This report was originally published 10/14/09.

A hearing was held today by the House Committee on Education and Labor entitled: “Ensuring Student Eligibility Requirements for Federal Aid”.  You can find all of the details here.  The hearing was called as a result of a report released by the US Government Accountability Office (GAO), which attempted to compare the cohort default rate of proprieatary institutions to traditional schools and highlighted issues related to the manner in which “ability to benefit” students have been enrolled at some for-profit higher education institutions.  You can find our reaction to the GAO reporthere.  The stocks of the publicly traded for-profit education providers had a volatile day.  COCO (17.49↑0.52%) traded in a 12% range on the day and after falling in excess of 4% in the morning rebounded after fears about what might come out of the hearings were somewhat pacified.  We had the opportunity to listen to the hearings first-hand and read the testimony of the four members of the panel.  We have to wonder if the market response to today’s hearing was inspired by Tripper Harrison (aka Bill Murray) who famously stated: “It Just Doesn’t Matter”.

Our Reaction to the House Hearing

We would characterize the House hearing today as more or less inline with our expectations.  The shares of most of the for-profit education companies we track traded down yesterday in anticipation of the Hearing and then subsequently experience some sort of a “relief rally” today.  When we speak to investors that own shares of COCO, ESI (109.49 ↑1.21%), or WPO (453.49 ↑0.74%) they inevitably will tell us that although they cannot refute our thesis, the stocks are relatively cheap and these names have experienced this kind of “noise” in the past.  Stated another way, even though there appears to be a steady increase in the amount of regulatory “noise” surrounding the space and pace of litigation activity, “it just doesn’t matter”.  We  could not disagree more.  As a reminder, the central tenets of our short thesis on some names in the space is 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 (111.41 ↑1.47%) 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 (475.79 ↑1.22%) and COCO (18.23 ↑7.30%) have the greatest risk profile with regard to cohort default rates.   You can read more on COCO here and WPO here.

Following today’s hearing we think it is reasonable to add a third component to our thesis, which is the various regulator consistuencies (Dept. of Education (DOE), Office of Inspector General (OIG), and Congress) appear far more motivated to enforce existing statutes than the prior administration, which could lead to more sizeable and rapid action.  We don’t intend to rehash everything that was said today during the testimony of the panelists and the subsequent Q&A, but here are a few of our key observations:

• The issue of the prevalence of altering or providing answers to an admissions test for an ability to benefit (ATB) student received a great deal of attention.  The fact is representatives from GAO conducted two “random shopper” tests and experienced two results where the individuals administering the test some how conducted fraudulent activity.  Can this be used as a proxy for the entire sector? No of course not, but it also cannot be determined how many schools conduct similar practices.  Our sense is that the GAO findings are not pure coincidence.
• The OIG is currently conducting 15 individual investigations of ability to benefit practices.  Obviously it has not been disclosed which schools have been targeted.  Any publicly traded company that is subject to OIG investigation would be required to disclose that in their quarterly or annual SEC filings.  Stay tuned.
• The Department of Education has ramped up its efforts to coordinate with traditional consumer complaint channels such as the FTC and those run by individual states.  We think this is a sign that the DOE has become more attune to some of the outcries of former students and will treat them with greater attention.
• The OIG is focusing on potential instances of fraud in the online education space.  Tracking what constitutes attendance and satisfactory academic progress has always been an issue in the online education space. It appears some individuals are bilking the student loan system (Octomom) by enrolling in a school to secure funds and then falsifying their attendance.
• Congressman Miller at one point characterized the students as “pawns” in a game to increase enrollments and compared the current situation with student loans to that of “LIAR loans” and no-doc loans.  There is no question in our view, that the higher education sector broadly and the for-profit sector in particular has a significant agency problem, which is similar in spirit to that which occurred at the height of the housing bubble.

Names such as COCO and ESI trade at depressed multiples compared to their historical averages.  Today’s stock price action and the depressed valuation might lead some to believe that the potential impact of regulatory or litigation action is priced in.  It certainly appears that for the time being that an actual action has to take place to cause another wave down in the shares of ESI and COCO, until we get more data on cohort default rates.  However, we would caution any longs to remember that the threat of regulatory action can be almost as bad as actual regulatory action.  We would characterize current EPS expectations for COCO and ESI as fairly aggressive. In the case of COCO, current consensus implies a 66% increase in earnings to $1.35/share.  For ESI the consensus EPS progression is $7.75 in FY09 to $9.25, or 19% growth.  Keep in mind that EPS for ESI in FY08 was $5.17. If  Harris N. Miller’s (President and CEO of the Career College Association) comments that some schools were already pulling back from ATB students is correct, then estimates for COCO and likely WPO will be particularly difficult to achieve.

