Sentiment is terrible, valuation is cheap, and we have no finally reached a point after 3-4 months of waiting where there are clear identifiable catalysts for THQI from both an industry and company specific perspective.  We think THQI shares are poised to witness significant upside over the next 6-12 months as sentiment shifts and the company starts to benefit from what we expect will be positive revisions to consensus EPS estimates for FY12.

How Did We Get Here?

THQI’s management has made it abundantly clear that it has positioned the company for an outstanding FY12/CY11, in many respects at the expense of FY11.  The poor performance of THQI shares over the past 3-4 months can be attributed to a clear lack of identifiable catalysts almost more than anything. Here are the other factors that have contributed to the sell-off in THQI in our view:

• Poor sentiment surrounding traditional packaged goods video game publishers and developers.  As we discussed above, we think the launch of Microsoft’s Kinect, Sony’s Move, and Nintendo’s 3DS should dramatically improve investor sentiment surrounding the space. Although sales of video games appear set to decline on a YOY basis for the second consecutive year, we think the magnitude of decline has been overstated due to NPD’s inability to capture downloadable content (DLC).  It also should be noted that console sales have been relatively strong even though sell through of packaged goods video games has been weak.  Will the sharp decline in “tie ratios” last, or are we set for a rebound in sell through as we head into holiday season?
• Disappointing sell through for UFC Undisputed 2010.  As we discussed here, the poor sell through of UFC Undisputed 2010 despite solid pre-order activity and strong reviews was a surprise to us and many other investors.  It seems at this stage investors have deemed THQI’s UFC license as significantly impaired. ERTS will release EA SPORTS MMA on October 19th.  Originally viewed as a significant competitor to THQI’s UFC video game, it now appears less likely to effect future sales given the decision to expand the amount of time between subsequent iterations of UFC Undisputed. We now expect THQI to release UFC Undisputed late in the third quarter of 2011 or even possibly in the first quarter of 2012.  THQI remains well positioned to benefit from the continued growth in interest in mixed martial arts and the UFC in particular. We expect the next iteration of UFC Undisputed to approach, if not exceed the sell through levels for the 2009 version.  Clearly this is not being discounted in the stock price today.
• Weak 2Q11 guidance. When THQI issued its 1Q11 earnings release, many investors were stunned at the company’s guidance for 2Q11.  Management’s guidance for non-GAAP revenues and a loss per share of $60-$70 million and ($0.60-$0.65) was well below consensus of $89.1 million and a loss per share of (-$0.35).  Many investors viewed this as further indictment of the weak underlying demand for packaged goods video games.  This is true – catalog sales have been weak across the board.  However, it is also important to note that outside of UFC Undispted 2010, THQI has not released a meaningful new game since Metro 2033 in March (with all due respect to the Wii version of the game based on the Last Airbender).  Realistically there’s not much in the catalog for THQI to rely on in terms of sell through.  As we head into the holiday season we expect this to change dramatically and THQI should have a more consistent cadence of new releases over the course of the year starting in 2011
• Stock sales from MAK Capital.  MAK Capital a reasonably well known investment firm that specializes in activism, recently sold more than 600,000 shares of THQI stock.  The investment firm acquired more than 7.7 million shares over the past year. We’re not clear what the firm’s intentions were, but it appears that THQI’s management was responding to something when it decided to adopt a “poison pill” earlier this year.  The recent stock dispositions by MAK Capital have unnerved some investors who would like to “get out of the way” in case the firm decides to unload the rest of their holdings.  We anticipate MAK’s ownership could remain an overhang on THQI shares until there are other catalysts to discuss.

The Catalysts for THQI Shares Now

The waiting truly has been the hardest part for THQI shareholders.  At long last we’ve finally reached the point where an absence of catalysts will be replaced by what we think could be a sequence of positive events for THQI shares over the next 3-6 months.  With THQI shares trading below book value, it appears that the positive catalysts on the horizon for the company have been given little consideration.  Here are what we expect to be the positive catalysts for THQI shares over the next 3-6 months:

• Insider buying. Over the past 2-3 weeks, members of THQI’s management team and board of directors have purchased more than 77,000 shares, including 35,000 by Brian Farrell, CEO.  We are surprised that insider buying did not illicit a stronger response from investors.  Yes it is true that this appears to be a direct attempt to mitigate the impact of stock sales from MAK Capital, but we still view it as a bullish sign.  The last time Brian Farrell purchased shares the stock tripled in 6-months.  In the table below, we outline the share purchase activity of insiders over the past month:

• Release of Company of Heroes Online – September 30th.  Originally released in September 2006, Company of Heroes is one of the highest rated real-time strategy (RTS) games of all-time achieving an average metacritic score of 93.  Subsequent expansion packs to the original game were also well received by gamers and critics alike. Company of Heroes Online represents THQI’s first major endeavor into the free-to-play genre and should represent an interesting litmus test of the company’s ability to leverage existing owned IP for this rapidly growing sub-sector of the interactive entertainment market.  The game has a strong standing among RTS players, but realistically demand for that particular genre is not as strong as for some others.  THQI has taken a measured approach with the development of the game, first testing it in Asia and then conducting closed beta tests in the US for several months.  We anticipate the game will be well received by critics and could gain an ardent, but modest fan base.  Margins should be high and lessons learned from the game should help THQI improve the quality of its other free to play endeavors (WWE Online, Red Faction Battlegrounds, Costume Quest).
• Release of uDraw in the US – November 21st, Europe – 1Q11.  On August 17th, THQI finally revealed the Wii peripheral the company had been working on for the past few years.  We are surprised that the market did not have a stronger response to the announcement of the peripheral.  The uDraw GameTablet enables users to create art and integrate the drawing experience into Wii based games (think how Scribblenauts or Drawn to Life used the DS stylus).  You can view the impressive capabilities of the device here.   The peripheral will be priced at $69.99 at retail upon its release.  THQI will also release three titles in conjunction with the debut of the device: uDraw Studio, Dood’s Big Adventure, and Pictionary each priced at $29.99.  Nintendo has been highly supportive of THQI’s efforts to develop the peripheral.  Although THQI has not yet opened up the development of games for uDraw to other third party publishers, we do expect Nintendo to announce one or two titles specifically for the peripheral this holiday season.  This could significantly increase sell through of uDraw. In the table below, we outline our base case scenario for the potential impact uDraw could have on THQI’s revenue and earnings in FY11.  Over time we expect the number of titles released specifically for uDraw to increase significantly.  Scribblenauts and Drawn to Life, which have sold millions of copies each on the DS are both tailor made for this device.  Overall we estimate uDraw could boost revenues and EPS in FY11 by $135-$140 million and $0.10-$0.15 assuming the peripheral achieves 2% penetration of the installed base of Wii’s worldwide, results in a 1.25x tie ratio (very conservative) and is produced with operating margins of 5.0-7.5%.

We would characterize our base case forecast for uDraw as highly conservative. We think the peripheral could achieve a 3-5% penetration rate of existing Wii owners, particularly with software support from Nintendo.  At a 5% penetration and a THQI software tie ratio of 1.5x, we estimate uDraw could boost THQI’s EPS by more than $0.30.

• Release of Homefront, de Blob 2, and Red Faction: Armageddon – 1Q11. Over the last two years, THQI has demonstrated that it can effectively develop and publish highly rated owned IP targeted towards the core gamer.  Saints Row 2, Red Faction Guerilla, and Darksiders all received strong rating and reasonable sell through.  THQI appears positioned to build on this momentum with the release of three key owned IP’s in the first quarter of 2011.  Sell through trends of de Blob 2 and Red Faction: Armageddon should be particularly noteworthy as they will be the company’s first major endeavors utilizing its “transmedia” strategy through its partnership with the Syfy network.  We think investor sentiment surrounding THQI could shift dramatically to the extent that all three titles receive strong ratings and achieve solid sell-though.  We are optimistic that these three titles could add further credence to our thesis that THQI has transformed itself into a leading publisher of owned IP on the cusp of meaningful profitability and free cash flow generation.
• Partnership with Guillermo del Toro – timing uncertain.  Although it has not been officially announced yet, THQI has been rumored to be in discussion with acclaimed director, Guillermo del Toro to develop a series of video games.  Mr. del Toro is an avid gamer and has a strong relationship with THQI EVP, Danny Bilson.  Mr. del Toro is viewed as one of the most “in-demand” directors in Hollywood for his unique vision and creativity (Pan’s Labyrinth).  We anticipate a partnership with Mr. del Toro could increase investor confidence in the company’s release slate beyond CY11 and CY12.

CY11 Looks Incredibly Compelling

It’s obvious that the investor referendum on THQI’s earnings prospects in CY11 has returned a resounding “show me” despite what appears to be a compelling release slate of titles targeted towards core gamers and kids/family alike.  It seems almost outlandish for us to suggest that THQI could achieve $1.00+ in EPS in CY11, given that the company has just completed its first profitable year in a long time and already guided down for FY11. However, THQI’s FY10 results should demonstrate that the company has right-sized its cost structure and can generate sizeable cash flow and positive earnings when it effectively has NO contribution from its increasingly impressive owned IP portfolio. As we have stated several times in the past, THQI is increasingly a free “call option” on the company’s ability to deliver a “breakthrough” hit from its owned IP portfolio. Based on the company’s increasingly consistent track record of developing highly rated games, we think the chances of that outcome improve with each passing release.

CY11 is setting up to be a perfect earnings storm for THQI – a strong slate of licensed franchises combined with a compelling list of internally developed titles. Outside of the summer months, THQI should have a major video game release each month in CY11. Management has indicated its expectations for “accelerated revenue growth and margin expansion in FY12″. We think the earnings inflection point will occur in the first calendar quarter of 2011. In the table below we outline our title by title unit sales and ASP assumptions for CY11. We would characterize our estimates as conservative. Should any of these titles “breakout”, it appears possible that THQI could easily eclipse our $1.2 billion sales estimate for the year. At an 8.5% operating margin, THQI would generate $1.18 in EPS (assuming full dilution of the convert) in CY11.

We would characterize our sell-in assumptions for each of THQI’s key titles for CY11 as conservative.  We think DeBlob 2, Red Faction Armageddon, and Saints Row 3 all have the potential to be breakout hits.  As we discussed earlier, each of these titles will benefit from THQI’s “transmedia” strategy. THQI has partnered with the SyFy Network to generate television and internet content based on DeBlob and Red Faction.  We think this should dramatically enhance the visibility of these two titles, which have not lacked in quality, but in awareness.  THQI management indicated that Saints Row 3 will be a major motion picture that will be released simultaneous with the video game.  In December of this year, THQI will release more details on the studio behind the Saints Row movie and the video game itself. We are hopeful that the game will include the GeoMod technology used in the Red Faction games, which would differentiate Saints Row from Grand Theft Auto.

The release of uDraw in Europe and the possibility for additional sell through in the US also could become a source of upside in CY11 as both THQI and Nintendo provide greater after market software support for the platform.  In the table below we outline our primary assumptions on a title by title basis for CY11 for THQI:

At a Discount to Tangible Book Value, What Do THQI Shares Discount Now?

