This report was originally published on 10/27/09.

Corinthian Colleges, Inc. will report 1Q10 results on Thursday before the market opens.  Overall we expect the company to post inline results highlighted by 18% YOY growth in new student starts and 23% YOY growth in total enrollment.  Bad-debt expense, student start growth, lead cost inflation, and ongoing concerns about the company’s efforts to recruit ability to benefit (ATB) students are likely to be the focus of the call.  Similar in spirit to what wethought ahead of ESIresults, consensus estimates no longer look like a “layup” for COCO. We expect the magnitude of enrollment, revenue, and EPS outperformance to decline over the next 1-2 quarters.

Source: Yahoo Finance, PAA Research

In our view, consensus estimates are too high for the back half of FY10 and all of FY11.  It appears consensus reflects overly optimistic assumptions from management about the company’s ability to sustain margin expansion even if industry-wide lead costs normalize.  As a reminder, management has established FY11 operating margin guidance of “15%+” and longer term guidance of “high-teens”.  We think this is unrealistic based on the following:

1. The likelihood that lead generation costs will start to increase following an unprecedented decline in spot advertising rates on cable and internet ad-networks in 2009. We would point toESI (109.03 ↓0.42%)’s most recent statements about witnessing a 10% increase in advertising expense YOY in 4Q09 as evidence that lead costs are poised to increase.  Remember, COCO is more exposed to cost-per-lead and cost-per-start than any other publicly traded for-profit postsecondary education company due to the short-term nature of its program offerings.
2. The potential that COCO will be forced to alter the type of student it enrolls and pursue a lower track of growth due to the transition from a 2-year to a 3-year cohort default rate calculation.  As we have discussed in the past, we think the transition to a 3-year cohort default rate calculation is a fundamental “game changer” for COCO based on the potential that as many as 25-30% of its schools could have cohort default rates in excess of 30% under a 3-year cohort default rate calculation, which if realized for three consecutive years would result in loss of their access to title IV funds.  The students enrolled today will show up in COCO’s FY11 cohort default data, which will include a three-year calculation.  We cannot foresee a scenario in which COCO achieves its margin objectives AND continues to enroll a similar type of student based on the higher standards of regulatory compliance now in place.

Other Issues of Focus for COCO’s 1Q10 Conference Call and Earnings Results

Here are a few other fundamental and regulatory issues we will be focused on for COCO’s 1Q10 results and earnings conference call.

• Revenue recognition policies in light of the APOL (63.04 ↓0.51%) SEC informal inquiry (more on this later)
• COCO’s approach to “ability to benefit” students and whether or not the company has been subject to greater scrutiny as a result of the GAO report or OIG activity
• An update on the probation status of Everest College in Phoenix, AZ. The school was recently placed on probation by the Higher Learning Commission.  It’s status is scheduled to be addressed at the Higher Learning Commission’s next meeting on Oct. 30th.  The school accounted for approximately 5% of COCO’s total enrollment base at the end of last year.
• Update on efforts to secure additional private lending sources
• Bad-debt expense and reserves for notes receivable.  We are hopeful that investors will start to track the company’s “real bad-debt expense” as we define it.  You can find more of the details here.  The company should include the combination of reserves on notes receivables and those for accounts receivable when evaluating progress on bad-debt. Anything else would be “slight of hand” in our opinion.
• Free cash flow expectations going forward.  COCO generated approximately $150 million in FCF in FY09, a large part of that was created through working capital swings. Based on our estimates for EBITDA, CAPEX, and balance sheet funding for student loans we anticipate FCF could decline  to $20-$30 million in FY10.

Based on consensus EPS expectations for FY10 COCO shares appear attractive, valued on FY11 consensus they look outright cheap.  We think current consensus fails to reflect COCO’s negative leverage to higher lead costs and the potential that the company will need to take a slower growth tact in order to prepare for compliance with a 3-year cohort default rate calculation.  Based on our estimates, the stock trades at 13.8x  FY10 (likely to be a peak earnings year) and 19.8x FY11. We think most cyclicals trade at 8-10x peak earnings (whether they be pro or counter cyclical).  Using that valuation methodology, COCO shares would trade at $12-$15.

As always, please act accordingly….