This report was originally published on 9/22/09.

For those of you that have followed our research since inception, you are probably intimately familiar with our concerns about the for-profit education sector.  We have been bearish on a few of the publicly traded for-profit education providers for the past few months. As a reminder, The central tenets of our investment thesis are as follows:

1. At many schools and for some programs, “the more you learn, the more you earn” student covenant has been broken.  Tuition levels now approach, if not exceed the level at which a graduate can consistently service the student debt burden.  In short, we believe the return on educational investment for students attending some for-profit postsecondary institutions is questionable, if not outright negative due to high tuition prices and relatively low starting salaries upon graduation.  We think ESI (109.49 ↑1.21%) is the biggest violator of the “more you learn, the more you earn” student covenant.  You can read more here.
2. Student cohort default rates for for-profit education institutions are poised to surge due to a combination of lax admissions standards, high priced tuition, low completion rates and rising unemployment.  We anticipate higher cohort default rates and potentially increased litigation could become the catalyst for greater political or regulatory scrutiny of the group.  We anticipate many schools will have cohort default rates in excess of 25% for FY08 and FY09 and could run the risk of losing access to Title IV funds in conjunction with the release of final FY10 cohort default rate data.  In addition, we think the transition to a 3-year calculation of cohort default rate could significantly impair the ability of many schools to enroll the highest risk students, which could substantially impact the business model of some operators in the space.  We think WPO(453.49 ↑0.74%) and COCO (17.49 ↑0.52%) have the greatest risk profile with regard to cohort default rates.

The GAO Report Sparks a Rally

The United States Government Accountability Office released a highly anticipated report today entitled: “Stronger Department of Education Oversight Needed to Help Ensure Only Eligible Students Receive Financial Aid“.  The report was commissioned for Representative Ruben Hinojosa Chairman of the Committee on Education and Labor in the House of Representatives.  Overall the report examined two specific issues:

1. How the student loan default profile of proprietary schools compares to with that of other types of schools
2. The extent to which the Department of Education’s policies and procedures for monitoring student eligibility requirements for federal aid at proprietary (for-profit) schools protect students and the investment of Title IV funds.

We are not exactly sure what investors were expecting from this report, but clearly it was not as bad as feared.  This should not be misconstrued as “good”. It’s not clear if GAO had a clear mandate as to what to look for, but here are the primary conclusions in the report:

• Default rates of borrowers from proprietary schools are higher than those of borrowers from other schools and increase over time
• Weaknesses in the Department of Education’s oversight of federal aid eligibility requirements place students and Title IV funds at risk of potential fraud and abuse at proprietary schools

The first conclusion is well known and understood by everyone who invests in the for-profit education sector.  GAO attributes higher default rates for students attending for-profit schools primarily to the demographics of the students the institutions enroll.  Overall, in determining the factors contributing to higher default rates for proprietary institutions GAO relied on 11 research studies conducted over the past 10-15 years.  It is astonishing to us that the GAO report did not mention student debt burdens and the cost of tuition once in its report as a potential contributor to higher defaults.  In fact, GAO references one study which indicates that students that graduate with lower debt levels actually default at a higher rate because higher debt levels have historically been associated with students enrolled at higher levels of education. Overall it appears that much of the data that GAO examined to determine causality of higher student loan defaults at for-profit institutions reflected a time when tuition was far more affordable.  We wonder if GAO even bothered to consider how servicing $40,000 in student loans on $33,000 in gross salary might impact the likelihood of default for an associate’s degree grad.