After more than three months without clear identifiable catalysts, THQI shares should start to benefit from a compelling video game release slate and the launch of uDraw.  We are encouraged by insider buying in recent weeks. At 12x consensus EPS estimates, 0.3x revenue, and a price to book value of 0.8x it appears investors have little confidence in THQI’s ability to return to profitability in the near future.  After 2Q11, we expect THQI to generate significant free cash flow on a quarterly basis for each of the next four quarters.  Management has targeted free cash flow generation in excess of $80 million for FY12, implying a yield of 33% with the stock at current levels.  For FY12, we estimate THQI can generate more than $1.2 billion in revenues and more than $1.00 in EPS, implying the stock trades at just over 3x our earnings estimates.  THQI shares are more than “washed out” in our view and could witness significant valuation expansion as investors gain confidence in the company’s video game release slate over the coming months.

As always, please act accordingly….

Savvy investors used the strength in WPO shares in response to the article to reduce holdings in the stock or initiate short positions.  WPO shares have now declined more than 28% from the day following the publication of Barron’s initial write-up on the company.  Shares rallied today in response to Mr. Bary’s follow-up article on WPO entitled “This Just In: Washington Post Is Cheaper Than Dirt“. We would use the strength in the stock today to sell long holdings or initiate shorts, for the following reasons:

1. Barron’s Sum of the Parts Analysis Remains Flawed.  Even though Barron’s has taken the step to acknowledge the potential regulatory risks at Kaplan, their valuation analysis of WPO’s cable and broadcasting divisions appears overly optimistic. Our more realistic valuation of each of WPO’s major operating divisions suggests that shares remain significantly overvalued.
2. WPO’s “cash cow”, Kaplan Higher Education is on the verge of a major restructuring whether or not new legislation is introduced or “gainful employment” is enacted. Outside of Kaplan Higher Education, only WPO’s broadcasting division generates favorable free cash flow.  Due to a host of issues meeting existing regulatory requirements, we anticipate Kaplan Higher Education could growth through a significant. Just as the case will be for COCO, we anticipate WPO’s campus based operations could generate operating losses for the next several years and margins at Kaplan University will be severely depressed.
3. “Tail risk” at Kaplan is growing rapidly.  If we’ve learned anything about the WPO investor base over the past year, it’s that shareholders only appear to react to litigation and regulatory issues in the form of a press release from the company.  This has presented opportunities for short sellers over the past 3-6 months.  Currently, we do not think WPO shareholders have a full appreciation for the mounting “tail risk” associated with owning WPO stock.  The balance of news will certainly be negative over the next 9-12 months. We think it is possible that the company could be subject to unfavorable litigation rulings, increased oversight and sanctions from the Department of Education, and greater scrutiny from accrediting agencies.  Based on historical precedents and the growing amount of “noise” around the sector, we can’t rule out that the Department of Justice or State AG’s might get involved.

A More Realistic Sum of the Parts Analysis

In their original write-up on WPO, Barron’s assigned the following values to each of the company’s major operating divisions:

• Kaplan – $5 billion, 17x EBIT (COCO, in many respects KHE’s closest competitor trades at 2.8x trailing EPS, do you think Barron’s was a little off base here?)
• CableOne – $2 billion, 12.4x EBIT
• Broadcasting – $1 billion, 14.3x EBIT
• Newspaper – No value
• Magazine – No value
• Net cash and investments – $500 million

We agree with Barron’s conclusions on the value of the newspaper and magazine divisions and little else.  Even the value of WPO’s cash and investments are not as straight forward as one might think. Below we discuss our sum of the parts analysis of WPO on an EBITDA basis.

Kaplan – 5.0x our FY11 EBITDA Estimate – $428 million

We’re certain that this assumption will receive the most push-back from WPO shareholders.  However, we think WPO shareholders continue to underestimate the negative leverage inherent in the for-profit education business model when total enrollments decline. Here’s how we think about each of the sub-components of WPO’s Kaplan division:

• Kaplan test prep is more or less structurally impaired due to online new market entrants which have permanently altered the pricing model in the industry. It’s not clear when or if profitability will be restored for this business.
• Kaplan international, an interesting mix of assets, but it’s not yet clear what the company’s operating strategy is overseas. It is a small piece of the puzzle.
• Kaplan Higher Education is best viewed as a combination of COCO and CECO’s AIU or APOL’s Axia/University of Phoenix.  KHE’s campus based assets most closely resemble those of COCO. More than 55% of KHE’s students are enrolled in diploma and associate’s degree programs. Although WPO does not disclose enrollments by area of study, we estimate a significant percentage of the company’s campus based students are enrolled in allied health programs.  Kaplan University, which makes up more than 60% of KHE’s total enrollments, offers a wide mix of programs and most closely resembles CECO’s AIU.  Over the past 2-3 years, KHE has generated the vast majority of EBITDA for Kaplan and for WPO in total.

As we will discuss later, we think KHE is poised to go through a significant restructuring in the next 6-12 months to improve compliance with existing regulatory statutes, most notably the transition towards a 3-year cohort default rate calculation.  Anyone who watched the market’s response to COCO’s initial restructuring announcement should recognize the inherent risks with assigning significant value to KHE’s campus based assets.  At this point they are more likely to be a drain on the company’s profitability and capital over the next several years, in our view.  That leaves Kaplan University as the sole source of value within Kaplan.  Consider the following issues Kaplan University now faces:

• Soaring cohort default rates – we expect KU’s final FY08 2-year CDR to exceed 15%, which implies the institution could have difficulty meeting 3-year cohort default rate standards
• Program review from the Dept. of Education
• Potential litigation risk from outstanding qui tam actions
• Credit hour inflation – KU might need to restructure some of its academic programs in response to the Dept’s decision to adopt the Carnegie definition of a credit hour

In light of these legal, regulatory, and operational risks we think a 5x EBITDA multiple is appropriate. It is important to note our FY11 EBITDA estimate does not include any impact from the Dept. of Education’s “gainful employment” proposal, which could further imperil KHE’s profitability prospects over the next several years.

CableOne – 4.5x Our FY11 EBITDA Estimate – $1.25B

As we have discussed in the past, there are two primary problems with WPO’s cable division: 1) CableOne operates networks in Mississippi and Idaho, less than favorable markets, and 2) The company’s RGU trends have lagged those of its peers in the cable industry for some time now.  CMCSA, TWC, and CVC trade at approximately 5.5-6.0x FY10 EBITDA estimates. Although some investors might make the argument that the lack of execution at CableOne and the low penetration of voice, digital, and high speed data make the asset more compelling to potential suitors, we doubt that interest in the end-markets WPO’s cable division serves would be particularly high.  As a result, we think CableOne would be valued at a discount to its peers.

Broadcasting – 7.0x our FY11 EBITDA Estimate – $850 million

WPO’s broadcasting division operates a total of six television stations in the following markets: Houston, TX, Detroit, MI, Miami, FL, Orlando, FL, San Antonio, TX, and Jacksonville, FL.  Broadcasting is a high margin relatively low capital intensity business. However, it is becoming increasingly evident that the Networks are starting to face the same secular demand issues that now plague the newspaper industry.  The average age of network TV show viewer now exceeds 50.  Competition from cable, the internet, and the proliferation of on-demand services has permanently altered the profitability of the Networks and their broadcasting partners.  Although we are still in the early stages of this structural shift in media consumption, it will only accelerate over time. In light of these factors, we think a 7x EBITDA multiple is appropriate despite the high margins in broadcasting.

Newspaper – 5.0x our FY11 EBITDA estimate – $52 million

Our FY11 EBITDA estimate certainly could be viewed as favorable given the ongoing secular decline in readership, circulation, and advertising spend in the newspaper industry.  Thus far, WPO has not effectively articulated how it plans to restore profitability in its newspaper division.  We’ve given the company the benefit of the doubt here, but the swing factor in the company’s full valuation is not that large. We certainly wouldn’t take issue with anyone who wanted to assign zero value or even a negative value to the company’s newspaper division.

A Quick Word On WPO’s Cash and Investments

As of the end of 2Q10, WPO had $659 million in cash $396.3 million in debt and investments in marketable equity securities and other investments of $392.5 million.  The company had $359.3 million in equity investments as of 6/30/10 comprised of the following:

• 2,214 BRKA
• 8,485 BRKB
• An undisclosed amount of COCO shares.  WPO initially purchased 7.5-8.0 million shares of COCO in the first quarter of 2008.  The company indicated it purchased additional stock over the course of 2009.  We can only assume that the company still holds the stock.

Based on COCO’s closing price on Friday, we estimate WPO is now sitting on a 35-45% loss on its purchase of COCO shares (assuming the company still owns the stock).  Presumably this will be reflected in a mark of those assets on the company’s balance sheet in its third quarter earnings.  Our sum of the parts analysis already includes the mark for WPO’s ownership in COCO.

Sum of the Parts Analysis on a DCF Basis Also Suggests WPO Shares Remain Overvalued

Relying exclusively on EBITDA to value WPO would significantly overstate the true free cash flow characteristics of the company’s operating divisions.  For example, the company’s cable business is particularly capital intensive.  In our original report on WPO, we evaluated each of the company’s operating divisions on a 10-year DCF basis.  We recently revised our divisional DCF analysis.  Here are some of our key assumptions:

• Kaplan – Revenues decline 10-15% at KHE for each of the next two years. EBITDA margins compress to low single digit levels and eventually recover to 8% over the next 10-years. CAPEX as a percentage of revenue remains fixed at 2.25%.
• Broadcasting – Revenues decline 5% in 2011 and increase 10% in 2012, after which revenues decrease 5% per annum.  EBITDA margins peak at 41% in 2012 and decline to 32% over time.  CAPEX remains fixed at $15 million per annum.
• Cable – Revenues decline 2-3% per annum, EBITDA margins average 38% over the next 5-years and then decline to 36%.  CAPEX averages 17.5% as a percentage of revenue.
• Newspaper – Revenues decline 5% annually and EBITDA margins remain at zero.  CAPEX averages $22.5 million annually for the next 10-years.

We would characterize our operating assumptions as reasonable, if not optimistic in some cases. Overall, our sum of the parts DCF analysis suggests that fair value for WPO is approximately $285-$290/share.  Keep in mind our DCF analysis does not include the impact “gainful employment” would have on Kaplan’s free cash flow profile, nor does it consider any potential fines or litigation settlements against the company.

WPO Shares Are Unlikely to Look Compelling on a P/E Basis for A Long Time

Amidst all the enthusiasm today about WPO’s “hidden value” on a sum of the parts basis, it should be noted that shares will not appear cheap on a price to earning basis for quite some time, in our view.  Based on our expectations for the amount of restructuring that could be required to restore regulatory compliance for Kaplan Higher Education’s campus based assets, we anticipate WPO’s earnings are likely to be depressed for quite some time.  In the table below we outline our estimates for the remainder of 2010 and for all of 2011.  Are WPO shares likely to command a 30x+ P/E multiple given the growing risks surrounding the company’s primary driver of earnings?  The market’s treatment of COCO could prove to be a cautionary tale for WPO shareholders.

