This report was originally published on 9/15/09.

Yesterday, the Department of Education released student loan cohort default rate data for the 2007 fiscal year.  Overall, the national student loan cohort default rate (CDR) increased from 5.2% to 6.7%.  As we noted in our previous report on the for-profit postsecondary education sector, the FY07 cohort default data only captures students that were delinquent as of January 4, 2008. As a result, we are not surprised that the student loan CDR remains low in a historical context.  As we have discussed in the past, real time measures such as default and delinquency data from Sallie Mae (SLM 12.19 ↓0.16%)’s private loan portfolio suggest students are defaulting at historically high rates.  The chart below outlines student loan CDR data over the past two decades.  As you can see, the early 1990’s were a period of extraordinarily high default rates, which is what prompted Congress and the Department of Education to introduce many of the regulatory restrictions in place in the sector today.

Source: Department of Education

The Deparment of Education also provides aggregate student loan CDR data by school type.  For FY07, proprietary schools (aka for-profit) had an overall cohort default rate of 11.0%, up from 9.7% in FY06.  This compares to an aggregate FY07 CDR of 5.9% for public schools and 3.7% for private schools.    For-profit postsecondary education institutions have had higher default rates for a long period of time, which we attribute to the lower socio-economic background of the students that most schools (not all) pursue and in some cases the relatively expensive cost of degree programs.  The table below compares the default data between public, private and proprietary schools over the past three years.

Source: Department of Education

Assessing the “Winners and Losers” from the FY07 Cohort Default Rate Data – Adding WPO (453.49 ↑0.74%) to Our List of Short Recommendations

We have reviewed the FY07 cohort default data for the schools owned by each of the publicly traded for-profit postsecondary education providers.  We have used three criteria to determine if a company was a “winner” or a “loser”:

1. The absolute level of defaults at each of the company’s school’s relative to the regulatory threshold of 25%
2. The increase or decrease in defaults relative to historical trends
3. The increase in student loan defaults relative to the industry average (130 bps).  We have looked at the percentage of schools owned by each company that witnessed an increase in their cohort default rate in excess of the industry average.

As we  have mentioned previously, we think those schools whose CDR was above 15% for FY07 have a reasonably high chance of generating a CDR in excess of 25% for FY08.  Those schools whose CDR was in excess of 18% for FY07 are at a very high risk of exceeding the 25% regulatory threshold in FY08, in our opinion.

The Winners – CECO, CPLA, LOPE, UTI

• Career Education Corp. – We can only speculate as to why the company’s cohort default rates are lower than the industry average and did not increase materially in FY07.  We attribute it in part to the regulatory “grinder” the company went through in 2004 and 2005, after which the company materially altered their enrollment processes.
• Capella – Capella targets working adults at the highest degree level, the company’s students default at some of the lowest rates in the industry
• Grand Canyon Education – A cohort default rate of 1.4% in FY07 at Grand Canyon University
• Universal Technial Institute – Solid placement rates and strong pay for graduates has enabled UTI to keep its cohort default rates below 10% for many years now. The company’s cohort default rates are 5-10% below the automotive schools owned by Lincoln Educational Services (LINC 25.98 ↑1.68%)Corporation.

The Losers – BPI, COCO, ESI, LINC, WPO

In each the case, the companies that we have identified as “losers” in the context of the FY07 cohort default data, have either witnessed a sharp uptick in their default rate, have a high percentage of their schools whose default rate increase have exceeded the national average, or have a large number of schools that are approaching or in excess of regulatory compliance standards.

• Bridgepoint Education- The company has experienced explosive growth over the past few years. One has to wonder if the growth has come at the expense of student quality or even student outcomes.  The company’s flagship university, Ashford University witnessed a 9.2% increase in its cohort default rate from FY06 to FY07.  That is one of the largest increases we have observed among the publicly traded for-profit education companies.
• Corinthian Colleges, Inc.- We have discussed COCO’s FY07 cohort default data here.  The company has 15 schools with a cohort default rate in excess of 15% and 5 that were above 20%.
• ITT Educational Services, Inc. – The company only has one school whose cohort default rate exceeded 15% for FY07.   However, 82% of its schools witnessed an increase in their default rate that exceeded the national average.
• Lincoln Educational Services Corporation – Five of the company’s schools had a cohort default rate in excess of 15% for FY07, while 2 exceeded 20%.  We think there is substantial risk that a good portion of those schools could have cohort default rates in excess of 25% for FY08.
• Washington Post Company- We thought the data for WPO’s higher education division might be bad, and it was.  One has to wonder what is going on right now at Kaplan Higher Education.  Clearly the company needs to address its enrollment and tuition policies, its retention practices and its job placement efforts for graduates. All of these are measures that could help the company lower its cohort default rate. Kaplan Higher Education is the earnings driver for WPO at this stage. We are wondering if WPO shareholders are aware of the regulatory standards in the higher education sector. Perhaps this latest dataset will prove to be an eye opener.  76% of schools owned by WPO experienced an increase in their default rates that exceeded the national average.  23 of the company’s schools had a default rate in excess of 15%. Of those schools, ten had a default rate of above 20%.  Kaplan now owns four schools whose default rate exceeded 25% in FY07.  Unless something dramatically changes in the next 12-months, we would expect those schools at the very least to lose access to Title IV funds.  It wouldn’t be unreasonable to assume that many of the company’s other schools are at risk as well.  Kaplan acquired Quest Education in 2000, at the time Quest was a “kissing cousin” of Corinthian Colleges.  Both companies chose to focus on diploma and associate’s degree programs primarily in the allied health sector.  The companies also targeted a similar student demographic.  Both companies have significant strides to make in order to ensure that none of their schools lose access to Title IV funding over the next few years, but Kaplan has significantly more “wood to chop”,which is why we are adding to our list of short recommendations.  We think the stock could see material downside as investors become increasingly aware of the escalating regulatory risks at Kaplan Higher Education.

The table below compares some of the key cohort default rate metrics we evaluated in order to arrive at  our “winners and losers” characterization.  We have highlighted the “losers” in grey.

Source: Department of Education

The FY07 cohort default rate data is “the tip of the iceberg” in our opinion.  FY08 and FY09 are likely to be materially worse and could result in meaningful regulatory scrutiny or political attention for the for-profit postsecondary education sector.  For example, Rep. Maxine Waters, a long-time and noted opponent of the for-profit education sector has recently done some “sabre rattling”.  She wrote a letter to a State Senator a few weeks ago about AB 48, which would re-introduce state level oversight on for-profit postsecondary education institutions in California.  You can find the letter here. If student loan cohort default rates continue to increase we think many other politicians could take up the vilification of the for-profit sector as a cause, which would cause stocks in the sector to trade off sharply.  We think those schools with the highest priced tuition AND above average default rates will fare the worst during any period of regulatory scrutiny.  We also expect some schools to suffer meaningful brand damage due to higher default rates.

We have added WPO to our list of short recommendations, our third such recommendation in the sector.  In the case of WPO, it appears the investor-based has yet to focus on Kaplan Higher Education’s regulatory compliance and the potential for recourse on the company’s profitability prospects.  We think they will in short order.

As always, please act accordingly….