like an endless cycle of layoffs, studio closures, and charge-offs.  Finally after three, for the most part excruciating years we now think THQI is on the cusp of realizing the vision we have always had for the company.

While the naysayers (take your pick – Michael Pachter, Kevin Dent, Strauss Zelnick etc.) will almost certainly focus on what was another quarterly operating loss in 4Q12, initial FY13 earnings guidance that was below consensus, and yet another charge-off for a title cancellation (Devil’s Third), we think the merits of the long standing bear case for THQI have been significantly reduced, if not altogether eliminated. After all, the central tenets of the bear case have been:

• THQI’s core gamer focused owned IP is weak
• The company’s cost structure is untenable
• THQI remains far too reliant on kids focused games that have been disintermediated by mobile devices
• Management continues to make poor capital allocation decisions
• THQI’s liquidity position is increasingly questionable

The negative halo surrounding THQI will not disappear overnight. However, we think investors continue to overlook many of the positive developments that have occurred over the past 2-3 years, the ultimate culmination of which occurred in 4Q12:

• Management took the necessary steps to eliminate $180-$200 million in annual fixed costs over the past 12-18 months
• THQI is out of the “kids business”
• With more than 4.25MM units shipped in the first 6-months following its release at full price, Saints Row the Third has become one of the most popular open world franchises in the video game industry.  Future releases are likely to be met with great optimism, not skepticism.
• The capital needs going forward for the company are completely different and as a result, THQI’s liquidity position is not as tenuous as some would have you believe.

We understand why investors remain highly skeptical of this company and its management team given the number of false starts and missteps that have occurred over the past 4-5 years.  However, there is little doubt in our mind that THQI’s chances to deliver meaningful revenue, earnings, and cash flow upside are appreciably greater than they were at any point over the past three years.  The simple fact is this: all it takes is one.  The company’s operating leverage to upside for any given title has increased dramatically.  We estimate every 100K units of upside to any given title could increase THQI’s non-GAAP EPS by $0.02-$0.04.  Stated another way, 1MM units of incremental sell through relative to expectations would yield $0.30-$0.35 of earnings upside in any given fiscal year.  In our opinion, THQI’s guidance for FY13 appears to be extraordinarily conservative. Management knows they can’t miss, so we understand why they have pursued this tact.  We think the stage has now been set for THQI to finally deliver on its promise and a sequence of positive earnings surprises and upward estimate revisions from here would wash away the overarching pessimism surrounding the company and yield enormous stock price appreciation.

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As always, please act accordingly….

Disclaimer: The author of this report owns shares of THQI. Positions can change at any time without notice.

• Demographic trends were likely to move from a tailwind to a headwind for companies like APOL over the next 3-5 years.
• Weakness in lead flow was likely to persist far longer than consensus expectations due to a SECULAR shift in how students perceive the return on investment for higher education programs and market saturation of the target demographic.
• Deflationary pressures could cause institutions from within and outside of the for-profit education sector to cut tuition, which would either result in softer demand for APOL or force the company into price reductions.
• Increased competition from traditional academic institutions in the online degree arena could lead to large market share losses for APOL over the next 3-5 years.
• Given the amount of brand damage the University of Phoenix has incurred over the past 2-3 years and the high cost of the company’s programs, we think APOL is poorly positioned for an era in higher education that is likely to be defined by “brand and price”.

Over the past 4-5 months, the operating results of APOL and other companies in the for-profit education sector have validated our short thesis. We remain as convinced as ever that many of the publicly traded for-profit education companies for the changing landscape in higher education.  However, as a firm we are 100% focused on identifying investment ideas with high absolute return potential.  We hold ourselves to the same standards that you do: returns.  At this stage, we no longer view the risk/reward from a short perspective as favorable.  This should not be construed as some sort of softening in our stance on the fundamentals in the for-profit education space.

Our decision to close out this investment idea is recognition that the stock has declined 32% in the past 5-months and now trades at valuation levels where a data point that is “less worse” could spark a rally in APOL shares.  There are a few levers that management could pull in the coming months that also could cause the stock to appreciate:

• Changing the criteria around the orientation program to boost starts. Even if it is an artificial measure, it could change sentiment surrounding the company.
• More aggressive cost cuts.  APOL has plenty of opportunity to manage costs at the facility level and increase average class size, both of which would lead to a much stronger earnings outlook.
• Introduce a dividend. STRA’s premium to the group, in part is largely a function of the stock’s sizeable dividend yield.  Stock buybacks for APOL have not been a source of shareholder value creation – quite the opposite
• Management changes.  In our view, this industry is in desperate need of an infusion of new management talent.  Should APOL hire an executive(s) with greater experience in brand creation and cost-management, the stock could rally.