Kaplan Higher Education Could Become a Significant Drain on WPO’s Cash Holdings Over the Next Several Years

Consider the following comparison between higher education institutions owned by COCO and those owned by WPO:

• Number of OPEID’s – COCO = 49, WPO = 34
• Campus based enrolllment – COCO = 87, 184 (as of 6/30/10), WPO = 49,912 (as of 6/30/10)
• Institutions with 2-year CDR in excess of 15% for FY07 –  COCO = 21, WPO = 23
• Institutions with 2-year CDR in excess of 20% for FY07 – COCO = 5, WPO = 10
• Institutions with 2-year CDR in excess of 25% for FY07 – COCO = 0, WPO =4
• Institutions with 3-year CDR in excess of 30% for FY07 – COCO = 20, WPO = 17
• Company-wide average repayment rate – COCO = 24.1%, WPO = 27.5%
• Number of institutions with repayment rate < 35% – COCO = 80 (out of 107), WPO = 61 (out of 71)

Based on the comparison above, we think it is reasonable to assume that KHE’s difficulties complying with a 3-year cohort default rate standard could be similar to those COCO.  As we discussed in our most recent report on COCO, we think the company could generate significant operating losses for the next several years due to its decision to halt the recruitment of ability to benefit students and other efforts to meet 3-year cohort default rate compliance standards.  WPO has never disclosed the percentage of its total enrollments that are ability to benefit students, but we think it could be among the highest among publicly traded for-profit education companies.  Similar to COCO, we think a number of KHE’s institutions could lose access to Title IV funds if the company does not make substantial progress in its default management efforts. We think this could be particularly challenging in the current economic environment. KHE’s campus based assets are likely to be a significant drain on capital and profitability over the next several years as the company attempts to “reel in” the excesses of the past 3-5 years and restore regulatory compliance standards.  Based on the trajectory of default rates at Kaplan University, we cannot rule out at this point that the school could witness a sharp decline in total enrollment and profitability over the next several years. Additionally, we anticipate Kaplan University might have to make significant revisions to its academic programs to better comply with a standard definition of a credit hour.  All signs point to a protracted period of lower profitability and capital usage for Kaplan Higher Education if the company wants to ensure its institutions remain in good standing with regulators.

“Tail Risk” for WPO is Growing

From our perspective, we think the “tail risk” associated with holding WPO shares increases seemingly on a daily basis.  On the heels of the GAO report on recruiting practices in the sector and the ABC News undercover investigation, it appears that oversight agencies across the board have increased their scrutiny of the sector.  Here are the regulatory issues, which we know about that could effect the performance of WPO shares over the next 6-12 months:

• Resolution of the four outstanding qui tams.  All four qui tam actions (a lawsuit brought by a private citizen on behalf of the federal government under the false claims act) are before a judge in Florida who will rule on WPO’s motion to dismiss. At issue is whether the “first to file bar” applies to all four cases, which precludes any whistleblower from filing suit against a company that is already subject to an existing qui tam action.  Based on conversations with our sources, we anticipate the judge could issue a ruling on the motion to dismiss in the next few weeks.  Although we are not legal experts by any stretch, we think there’s a strong chance that one, if not several of the outstanding qui tam actions against WPO could go forward.  We think the ultimate outcome of the qui tams could be a legal settlement, which could result in the award of $10’s of millions to the plaintiffs.
• Program Review at Kaplan University. Launched in September 2009, as of WPO’s most recent 10-Q filing a review report for Kaplan University from the Department of Education had not yet been issued.  Given the amount of noise surrounding Kaplan University we can’t rule out that the Department could issue findings with determinations (effectively fines).

The potential liability associated with the qui tam actions and the Dept. of Ed.’s program review report could be significant in our view.  Additionally, increased regulatory scrutiny/activity COULD potentially come from the following sources, which we would argue are not priced in the stock at this point:

• Accrediting agencies – It appears that probation and show cause actions on the part of accrediting agencies have increased considerably in recent months.  Accrediting agencies have had their entire modus operandi called into question by Sen. Harkin and others and now need to prove the merits of independent peer review.
• State regulating agencies – our contacts in the industry indicate that state agencies are ramping up oversight.
• Congress – it appears almost certain that Congress will introduce new legislation at the very least at the committee level sometime in the next 3-4 months.  The introduction of risk sharing or other restrictive measures could further dampen WPO’s profitability prospects.
• State attorney generals – There are rampant rumors in the marketplace that any number of state attorney generals could be looking at the for-profit education space more closely.  At a time when state budgets are under duress, we think there is a great deal of incentive for enterprising state attorney generals to launch investigations into companies that are perceived to have taken advantage of minorities and individuals from a lower socio-economic background.
• Department of Justice – Following the GAO report on recruiting practices in the sector, we know that some of the information from the “random shopper” test was forwarded to the Department of Justice. It seems reasonable to assume that the DOJ could take action against one, if not several operators in the space.

CECO Former Student Lawsuits Could Create Troublesome Precedents

Approximately one month ago, 14 former students of CECO’s American Intercontinental University filed civil suits against the company in the state court of Georgia. Former student lawsuits are not uncommon by any stretch in the for-profit education industry. Interestingly each of the students filed separately instead of under a class action.  The plaintiffs allege AIU committed several counts of fraud and are seeking damages under various statutes including the Georgia RICO Act.  While we cannot speak to the veracity of the claims, we think these particular cases are noteworthy because the plaintiffs are alleging RICO violations.  To the extent that the case proceeds and the plaintiffs are awarded damages, we think other former students could pursue a similar legal strategy. This is yet another example of increasing “tail risk” in t he for-profit education sector.

A combination of reduced profitability, if not outright operating losses at WPO’s Kaplan division and increasing evidence of secular headwinds in the company’s other operating divisions could lead to significant multiple compression for WPO shares which are already pricey on a forward earnings basis.  With all due respect to Barron’s, we still think the following question should be at the forefront of the minds of WPO investors:

“How will WPO shares respond when the Kaplan Higher Education growth engine unravels and the rest of the company’s operating divisions are deemed “structurally impaired”?

As always, please act accordingly….

COCO 4Q10 Earnings Highlights

COCO reported 4Q10 earnings this morning, here are some of the highlights:

• Total revenues of $482.7 million exceed both consensus and PAA Research estimates of $477.1 million and $475.9 million, respectively. Revenue upside was driven by slightly higher student start growth and continued improvement in student retention.
• Total student starts increased 18.2% YOY, but only 6.1% pro-forma for the acquisition of Heald. We had been looking for 4% student start growth. The continued slow down in starts is a reflection of moderating demand due to relative stabilization in the labor markets and some element of “self regulation” on the part of the company.
• Bad debt expense as a percentage of revenue declined 2.0% YOY to 5.1%.  As we have pointed out for more than a year, COCO’s bad-debt expense disclosure is irrelevant.  We prefer to evaluate the company’s “real bad debt expense”, which is the sum of reserves on accounts receivable and notes receivable. On that basis, we estimate bad-debt expense continues to rise.
• Marketing cost per start increased 12.8% YOY to $2,884. This is the second consecutive quarter in which COCO has witnessed a double-digit YOY increase in marketing costs per start. We expect negative leverage on COCO’s marketing spend to be a significant drag on earnings for the next several years as demand moderates and advertising costs continue to increase.
• EPS of $0.38 fell short of our estimate and consensus of $0.40 and $0.39, respectively.

Existing Regulatory Standards Ensare COCO

As part of its earnings release, COCO provided an update on its compliance with existing 2-year cohort default rate standards and how the company is positioned for the transition to a 3-year standard.  COCO finds itself in a precarious position:

• Based on current data for the FY09, it appears that at least three of the companies schools could exceed the 25% threshold for 2-year CDR’s.  An institution whose 2-year CDR exceeds 25% for three consecutive years is at risk of losing access to federal financial aid.
• The number of institutions owned by COCO that could exceed the 25% 2-year CDR threshold has increased substantially from FY08 to FY09. In FY08 the company had 9 schools whose 2-year CDR exceeded 25%.  This implies that approximately 9 of the companies 49 OPEID institutions could be at risk of losing access to Title IV if the company does not make major strides in its default management for the FY10 cohort.
• Perhaps more importantly, the company indicated that a majority of its schools will exceed the 30% regulatory threshold under a 3-year CDR calculation.  Starting with the FY09 cohort, any institution whose 3-year CDR exceeds 30% for three consecutive years could lose access to Title IV funds.  Based on the preliminary 3-year CDR data provided by the Dept. of Education, COCO had 20 schools whose 3-year CDR exceeded 30% in FY07. We can only assume that a greater number of schools had a 3-year CDR in excess of 30% for FY08. This implies that as much as 40% of COCO’s existing schools would be at risk of losing access to federal financial aid if the 3-year cohort default rate standards were in place today (20 of 49 OPEID’s).

In addition to issues with CDR management, the company indicated that the Higher Learning Commission’s evaluation team has recommended to revoke the accreditation of the company’s Everest location in Phoenix, AZ. Revocation of accreditation is a rare event in the higher education space, but the accrediting bodies are under tremendous pressure from the Dept. of Ed. and Congress to demonstrate that they are not being delinquent in their responsibilities. Probation and “show cause” directives can no longer be viewed as idle threats.

Removal of ATB Students, Rising Marketing Costs, and Increased Compliance Costs Alone Could Lead to Operating Losses for the Next Several Years for COCO

We expect COCO shares to come under pressure today due to increased concerns about the company’s ability to generate operating profits on a going forward basis. The company’s decision to stop recruiting “ability to benefit” students (those who did not graduate high school) is long overdue. For far too long the senior management team of COCO has viewed it as the company’s mandate to enroll any potential student that was interested in pursuing a higher education diploma or degree.  Unfortunately this mandate did not come with a serious consideration of each student’s ability to complete the program, nor did it contemplate COCO’s ability to deliver quality education outcomes.  As a result of management’s short-sightedness, the company finds itself in a regulatory “maelstrom” and in the cross-hairs of quite a few oversight agencies.  Simply providing access is not sufficient, although for a period of time it has been an incredibly profitable operating strategy.

In the table below, we compare the company’s 4Q10 results to our estimates and also present our revised FY11 and FY12 enrollment, revenue and EPS estimates.  The company has provided initial 1Q11 guidance for revenues of $492-$502 million and EPS of $0.38-$0.41.  This compares to current consensus of $491.1 million and $0.45.  With the stock at $5.40, the company’s initial 1Q11 guidance might be viewed as a relief to some investors. However, we think that would be short sighted. The company’s decision to halt the enrollment of ability-to-benefit (ATB) students will be a significant drag on enrollment, revenue, and EPS growth.  ATB students represented 15% of the company’s student population as of June 30, 2010.  We have assumed that start growth declines 12% YOY as a result of the company’s decision to “teach out” ATB students.  Incremental margins in the higher education space range from 75-80%, but it’s important to note they cut both ways.  As the table below demonstrates we now think the company will generate a slight operating loss in FY11 as a result of a decline in starts, higher cost-per-start, and increased spending on regulatory compliance initiatives.