Overall, if we enter an environment where schools become more judicious (some would say less aggressive) in the type of students they enroll, current consensus estimates for FY10 are likely to be way too high.  We would encourage you to revisit the experience of Career Education (CECO 29.92↓0.56%)Corp. after 2004/2005.  The company faced several regulatory issues in 2004 and 2005 following a period of rapid enrollment growth.  In 2005, the company earned more than $2.00 share, five years later the company is no where near approaching those EPS levels after closing schools and recasting its entire enrollment and academic infrastructure.  The issues CECO faced are not perfectly comparable to those we see today for COCO, ESI and WPO, but it does exemplify how a school’s growth trajectory can be significantly altered without specific regulatory sanctions.  We continue to think there are a number of regulatory issues on the horizon that could force meaningful changes to the business models of COCO, ESI and WPO, not the least of which is the transition to a 3-year calculation for cohort default rates.

Up Next: Earnings and Negotiated Rulemaking (NegReg)

ESI will report 3Q09 earnings on 10/22/09. We will have more on our expectations at a later date. Overall for the group, we think the central areas of focus will remain the same:

• The pace of enrollment growth and any signs of a slowdown in demand caused by stability in the economy
• Bad-debt expense, private student loan programs and internal financing
• Lead cost inflation and the outlook for marketing costs in 2010

Negotiated Rulemaking Sessions Could Lead to Some Changes to the Regulatory Landscape

On September 9, 2009, the Department published a notice in the Federal Register announcing its intent to establish two negotiated rulemaking committees to prepare proposed regulations under Title IV of the Higher Education Act of 1965, as amended.  The schedule for the negotiated rulemaking sessions on “Program Integrity” is as follows:

• Session One: November 2-6, 2009
• Session Two: December 7-100, 2009
• Session Three: January 25-29, 2010

We expect concerns about what might come out of the negotiated rulemaking sessions to limit any upside in the group even if earnings are considerably better than expectations (we’re not so sure that will be the  case).  The Department of Education recently released all 226 comments it received on issues that should be considered for action by the negotiated rulemaking committees.  Among the issues that will be discussed and debated are:

• satisfactory academic progress
• the definition of a credit hour
• the definition of “gainful employment in a recognized occupation”,  a key metric for the for-profit education sector
• incentive compensation
• complaints about generally false or misleading advertising to prospective students
• state level oversight of higher education institutions

We have read through all of the comments, here are some of the highlights:

• The most number of comments were from former students who now face considerable financial headwinds as a result of unwieldy student debt burdens.  Almost all of the individuals who submitted comments of this type asked for some form of student loan forgiveness
• More than a dozen of the comments related to specific requests about Ashford University. Only one comment had a negative bias among those specifically about Ashford
• Approximately 20 comments were submitted by school’s owned by DeVry in support of maintaining rigorous standards but with the intent of keeping access to higher education paramount as part of this process
• Comments 137, 157, and 215 contained negative comments about schools owned by COCO. Comment 137 was submitted by a former collections officer for the company who discusses some issues at a few of the company’s schools surrounding incentive compensation, attorney general inquiries, former student lawsuits, student quality, and job placement. Comments 157 and 215 were submitted by former students who felt that the educational quality was poor
• Comments 131, 133, 141, 168, 176, and 177 were all submitted by lobbying groups or associations in the industry that offer different perspectives from both the non-profit and for-profit viewpoint.
• For any of those interested in reading a short thesis on the group from someone else, we would encourage you to look at comment 5 from Quilcap Corp. and comment 138 from Alternative Research Services

Overall we expect the next few months to be incredibly volatile for COCO, ESI and WPO shares.  We increasingly see downside to estimates given how high the bar has been raised and the likelihood that fundamental headwinds could increase as a result of economic stability and regulatory intervention.

As always, please act accordingly…