We’re not arguing that any of these are being actively considered by APOL management.  However, we need to acknowledge that they are in the realm of possibility and could lead to better share price performance in the short term.  We think any meaningful rally in the stock will likely present another opportunity to establish a short position in APOL until further notice.

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As always, please act accordingly….

In our view, the negativity related to WWE Studios and the potential launch of a WWE Network have created a compelling investment opportunity in one of the most well-known and longstanding franchises in all of media.  It appears that investors seem to forget that for the five year period from 2006-2010, WWE generated average EBITDA of roughly $85 million, which suggests the core franchise is currently being valued at roughly 5.7x EBITDA if the network and WWE Studios are worth zero.  More importantly, the intense focus on the company’s historical loss experience with its studios division and the magnitude of the investment in the network initiative have caused investors to lose sight of two critical developments: 1) It appears the popularity of WWE’s core product is on the upswing, and 2) the company’s growth initiatives just might actually yield meaningful returns for shareholders.  There is no question that 2012 will be a significant year of investment for the company, which will mask the financial impact of improvements in WWE’s creative cycle.  However, as investors become more confident in the improving popularity of WWE’s core product offering globally and less skeptical about the prospects for success of the cable network and other content monetization strategies, we think shares could see meaningful multiple expansion.

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As always, please act accordingly…

As we outlined in our lengthy report on housing and Zillow earlier this week, we think the company has the potential to transform the residential real estate landscape and alter the purchase and home sale process.  Given the company’s enormous potential and low penetration rate of its total addressable market, we think more and more investors will focus on the signposts that Zillow is achieving critical growth benchmarks and creating a foundation on which a $1B+ revenue and 40%+ EBITDA margin company can be built rather than near term earnings results.  Through this prism, we would argue that Zillow delivered on all fronts in 1Q12 and management appears to be making all of the right moves to ensure that the company delivers on its vast promise.  Below we quickly discuss what we think were the most critical takeaways from the company’s 1Q12 earnings results and subsequent conference call:

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As always, please act accordingly….

OPEN’s former chairman and CEO cashed out and abruptly left the company.  OPEN’s operating metrics started to show meaningful signs of deterioration just as competition in the marketplace started to heat up.  The timing of the integration of TopTable was pushed out.  The Spotlight group buying initiative proved to be a bust and was quickly shuttered.  The company consistently missed topline forecasts but delivered EPS upside in large part due to cost containment.    Restaurants increasingly started to question the value proposition of the company’s service offerings relative to its cost.  Insiders continued to sell stock.  Scripps Network owned City Eats launched in Washington D.C. and Philadelphia to wide acclaim.  Urbanspoon launched a television advertising program for its Rezbook product.  LiveBookings gained share in the UK, Germany, and the Nordics at the expense of OPEN.  In short, things fell apart.

Even though many of the key components of our short thesis on OPEN have started to manifest themselves in the company’s operating metrics, we have not yet witnessed the ultimate realization of our bearish call from a financial perspective.  There is little doubt in our minds at this point that OPEN’s revenue growth is poised to continue its rapid deceleration and the company is far closer to peak earnings than most investors currently realize.  On the heels of a quarter that should be remembered not for the EPS upside delivered, but a continued deceleration in growth, we think investors are left to ponder the following questions:  Has Opentable reached maturation?

We were never firm believers in the total addressable market thesis for OPEN.  Ultimately we thought the value proposition of the company’s core service offering was limited (a solution without a problem) and the notion that an incremental layer of cost could be absorbed by an industry with razor thin operating margins seems increasingly questionable.  More than anything, OPEN’s current pricing strategy which even many of the company’s biggest and most supportive clients would identify as “expensive” leaves the company exposed to two forms of competition. The first would be from lower cost providers entering the marketplace, whether they are subsidiaries of large public companies or small venture backed enterprises.  The second would come from the restaurants themselves who have every incentive to drives as much traffic to their own websites and hold back an increasingly high percentage of quality table inventory from OPEN’s system to avoid cover fees.