The second major conclusion and subsequent recommendation to the Department of Education revolved around the “Ability to Benefit” program.  Here is how the program is described in COCO’s FY09 10-K:

“Under certain circumstances, an institution may elect to admit non-high school graduates into certain of its programs of study. In such instances, the institution must demonstrate that the student has the “ability to benefit” from the program of study. The basic evaluation method to determine that a student has the ability to benefit from the program is the student’s achievement of a minimum score on a test approved by the ED and independently administered in accordance with ED (Department of Education) regulations. In addition to the testing requirements, the ED regulations prohibit enrollment of ATB students from constituting 50% or more of the total enrollment of the institution. “

The ability to benefit program was created to expand access to higher education. In theory, it is a wonderful social initiative.  High school dropouts deserve a chance to improve their lot in life.  Unfortunately, there are several seemingly commonplace fraudulent practices in place at for-profit institutions for the ability to benefit program. GAO discovered that some schools change the answers to ATB tests in order to ensure that a potential student passes so that they can receive Title IV funds.  Additionally, GAO discovered that some schools pay “diploma mills” to grant high school degrees to potential students. We view these as serious violations and anticipate the Department of Education will do more to limit these abuses in the future.  Additionally, these activities, now that they have been exposed are almost certain to attract the attention of politicians looking to gain favor among voters from lower socio-economic backgrounds.

COCO Has the Greatest Exposure to “Ability to Benefit” Students

As part of its analysis of the ATB program, GAO conducted a “random shopper” test at a school owned by a publicly traded for-profit education institution. We do not know which school it was - almost all of the major publicly traded for-profit education providers own at least one school in the DC area.  For those investors that are focused on what company might be impacted the most from greater scrutiny of the administration of ability to benefit programs, COCO would be the one to watch.  83 of the company’s schools enroll ability to benefit students and approximately 23.8% of COCO’s students were enrolled through the ability to benefit program.  Closer scrutiny of this program could hamper COCO’s enrollment growth prospects over the next 12-18 months.

The Move to a 3-year Calculation for Cohort Default Rates Is a Game Changer – Just Look at the GAO Report

Needless to say we were surprised by investor reaction to today’s GAO report.  It is hard for us to determine exactly what investors expected, perhaps something far more aggressive with greater instances of fraud and bolder recommendations.  Still we wonder if investors have started to contemplate the implications of the transition to a 3-year calculation for cohort default rates. We have written about cohort default rates extensively here and here.  As a reminder, as part of the Higher Education Opportunity Act of 2008 the calculation of the cohort default rate was expanded from 2-years to 3-years.  In conjunction with expanding the measurement period, the threshold for the maximum default rate allowed for three consecutive years was increased from 25% to 30%.  The one-year cohort default rate threshold of 40% remains in place.  The reporting of the new cohort default rate will begin in FY12, for borrowers who entered repayment in FY09. Sanctions based on a three year calculation won’t begin until FY14 (borrowers entering repayment in FY11).

When the legislation was passed we were surprised that most investors shrugged off the transition to a three-year calculation.   Data from Sallie Mae (SLM 12.19 ↓0.16%) suggests that a considerable portion of student loan defaults occur in the third year of repayment.  A few of the student loan guaranty agencies have provided some data on the impact the transition could have on a school by school basis.  In a presentation at its 2009 annual meeting entitled: “On the Horizon: A Look at the New Three-Year Cohort Default Data“, the Texas Guaranteed Student Loan Corporation (one of the largest student loan guarantors in the  country) provided some detail on how student loan performance varied at a select number of schools based on the measurement period.  Default data for the FY99, FY00, and FY01 cohorts were evaluated on a 2-year, 3-year and 7-year basis for a total of five schools.  Representatives from the Texas Guaranteed Student Loan Corporation provided the names of each of the schools except the for-profit institution.  As the table below demonstrates, default data increased for each school when the calculation was moved from a 2-year to a 3-year basis. However, in the case of the for-profit institution the increase was considerably larger.  We were stunned by the default data calculated on a 7-year basis. According to the data provided by the Texas Guaranteed Student Loan Corporation, it appears approximately 40% of students enrolled at this particular for-profit institution eventually default on their government student loans!

Source: Texas Guaranteed Student Loan Corp.

Perhaps the most interesting element of the GAO report released today was the detail provided on how the transition from a 2-year to 3-year calculation would have impacted default rates for the FY04 cohort.  Similar to what the individual school data from the Texas Guaranteed Student Loan Corp. implied, two trends about for-profit institutions relative to their non-profit brethren are true:

1) The increase from a 2-year to a 3-year definition has a greater impact on the aggregate number of defaults for proprietary institutions

2) Overall, default rates are considerably lower for public and private non-profit institutions.

