This report was originally published on 10/30/09.

We wanted to address a few issues related the for-profit education sector: WPO (445.09↓1.85%)’s 3Q09 results, a few thoughts on COCO (17.28 ↓1.20%)’s 10-Q filing and a playbook for the Negotiated Rulemaking sessions (NegReg) to be held next week.

Washington Post Company is a For-Profit Education Company That Also Owns Newspaper, Cable, Magazine and Broadcasting Businesses, Please Act Accordingly…

We continue to remain baffled as to why the stock price performance of WPO exhibits such a strong correlation to the shares of NYT and GCI (16.12 ↑0.25%) and not COCO, CECO (29.88 ↓0.13%), ESI(109.11 ↓0.35%), and DV (66.36 ↑0.85%).  Afterall, in the company’s most recently reported quarter, approximately 60% of total revenues came from Kaplan, with Kaplan Higher Education accounting for 36% of the total.  From a profitability perspective, Kaplan Higher Education accounted for more than 60% of EBITDA in WPO’s 3Q09.  Yet, when the shares of leading for-profit postsecondary education companies sold off sharply this week following APOL (63.1 ↓0.41%)’s announcement that it was subject to an informal inquiry from the SEC, WPO’s stock was largely unaffected.  We have rarely seen such a large disconnect between the true fundamentals of a company and how a stock trades.  As we mentioned in our recent letter to Warren Buffet, the correlation of WPO’s stock price to those of NYT and GCI has been more  than 0.8 on a 6-month, 3-year, and 5-year basis.  Today, WPO shares opened higher after reporting 3Q09 results and quickly traded lower, in sympathy with a broader market sell-off.  We maintain the view that the vast majority of intrinsic value for WPO resides in the company’s Kaplan division and to a lesser extent its cable networks.  Based on our discounted cash flow analysis of each of WPO’s operating divisions, we think shares could be worth less than $300 in the event that growth at Kaplan slows due to fundamental headwinds are greater regulatory scrutiny, both of which we think are increasingly likely.

WPO’s 3Q09 Results: It’s All About Kaplan

WPO reported 3Q09 results this morning.  You can read all of the details here.  The company does not host a conference call and there is little sell-side coverage, so we thought it might be helpful to review the performance of each of WPO’s major operating divisions.  Total revenues of $1.148 billion increased 1.8% YOY, while reported EPS of $1.81 increased 64.6% YOY. Excluding one-time charges related to accelerated depreciation, goodwill impairment and severance, we estimate core EPS decline 20% YOY to $6.21.  Here’s a quick overview of each of the company’s major operating divisions:

• Kaplan: Total revenues increased 13.5% YOY to $684.5 million.  A decline in revenues at the company’s traditional test prep operations, which are pro-cyclical was offset by a large increase in revenues at Kaplan Higher Education, which is counter-cyclical.  As of 9/30/09, Kaplan Higher Education had 103,800 students enrolled across its schools, which the company reports as an increase of 28.0% (more on this later).  Operating margins at Kaplan Higher Education expanded from 17.6% in the second quarter to 21.7% in the third quarter.  This represented a 9.0%+ margin increase on a YOY basis.  It appears Kaplan has started to reap the rewards of its national advertising campaign.
• Cable: Revenues increased 1.1% YOY to $189.6 million due to a 0.5% YOY increase in RGU’s.  However, on a sequential basis (Q/Q), the number of RGU’s has now declined for two consecutive quarters.  EBITDA margin of 37.6% was effectively flat on a YOY basis.  We have discussed in the past how WPO’s cable division has a lower penetration of voice and data customers relative to its larger peers.  We wonder if the opportunity has passed to increasingly penetrate its existing subscriber base as competitive threats from traditional phone companies and VOIP services increases.
• Broadcasting: Revenues at the company’s broadcasting division declined 17%  YOY to $65 million.  EBITDA margins declined 13% YOY due to the fall-off in advertising revenues.  This is yet another division for WPO that faces significant secular headwinds due to the threat of a permanent decline in television advertising expenditures.
• Newspapers: The newspaper division accounted for 13.6% of total revenues in the quarter.  Total revenues declined 20.4% YOY to $156.3 million.  The rate of revenue decline actually increased from the second to third quarter.  Perhaps more alarming is that the company’s online revenues for its newspaper operations declined 18% YOY.  The company has yet to demonstrate that it is retaining readers as the secular migration from print to internet based media continues.  Excluding charges for accelerated depreciation and severance, we estimate the newspaper division generated and operating loss of approximately $5 million.
• Magazines: The YOY decline in revenues accelerated at Newsweek from the second to third quarter. Total revenues declined 32.7% YOY to $40.2 million.  Excluding  severance charges, the division operated at break even during the quarter.  The company has taken significant steps to reduce overhead in order to restore profitability for its magazine division.  We still find ourselves asking a question to which we cannot find an answer: Why does Newsweek exist?

At Kaplan Higher Education, What is an Enrollment?