This is where we are today. Amazingly, OPEN has not deviated from its pre-established go to market strategy or growth plans.  For management, it appears that the “song remains the same”.  However, growth is slowing and OPEN seems suddenly ill prepared to deal with the combination of well capitalized new market entrants and increased resistance from the company’s OWN client base.  Indeed OPEN’s once limitless growth story is falling apart and from all that we can tell management’s only solutions are: to complete the integration of toptable, enhance data mining and improve mobile conversion.  That is highly unlikely to satisfy growth investors, in our view.

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As always, please act accordingly….

Given the importance of the US housing market to investors across the globe, it shouldn’t come as a complete surprise that there is a wealth of research in the public domain on the state of home sales.  From what we can tell, most investors frame their views surrounding housing based on the following data points: new and existing home sales from the US Census and National Association of Realtors, the Case/Schiller Index, foreclosure data from RealtyTrac, the weekly mortgage volume report from the MBA, and commentary from the management teams of publicly traded homebuilders.    There are other data sources that people rely on as well, but the aforementioned appear to have the greatest influence on investors.    There’s no shortage of data (or views) in the marketplace on the state of housing, but despite the deluge of information available we still find we have an incomplete picture of what is really happening on the ground level.  There are questions we want answers to that are not captured by existing research providers.  Over the past few weeks we conducted a survey of more than 700 real estate agents across the country which attempts to address some of our lingering questions and provide a more granular snapshot of the state of the housing market.  Here are some of the primary conclusions from our survey:

• In general, the housing market is improving more quickly than most people believe.  Our survey work suggests that the US housing market is now analogous to a stock that has been “washed out” and is showing signs of accumulation even as prices decline. Volume remains light.  Housing units have been transferred from “weak to strong hands”.  Units for sale have declined. Sentiment is awful, but showing signs of improvement. Valuation is compelling.
• Listings in most markets have declined YOY and many of the agents we surveyed suggested that their local market was somewhat inventory constrained.  Skeptics will be quick to point out that “shadow inventory” could represent as much as 1.5-2.0 million additional homes that are not on the market but could become some form of distressed sale candidates.  Controversy surrounding “robo-signing” and other alleged transgressions committed by creditors has slowed down the foreclosure process across the country.  Shadow inventory remains “an anvil over the head” of any potential housing market recovery.  However, we think most investors would be surprised to learn that more than 60% of respondents to our survey characterized inventory in their local market as “adequate” or “too low”.  On a listed basis, the housing market at the national level appears to be in relative equilibrium (6 months of inventory, 2.0MM existing homes for sale in the market place).  Is it possible that a reacceleration in the foreclosure process will not yield the type of pressure on home prices that seems to be largely reflected in consensus? Our survey results suggest that could be the case.
• Credit availability is improving and the supposed 20% down payment requirement is not as big as an impediment as you might think. We are nowhere near the halcyon days of 2005-2006, but there is growing evidence that credit availability has started to improve across the marketplace.  Additionally, at least based on our survey the supposed requirement that all new buyers must provide a down payment of 20% of home value appears to be more myth than reality.  Less than a third of agents indicated that the buyer on the transaction on which they most recently worked provided a down payment equal to or above 20% (including all cash buyers).  There is a prevailing view in the marketplace that the 20% down payment requirement will be a big impediment to any recovery in housing because so few buyers have the wherewithal to produce that kind of capital in the current economic environment.  Underwriting standards while tight, probably are not as restrictive as some would have you believe.
• Pricing appears to be firming up even as buyers are increasingly conditioned to expect a discount to list prices.  55% of respondents to our survey indicated that average home prices in their local market were up or down 5% compared to a year ago.  Perhaps more importantly, only 34% of respondents indicated that prices in their local market had declined more than 5% on a YOY basis.  Even as prices flatten out, most buyers are still conditioned to expect discounts relative to initial list price.  Most transactions only have one bidder, few transactions close above list price, the average home that gets sold has its price lowered twice, and the average discount to initial list price to get a home sold appears to be in the 5-15% range.  Make no mistake, prices are not ripping, but there’s evidence to suggest stability is here or otherwise could be imminently upon us.
• Agents are as optimistic about the housing market as they have been at any point in the past three years.   Two thirds of respondents to our survey expect the health of the housing market to improve over the next 6-months.  This compares to only 44% and 43% of agents who would have made a similar statement in the Spring of 2011 and 2010, respectively.  Additionally close to 50% of respondents to our survey expect home prices in their local market to increase over the next 12-months.  While pessimism surrounding housing remains omnipresent in the investment community, those living and breathing it day-to-day on the ground level appear to be far more optimistic.