Source: US Government Accountability Office

Let’s think about what this data implies, assuming that the increase in default rates would be the same (on a percentage increase basis) for the FY07 measurement period if it were increased from a 2-year to 3-year calculation.  Please keep in mind these are simply calculations based on the “2 to 3-year multiplier” implied by the cohort default data by GAO, actual results could differ MATERIALLY.  Using the 2-year cohort default data from FY07, under a three-year calculation:

• COCO would potentially have 19 schools whose default rate exceeded 30% and 5 schools that would have a default rate in excess of 40% (which would cause revocation of Title  IV access immediately)
• WPO (Kaplan Higher Education) would potentially have 23 schools whose cohort default rate would be in excess of 30% and a possibly 10 schools that would violate the 40% one-year threshold
• ESI would have only one school whose cohort default rate would exceed 30%

Some might argue that companies in the space have plenty of time to navigate the transition from a 2-year to a 3-year calculation.  This would be a major oversight by investors and operators in the space. First the measurement period starts with the FY09 cohort. Second a student enrolling an associate’s degree program TODAY will likely be included in the FY11.  Simply stated, tuition and enrollment practices that are being employed today will have a direct impact on the FY11 cohort.  We wonder if operators in the space recognize the severity of the situation.

A Question of Recourse – Does Anyone Care About Return on Educational Investment and Cohort Default Rates?

When we speak with fellow travelers in the for-profit education investment arena, the “bulls” will typically tell us that our thesis is wrong and that we’ve been through this before. They will point to the 2004/2005 period during which a few companies in the sector came under increased regulatory scrutiny and faced a number of lawsuits from former employees and students.  We would argue that this time period is vastly different due to the overall student debt burdens being placed on students and the likelihood that default rates are poised to surge. In 2004/2005, the stocks dramatically underperformed, but the issues in the space never became a public policy debate.  Cohort default rates have always been a source of scrutiny for politicians and the public alike, after all it’s the tax payer who foots the bill for access to higher education.  At this stage, very few people have thought about student loan cohort default rates, but we think this is likely to change in conjunction with the release of the FY08 data.

Some have accused us of being anti-for-profit, socialist or a host of other things, which of course couldn’t be further from the truth.  There are countless for-profit education institutions that provide high quality programs at a reasonable cost with great student outcomes.  There are many students who would never have had the opportunity to attend college that have enrolled at a proprietary institution and had their lives enriched as a result.  However, tuition levels have increased to the point where many students can no longer afford to service their cost of education even if they have the optimal educational outcome (graduation and job placement). Default rates are surging because of high tuition and enrollment practices that allow students to matriculate that probably should not.

We pose the question: If there are many schools whose 7-year cohort default rate (40%+) looks similar to the example provided by the Texas Guaranteed Student Loan Corp. is higher education access to all good public policy? Remember, this particular school’s FY99-FY01 default rate looked relatively innocuous on a 2-year basis (less than 10%).  In many respects, there is an “agency’ problem in the higher education system. It might be difficult politically to compare a student loan to other debt instruments (i.e. mortgage), but a similar dynamic exists in the student loan market today that caused a great deal of problems in other credit markets.  An enrollment representative has little incentive to scrutinize a potential student’s ability to pay, after all it is the tax payer, not the company that foots the bill.  Some companies in the sector secure tax-payer supported Title IV funds on behalf of their students, but when it is time to extend their own capital they reserve as much as 50% against those loans for the same type of students.  What does that say about the student’s ability to pay?   Right now, it does not appear that there is significant recourse in the higher education system for having high default rates, we think that will change very soon.

In an environment in which there is recourse for high default rates (whether it be litigation risk or increased regulatory oversight) and the educational consumer becomes increasingly concerned about return on educational investment, there are two remedies which companies like ESI, COCO and WPO can pursue to preserve their business models:

• Restore the return on educational investment equation through substantial tuition price cuts
• Increase enrollment standards to ensure compliance with existing regulatory standards

In either case, we think FY09 will go down as the earnings peak for companies like ESI, COCO, and WPO.

As always, please act accordingly…