In many respects, we think our revised forecasts could prove to be optimistic. The most popular refrain from bulls on COCO is that Heald has substantial value.  We would make two points: 1) the operating losses and restructuring costs for COCO’s Everest platform could more than offset any cash flow and profitability at Heald, and 2) Based on cohort default rate and repayment rate data, it’s not exactly clear that Heald would sail through a shifting regulatory landscape over the next several years.  COCO management will host a conference call at noon today to discuss its 4Q10 results and strategic initiatives to reduce regulatory risk for the company.  With a net debt position of more than $100 million and operating losses on the horizon for the next several years, the burden of proof falls on management.

As always, please act accordingly….

Key Observations from the Quarter:

• Contrary to what our dealer feedback would have led us to believe, TTC actually benefited from stronger demand from its commercial clients and orders from golf course operators.  Revenues from the company’s professional segment were the primary driver of upside.
• Results from TTC’s residential division were somewhat alarming. The company witnessed a 70 bps YOY decline in operating margins, while YOY topline growth decelerated from 14.5% in 2Q10 to 7.8% in 3Q10.  We think this will be an area of focus on the  conference call.
• Total inventory increased in 3Q10 for the first time on a YOY basis in eight quarters.  Annualized inventory turnover during the quarter of 6.8x still remains very favorable relative to historical trends.
• TTC continues to benefit from its joint venture with TCF Inventory Finance through which the company formed Red Iron Acceptance Corp,  a provider of floor plan financing to Toro and Exmark dealers. The formation of Red Iron Acceptance Corp. has significantly reduced the company’s accounts receivable. The company anniversaries the formation of Red Iron Acceptance Corp. this August and will not see a similar YOY DSO or cash flow benefit going forward.
• Free cash flow for the quarter actually declined on a YOY basis, due primarily to a shift in the timing of the company’s working capital accounts.  Overall free cash flow has increased 32% through the first three quarters of FY10.
• Approximately $0.03 of the company’s earnings beat related to a lower share count
• Management’s revised FY10 guidance of full year revenue growth and EPS of 10-11% and $2.70 implies the company will generate 10-11% total revenue growth in 4Q10, operating margins of 1.5-1.7% (up 50-70 bps YOY), and EPS of $0.02 – inline with current consensus.  Given TTC’s track record of topping analyst estimates, this guidance will be viewed as “conservative”
• TTC ended 3Q10 with total debt of $225 million which implies total leverage of 1.1x on a total debt/trailing EBITDA basis and 50.8% on a debt/cap basis.  This compares to total leverage for BGG as of 6/30/10 of 1.2x on a total debt/trailing EBITDA basis and 24.1% on a debt/cap basis.

Key Questions for the Earnings Conference Call

Here are a few key questions we would like answered on the earnings conference call:

• What caused the deceleration in sales in the residential channel and how did sales trends over the course of the quarter?
• How much did replacement driven demand boost sales from the commercial channel?
• What are the company’s expectations for demand from golf course operators in the US vs. Intl.?
• How much has TTC hedged its international revenue exposure for FY11 and at what levels?
• How would management characterize sell through and inventory levels in Europe (BGG mgmt. indicated Europe was relatively weak)?
• After reaching the 12-month anniversary of the Red Iron Acceptance JV, will the company revert to its normal net income to free cash flow conversion rates of 1.2-1.5x?
• What are the company’s capital allocation priorities going forward?

Still Favor Long BGG/Short TTC – TTC Appears Priced for Perfection

We are perplexed by the relative reaction of TTC shares to those of BGG in response to a healthy earnings beat. BGG topped consensus EPS estimates for 4Q10 by 50%, while TTC topped street estimates by 33% for 3Q10.  Both companies guided inline.  TTC shares are up 4% and those of BGG traded up 1% on the day the company reported 4Q10 earnings.  Go figure.  As we discussed above, BGG now boasts similar balance sheet strength and flexibility to that of TTC.  Briggs and Stratton has taken several steps to improve operating efficiency and enhance free cash flow generation.  Going forward, we expect returns on capital and equity to increase at a more rapid rate for BGG than they will for TTC given the significant structural headwinds the company faces in some of its key end-markets.  As a result we think BGG shares are poised for multiple expansion. Whereas TTC shares already discount significant cycle-to-cycle growth, BGG’s current valuation appears to imply the company could have difficulty achieving prior peak EPS.  At more than 15x prior peak EPS, we think TTC shares are already priced for “perfection”.

As always, please act accordingly….

Performance Update

The PAA Research SMid Cap Portfolio is rapidly approaching its first year anniversary and we’re pleased to say there still is a “puncher’s chance” that the portfolio could achieve our annual target return of 20-25% (gross).  From an attribution perspective, the portfolio has benefited from solid returns on both long and short positions since inception.  Over the past month, short positions in the for-profit education sector have been the primary contributor to performance.  We articulated our short thesis on ESI, COCO, and WPO in particular and the sector by proxy more than one-year ago.  Most of the principal elements of our short thesis have played out as expected and in an accelerated manner in the past 4-8 weeks. Despite the significant price declines in the shares of several companies in the sector, there are a few stocks which do not yet fully reflect the implications of a fundamental slowdown in enrollment demand and a shift in the regulatory landscape.

As we discussed in our last update on the PAA Research SMid Cap Portfolio, we continue to position the portfolio to reduce market risk and take on a level of idiosyncratic risk among names in which we have high conviction with clear identifiable catalysts.  While this approach resulted in returns that lagged the broader indices in July, our conservative portfolio positioning has enabled the portfolio to deliver substantial outperformance thus far in August.   Thematically, we continue to focus on companies with secular revenue growth or that should benefit from a strategic or operational turnaround. Here are the performance highlights for the month of August, year-to-date, and inception-to-date:

• Thus far in August, the PAA Research SMid Cap Portfolio has returned 1.1% compared to (-0.8%), (-1.6%), and (-3.7%) declines for the S&P 500, S&P 400, and Russell 2000, respectively. Our short positions in COCO, ESI, LINC, and WPO have been the primary drivers of performance thus far this month.
• On a year-to-date basis, the PAA Research SMid Cap Portfolio has gained 10.0% compared to a (-2.0%) decline for the S&P 500 and 2.9% and 0.1% gains for the S&P 400, and Russell 2000, respectively. The table below compares performance of the PAA Research SMid Cap Portfolio to its relevant benchmarks on a year-to-date basis:

• IPSU (our largest weighting) has been the primary standout thus far this month among our long positions with a 14.5% gain.  Offsetting appreciation in IPSU have been our positions in THQI (-15.8%) and WWE (-12.5%).  We are adding to both names as we will discuss in more detail later.
• Our shorts performed well over the past 2-3 weeks, particularly those in the for-profit education sector. Our short positions in COCO, ESI, LINC, and WPO have declined (-45%), (-34.9%), (-22.0%), and (-46.1%) thus far this month respectively.
• Inception to date the PAA Research SMid Cap Portfolio has returned 17.3% compared to gains of 9.8%, 17.5%, and 12.7%, respectively

Portfolio Characteristics

We are not making many significant changes this week to the PAA Research SMid Cap portfolio, we expect the next two weeks to be relatively quiet from a trading perspective (famous last words).  Overall, the characteristics of the portfolio remain largely the same as they were at the start of the month after giving effect to our minor changes:

• Gross exposure – 134.4% (down from 141.9%)
• Net exposure – 33.3% (slightly up from from 30.8%)
• Net position beta adjusted – 40.2%
• Top five long positions as a percentage of equity – 30.7% (down from 31.4%)
• Top ten long positions as a percentage of equity – 49.6%
• Average market cap of long positions – $1,867.3MM
• Average market cap of short positions – $2,525.1MM

Changes to the PAA Research SMid Cap Portfolio – Long Positions

We have added to four long positions and reduced one. Otherwise the positions in the long book remain unchanged.  Our top five long positions are:

• IPSU – 9.1%
• AYI – 6.2%
• THQI – 5.7%
• KNOT – 5.2%
• AWI – 4.4%

Increased Positions – FCN, SIG, THQI, WWE

FTI Consulting shares sold off sharply following the company’s 2Q10 earnings pre-announcement. At that time management lowered guidance, in part due to a slower than expected recovery in some of the company’s pro-cyclical business units, particularly those tied to the capital markets. In the interim, the company continues to generate strong revenues and free cash flow from its restructuring, forensic and litigation, and economic consulting divisions.  Recently there have been increasing signs that broader capital markets activity could improve after Labor Day and that M&A is slowly recovering. We think the stock is poised for multiple expansion as investors gain confidence in the company’s revised guidance.  We are also encouraged that senior management purchased stock following the sharp sell-off.

Signet Jewelers has been one of our favorite retail names over the past year.  We have paired our long position in SIG against a short position in NILE quite successfully.  Recent same store sales and macro-economic data suggests that consumer spending has slowed precipitously. We think SIG remains well positioned to continue to gain market share from independent specialty jewelers during a slowdown as it has for the past two years.  More importantly, the  company continues to improve its inventory management and should deliver another year of strong free cash flow. We think it is possible that SIG could reinstate its dividend in the next 6-9 months, which would be a positive catalyst for shares.

THQI has been a top holding in the PAA Research SMid Cap Portfolio since inception. The stock has been slammed over the past 2-3 months due to disappointing sales of UFC 2010 and uninspiring guidance for 2Q10.  Shares came under additional pressure in recent weeks when MAK Capital, an activist fund and the largest single shareholder of the company, decided to liquidate a significant portion of its holdings. THQI adopted a poison pill earlier in the year, which we think could have caused MAK to reconsider its investment.  Earlier today, THQI announced the launch of uDraw, an innovative new peripheral for the Wii. We think the periphal has the potential to sell at least 2 million units for this holiday season which would add as much as $100 million to the company’s topline and $5-$10 million in profits.  More importantly, we think the unique nature of uDraw should provide further confirmation to skeptical investors that the company has indeed changed its stripes and will be a source of innovative video game content over the next several years. Additionally, THQI’s CEO and several members of the board purchased stock in the past week, which adds to our confidence that the stock might have seen its lows for the foreseeable future.

Reduced Positions – HRB

Changes to the PAA Research SMid Cap Portfolio – Short Positions

We have closed out two short positions and established two new short positions.  Our top five short positions after giving effect to these changes are:

• JLL – 3.2%
• WYNN – 3.1%
• WRLD – 2.8%
• SFLY – 2.8%
• MAN – 2.7%

Closed Out Positions – LINC, MLM

We are closing out our position in LINC following the 46% decline in shares in the past three weeks. In retrospect, LINC’s 2Q10 earnings release in which the company guided down for the first time will likely be viewed as the inflection point for the for-profit postsecondary education sector. While there were plenty of other warnings signs in the sector from both a fundamental and regulatory perspective, most bull held the argument that cheap valuations indicated the stocks were poised to witness gains.  However, the performance of LINC over the past few weeks stands as a testament to investor understanding of the negative leverage in the for-profit postsecondary business model as enrollments decline.  It is more likely and not at this stage that LINC could go through a period in which the company generates little to no net income and free cash flow.  We still think shares could trade lower, but see more compelling opportunities to establish short positions in the sector.