We are not trying to argue that housing is on the cusp of a high flying recovery, but we do think the underpinnings of stabilization are now in place and we can start to move forward with what we expect to be a gradual, yet increasingly steady recovery.  We find it ironic that so many people who normally are the first to criticize any investment thesis predicated on the notion that “this time is different” are in the fact the most bearish on housing.  At this stage in the housing downturn it appears more and more people are trying to make arguments that the decline in housing is in fact secular, not cyclical.  The principal arguments supporting this thesis are as follows: 1) Consumers no longer view housing as a good investment, 2) Household formation is in secular decline, and 3) Every decline in home prices will cause another round of selling as owners recognize they’re effectively underwater.  We could spend a great deal of time discussing the merits (or inadequacies) of these arguments calling for a secular decline in housing, but we would like to offer you the following observations:

• Young people still want to own a house. According to an October 2010 survey from the National Association of Realtors, 75% of respondents ages 18-29 indicated they wanted to own a home.
• Demographics suggest the economy more than secular trends has impeded household formation. Echo baby boomers are more likely to live at home and remain single than their predecessors.  However, they are also likely to be more college educated (which means they probably have student loan debt as well – an issue long time followers of PAA Research know we are intimately familiar with), which would suggest their earnings power over time should be higher.
• Consumers want to own their homes even if they’re “underwater”. Increased price transparency in the marketplace (more on this later) has enabled consumers to make more informed decisions about housing.  In many cases this has caused home owners to “hand over the keys” to the bank rather than continue to make payments on a house that is worth less than the mortgage outstanding.  However, not all consumers make that decision – people want to own their homes.  Additionally, we think people tend to overstate how aware consumers are of the market clearing value of their homes.

As is often the case surrounding prolonged cyclical moves (up or down), people often confuse the cyclical with the secular.  We think we have arrived at that point in housing. It appears good news is being ignored and every single negative data point celebrated.  The housing market is still in rough shape, but the underpinnings for recovery appear to be forming.

There are many ways to play a housing recovery.  Homebuilder stocks which were as recently as a month ago starting to discount a meaningful improvement in fundamentals in the marketplace have seen those gains evaporate.  In general, we view those stocks as trading vehicles, they’re not great businesses and historically the management teams have not demonstrated a tremendous amount of strategic vision.  However, the earnings power of the homebuilders in a true housing market recovery would yield materially higher price to book ratios than what we’re seeing in the stocks today. For what it’s worth, KBH is our favorite builder to play for a cyclical recovery in housing.  Otherwise, the banks should also benefit from a recovery in housing which would likely yield improved credit demand, lower delinquencies/charge-offs, and improved net interest margins.  There are the home improvement retailers, the outdoor power equipment players (BGG is our favorite),  tools manufacturers, forest products companies, the list goes on and on.  Those are textbooks plays on a cyclical recovery in housing.

We think investors should focus on companies that have the potential to weather what could be a prolonged period of stabilization in housing through secular growth AND could very well transform the marketplace altogether, which leads us to one name – ZILLOW.

Zillow Could Transform the Home Purchase and Sale Process

In our view, Zillow has the potential to be a transformative company in the US housing market.  Historically price transparency has been a pressing problem in the marketplace.  Through its “Zestimates”, historical pricing data, and other analytical tools Zillow provides a tremendous service to consumers that goes beyond basic listings aggregation (which in and off itself is highly valuable).  For real estate agents, Zillow offers a steady stream of high quality leads and customer relationship management tools.  Residential real estate agents and brokerage firms have been slow to adopt many of the internet lead generation techniques that dominate other forms of consumer purchasing activity.  Zillow is uniquely positioned to benefit from the transition of advertising expenditures in the residential real estate space from traditional media sources to internet based lead generation, which is still in its nascent phase.  Additionally, the company has opportunities to expand into tangential marketing services in residential real estate, grow its lead generation for mortgage providers, enhance the value of its transaction database, and capture more traditional marketing dollars from both national and local advertisers.  Zillow now generates more than 30 million monthly unique visitors to its desktop and mobile websites.  In our view, the company is rapidly emerging as the leading residential real estate search engine with explosive traffic growth and enormous opportunities to increase monetization.  We anticipate Zillow shares could witness material upside from current levels despite its lofty valuation for the following reasons:

1. 1. The housing market once a headwind, has now become a tailwind for Zillow.  Improved agent sentiment should become a gateway to increased inventory monetization. Zillow has increased traffic four-fold and revenues 10-fold over the past three years despite operating in a housing depression.  As we will outline, real estate agent sentiment has started to improve meaningfully, which we think will yield increased spending on lead generation.  Increased revenue per agent should be a huge part of Zillow’s growth story over time.  While we would hardly characterize Zillow as a cyclical growth story, there is little doubt improvement in the housing sector would finally create a revenue tailwind for the company.
2. We’ve seen this story before and that’s a very good thing.  In our view, there are three publicly traded companies that serve as the best proxy for Zillow’s immediate revenue, earnings and cash flow appreciation prospects – REA Group Limited (REA.ASX), Rightmove PLC (RMV.LON), and LoopNet, Inc.  Each of these companies created a leading destination for buyers and sellers of real estate in their respective markets.  As we will demonstrate, in every case each of these companies experienced explosive growth in agent monetization, increased agent subscriber growth, and generated incremental EBITDA margins of40-50%+ for a period of 5-7 years.  If past is prologue, than the outlook for Zillow’s earnings prospects are incredibly bright.  Given the enormous size of the US housing market relative to the environments in which the company’s comp group operated, we think Zillow has the potential to be appreciably bigger.  We estimate the company has the potential to generate more than $1.0 billion in revenues and $400-500 million in EBITDA in 7-10 years.
3. Mobile is a game of huge winners and enormous losers; Zillow’s rapid ascension as the de facto real estate search engine should accelerate in the transition to mobile. Traditional methods of internet based lead generation that are heavily reliant on the Google ecosystem are likely to be increasingly disrupted by the transition to mobile.  Ultimately, the lack of “real estate” or “square footage” in the mobile interface is a killer.  As a result we expect apps to increasingly dominate the lead generation landscape.  With more than 155 million homes viewed on Zillow Mobile in the month of March 2012 alone, the company has quickly established itself as the leading mobile destination for residential real estate.  Realistically, there are only likely to be 2 or 3 residential real estate apps that achieve meaningful critical mass in the marketplace.  Thus far it appears Zillow has quickly established itself as a “winner” in the mobile landscape.  We think this will ultimately yield a higher wallet share of marketing spend for Zillow from real estate agents over time.
4. Make no mistake this is a total addressable market (TAM) story and in that context Zillow’s shares are actually quite cheap. Zillow is a transformative company operating in enormously large markets.  For 2011, the company generated $66 million in revenue from residential real estate agents, mortgage providers, and traditional display advertisers.  We estimate the annual advertising spend in the markets that Zillow currently serves in the US exceeds $18 billion.  Depending on whose estimates you want to use, there are 500,000-1.0 million residential real estate agents in the US.  Zillow has barely scratched the surface of its opportunity across a variety of revenue streams.  While Zillow shares appear expensive based on consensus estimates, we would argue those forecasts are woefully low and do not reflect the company’s potential earnings power.  We anticipate Zillow could ultimately become a $1.0 billion revenue company operating with 40-50%+ EBITDA margins.  The company’s rapid growth trajectory and minimal share in large addressable markets is likely to provide a floor on valuation.  The stock currently trades at 29x our fully taxed FY14 EPS estimate, which suggests shares could see upside once we start to see meaningful positive estimate revisions to consensus forecasts.

Risks to Our Thesis:

Obviously given Zillow’s steep valuation (at least based on consensus forecasts) and the early nature of its growth trajectory there are a number of risks to our investment thesis.  We would argue that the quality of the management team represents the biggest single offset to any of these factors.  While there are a number of potential issues that could cause the stock to sell off in the short term, we have a high degree of confidence in this management team’s ability to establish Zillow as a leading residential real estate platform and a critical marketing partner for agents, mortgage providers, and traditional advertisers.