The definition of what constitutes an enrollment has become a hot button issue in the for-profit education sector in light of the upcoming Department of Education led NegReg sessions and the recent announcement that APOL was subject to an informal inquiry from the SEC related to its revenue recognition practices.  The definition of an enrollment would seem to be fairly straight forward.  However, when you start to consider issues around when a student is viewed as a dropout, how often attendance is taken (if at all) or a student attending one module in a quarter or semester (and none of the others) you can quickly see how the calculation can become more complicated.  There is no uniform definition of an “enrollment” in the higher education space.  As part of the NegReg process, The Dept. of Ed will attempt to bring greater clarity to what constitutes an enrollment in the context of attendance policies, the calculation of credit hours, and determining Title IV refunds (and subsequently revenue recognition, although that is out of the purview of the Dept. of Ed.).  These are huge issues to say the least.

We bring this up in the context of WPO because the company’s enrollment disclosure does not appear to be consistent.  In the table below we have compiled the enrollment data for Kaplan Higher Education since 2007.  In the column labeled “Original enrollments” we have provided total enrollment data as it was disclosed in the company’s press release.  The column entitled “enrollments disclosed a year later” captures how the company represents enrollments in a subsequent press release a year later.

Source: Company reports

For example, for 3Q09 Kaplan said the following in its press release:

“At September 30, 2009, KHE’s enrollments totaled 103,800, a 28% increase compared to total enrollments of 81,400 at September 30, 2008. Enrollment growth was particularly strong at Kaplan University’s online offerings, which grew at 37% in the first nine months of 2009.“

28% growth sounds great, and reasonably matches the company’s 27% YOY growth in revenues.  The only catch is that a year ago in the company’s press release Kaplan Higher Education had 99,700 students enrolled as of 9/30/08.

“Enrollments increased 22% to 99,700 at September 30, 2008, compared to 81,600 at September 30, 2007, due to growth in both online and residential programs“

WHAT? Perhaps there is a logical explanation here.  However, WPO is the only publicly traded higher education company that we know of that changes its enrollment metrics on a retroactive basis.  If enrollments really were 99,700 as of 9/30/08, that would only imply 4% enrollment growth in the most recent quarter compared to the 27.5% reported in today’s press release and revenue growth of 27%+.  Additionally, the 103,800 in total enrollment as of 9/30/09 only represents a 0.5% increase from June 30, 09.  Traditionally, higher education institutions witness a large increase in total enrollment from the second to third quarter.  Lastly, total enrollment has now declined a total of 9% from 3/31/09 at Kaplan Higher Education, which is not consistent with the enrollment trends of any of the publicly traded for-profit postsecondary education companies we track.

If Kaplan has a different methodology for calculating enrollments on a retro-active basis, it should be disclosed.  Otherwise, the variance in the enrollment data in light of Kaplan’s acquisitive nature, high growth, high default rates and regulatory issues should be a red flag for investors, in our view.

A Brief Comment on COCO’s 10-Q

In our preview of COCO’s’ 1Q10 earnings results we listed a few issues that we were hoping to gain more clarity on.  Perhaps the biggest would have been the company’s ”real bad-debt expense”, as we define it which is calculated as: reserves on accounts receivable + reserves on notes receivable.  Seems logical right? Well, COCO reported an improvement in bad-debt expense as a percentage of revenue to 6.4% down from 7.1% in 4Q09 and 8.9% in 1Q10.  On the surface this would appear to be a favorable trend, but as we noted in the past, the company’s disclosure of bad-debt expense has now become an irrelevant metric.  Unfortunately, COCO does not provide full disclosure on the amount of charge-offs and reserves it builds on a quarterly basis for its notes receivable.  The best we can do is to examine the total allowance for accounts and notes receivable and how that compares to historical trends. As the chart below demonstrates, the allowance against notes receivable has been declining as a percentage of gross notes receivable for the past three quarters.  On the surface this does not appear to be a favorable trend; does this imply that charge-offs for notes receivable have eclipsed reserves over the past few quarters?  Is the company reserving at a lower rate?

Source: Company reports

Overall the 10-Q did not introduce any new issues. The company clearly has made progress in packaging financial aid for students as evidenced by the 75% increase in pre-paid tuition, which enabled the company to generate $66 million in FCF in 1Q10 compared to $17 million a year ago.  We would welcome more disclosure on the company’s contra-revenue accounting for tuition COCO finances as well as detailed quarterly reserve data on notes receivable.

The Department of Education will conduct Negotiated Rulemaking sessions next week.  You can review the details of the issues to be discussed here.  Thus far the tone of the Program Integrity Issue paper and list of presenters suggests that the outcome(s) could be less than favorable for the for-profit providers of postsecondary education. You can read more about the schedule for negotiated rulemaking and the comments received by the Department of Education in advance of the meetings here.

We expect the stocks to continue to be volatile next week.  Although we do anticipate the outcome of negotiated rulemaking could result in tighter governance of for-profit education companies, our investment thesis on COCO and WPO is not predicated on any major regulatory changes.  Rather, we think the structural and regulatory issues both WPO and COCO face are substantial within the CURRENT fundamental and legislative construct.

As always, please act accordingly…