We are closing out our short position in MLM with a gain of 18.9%.  We think the stock fully reflects what is likely to be a lackluster recovery in construction activity.  We see few catalysts to drive the stock lower in the near term.

New Positions – CECO, QNST

We are replacing our short position in LINC with a 1.9% position in CECO. We are surprised that Career Ed. shares have outperformed their peers over the past 6-months.  The company will likely face significant difficulty complying with the Department of Education’s “gainful employment” proposal. Additionally, we think the Dept.’s proposal to standardize the definition of a credit hour could have a disproportionate impact on CECO’s earnings prospects.  In our view, the company could become subject to greater scrutiny from its accrediting bodies and the Department of Education over the next 6-12 months.  Shares appear cheap, but we don’t think investors have a full appreciation for the scope of difficulties that could plague CECO over the next 12-24 months.

QNST is a lead generation company which generates a significant percentage of its revenue and earnings from for-profit education companies. The changes to the “incentive compensation” safe harbors and increased scrutiny on the manner in which for-profit institutions recruit students could lead to a structural shift in dollars allocated to lead generation. We think senior management of QNST has misled investors in recent weeks by claiming that the shake out would be a net positive for the company.  QNST is a 1.5% position.

Please click on this link to view the position by position detail of the PAA Research SMid Cap Portfolio.

As always, please act accordingly…

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

We Thought the Repayment Rate Data Would be Bad, It Was Worse

On Friday, after the close the Department of Education released “Cumulative Four-Year Repayment Rate by Institution” for the entire US higher education sector.  The overall repayment rate for all schools was 51%, which probably will come as a surprise to most followers of the US higher education sector.  If 33% of students are pursuing deferment and forbearance options and the Dept. of Education most recently budgeted for 15% lifetime default rates for the FY07 cohort, that implies that the repayment rate should be around 50%, which is what Friday’s data corroborated.  If the low repayment rate for all US higher education institutions came as a surprise to some, the data for for-profit institutions could best be described as “shocking”.  Heading into the release of Friday’s data from the Dept. we thought most institutions owned by publicly traded for-profit education companies would have a repayment rate of 40-45% (based on the data in the table above). We were wrong.  Most schools had a repayment rate approximately 10% lower than our expectations.

We attribute the wide variance between actual 4-year repayment data and our expectations to two factors:

• Although the percentage of students pursuing forbearance or deferment for the FY07 cohort across the entire US higher education system was 33%, the rate for students attending for-profit institutions might have been considerably higher.  Institutions are highly incentivized to encourage students to pursue deferment or forbearance if those individuals are at a risk of not paying.  Students that seek out deferment or forbearance are not included in the numerator in the calculation of the 2-year cohort default rate, but are included in the denominator. As we have argued for sometime this has resulted in a cohort default rate that significantly understates actual credit outcomes.  Most for-profit institutions use deferment and forbearance as their primary default management tool. It seems reasonable to assume that the percentage of students pursuing those options after graduation would be higher at for-profit institutions.
• The extension of the measurement period from 2-years to 4-years probably had a greater impact than 2.7x on the cohort default rate. In our original analysis we viewed the repayment rate as the following: 2-year cohort default rate x 2.7x + the % of students in deferment and forbearance.  We used 2.7x based on data provided in a GAO report analyzing the efficacy of cohort default rates. In that report, GAO determined that expanding the measurement period of the cohort default rate had the effect of increasing the percentage of defaults at for-profit institutions by 2.7x based on an analysis of FY04 data. Given that the economy weakened considerably since FY04 it’s possible that the 2.7x multiplier understates the actual increase in student loan defaults.

In the table below, we outline the number of institutions owned by each publicly traded for-profit education company whose repayment rate did not exceed 35% and 45%, as well as the total average repayment rate for those institutions.  The data can be described as nothing short of anemic.

It is important to note that the data released on Friday reflects the repayment rate at an institutional level, while the actual regulation will be enforced on a program by program basis at each individual campus.  This could lead to some eventual outcomes that don’t match the conclusions drawn from the institutional level data. For example, it appears that the University of Phoenix couldat worse be restricted and at best be fully eligible for federal financial aid programs. However, we think it is possible that APOL has some programs whose repayment rates are below 35% and as a result could be rendered ineligible.  More than anything, the data suggests that an incredibly high percentage of programs offered by publicly traded companies in the sector could be in the lower left hand corner of the grid below.  To call this troubling for shareholders, would be an understatement.

After “Black Monday” There Will Be Many Lingering Questions in the For-Profit Education Sector

When the market opens tomorrow, we expect most stocks to gap down.  Up until now the decline for most stocks (except for LINC) has been a steady bleed, tomorrow could represent the first stages of capitulation in the space.  The implications of the repayment rate data are enormous – it provides almost no “safe harbor” from the other income based standards for the gainful employment provision.  As we have argued for some time, the return on educational investment for many students attending for-profit education institutions has been diluted by aggressive tuition policies and poor educational outcomes.  ”The more you learn, the more you earn” student covenant has been broken and the Dept. of Education’s gainful employment provision attempts to restore some form of balance for students and ensure a more favorable return on capital committed to the student loan program for tax payers.

Should the Dept. of Education’s gainful employment provision be enacted, we expect the following to become commonplace for operators in the sector:

• Tuition price reductions
• A greater focus on higher quality students
• Increased investment in educational quality, job placement professionals
• Program and potentially school closures
• Dramatically reduced profitability, operating losses for many companies

The implications for earnings in the sector could be enormous and you certainly will start to see that discounted in the stocks starting tomorrow.  After the fireworks, we think there will be a number of lingering questions about the for-profit education sector:

1. How will the Department of Education handle 90/10 going forward?  The simplest response for those institutions that fail to meet the Dept’s gainful employment proposal would be to cut tuition. However, reducing tuition would leave most schools in violation of “90/10″, which prohibits an institution from generating more than 90% of its revenues from federal financial aid.  As of now, the Department of Education has provided little guidance as to how it plans to handle institutions that seek tuition price reductions to gain compliance with gainful employment.  We’re not sure if the Department has the jurisdiction to modify 90/10 which is mandated under the Higher Education Act.
2. How will institutions structure programs going forward? As we discussed above, tuition price reductions, a focus on higher quality students, and greater investment in educational quality will likely become the immediate response to the enactment of gainful employment. Most schools will likely make preparations for regulatory changes as soon as the fall term.  We think investors might overestimate the magnitude and breadth of these changes within the sector.  Schools must now adopt a “lowest common denominator” approach to program structure.  Even if a particular program is in compliance with gainful employment because of a greater reliance on students with transfer credits, we think most operators will evaluate their programs assuming “first time, full time” students make up close to 100% of the mix.  Institutions cannot run the risk of falling out of compliance with the standards and any shift in the demographic of incoming students could result in that outcome. The only alternative to the “lowest common denominator” approach is to only allow students to enroll with a specific threshold of existing credits.  Either way, it’s a choice between lower tuition or lower enrollment growth.
3. Does anyone believe the Office of Management and Budget data on federal financial aid? The most common refrain from the Career College Association and others that deny the existence of a student loan crisis in the US has been that the government collects 108% of principal on every student loan default. This data has been provided by the OMB.  The 51% average 4-year repayment rate for all institutions implies that OMB’s estimates are way too high.  Additionally, OMB’s estimates do not include the fees paid to third party collection agencies which typically represent as much as 20% of principal.
4. How quickly will Sen. Harkin and others jump on this latest round of data? With each passing day it seems the critics of the sector receive more ammunition, while supporters find less and less to back their claims.  The repayment rate data adds further credence to Senator Harkin’s efforts to place tighter restrictions on the sector, in our view.  The recent GAO report on recruiting practices in the sector and the release of the repayment rate data could embolden other members of Congress to seek out tighter regulations.
5. Is Blum Capital in trouble? Based on publicly available data from the SEC, it appears that Blum Capital’s positions in CECO and ESI represented close to 40% of the company’s portfolio as of 3/31/10.  We have not seen any filings that indicate the firm has reduced its holdings in either CECO or ESI.   We think it is highly possible  Blum Capital hedged out its risk in these stocks to minimize the damage to the company’s portfolio. However, given the significant concentration in these two stocks we think the firm could face redemptions and potential selling pressure in its other holdings.
6. What is going on at STRA? 46 of 52 institutions with a repayment rate of less than 35%, a corporate average repayment rate of 25%, the data released for STRA was truly stunning.  The company will host a conference call tomorrow morning at 7:30 to provide investors with its version of “the facts”.  While we find it hard to believe that the company’s repayment rate is as low as the data provided by the Department of Education suggests, we also have had a hard time reconciling some of the statements made by STRA management of late.  For instance, on its most recent conference call, STRA management indicated that its lifetime default rate on a per student basis for the past 15 years has averaged approximately 9%. However in FY05, FY06, and FY07 the company’s 3-year cohort default rates were 9.3%, 10.5%, and 13.0%.  Additionally, management has asserted that its graduates earn $60,000 on average three years after completing their degree programs.  Students earning $60,000 would not likely seek out deferment or forbearance, at least not at the levels implied by the Dept. of Education’s data.
7. How much downside could stocks in the sector see? The short answer is quite a bit.  Even though the group has underperformed significantly over the past year we think additional downside for CECO, COCO, DV, EDMC, ESI, LINC, STRA, and WPO could be significant.  For COCO, ESI, and WPO we think the stocks could witness and additional 40% downside if not more as investors fully discount the impact of reduced enrollments, lower tuition, and higher compliance costs.

As always, please act accordingly….

1. A meaningful “replacement cycle” for outdoor power equipment has commenced.
2. Although overall sell through has been strong, demand from commercial end users has been weaker than average which should lead to slower revenue growth for TTC relative to BGG.
3. TTC’s relative balance sheet advantages to BGG are eroding rapidly. BGG has rapidly reduced leverage, which could enable the company to pursue tuck-in acquisitions or share repurchases.
4. After outperforming shares of BGG by more than 40% over the past year, we think TTC is poised to witness valuation compression while Briggs and Stratton’s stock could witness multiple expansion.

BGG report strong 4Q10 results this morning, which were well above our estimates and consensus expectations.  The company’s operating results confirmed all four elements of our investment thesis.

4Q10 Upside Sparked By Strong Sell Through on Replacement Driven Demand

BGG reported 4Q10 revenues and EPS of $616.2 million and $0.36 compared to consensus of $558.7 million and $0.24 and our estimates of $547.0 million and $0.27.  After four consecutive years of declines in outdoor power equipment demand in the US, it now appears that sell through in 2010 will top 2009 levels.  The feedback from our proprietary survey of outdoor power equipment dealers conducted approximately one-month ago indicated that:

• Sell through trends were stronger than previously anticipated. Approximately 40% of dealers have witnessed a YOY increase in sell through in excess of 10% thus far in 2010.
• Inventory levels in the dealer channel declined significantly YOY through the end of the second quarter.  More than 55% of dealers witnessed a YOY decline in inventory through the end of the second quarter.
• Demand for replacement products has been the strongest driver of demand.
• Sell through expectations for 3Q10 remained favorable.  Most dealers expect high single digit to low double digit sell through.