• Traffic growth could slow.  On April 16, 2012, Zillow announced plans to open a new office in California and hire approximately 80 more sales professionals and 20 other staffers for growth initiatives.  In conjunction with this press release, the company announced its traffic statistics for the month of March.  Total unique visitors increased 67% YOY to more than 32 million across Zillow’s website and mobile apps.  There’s no question this is impressive growth, but it still represented a material slowdown from the 100%+ and 80%+ growth in traffic witnessed on a YOY basis in January and February.  From our perspective, Zillow already generates enough traffic to achieve our subscriber and revenue per agent growth estimates.  While we expect Zillow to continue to generate traffic growth, we think it will be difficult for the company to generate meaningful traffic growth beyond 40-45 million unique visitors given overall transaction volume in the US housing market (purchase and rental).
• The company could announce a secondary offering.  Insiders own roughly 44% of Zillow, while venture capital firms own more than 25% of the company.  At this stage we think it would be reasonable to assume that the VC firms at the very least could take some profits in Zillow.  Many of the company’s senior executives established 10b5-1 plans in November 2011 following the expiration of the lockup. Obviously this has not had a material impact on the performance of Zillow shares over the past 6-months.  Investors should expect a steady diet of Form 4 filings for the foreseeable future.
• Other players could emerge. Currently, we would argue Zillow’s path to leadership in the residential real estate marketplace is only being challenged by Trulia and to a lesser extent Move, Inc.  Trulia represents Zillow’s most viable competitor in the US in our view.  Realistically, the data sets and listings Zillow relies on to provide consumers with information about housing are publicly available. In theory, any number of companies could attempt to replicate and even improve upon Zillow’s offering.  However, Zillow has now spent more than $80 million in the aggregate on its historical transaction data and other data sets available on its website.  Over time, Zillow’s growing brand resonance with consumers and increased investment in data sets should create a material barrier to entry for competitors.
• Brokers and agents could hold back listings.  Make no mistake, Zillow is heavily reliant on the data feeds and listings information it receives from agents and brokers. Without this information, traffic to Zillow would suffer materially.   At this stage, brokers and real estate agents have every incentive to list their homes for sale on Zillow and other third party aggregators.  However, over time we think brokers in particular (not to be confused with agents) could become increasingly wary of the role that Zillow and other third party listing aggregators play in the marketplace.  In theory, a strong argument can be made that the ascension of Zillow and perhaps a few others would materially dilute the value proposition of a broker to any particular agent and even possibly consumers.  We’re not arguing that Zillow, Trulia, and Move are going to fully disintermediate brokers, but we think there popularity will make it easier for agents to operate independently and even for consumers to list their homes individually without the benefit of agent oversight.  We are a long way from brokers thinking of Zillow as a potential risk to their business model, but it is possible that it could ultimately come to that.

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As always, please act accordingly….

ESI reported 1Q12 revenue and EPS results that were significantly better than consensus estimates.  Despite the overall outperformance, there are CLEAR signs now that the company could be “running out of bullets” in its efforts to preserve EPS through share repurchases.  Share buybacks have been a meaningful buffer to what otherwise would be a much more precipitous decline in EPS.  For example in the most recent quarter, net income declined 28% YOY, while EPS only decreased by 18%.  With decremental operating margins in the 90-100% range, the negative operating leverage story is only starting to play out for ESI.   More than anything, ESI’s 1Q12 results and winter term enrollment intake add further credence to our view that the company is on the verge of a hard earnings reset.  It appears increasingly obvious why the company pursued a new credit agreement in the past quarter: to buoy ESI’s liquidity, to help fund share buybacks in the face of evaporating free cash flow, and in all likelihood to help “dress up” the company’s compliance with the Dept. of Education’s financial responsibility composite ratios at year end . Below we discuss some of the most worrisome signs from the quarter and SPRING term enrollment intake:

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As always, please act accordingly….

There are a host of problems now facing executives in the industry:

• Increased competition from traditional higher education institutions, particularly for online degree programs
• Increased competition from WITHIN the industry following a period of irrational capacity expansion (400+ new campuses from for-profit education providers, capacity for 100,000’s of online degree students added in the past 5-6 years)
• Lack of programmatic differentiation
• Potential program obsolescence due to low job placement rates, changes in student behavior, or actual technology changes (cloud computing is not going to be a good development for the hiring of networking professionals)
• MARKET SATURATION, at 40-45 million leads generated annually, who in the target demographic for this industry has not been “touched” in some way shape or form by a for-profit education institution?
• Negative press, which continues to offset increased branding efforts by many institutions
• Student debt aversion
• Reductions to Pell Grant funding
• Potential changes to federal financial aid funding
• Rising cohort default rates
• Weakness in demand due to concerns return on educational investment
• Softness in job placement rates
• Regulatory risk
• Litigation tail risk

There are plenty of other potential issues that we have left out, but in our view these are the big ones.  Review that list again, notice how very few of these structural problems relate to changes in the regulatory or political landscape?  We would argue that the issues plaguing the sector currently are almost entirely market driven and fundamental in nature.  For all of the noise surrounding Gainful Employment, changes to Pell Grant funding, 90/10 compliance challenges, and rising 3-year cohort default rates, the reality is that market forces are driving weakness in the sector.