These factors enabled BGG to generate 26% and 27% topline growth from the company’s engine and power products division, respectively.  The company’s operating margins actually were slightly below our expectations. The benefits of lower commodity costs and improved facility utilization were offset by a mix shift towards lower ASP engines and increased spending on G&A. In the fourth quarter the company elected to fully repay employee salaries and 401K match benefits that were reduced earlier in the year.  This resulted in a $16 million sequential increase in G&A spending.

BGG’s Initial FY11 Appears Conservative

BGG provided initial revenue and EPS growth for FY11 of 2-4% growth and $1.20-$1.40, respectively. This compares to current consensus of $1.97 billion in revenues (1% growth) and EPS of $1.31. We would characterize management’s initial FY11 guidance as conservative given the significant drawdown in lawn mower inventories that occurred over the course of the Spring/Summer selling season. Thus far, demand for power generators has declined significantly YOY given the lack of storm activity.  Additionally, snow thrower inventory exiting Winter 2010 was slightly elevated, which could result in lower initial orders over the next 3-4 months, unless snow activity commences earlier in the season.  While this could mute the magnitude of earnings upside relative the consensus for 1Q11, we anticipate the company could benefit from high single digit order growth for lawn mowers and other outdoor power equipment for 2Q11 and 3Q11.  In the table below we compare BGG’s 4Q10 results and guidance to our estimates and consensus:

“Monster” Free Cash Flow Generation in FY10 Leaves BGG with Significant Balance Sheet Flexibility Comparable to that of TTC

We think one of the primary reasons that TTC has commanded a premium to BGG shares over the past several years has been the relative lack of leverage on Toro’s balance sheet and the company’s frequent share repurchases. Over the past 18-24 months, BGG has transformed itself into a capable free cash flow generator and has rapidly reduced leverage.  For FY10, BGG generated $199 million in free cash flow. The company closed its fiscal year with total debt of $206 million and net debt of $89 million.  Total debt and net debt are at their lowest levels for BGG in more than a decade. BGG also now has a lower total debt balance than does TTC and boasts a trailing free cash flow yield in excess of 22%.  As the chart below demonstrates, BGG is well within compliance with its total leverage covenants which should enable the company to pursue strategic tuck-in acquisitions, share repurchases, or a combination of both. We also cannot rule out that the company would consider increasing its dividend substantially.  The company slashed its dividend approximately two years ago to preserve liquidity during the recession.

BGG Shares Appear Ripe for Multiple Expansion, While those of TTC Could Witness Valuation Compression

After outperforming shares of BGG by more than 40% over the past year, we think TTC is poised to witness valuation compression while Briggs and Stratton’s stock could witness multiple expansion. As we stated in our original report on TTC, it already appears that Toro shareholders have already started to discount significant peak cycle-to-cycle earnings growth. TTC shares now trade at 14.6x prior peak EPS. In the case of BGG, it appears the exact opposite is true. At 7.6x the company’s prior peak cycle EPS, it appears investor do not expect the company to witness meaningful cycle-to-cycle earnings growth.  We think BGG shares are poised for revaluation following the company’s strong 4Q10 results and strong free cash flow generation in FY10.  Balance sheet flexibility has improved dramatically over the past 18-24 months and the company has improved manufacturing efficiency during the downturn which should lead to cycle to cycle margin growth.  TTC shares could face a number of headwinds over the next several quarters based on its relative reliance on commercial users and high expectations for earnings outperformance from investors.

In the table below we compare BGG and TTC’s valuation level relative to our estimates and prior peak cycle earnings. At 7.6x prior peak EPS and 12.1x our estimate for FY11, we think BGG shares are attractively valued at this point, particularly in light of the significant fundamental improvement in the company’s end-markets. While TTC will also benefit from continued improvement in demand for outdoor power equipment, this is largely reflected in the company’s premium valuation. We also think it is worth noting that both companies look similarly valued on a free cash flow yield basis. We think this will surprise some investors given TTC’s broad-based perception as a free cash flow monster.

We think BGG shares are poised for multiple expansion over the coming quarters while TTC could suffer through potential negative estimate revisions and valuation compression. Our target return for this pair trade is 25%.  We anticipate BGG shares could trade as high as 15-17x our FY11 EPS estimate as investors gain more comfort with the replacement driven nature of the rebound in outdoor power equipment and company specific operating improvements. At 15-17x our FY11 EPS estimate BGG shares would trade at $21-$24, which would represent 27-44% upside from current levels.  For TTC, we anticipate shares could sell-off as much as 10-15% once investors gain a stronger understanding of the secular headwinds the company faces in some of its end-markets.

As always, please act accordingly….

A More Realistic Timetable for Productivity Gains at Port Wentworth

From 1Q10 to 3Q10, production at IPSU’s Port Wentworth refinery increased by approximately 47% to 4.7 million pounds a day. On some level the gains are encouraging, but are still well below the levels management targeted and investor expectations.  Based on our conversation with management, we are revising our total production estimates for 4Q10 and to a lesser extent 1Q11. In the table below we outline our monthly production forecasts for IPSU’s Port Wentworth and Grammercy refineries.  The company incurred several issues in the first two weeks of July, which significantly hampered production.  Based on our conversation with management, we have learned that the company had a lightning strike at Port Wentworth at the end of June, which resulted in a shutdown of the boiler systems for a few days.  Additionally, several other issues caused Port Wentworth to operate at sub-optimal production over the first two weeks of July.  This has caused the company to delay shipments to certain customers for 2-3 weeks.  Management has indicated that production average 4.8 million lbs. a day in the last two weeks of July and more than 5 million lbs. a day in the past 7-10 days.  We are encouraged by the production improvements.  Realistically, IPSU has little margin for additional down-time at Port Wentworth or it could face customer cancellation charges as it did in 3Q10.  We now expect IPSU’s Port Wentworth refinery to average 5.2 million lbs. a day in September on a 27 day production schedule.

Our Revised Estimates for IPSU

We are revising our 4Q10 and FY11 estimates primarily to reflect a slower rate of productivity improvement at IPSU’s Port Wentworth refinery.  We have made the following changes to our 4Q10 estimates:

• We have actually increased our total production estimates for 4Q10.  We expect IPSU to run both its Port Wentworth and Grammercy refineries on a 27-28 day schedule per month for the entire quarter. As a result, we think the company should be able to produce 6.6-6.7 million cwt for the quarter.
• We have lowered our pricing expectations for consumer/retail customers.  Among the biggest surprises in IPSU’s 3Q10 results was the sequential decline in realized price to consumer/retail customers.  IPSU management indicated that pricing for small package sugar delivered to retailers was particularly competitive during the quarter. In a period of acute sugar shortages we still find this hard to believe. We can’t help but wonder if IPSU’s relatively weak realized price in the retail channel is a function of an unfavorable mix shift away from specialty products.  Spot bulk industrial pricing is well above $50/cwt for the calendar third quarter and into the mid-40’s for the calendar fourth quarter. We expect the competitive pricing dynamic in the retail channel to be short lived as refiners shift excess capacity to industrial users in order to capture better pricing.
• We have reduced our gross margin estimate for the quarter from 6.0% to 1.8%.  Gross margins will be hampered by extra-production schedules and the aforementioned disruptions in the first two weeks of July.  We have not contemplated any charges for customer cancellation fees.
• Our estimates do not include any impact from the company’s sugar hedges. Based on current trading levels for the 12-month forward futures strip for the #16 contract, we estimate IPSU would report a gain of $3-$5 million on its sugar hedges if the quarter ended today.

Our new revenue and loss per share estimates for the quarter are $269.1 million and (-$0.27).  In the table below we outline IPSU’s 3Q10 results compared to our estimates and our revised forecasts for 4Q10.

$2.00+ in EPS for FY11 Remains Possible Even With Slower Productivity Gains at Port Wentworth

Obviously we have been overly optimistic about IPSU’s ability to execute and restore production levels at Port Wentworth.  However, with current bulk industrial refined sugar pricing at $43/cwt and the 12-month raw sugar futures strip trading at $29.00-$30.00, IPSU is booking business today for delivery in FY11 that has an unprecedented margin profile. A $14.00-$14.50 spread on refined sugar is unprecedented at this point in the season. It’s important to remember that natural gas and coal prices are at half the levels they once were when IPSU benefited from refined sugar premiums of this magnitude. Following IPSU’s 3Q10 results and our conversation with management we now expect Port Wentworth to achieve 5.9-6.0 million lbs. in daily production on a normal schedule in the calendar first quarter of 2011.  We have also lowered our realized price expectation for production volumes for retail and food services/distributor clients.  As a result we expect the company to generate an operating loss in 4Q10 and effectively break even EPS in 1Q11.  Here are our key assumptions for FY11:

• IPSU will contribute the Grammercy refinery to the LSR/Cargill JV in exchange for a one-third ownership in the joint venture on 12/31/10.
• IPSU DOES NOT acquire the remaining ownership stake in Wholesome Sweeteners. Even though we expect this to happen sometime between 10/1/10 and 3/31/11, we do not include unannounced acquisitions in our estimates as a matter of policy
• Port Wentworth produces approximately 15.5-16.0MM cwt of refined sugar for the year. Remember full melting capacity is 63,000 cwt/day, which implies full production would be 16.5-17.0MM cwt assuming the plant is operated 22 days on average a month throughout the year.
• IPSU realized price on industrial contracts is $42.47/cwt, for consumer $49.77, and for food services clients $48.70.
• IPSU’s raw sugar costs average $30.00/cwt for the year
• Gross margins improve steadily over the course of the year from 3.5% in 1Q11 to 9.4% in 4Q11.  While this sounds aggressive at first glance, it is important to remember down time, consulting fees, and extra production schedules have been a huge drain on IPSU’s margins for the past three quarters.  In an environment with a $14.00+ refined/raw sugar spread IPSU has historically been able to generate high single digit if not low double digit gross margins.
• Full year depreciation expense of $21 million
• Other operating income approaches $12.5 million, which includes operating earnings from Wholesome Sweeteners, Santos, and the Cargill/LSR JV

Revisiting Our Normalized Earnings and Free Cash Flow Estimates for FY11

For at least the next two fiscal years we think IPSU will be able to generate above average earnings based on the expected tightness in raw sugar supplies and high level of capacity utilization among sugar refiners. We still think IPSU will eventually trade off its “normalized earnings”. Over the past 5-7 years it has been difficult to discern what IPSU’s “normalized earnings” are given the volatility in the sugar markets. Going forward, IPSU will increasingly generate a higher percentage of its earnings from higher margin, less volatile earnings streams such as Wholesome Sweeteners and eventually its Stevia joint venture from Pure Circle. We think this will result in valuation expansion for IPSU shares. Wholesome Sweeteners continues to generate extraordinary revenue growth and has a margin profile 2-3x that of IPSU’s core refining business.  We estimate IPSU’s EXISTING ownership in Wholesome Sweeteners could be valued north of $85 million, or $7/share.  At 3.6x and 6.9x our normalized EBITDA and EPS estimates, we would argue very little is priced into IPSU shares at current levels. Once IPSU completes its last expenditures related to the Port Wentworth rebuild and OSHA mandated safety improvements, the company will become a significant free cash flow generator even after giving effect to the required pension contributions IPSU will make over the next five years. As a reminder, here are some of our key assumptions for our normalized earnings and free cash flow estimates:

• Raw sugar prices of $25 (we think this could be conservative) and a realized refined sugar price for IPSU of $33.50
• Port Wentworth produces 16MM/cwt of refined sugar annually
• IPSU retains one-third ownership of the Grammercy facility as of 1/1/11
• IPSU retains ownership of the small packaging facility, which produces 3.5MM cwt annually
• IPSU purchases the remaining 50% ownership stake in Wholesome Sweeteners on 1/1/11 at a price of $75 million which will be financed with debt at an interest rate of 6% ($$4.5 million annual interest expense). We expect IPSU to generate meaningful free cash flow in the next 6-9 months, so the amount financed could be considerably smaller.
• Gross profit margins of 7% at Port Wentworth and 26% for Wholesome Sweeteners.
• $4.50-$5.00 natural gas costs and coal equivalents
• $3 million in annual equity earning from both Santos and the Pure Circle JV.
• Annual pension contributions of $15.0 million

Based on Sum of the Parts, Normalized Earnings, or Our FY11 Estimates, IPSU Continues to be One Cheap Stock

We recognize investors continue to be disappointed by the rate of production improvement at IPSU’s Port Wentworth refinery. Despite a series of missed targets, we remain cautiously optimistic that management is inching ever closer towards enabling IPSU to realize its full earnings potential.  Historically IPSU has not reported fourth quarter earnings until the first week of December. We are hopeful management will provide production updates at Port Wentworth in early October at the latest.  Outside of a settlement of the civil litigation related to the Port Wentworth refinery accident or another increase in refined sugar prices, we cannot identify any other clear catalysts for IPSU shares.

We remain bullish on the prospects for structurally higher refined sugar prices and wider raw sugar spreads over the next several years.  Sugar demand continues to increase at a time when refined capacity remains tight.  IPSU is well positioned to take advantage of the “new normal” in the US sugar market once production levels at Port Wentworth are restored.

In our view, the stock trades at more than a 50% discount to its true value based on our earnings outlook for FY11 (5.5x P/E), the company’s normalized earnings power (6.9x P/E), and our sum of the parts analysis ($25/share), which includes a significant valuation adjustment for a contingent non-insured liability related to the Port Wentworth refinery accident. We expect IPSU shares to witness substantial upside over the coming months as investor become increasingly aware of the favorable dynamics in the US sugar market and the company achieves production benchmarks at Port Wentworth.

As always, please act accordingly….

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

Causality in the stock market is a fickle beast.  Make no mistake, WPO’s second quarter results were above our expectations.  However, there were several things related to the company’s operating results that were cause for concern.  Still, we found ourselves hard pressed to justify a 7-8% sell-off in the stock based exclusively on our fundamental concerns.  In our discussions with other investors today we found ourselves debating the following questions to attempt to justify the sharp sell-off in shares:

• Are investor responding to the sharp slowdown in campus based enrollment growth at Kaplan Higher Education?
• Are people un-nerved by the removal of student start data for Kaplan Higher Education from the press release?
• Has another quarter of poor relative (to TWC, CMCSA, and CVC) and absolute RGU growth at CableOne caused investors to question the long term earnings prospects for that division?
• Or is it simply the acknowledgement by WPO management that the Dept. of Education’s Negotiated Rulemaking proposals could have a significant impact on the profitability profile of Kaplan Higher Education?

As hard as it is to believe for any follower of the for-profit education sector for the past 12-18 months (and subscribers of PAA Research), it is clearly the last question listed above that has dictated stock price action today.  The sharp sell-off in shares today provides evidence that WPO investors have not yet discounted the implications of the regulatory scrutiny surrounding Kaplan Higher Education, in our opinion.  Whereas the stock market has always been viewed as an accurate predictor of future economic growth and a “discounting mechanism”, it appears in the case of WPO, investors have chosen to wait until the facts are explicitly detailed by management before taking action. Given the volatility in the rest of the for-profit education sector over the past several months, performance of WPO shares up until today has been nothing short of fascinating.  We think today’s stock price action could serve as the first indication of an answer to a question we posed in our earnings preview:

“How will WPO shares respond when the Kaplan Higher Education growth engine unravels and the rest of the company’s operating divisions are deemed “structurally impaired”?

WPO’s Earnings Results Yield More Questions Than Answers

In our earnings preview, we outlined a number of questions we hoped the company would address related to each of its major operating divisions. For the most part, our questions remain unanswered.  WPO reported revenues and EPS (adjusted) of $1.222 billion and $10.87 compared to our estimates of $1.228 billion and $6.37.  Earnings outperformance was largely driven by better than expected EBITDA margins at the company’s higher education and broadcasting divisions.  In the table below we compare the company’s results relative to PAA Research estimates and outline our forecasts for the rest of FY10 and FY11.    We actually have RAISED our estimates for 3Q10 and 4Q10, while our estimates for FY11 remain largely unchanged.

The company’s 2Q10 results failed to provide answers to most of our questions heading into the quarter and raised a few more, which we discuss below.

Kaplan Higher Education

1. What happened to the company’s disclosure on student starts at Kaplan Higher Education? In WPO’s earnings release for 1Q10 the company provided detail on student starts for Kaplan University and its other higher education assets for the first time.  However, in the company’s second quarter earnings release, student start data was conspicuously absent.  We’re not certain why the company chose to hold back the data, but it represents yet another “red flag” in a growing list related to Kaplan Higher Education.
2. How will the implementation of a required orientation program similar to that instituted by APOL impact student start growth in the next 12-18 months? Starting in the spring term, Kaplan University implemented a required orientation program similar to that instituted at Axia Online where students with minimal prior college experience are required to complete a course for free before they can be enrolled at the university. In the long term, this program should lead to higher student retention rates and lower student loan default rates.  However, in the short term the implementation of this program could negatively impact student start growth by as much as 3-5%, perhaps more.  Additionally, the program will lead to lower student conversion rates and pressure on gross margins.  2Q10 was the first in which WPO was impacted by the introduction of the orientation initiative. None of this was discussed in the company’s press release.
3. Did student start growth decelerate further for the summer term? As we discussed above, WPO chose not to disclose student start data for the second quarter despite providing that data in its earnings release in the first quarter.  For 1Q10, campus based student starts increased 5% YOY, well below its peer group average.  The feedback from our recent survey of privately held for-profit postsecondary education institutions suggests start growth could have slowed further for KHE’s campus based programs and online for the summer term.  During the second quarter, total YOY enrollment growth for Kaplan University and the company’s other higher education assets decelerated from 36% and 11% for 1Q10 to 28% and 6%, respectively.  The sharp deceleration in enrollment growth for KHE’s campuses implies that student starts could have declined on a YOY basis.
4. How much did the gain on the sale of Education Connection contribute to earnings in the quarter and in which division was that gain reported? Kaplan completed the sale of Education Connection in April 2010.  Education Connection is a lead generation provider to the higher education space.   Education Connection was part of the Kaplan Ventures portfolio.  Based on conversations with our sources, Education Connection was sold to Education Dynamics for $20-$25 million.  While Kaplan does not provide detailed disclosure on the carrying value of its investments in the Kaplan Ventures portfolio, we estimate that Education Connection had a book value of no greater than $5 million.  This would imply that the company recognized a gain on the sale of as much as $15-$20 million (or $1.00-$1.35 per share tax effected).  WPO did not disclose the amount of the gain, nor did the company indicate in which division the gain was recorded. We have a hard time believing that the gain was recorded in the Kaplan Ventures division, which reported an operating loss of $7.2 million for the quarter.  This leads to our next question.
5. How did EBITDA margins at Kaplan Higher Education increase more than 9% YOY and 7% sequentially for 2Q10?  Arguably the most powerful financial element of the for-profit education business model is the incremental margins created by increasing enrollment.  Adding a few more students to a class requires little expenditure beyond recruiting costs.  Surging enrollment growth has enabled a number of companies in the sector to increase their margins by as much as 5-10% over the past few years. However, Kaplan Higher Education delivered that type of margin expansion in a single year on an 18% increase in total enrollments.  The magnitude of EBITDA margin expansion on a sequential basis is particularly conspicuous given it coincided with a sequential decline in total enrollments.  Additionally, we know that student start growth likely declined for the company’s campused based assets in the second quarter.  We also know that Kaplan instituted an “orientation” program in the second quarter, which for other companies that have introduced similar measures has led to margin compression.  Is it possible that WPO ran the gain on the sale of Education Connection through the Kaplan Higher Education line?  That seems to be a possibility in our view.
6. How are students financing tuition costs? What is the company’s exposure to internal lending? It is well known that WPO provides very limited disclosure about its higher education division compared to other publicly traded for-profit postsecondary education companies. We think this is particularly problematic when it comes to the balance sheet risk the company is likely incurring through its internal lending program. The company does not disclose bad-debt expense by division, nor does it discuss its internal lending program. Given the nature of the KHE’s target student demographic and the high cost of tuition relative to federal student loan limits, it is natural to assume that the company finances a significant portion of its students’ program costs. We would like to see greater disclosure on the company’s bad-debt expense, magnitude of internal lending, and its reserve policies.  We are hopeful this type of detail will be provided in the company’s 10-Q filing, but we’re not holding our collective breadth.
7. What are the company’s expectations for its FY08 final 2-year cohort default rate? How are 2-year cohort default rates for FY09 trending? How does the company plan to comply with 3-year cohort default rate standards? To say WPO faces significant issues with its compliance with cohort default rate standards would be an understatement.   You can read more about Kaplan Higher Education’s cohort default rate issues here, here, and here.  We have yet to hear management articulate how it plans to navigate a 3-year cohort default rate environment.  For FY07, 17 of the company’s 34 OPE-ID institutions had a three-year cohort default rate in excess of 30%.  As a reminder, under the new regulations that go into effect starting with FY09, any institution whose 3-year cohort default rate exceeds 30% for three consecutive years would lose access to federal financial aid.  Increased investment in default management services is the only significant initiative that the company has announced as a potential solution to its cohort default rate problems. We think this is a precarious strategy and might not lead to the kind of wholesale improvement in outcomes that Kaplan Higher Education needs.  The company’s recent decision to introduce the orientation program is an admission in part that a significant percentage of students in their system that probably do not belong, or are unlikely to successfully complete the program.
8. Does the company have an update on the program review of Kaplan University? In its 1Q10 earnings release, WPO did not provide any additional detail on the Dept. of Education’s program review of Kaplan University, which was launched Sept. 2009, but first disclosed in the company’s 10-K filing 5-6 months later. It still appears that investors have not discounted any possibility that the outcome of the program review could be negative. Based on our conversations with former KHE employees, review of legal filings, and analysis of publicly available data, we think there are a host of issues that could be the Dept. of Ed’s focus in the program review. Thus far the program review has been largely ignored by shareholders (the stock actually traded higher on the day the program review was first disclosed). Given the lack of attention to some of the regulatory issues KHE now faces, we think any negative outcome for the program review could cause WPO shares to trade lower.
9. How will the government’s proposal to standardize the definition of a credit hour impact program structure and the cost of educational delivery?  Not enough attention has been paid to the issue of credit hour inflation in the broader higher education space and at for-profit educational institutions in particular. The accrediting agencies, whose mandate it is to enforce the definition of a credit hour in higher education programs have proven to be delinquent in their responsibilities based on recent reports from the OIG and testimony from Sylvia Manning of the Higher Learning Commission.  You can read more about this specific issue here. As part of NegReg 2009, the Department of Education recently proposed to establish a standard definition of a credit hour based on the “Carnegie system”, which implies one credit hour equates to one hour of class time and 2-3 hours of outside study.  Kaplan University, in our view, has been one of the biggest beneficiaries of lax enforcement of the definition of a credit hour. One former executive of the company characterized the company’s decision to increase the number of credit hours per class from four to five to six in many cases as a “race to the bottom”.  The decision to increase the number of credit hours per class without a commensurate increase in class time was a direct response to competitive pressures from schools like CECO’s AIU.  We anticipate Kaplan University could have to take significant action to ensure compliance with the proposed definition of a credit hour, which will likely lead to higher educational delivery costs, lower revenue-per-student, and possibly lower student start growth.
10. How could the Department of Education’s recent “gainful employment” proposal effect the company’s tuition policies, revenue, and earnings growth?  Management provided little detail on the potential impact, but the short answer is VERY SIGNIFICANT.

Kaplan Test Prep

1. Are operating margins at Kaplan Test Prep structurally impaired? WPO’s test prep division delivered another quarter of break even profitability.  Margins have been negatively impacted by drastic price reductions to many of the company’s test prep programs in an effort to compete with new online market entrants.  Over the past few years, an increase in the number of online new market entrants into the test prep industry has broken down the pricing paradigm and the stranglehold Kaplan and Princeton Review once had on the business. In the past, Kaplan test prep consistently generated 20%+ EBITDA margins, we’re not certain if the company can ever again achieve those levels.

Cable Division

1. When will video RGU’s stabilize?  For seven consecutive quarters now, CableOne has witnessed a YOY decline in video RGU’s.  Historically, RGU growth has been somewhat correlated to household formation, as well as new and existing home sales. Major cable companies such as Comcast, Time Warner, and Cablevision have witnessed YOY declines in video RGU’s in recent quarters due to macro-economic factors as well as increased competition from satellite and traditional wireline providers.  For the second quarter, CableOne’s total RGU’s declined 60 bps YOY and video RGU’s declined 5.3%.  CableOne’s primary competitors Time Warner, Cablevision, and Comcast all generated YOY growth in total RGU’s for the second quarter and did not witness a similar level of decline in video RGU’s as WPO’s cable division did.  CableOne continues to underperform its peers.
2. What is the company’s plan to improve the penetration rate of voice and high speed data?  Through the end of the second quarter, CableOne had only achieved 47 and 14% penetration of its video subscriber base for its high speed data and voice services, respectively.  As the table below demonstrates, the penetration rate of these ancillary services is half that of major cable networks.  With each passing week competition for those subscribers increases.  We continue to wonder if CableOne has already missed its opportunity.

Broadcasting Division

WPO’s broadcasting division exceeded our estimates on both a revenue and EBITDA basis. It now appears the company’s broadcasting division is on-track for 15-20% YOY revenue growth and 38-40% EBITDA margins for the rest of the year.  We have one lingering question:

1. Given the secular decline in network television advertising spending, what are the company’s goals for peak cycle revenues and EBITDA margins? In 2006, WPO’s broadcasting division generated $362 million in revenues and an EBITDA margin of 37.9%.  We currently forecast revenues of $317 million and EBITDA margins of 33.7% for 2010 for WPO’s broadcasting division.  GCI is one of the largest owners of broadcasting assets in the US that has already reported earnings. While revenue growth increased 20% YOY for 2Q10f for GCI’s broadcasting division, total sales were still 4.4% below 2Q08 levels.  At this stage we think it could take until 2012 for the broadcasting division to match 2008’s revenue levels.

Newspaper Division

For now, it appears that WPO has “stopped the  bleeding” from its newspaper division, although we would characterize any financial stability as tenuous at best.  Our central question about the company’s newspaper division remains the same:

1. What is the long term profitability profile of the Washington Post?

The Noise Surrounding WPO Could Reach a Deafening Pitch, the Questions are Likely to Get Harder from Here

As hard as it is for us to believe, clearly today’s earnings release served as a wakeup call about the potential risk associated with WPO’s earnings growth engine, Kaplan Higher Education.  As investors “dig-in” about the details surrounding KHE’s potential regulatory issues we are confident they’re not going to like what they see.  We anticipate Kaplan Higher Education could be at the early stages of what could be a mutli-year restructuring process which could entail everything from changes to how the company’s institutions recruit students, to the structure of its educational programs, to the type of students the schools enroll, to the tuition charged and a host of other items.  It will not be an easy process for the company operationally or financially.

As always, please act accordingly….

Where Our Estimates Were Wrong

For such a seemingly simple business, forecasting IPSU’s earnings can be extraordinarily difficult. The uncertainty surrounding the rate of production improvement at the company’s Port Wentworth refinery and the volatility of IPSU’s gains and losses on sugar hedges have made forecasting more challenging.  While we did expect IPSU to report an operating loss excluding sugar hedges for the quarter, the loss reported was much wider than we expected. This is particularly surprising given the revenue upside IPSU delivered.  Below we discuss the major variances to our forecasts heading into the quarter. You can read our quarterly preview here.

• Overall volumes were stronger.  The company achieved total production of 6.192 million cwt during the quarter the highest level of production since the fiscal first quarter of 2008.  To achieve these levels of production, IPSU ran the refinery for 82 days during the quarter, or 27 days for each month. A normal production schedule for the company’s fiscal third quarter would result in the refinery being operated 22-23 days/month.  The company has made progress in improving production levels at Port Wentworth, but not in a cost efficient manner.  In the company’s 10-Q filing, IPSU provided some more detail on the progression of productivity improvements at Port Wentworth over the past three quarters and compared it to “normalized” output levels realized in FY06 and FY07  on a quarterly basis. As the table below demonstrates, the company achieved 90% of total normalized production during 3Q10 by operating the refinery by 9 extra days.  It is normal for the company to run the plant 80-85 days in the company’s fiscal fourth quarter, which could imply that IPSU will be pressed to meet all of its contracted volumes on a timely basis if production levels have not improved meaningfully over the past 4-5 weeks.

• Pricing on consumer and food service/distributor contracts were lower than expected.  Although the company exceeded our volume expectations, pricing on the company’s consumer and food service/distributor volumes were lower than we expected. As we discussed in our preview, spot pricing on industrial bulk sugar increased significantly over the course of the quarter. Current spot pricing for industrial bulk refined sugar has widened out to the low to mid 50’s for the rest of this fiscal year.  Supplies are extraordinarily tight.  As a result, we thought IPSU would realize higher pricing for consumer and distributor/food services customers, where the contracts are primarily priced on a spot basis.  IPSU historically has witnessed some lag in realizing spot level pricing in the consumer and food services/distributor space. We expect pricing to trend towards the $50+/cwt for the fourth quarter for both consumer and food services/distributor contracts.
• Gross margins were lower due to productivity issues at Port Wentworth.  We had forecast 2.7% gross margins for the quarter, the company actually delivered gross margins of 0.7%, which included the benefit of $10.7 million in hedging gains.  The company indicated that disruptions costs related to getting productivity at Port Wentworth up reduced gross margins by $3.8 million, or 150 bps.  Excluding severance costs, hedging gains, and one-time disruption costs we estimate gross margins were an actual negative 160 bps, which is particularly disappointing given what was likely solid profitability at the company’s Grammercy facility.  Operating the plant for an additional 9 days was also a significant drag on margins.  Additionally, as discussed above we were expecting a much wider realized refined/raw sugar spread for the quarter.
• Raw sugar hedging gains exceeded our estimates. IPSU reported raw sugar hedging gains of $10.7 million during 3Q10 compared to our estimate of $6.7 million.  It is difficult to model the company’s sugar hedges given that the company only discloses its sugar hedges for each fiscal year, not based on monthly expiration dates.

Other Key Observations from the Quarter

• Severance charges of $700K were a $0.04 drag on EPS.  The company restructured its sales force and reduced some other corporate level employees in anticipation of the transition of the Grammery refinery to the LSR JV at the end of this calendar year. We expect the company to incur additional severance charges in the calendar fourth quarter.
• Depreciation expenses was $400K higher than expected. As the final capital expenditures on the Port Wentworth refinery are completed it now appears that quarterly depreciation will trend towards $6.0 million.
• IPSU benefitted from a LIFO liquidation.  The company’s cost of goods sold during the quarter included a $4.9 million benefit from a LIFO liquidation.  We expected this to happen as the company started to work down its elevated inventory levels over the second half of the fiscal year. We are hopeful that management can provide us with some more detail on how to think about raw sugar costs for the remainder of the year and into FY11. Disclosure in the company’s 10-Q implies that raw sugar costs could be $28.50-$29.00 for the fourth quarter.
• IPSU generated free cash flow of $3.3 million for the quarter. As CAPEX spending related to Port Wentworth tapers off and IPSU starts to work down its above average sugar inventories, we expect the company to generate significant free cash flow over the next 3-6 months.  Total inventories declined from $133.1 million in 2Q10 to $114.3 million in 3Q10.  We anticipate the company could reduce inventories by an additional $20-$30 million in 4Q10.
• Wholesome Sweeteners continues to shine.  Wholesome Sweeteners (50% owned by IPSU) generated another outstanding quarter. Total revenues increased 57.9% YOY to $28.1 million, while gross margins increased 450 bps YOY to 25.4%.  Wholesome Sweetners is on pace to generate $7-9 million in net income this year. As a reminder, IPSU has the right to purchase the 50% ownership stake in Wholesome Sweeteners it doesn’t own starting September 30 of this year. We expect that transaction to be highly accretive and will provide IPSU with a more stable, higher margin earnings stream which should result in multiple expansion for the stock.

IPSU management will host an earnings conference call at 11AM today. We expect the vast majority of the conference call to focus on the company’s progress at Port Wentworth and IPSU’s strategy to fully take advantage of the outstanding pricing dynamics in the sugar market.  While we are disappointed generally with the level of profitability delivered in the quarter, we are much more focused on FY11. If IPSU can restore normal production levels at Port Wentworth on a traditional operating schedule, we estimate the company can generate EPS in excess of $3.00.  Clearly that is not reflected in the share price today.

As always, please act accordingly….

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