This brings us back to the upcoming earnings season.  It is interesting to us that so many bulls on the for-profit education sector seem to be “rooting” for the following this earnings season:

• “less worse” starts – something in the (-5%)-(-10%) range will likely be celebrated by some on the sell-side and maybe even some management teams who will try to spin that type of result as a sign that an inflection point for starts is just around the corner (yet again). Through the prism of 2-year stacked comps, a (-5%)-(-10%) decline new student starts will look like anything but “less worse” for most companies in the space.  THE EASE OF THE COMP MATTERS.
• EPS upside – With a few notable exceptions in the sector, earnings are not likely to be the area of focus for most investors
• More share buybacks – Management teams/board members in the sector have put billions of dollars to work in share repurchases at prices significantly higher than current levels.  In short, billions of dollars of shareholder capital has been wasted.
• Optimistic commentary on the summer term – Most investors expect spring term starts to be soft at this point and our checks certainly corroborate that (more on this later).  However, we think the sell-side and value investors are likely to glom onto any commentary about a potential improvement in “leading indicators” for starts for the Summer term, even though management teams have been predicting a turn for more than a year now.

From where we sit, this looks like the recipe bulls are hoping to facilitate a short squeeze and rapid valuation expansion in the sector. We acknowledge that this could happen, but we would view any of those gains as likely to be fleeting in nature.  After all, which of the four factors we mentioned above that could lead to a rally in the group, according to the bulls, actually address any of the STRUCTURAL issues facing companies in the for-profit education sector?  The short answer is: NONE.

In our view, there are four or five things stake holders should be rooting for that would likely position companies in the sector for enrollment, revenue, earnings, and cash flow stability for the long term and perhaps meaningful valuation expansion near term.  Unfortunately, these changes would likely result in a hard earnings reset for most companies in the sector in the short term (and perhaps long term) relative to consensus expectations.  Ultimately, we anticipate most if not all companies in the sector will eventually adopt some if not all of these strategies to improve their long term earnings prospects.  In the face of major secular changes to demand, companies can only delay the inevitable before the dynamics in the marketplace force their hand.  Here are the five strategies we think companies need to embrace as soon as possible:

• Capacity rationalization and program teach-outs – There is a pervasive view that the higher education system is capacity constrained. With the proliferation of online degree programs from traditional higher education institutions and aggressive capacity expansion from for-profit education companies over the past 5-7 years, there are simply too many “seats” available. Additionally, there are some programs that consistently deliver substandard outcomes from a default and job placement perspective (for example, criminal justice).  They should be downsized significantly or eliminated.
• New program development – There was a time when schools in the industry did a better job of new program development.  We recognize that it’s increasingly difficult to gain regulatory approval for new programs today than it was 5-10 years ago, but there has been a profound lack of innovation in the marketplace for years.  The common strategy has been to emulate, not differentiate.  As a result we have program ubiquity.  It seems everyone offers the same type of programs (business, IT, criminal justice, allied health, and now nursing!) In a robust demand environment cross-pollinating programs leads to outsized earnings, however the prospects for program obsolescence have never been higher in our view given changes to students’ reluctance to borrow, increased regulatory risk, and increased competition. Despite all of the capital available to publicly traded for-profit education companies, all of the innovation and experimentation appears to be coming from the venture community.
• Dramatic changes to funding models/tuition structure. If APEI has proven anything, it’s that a more intelligent approach to tuition pricing and funding can lead to a far more compelling operating structure over the long term.  We cannot predict if APEI will continue to grow at these rates in the face of a number of lower priced new market entrants.  However, it’s quite clear the company has a better “mouse trap” relative to its peers in the space when it comes to tuition and the student funding model.  Companies are quick to point out that they cannot cut tuition because of 90/10.  They argue, that 90/10 creates tuition inflation.  However, we would argue there are many companies in the space that could cut tuition aggressively to the point where a modest contribution from students would represent enough to maintain compliance with 90/10.  Additionally, corporate tuition reimbursement, scholarships, and state grants all become more meaningful under at a lower tuition price point.  Most of the current management teams in the sector lived through a period in which the annual 3-5% tuition price increase was viewed as sacrosanct, so we realize they are not likely to be receptive to this approach even if it would yield an immediate improvement in demand and substantially less regulatory risk.
• Better capital allocation/growth investments.  It happens all the time in industries that undergo secular change.  Management teams all too often in the face of valuation compression allocate as much capital as possible towards share buybacks.  We have seen a similar strategy employed across a variety of industries and it has almost always failed.  In many cases, it’s because management teams confuse the secular with the cyclical, while they await a return to normal.  We have observed a similar pattern emerging in the for-profit education sector.  The rallying cry all too often appears to be “We’ll fix this problem (and the shorts) by buying back more stock”. The only problem is, inevitably in the face of secular shifts a company will “run out of bullets” to repurchase stock due to lower earnings and cash flow.  Instead of squeezing the shorts, management teams in the face of secular decline all too often reward them.  In the for-profit education space, there are a few companies that appear to be allocating a fair amount of capital towards growth initiatives, expansion into new markets, or even meaningful modifications to their core product offering.  In our view, the shares of these companies are likely to significantly outperform in the long run relative to their peers.
• Management changes.  At least based on their public comments, it appears that very few of the senior executives in the sector have embraced the “new new” in the US higher education landscape, in our opinion.  It is rare for an executive running a growth company to change his/her stripes to embrace dramatic business model changes and aggressive cost-cutting. It’s just not in their DNA.  In order to survive and/or thrive in the long term, we think many companies in the space need an infusion of management talent that can bring a focus on operating efficiency, cost cutting, and new strategic directions to the table.  Given how board members continue to compensate executives in the space, it appears that any meaningful management changes could be a long way off.

Unfortunately for current investors, we think the adoption of the four or five strategies that we have identified above as critical to the long term success of the industry are likely to lead to meaningful downside to stocks from current levels.  We view these changes as a question of “when” not “if”.  In a strange paradox, in our view, the sell-side bulls continue to “root” for outcomes that in the optimal scenario will lead to modest short term gain and could ultimately yield meaningful positive long term returns for bears.

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As always, please act accordingly….

In the face of all of this negativity, it seems no one, not an industry participant, nor anyone in the investment community (with a few notable exceptions) has taken the time to figure out the financial merits of the revised strategy developed by THQI’s management team and board of directors.  We don’t know this for a fact, but we have good reason to believe, there was some appetite to purchase the company at some point in the past 6-9 months.  The board elected to pursue other options, at least for the time being.  What does that say about THQI’s liquidity and profitability prospects following the drastic restructuring undertaken in the past 3-4 months?  For now, investors, industry pundits, and even the company’s competitors have deemed THQI’s efforts to streamline itself as doomed for failure.  Then again, we have never seen anyone articulate what the company’s cost structure looks like pro forma for these changes, nor have we seen a rational depiction of the company’s cash needs going forward.  In our view, today’s press release, in which the company announced better than expected revenues and a smaller non-GAAP loss per share for the March quarter in conjunction with a fiscal year ending cash balance that was $50 million higher than prior expectations just demonstrates how wide the gap is between perception and reality  for THQI.   With $76 million in cash and an undrawn $50 million revolver at year end, in our view THQI has sufficient liquidity to fund its development plan for FY13 and beyond even though it will go effectively 6-months without releasing a new game now that the launch of Darksiders II has been pushed out to August.  For now, bankruptcy risk has been reduced meaningfully, if not eliminated altogether and THQI’s appreciation prospects now will increasingly be correlated to the performance of their next suite of games.  The company is not out of the woods yet from a capital perspective, but a few “singles” over the next 6-9 months from their product portfolio will all but eliminate liquidity concerns, engender confidence in management’s ability to execute, and likely lead to significant stock price outperformance.

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As always, please act accordingly….

Disclaimer: The author of this report owns shares of THQI.  Positions can change at any time without notice.

Amazingly, all of these strategies have been implemented to support what we think is a fundamentally flawed business model.  The return on educational investment for the company’s students remains abysmal based on our analysis.   Ultimately the market could force the company’s hand to make substantive changes to its business model in the new higher education landscape of “brand and price”.  However, there is also ample reason to believe the company is running out of solutions to what have become increasingly complex regulatory challenges for ESI.  Over the past few years, ESI management has in effect levered up the company’s balance sheet to preserve its tuition price structure and sustain 90/10 compliance.  As a result, we would argue the company finds itself with increasingly limited financial flexibility and growing balance sheet risk, which brings us to the new credit facility announced yesterday after the close.

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